The Risk House

By expanding the role of the captive to that of the “risk house,” and establishing one focus for all risks, a captive would allow for a more integrated and effective management of risk

As corporations continue to grow through mergers and acquisitions and increased investment in new markets, risk management practices and discipline are also changing. No longer is the main focus on hazard risk, credit risk or foreign exchange risk; now risk management has recognized risk in such areas as human capital, reputation, climate change and supply chain. Risk management practices and traditional uses of captives must adapt to the ever-evolving business environment: this is essentially what is now termed “enterprise risk management” (ERM) — managing all the risks of a corporation through a strategic decision-setting process, identifying potential events that may affect the entity.

Although the global economy affects the way we manage our business processes, the following fundamentals of risk management continue to be paramount in managing these risks:

Risk Identification How can we identify the direct and indirect exposures among the hazard, operational, financial and strategic risks our organizations face?

Risk Assessment Risks might be identical across industry, geographical and company boundaries, but each type of exposure has a unique priority associated with its consequences to the organization.

Risk Mitigation Usually risk mitigation involves using a combination of the following techniques: understanding the company’s risk appetite, acceptance, using innovative solutions to meet those objectives, insurance programs, captive programs and/or avoiding the risk altogether (getting out of the business altogether, or the country in which the business is run).

So how can a captive be used in the new global economy, and what are some of the challenges risk managers face in managing their captive or risk management processes?

CHALLENGES

Changing security environment The Sarbanes-Oxley Act 2002 requires corporations to improve quality and transparency in financial reporting and independent audits and accounting for public companies.

So what does this mean for the owners of captives? This may require that separate entities control the independence of the auditor, captive management, legal and actuarial services. In addition, it will require more review by the risk manager in managing its captive.

The Canadian Institute of Chartered Accountants has made significant changes to auditing guidelines, including revised auditing standards regarding the auditor’s responsibility to: • consider fraud and error • understand the entity’s control environment, and • audit the policy liabilities of insurance companies. These changes require more scrutiny by the actuary, the captive and risk manager in providing reasonable assurance that the policy liabilities are reasonable. This involves making sure the data is 100% accurate, including the assumptions that reserving techniques meet acceptable standards. This will also involve the actuary being audited by the auditor’s actuary.

Proposed changes by the IRS in 2007 would end the allowance of deductions for loss reserves by single-parent captives that file income tax returns on a consolidated basis with their parent corporation. If this regulation goes through, what impact will it have on a captive domiciled in the United States?

Globalization Many corporations operate on a global basis, and so the need for risk management to become integrated with the strategic planning process requires a greater investment in the risk management function and resources. There will be more focus on non-traditional risk issues including human capital risk, climate change, reputation risk and the supply chain.

As risk managers, we need to look at each of these areas and provide solutions to CEOs, CFOs and boards to minimize exposure to the risk of shareholder discontent and consequent class action litigation.

In managing human capital risk, we will need to work more closely with human resources to find solutions to manage the loss of key personnel, labour shortages, succession planning and workers compensation issues. One area that is becoming more challenging is political unrest in countries in which a company’s manufacturing plant is located. How will you fulfill a contract if the workers are unsafe, and how will you get your employees out of the country if it is deemed necessary? A good plan involving risk management, security and human resource will mitigate the potential loss of personnel.

Climate change is affecting all regions of the world and the way in which we conduct business. Changes to government regulations may affect the cost of manufacturing, shipping and distribution of products.How is this risk being managed? What about the cost of energy or the lack of water? Can we use the captive to manage the incremental cost as a result of regulations associated with climate change?

The damage to an organization’s earnings and shareholder value as a result of an incident that affects the reputation of an organization is sometimes irreversible. Risk management needs to be integrated into the strategic process to understand the process and offer solutions to minimize these risks. For example, firms using “sweatshops” in their manufacturing processes may lose business within their sector and from organizations that don’t wish to be associated with companies

Another reputation risk involves thirdparty suppliers: Dell computers, for instance, had to recall some 4 million computers as a result of fires caused by the batteries manufactured by Sony.

Globalization might also affect the supply chain, which in turn would affect risk management. Organizations are outsourcing more, automating their manufacturing process and managing inventories in order to minimize cost and maximize profits.Without a strategy to manage the supply chain risks, significant disruptions of the supply chain can reduce the company’s revenue and market share. Using good risk management techniques can mitigate the potential for loss of a key component from a supplier. If you review a supplier’s manufacturing plant, for example, and recommend an upgrade to their fire protection system, you might reduce the potential of a fire in the plant, thereby reducing the chances of a disruption to your supply chain.

Risk managers need to understand the value added in each stage of the supply chain (risk identification), assess the risk to delivery of this value (risk assessment) and determine the company’s risk appetite for accepting or mitigating the risk. Changing risk management practices to realities of a global infrastructure As a result of the complex global business environment, and the demands of various stakeholders who want to understand the broad spectrum of risks facing complex organizations (to ensure they are appropriately managed), boards are driving their management to invest and implement effective, transparent risk management practices. These risk management practices need to go beyond traditional hazard risks: they need to identify and address a complete gamut of risks and opportunities encountered by business enterprises in protecting and creating value. This is otherwise known as ERM.

ERM is now the standard for achieving stakeholders’ demands for greater disclosure and accountability. ERM can be described as a risk-based approach to managing an enterprise, integrating concepts of strategic planning, operations management and internal control. The approach provides a comprehensive view of risk from both operational and strategic perspectives. The process supports the reduction of uncertainty and promotes the exploitation of opportunities related to the achievement of an organizati
on’s objective.

The concept underlying ERM has been around a long time. The application of this concept emerged in financial institutions and world-class corporate treasuries: they applied at-risk frameworks, capital attribution techniques and other measurement methodologies to the management of market and credit risk. Market developments over recent years have made it clear that volatility isn’t just a matter of currency, interest rate or equity security risk anymore. Customer preferences, competitor product offerings, labour markets and technology are all changing with increasing frequency; their behaviours now resemble that of financial markets. Change is no longer linear; it is exponential as the life cycles of organizational business models compress.

No business model is impregnable. Successful companies must innovate and create new sources of value for their customers and markets over time or they will lose ground to nimbler, more creative rivals. Establishing market strategies is a fluid, dynamic process. Risk management, which augments that process, is equally fluid and dynamic.

Company profits in face of global adversity Risk management can help a business unit achieve its profitability goals through enabling better, risk-adjusted decisions. For this to be achieved, the risk management culture needs to permeate and be embedded in the business culture, protocols and processes.

Implementing ERM requires buy-in and commitment from all stakeholders within an organization. To start, a proper strategic planning process should be established, in which those responsible for risk management develop partnerships with boards, senior management and across all levels and functions of an organization. This partnership should be expanded to service providers, including brokers, investment analysts, insurers and reinsurers, etc.

A captive insurance program can play a central role in assisting an organization in maintaining and enhancing its profitability, by enhancing management in preparation for the global challenges it faces.

Making sure your captive has the flexibility to respond to marketplace uncertainty is the key. In traditional captive programs, each risk is managed separately, limiting the effectiveness of a captive in the context of an enterprise-wide approach to risk management. In addition, in traditional captive arrangements, coverages are purchased in traditional silos so the covariance effect cannot be captured. By expanding the role of the captive to that of the “risk house,” and establishing one focus for all risks, a captive would allow for a more integrated and effective management of risk, the capture of scaling effects and efficient enterprise risk financing.