Enterprise Risk Management

Implementing the value-based approach

Insurer improves ERM program with Segal's approach

By Michael J. Moody, MBA, ARM

Recently, Rough Notes magazine provided an overview of a new approach to enterprise risk management. (See the ERM column in the April 2011 issue.) This approach is presented in a new book titled Corporate Value of Enterprise Risk Management: The Next Step in Business Management and illustrates how ERM can provide a business case that is more easily accepted by management. The book's author, Sim Segal, FSA, CERA, president of SimErgy Consulting, notes that most of the current crop of ERM frameworks lack the critical business case aspects that are necessary to connect ERM to an organization's decision-making processes.

This article will provide additional support for the value-based approach to ERM, based on an actual case study of a corporation that has implemented the approach. From a competitive advantage standpoint, the vice president of the large multi-line insurer—who made significant contributions to the ERM program implementation—does not wish to be identified. The executive had been involved in the original project that approved the development of the value-based approach and has subsequently been involved in the implementation of the program. This article is based on the insurer's experiences as it began to build a value-based program.

A picture is worth a thousand words

The insurer had been an advocate of ERM for a number of years and had an ERM program in place. This included an ERM committee that was assisting in the active implementation of an ERM strategy. However, the program was not producing all of the results that senior management had hoped it would. So, in 2008, they began working with Sim Segal of SimErgy Consulting in designing and implementing a more value-based approach to ERM. "From the beginning," said the executive, "Segal indicated that the value-based approach would utilize a 'light touch'; and that we could build on what we were already doing." Both of these aspects contributed to achieving internal buy-in, which is one of the key challenges ERM implementations must overcome.

A central element in the value-based approach is to start by examining the organization's strategy and build a model to calculate an internal valuation of the firm based on achieving the strategic plan. Beginning from this vantage point allowed the insurer "to develop an internal valuation of the firm." And, the executive we spoke with noted, "This exercise of building a model proved very valuable. It let us take more of a traditional corporate finance view to the ERM process." And, he indicates, "We found this exercise to be a very useful experience in and of itself."

One of the issues that Segal identifies in his book is the problems surrounding a suboptimal definition of risk. The executive we spoke with echoed this important point. "Being in the insurance business, we felt we knew the definition of risk, but today everyone at our company defines risk as the deviation from our strategic plan." Further this person said, "They realize that we measure risks relative to the plan. While the plan has always been important in our organization, now we are focused at a higher level than before."

True value-based ERM

Segal also indicates in his book that it is critical to quantify all types of risk—strategic, operational, financial, and insurance risks—and to prioritize focus on those that pose the largest potential threat to the value of the organization. To achieve this in a practical way, Segal advocates the use of a long-standing technique known as Failure Modes and Effects Analysis. According to Segal, this is a technique that has been adapted from the manufacturing sector and can be used to develop risk scenarios.

The insurance company found real value in this approach. Developing these risk scenarios "was essential to our overall ERM program," noted the executive. It allowed the firm to provide a wide range of different scenarios which were incorporated into the ERM process. The company accomplished this by "bringing subject matter experts into our discussions to describe their area, and then build various risk scenarios based on their input." These scenarios ranged from "plausible worst case to optimistic cases," thus including both downside and upside scenarios to be incorporated into the baseline strategic plan. As is common in many organizations, "You have smart people with a lot of expertise on their businesses and their key risks, but you are not always using them as efficiently as you could. The value-based approach gave us a framework that allowed us to talk through all of the issues in a more formal, robust manner, and to better leverage the knowledge of these internal experts," the vice president noted.

In the initial pilot stage of implementation, the company selected fewer than a dozen key risks from a list of hundreds. By focusing "on this short list of key risks, we were able to sit down and build an illustrative corporate model that was derived from our strategic planning process. We found that piloting the approach using just the top risks, and spending a couple of months focusing on these, it quickly cut to the heart of the matter," according to the insurance executive. Once internal buy-in was achieved, they expanded the approach to other risks as well.

The company also found, according to the executive, that another huge advantage provided by this work was "to get a dialogue going across the enterprise. This makes it easier to move people beyond their traditional silos." These discussions "let others note their views on risks and ultimately built more consensus across the organization."

Each firm that implements the value-based approach will find which aspects are most important to them. "A key aspect for us was assistance in quantifying risks. By using this approach, we have been able to quantify risks that are normally not considered as part of the analysis," the executive said. These would include such risks as strategic and operational risk, "which are frequently just too difficult to quantify in other frameworks." Quantifying all types of risk is one of the 10 key ERM criteria Segal outlines in his book, in which he also illustrates, through a number of research studies that strategic and operational risks actually account for the majority of an organization's volatility, even at financial services companies.

Conclusion

In the final analysis, has the value-based approach worked? "We are better off today than we were three years ago," responded the executive. Obviously, he said, "There is always room for further improvement, but our senior management team is pleased with the progress we have made thus far. We also have received positive feedback regarding our ERM approach from several outside parties."

While  the insurance company we spoke with had been implementing its ERM program for a few years, by shifting to the value-based risk ERM approach, it was able to more easily achieve internal buy-in, develop a more collaborative approach that leveraged existing internal risk management expertise, and identify and quantify some of the most important threats to the firm. In addition, the approach led to an enhanced perception of the company by key external stakeholders. The executive noted that by using the approach outlined in Segal's book, "You can gain a lot of value quickly." While there are some aspects of the approach that require experienced guidance, utilization of an outside consultant is recommended at some key initial stages. "The approach is straightforward and based on fundamental building blocks in finance, and can fairly quickly be carried forward."

And since there was so much interaction among all the parties involved, the insurance company found "that while we already had good relationships with departments such as accounting and corporate planning, for example, our interactions further  improved through the dialogue precipitated by the value-based ERM approach early on in the process." It was then a "lot easier to build consensus buy-in within the organization for our current approach to ERM." Being able to leverage the knowledge of "our internal subject matter experts was one of the keys to our success." It allowed the company to improve decision-making by using a more appropriate and consistent set of risk/reward metrics throughout the organization.

The author

Michael J. Moody, MBA, ARM, retired as the managing director of Strategic Risk Financing, Inc. (SuRF). As a regular columnist, he provides current, objective information about enterprise risk management.