What Is Enterprise Risk Management (ERM)?
Enterprise Risk Management (ERM) is a planned strategy for assessing and controlling organizational risks. It identifies the potential risks and provides a quick fix before it affects the entity. ERM helps in creating awareness about the business risks among the entire corporation. It helps in achieving the company’s long-term goals
Through ERM, enterprises create a more standardized risk reporting system. As a result, there is an efficient use of the business resources. All of this, however, requires a considerable amount of investment and framework.
Table of contents
- Enterprise risk management is a process where companies identify the risks and provide solutions. The Board of Directors and Chief Risk Officer (CRO) are solely involved in the decision-making process.
- The four components of ERM involve risk identification, risk analysis, risk response, and risk control.
- The five types of risks include financial, operational, hazard, compliance, and strategic risks. In addition, it involves certain internal and external factors.
- ERM helps to protect companies from any sudden threat or loss. It also enables standardized risk reporting leading to a more risk-focused culture.
Enterprise Risk Management (ERM) Explained
Enterprise Risk Management is a process designed to identify and manage events that can cause risk to the entity. It is a multidimensional and repetitive process. ERM is primarily managed and handled by the company’s board of directors (BOD). They use ERM at the seniority level and create a risk awareness culture among the employees.
The enterprise risk management model was popular among companies in the 1940s and 1950s. Prior, the department itself used to handle the risk associated with it. For example, the finance section used it to handle currency and interest risks. However, as the intensity of risks increased, firms transferred them to the top management.
During the 1970s, companies closely examined financial risks and management. Then, they applied various financial instruments to hedge the risk. During this process, traditional risk management shifted to a holistic approach. In 2001, risk-associated academic researchers Lee Colquitt & Robert E. Hoyt & Ryan B. Lee mentioned ERM as integrated risk management. Thus, companies started employing enterprise risk management tools in their daily operations.
Thus the enterprise risk management process follows a holistic approach toward risks. Simply put, the top-level management will make decisions regarding ERM instead of certain individual units. The management appoints a chief risk officer (CRO) to identify and analyze the risk factors. In addition, it ensures that the enterprise follows all the enterprise risk management frameworks and guidelines, such as ISO 31000.
For example, the CRO’s job is to find legal and financial risks in the corporation that can lead to closure. He, along with BOD, considers, analyzes, and provides a solution to them. However, the finance department has no role in the decision-making process.
The ERM develops indicators that can help in avoiding an unusual event. However, their application is only possible when the BOD uses them in its decisions. So, let us look at the components of ERM that influence decision-making:
1. Risk Identification
Identifying risks is one of the most important components of the ERM process as it builds the base for other steps. The CRO tries to identify the external and internal factors that can invite risk to the company. Also, list identified risks, root causes, and risk categories. Companies can also use the SWOT (strengths, weaknesses, opportunities, and threats) analysis to identify potential risks.
2. Risk Analysis
Risk analysis involves the assessment of the identified risks. Its goal is to detect any possible interrelations between them and rank the high risk. Firms can use different enterprise risk management tools like ERM software and power analytics to deal with it. They can also assign a high to the low metric chart for determining the riskier factor. For example, based on cost, quality, time, and scope, companies can rate every factor. It will ensure the probability and impact of each factor on the firm.
3. Risk Response
After considering and analyzing the risk factors. Then, they can mitigate, avoid, transfer, share or deal with risk.
For example, during its ERM analysis, Airbus, a European aerospace company, transferred its R&D operations to countries like France, Germany, and Britain. However, companies do their best to avoid risk instead of responding.
4. Risk Control
The last component of the enterprise risk management process involves risk control. Enterprises try to install the risk strategy, communicate, and monitor the whole process. During this phase, there can be fluctuations in the project’s scope, time, and budget. If there are any hurdles, the BOD and CRO take appropriate steps to control the risk.
Let us look at the types of ERM that affect the internal working system of firms:
#1 – Financial risks
Financial risks refer to the risk associated with capital or money. For example, a company’s goals cannot be sound enough unless there is a sufficient flow of capital. Thus, finance adds value to the firm’s potential growth. For example, interest rate risks, cash flow, inflation, and asset value, are a part of financial risk.
#2 – Hazard risks
There is a major connection between these risks and the health and safety of employees and customers. Thus, it is necessary to monitor and control them to safeguard the interest of the employees. Hazard risks include fire and property damage, climatic factors, theft, and crimes.
#3 – Compliance risks
Compliance risks refer to risks related to legal matters. For example, any crime or violation concerning government regulations can invite a compliance risk. Legal risks include negative environmental effects, insider information, and legal crimes.
#4 – Strategic risks
Changing consumer demand or rivalry can create strategic threats. If this risk gets ignored, it can bring huge losses to the firm. Examples of strategic risks include reputation loss, entry of new competition, social trends, technology changes, and other such things.
#5 – Operational risks
Operational risk is majorly due to the internal factors and decisions of the firm. It refers to risk arising due to the disruption in the day-to-day operations. For example, product development, change in the business cycle, change in operational heads, etc.
Examples of Enterprise Risk Management
Let us look at the examples of enterprise risk management to comprehend the concept better:
Suppose Harris is one of the board members of Milkista, a dairy company. In the past few days, there has been negative news about the dairy industry. Customers were getting allergies and infections after consuming dairy products. The management immediately calls a meeting regarding this hazardous strategic risk. The board of directors and Harris appoint a CRO to identify the risk. On analyzing, CRO confirms active substances in the milk. The company calls off all the production of the entire batch.
If the company had distributed the packages, it would have faced various legal and reputational risks.
In the 2021 report by the American Institute of Certified Public Accountants (AICPA), among 420 enterprises, 60% of large organizations face nine or fewer risks. On the other hand, 81% of public companies report 5-19 risks to the board. In addition, 78% of the enterprises keep a separate meeting for risks, whereas only 51% of non-profit organizations keep it. In terms of reporting, public and financial companies report quarterly while the rest do it annually.
Let us look at the benefits of enterprise risk management:
1. Creates A More Risk-Focused Culture
Implementing the ERM model helps in developing awareness about risks to seniors. By doing so, companies can address problems and threats more effectively. Also, it allows effective communication in the organization.
2. Standardized Reporting
ERM enables standardized risk reporting that helps directors with the decision-making process. It also helps the executives improve their risk appetite, tolerances, etc.
3. Efficient Use Of Resources
Among all, cost-cutting and resource-saving is the ultimate goal of the company. Companies can discover the bug through the enterprise risk management model and save themselves from losses. Without ERM, firms might have to invest separately.
4. Protection Against Losses
It is one of the vital benefits of an enterprise. The ultimate goal of ERM is to inform companies about any sudden risk and protect themselves from losses. Without risk management, there can be a huge loss of reputation and capital.
Frequently Asked Questions (FAQs)
While enterprise risk management aims at creating a common goal and risk strategy, traditional risk management focuses on dealing with risks separately. However, the latter results in huge losses for the firm.
ERM framework is a set of guidelines firms follow for risk reporting procedures. Some frameworks are ISO 31000, Sarbanes Oxley Act, corporate governance codex, and COSCO I and II (Committee of Sponsoring Organizations).
It depends on the company. However, they often review quarterly. However, some non-profit organizations prefer doing it annually.
Following are the steps for implementing ERM in an organization:
– Create ERM objectives
– Identify the stakeholders
– Identify the risks and access them
– Create a risk register palette
– Control and monitor the deviations.
This article is a guide to What is Enterprise Risk Management (ERM). Here, we explain its components, types, benefits, and examples. You can also go through our recommended articles on corporate finance –