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Editorial: ERM And The Economy

Editorial

ERM And The Economy

By Narayan Shankar

ALL INDIVIDUALS and organizations face risk. Managing risk is an intrinsic need for everyone, tied to our psychological and material well–being. Most people understand that there is risk in opportunity. The bold promise of the actuarial profession is that there is also opportunity in risk. It can be a source of competitive advantage if we manage a risk effectively when others don't. Yet, this potential mostly goes unrecognized and therefore unrealized outside the financial services industry.

Historically, risk management has been practiced in the insurance industry and more recently in other financial services firms. The Holy Grail should be to make Risk is Opportunity a commonplace reality across all firms, including the nonfinancial enterprises that make up most of the economy. Achieving this goal can have a profound beneficial impact on the prosperity of every person. Getting there requires developing a framework for risk management of nonfinancial firms. Actuaries, with their theoretical and practical expertise in risk management, are well–positioned to take the lead in this endeavor.

There are aspects of enterprise risk manage–ment (ERM) that apply primarily to diversified firms. Environmental factors will impact its various businesses differently. Measuring and aggregating these impacts pose challenges and are an important area of ERM practice. However, it is also important to consider the primary risks faced by a simple pure–play nonfinancial firm. Let us take a look at the risk management needs of this type of enterprise.

For the most part, a simple nonfinancial firm faces control risk, catastrophe risk and business risk. The COSO framework has been developed by the accounting profession for addressing control risk. Catastrophe risk is usually managed using prevention strategies and the insurance mechanism. Property and casualty insurers have expertise in addressing catastrophe risks. A well–developed framework exists for analyzing them and at least to some extent, most firms address their catastrophe exposure.

However, by far the greatest risk faced by a firm is business risk. Economists have separated business risk into systematic and firm–specific components. The systematic component, tied to such things as the business cycle, is reflected in the firm's beta, and determines the company's cost of capital. Firm–specific risk can be diversified away by the investor, but is of concern to other stakeholders, including employees. To recruit the best talent and reduce certain contracting costs, a firm may be well–served to lower its firm–specific risk, which in turn can have positive economic benefits for investors as well. Thus ERM should consider all aspects of business risk and make optimal trade–offs between cost and benefit.

Business risk manifests itself in financial losses or reduced market share. Large losses can spell the unexpected quick demise of a firm. Persistent subpar performance without corrective action may also lead to firm closure. Generally, business risk has two faces —a strategic side and an operating side.

The strategic side is the primary driver of revenue and market share. At its most fundamental level, it is the simple question of whether there is demand for the firm's products. The typical pure–play firm, however large it may be, makes a small number of products targeted at a certain type of customer. Its market success is all about the choices it makes about the products to offer and how it decides to deliver them to its target customer. There are ways to mitigate this risk. Techniques commonly employed include prototyping, piloting and market testing. The key to risk management is maximizing information availability prior to financial commitment, making rational informed choices based on data rather than speculation. It is a Bayesian process, with an optimal commitment point. Waiting too long can result in competitors owning the market.

The operating side is the primary driver of profitability. It includes the elements of cost management, supply management, revenue realization and production technology. Supply disruption can be a major concern in certain industries, with disastrous consequences for a firm's business. If a crucial input is unavailable, it can completely shut down operations and severely damage market share, if competitors are not similarly affected. Sometimes input prices can be volatile, in which case a firm might want to make forward purchases to achieve predictable costs. If output prices are volatile, forward sales may be appropriate. However, buying or selling forward can be risky, unless the two can be appropriately matched to lock in profits. Actuarial techniques can be used to make the best choices in these situations.

The choice of production capabilities can have risk management implications. Facilities with multiple uses and the flexibility to be easily retooled can substantially mitigate the risk of product failures and allow for fine–tuning of product design during the market testing phase. However, such flexibility comes at a cost. The choice of technology and the labor–capital input mix can have long–term implications depending on the pace of technology advance and the cost or availability of skilled labor. The location of production facilities is often a critical choice for these reasons. Production technology shifts, especially in an industry with high fixed costs, can run a firm out of business.

It must be evident from this discussion that firm– and industry–specific data and considerations play a crucial role in risk management. However, there is a very general framework for the questions that need to be asked and a taxonomy of risk drivers. These questions all derive from an understanding of the nature of business risk, which is a cornerstone of microeconomic theory. I hope that investigation of these issues in the actuarial literature, and application of actuarial techniques to analyzing these risks, will place our profession in a position of preeminence in the emerging field of ERM, beyond its historical role in the insurance industry. Management of these risks lies at the core of sound investment and production decisions in our economy, leading to efficient resource utilization and prosperity for all. As we have all heard, most startup businesses fail in the early years, and few businesses succeed in the long run. It doesn't need to be this way. As actuaries, we can work towards turning other people's risks into our opportunity, making the world a better place in the process.

Narayan Shankar, FSA, MAAA, is senior actuary and director at Allstate Financial. He can be contacted at nshac@allstate.com.