Enterprise Risk Management as a Tool in Strategy Formulation

By Sorin Rogojinaru

Toronto, April, 2006 – Enterprise Risk Management (ERM) is a fairly new concept. Some view the ERM function as a response to the new regulatory compliance, others as a new approach in dealing with the multitude of interrelated risks facing an organization. This paper sees ERM as a tool in shaping the strategic direction in which modern organizations compete.

The first step in any ERM process is identifying risks inside and outside of the organization that can impact the future results and value creation. It is the same as performing a SWOT analysis, a method of screening the environment for Opportunities and Threats and the internal context for Strengths and Weaknesses. Either through a top-down approach or a bottom-up collection of information the risk management ends up with having a map of risks characterized by their frequency and severity towards the organization. These can be seen not only as threats but also as opportunities in creating a competitive advantage and therefore can be defined as strategic initiatives.

The World Economic Forum in collaboration with Merrill Lynch, Swiss Re and MMC (Marsh & McLennan companies) identified key current and emerging systemic risks to global business 1. One of them which is considered to be likely to occur and has a major impact is the Global Pandemic risk. The study agrees that “The risk of a pandemic flu virus, particularly one caused by human-to-human transmission of the H5N1 or another avian flu virus is now a dominant theme in the global conversation on risk.” Whilst risk managers look at this pandemic as a threat, executives can view it as a new strategic initiative.

What differentiates the ERM process from the traditional risk management process is an enterprise-wide view of the risks. Information and data are collected for each business unit, risks are correlated with each other and an “enterprise-wide” risk map is drafted. A strategic approach uses a similar wide perspective in identifying ways to differentiate an organization from its competitors. In order to survive and prosper, an organization needs first to identify the external opportunities (positive risks) and second to survive competition. By analyzing the opportunities and the competition, management can define key success factors of competing in its industry.

In the retail industry, pandemic is an external threat/risk. Competitors are responding by concentrating on cost savings and scale economies in operation and advertising. The key success factors can be: differentiation by imposing a strict quality check on all products; creation of home distribution centers; communicate with customers more often on all new initiatives with respect to controlling and mitigating the pandemic risk; training provided to employees on how to prevent spreading a contagious disease; prepare a pandemic response strategy and simulate its implementation with the participation of all managers.

ERM uses risk analytics to identify and measure the different components of risks. The same analytics can be used in defining strategic issues and monitor signals of changes in the business environment. Although the intended strategy of the organization is the one as conceived of by top management, in the end the result is what emerges from individual managers decisions to adapt to changing external circumstances. A key aspect of the strategic management process within an organization is not simply formulating strategy, but linking strategy to performance through setting performance targets and appraising actual performance against these targets.

Risk analytics used in monitoring the pandemic influence can be: absenteeism of employees, reduction in number of customers, disruption of regular internal meetings, reduced income from affected areas, etc. Financial indicators are also used as risk optimization analytics: Risk-adjusted return on capital, economic income created, shareholder value or shareholder value-added. All these risk indicators can be used in diagnosing profit performance — by relating overall risk-adjusted return on capital to factors such as cost of goods sold, general expenses or sales expenses. They can also be used in setting targets for each department and comparing performances of different managers.

The next step in ERM is to identify ways of mitigating risks by means of financing or controlling them. If we treat risks as strategic initiatives we can identify methods of leveraging internal resources and capabilities to take advantage of the risks. Much like a resource based approach in defining strategy. The assumption here is that the same risks affects not only our organization but our competitors and our customers too. As part of the ERM we need to find out if our resources are equipped to deal with that risk, but in the strategy formulation we need to find out if our capabilities can be used to create new products for our customers to deal with the same risk.

New strategic initiatives in dealing with a pandemic risk can vary from reorganizing its internal systems and resources, to identifying new products or services that respond to customers’ demands. A financial institution may create new saving accounts accessible for medical emergency expenses; an IT company may sell applications allowing employees to work from their own house avoiding office spread of the flu; a fashion designer may launch a line of colorful face masks attractive to younger population or a department store may create a home delivery service if people will avoid interaction with others.

Enterprise Risk Management is a lengthy and sometimes costly process that can be utilized in creating a differentiation advantage for an organization. The attraction of such a strategy over a low cost one is its potential for sustainability: it is more difficult to be duplicated by competitors and has an immediate positive impact on the financial outcome. The essence of differentiation advantage is to increase the perceived value of the offerings to the customer by taking advantage of an immediate need that is not perceived by firm’s competitors. Strategy is about winning irrespective of the risks affecting an organization. ERM can identify, analyze and manage risks that can contribute to a winning strategy.

“Strategy is a great work of the organization. In situations of life or death, it is the Tao of survival or extinction.” — Sun Tzu

1. World Economic Forum Global Risk Report 2006.- www.weforum.org
2. Sun Tzu, The Art of War. – www.chinapage.com

About the Author

Sorin Rogojinaru, MBA, CRM, can be reached at [email protected]. The comments in this article represent his own personal opinion, and do not necessarily reflect the vision of his employer.

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