Once management and the Board understand the enterprise’s most significant strategic, operational, financial and compliance risk exposures embedded in the business and have a process in place for refreshing this assessment as markets and operating conditions change, management must address – with the Board’s input – which of those risks should be rejected or retained.
Steps to Avoid the Risk
These decisions have risk policy implications. If the decision is to reject a risk exposure because it’s off-strategy, it offers unattractive rewards, it’s simply the right thing to do (compliance and threats to public safety, for example) or it’s too risky and the organization doesn’t have the capability to manage it, then management must take the appropriate steps to avoid the risk:
- If the risk is strategic in nature – Steps to avoid the risk might include adopting an exit strategy to get out of a market, business or geographic area, targeting more specifically the entity’s business development and market expansion activities to avoid pursuit of “off-strategy” opportunities or screening alternative capital projects and investments to avoid low-return, off-strategy and unacceptably high-risk initiatives.
- If the risk is operational in nature – Steps to avoid the risk typically include eliminating the risk at the source by, for example, re-engineering a flawed process or by designing and implementing internal preventive processes to eliminate product defects at the point they originate.
- If the risk is financial in nature – Examples of risk avoidance would include unwinding a derivatives or securities position or prohibiting or stopping completely the trading activities giving rise to the risk in question.
- For compliance risks – Examples include decisions to avoid doing business in certain geographies or with certain customers resulting in prohibitive policies, enhanced monitoring processes and training.
If an entity retains a large risk exposure – that is, it chooses not to avoid it – several risk responses are available. The enterprise can:
- Accept the risk at its present level – This choice is one management should not make without consulting the Board and potentially disclosing to shareholders. For example, some global oil companies make no secret that they are taking a risk on oil and natural gas prices and, in effect, are passing the risk on to their shareholders. In some instances, the organization may use a captive to fund or self-insure the risk.
- Reduce the severity of the risk and/or its likelihood of occurrence – For instance, control activities (policy and procedures) reduce the severity of impact of a risk event through effective detection and correction controls and response plans. Control activities also can reduce the likelihood of occurrence of a risk event. Geographic dispersion of assets reduces the impact of the occurrence of a single catastrophic event, such as an earthquake or a hurricane, on the company.
- Share the risk with a financially capable, independent party – Risk-transfer strategies include hedging, insurance and joint ventures.
Whether a decision is made to reject or retain a risk, it is important to designate someone, or a group, function or unit, with the responsibility, authority and accountability to “own” the risk response. Top-down reject/retain decisions drive the need for formulating focused risk responses that are integrated within the enterprise’s strategy and business plan. This integration process drives transparency across the organization as to the risk exposure, how it is managed and who is accountable.
To that end, the lines-of-defense model stipulates that each operating unit owns the risks and risk responses integral to its respective business activities. To be effective as “risk owners,” the accountable parties, at a minimum, must be responsible for (1) deciding on the tactics around executing the selected risk response, (2) designing (or being responsible for the design of) the capabilities for managing the risk in accordance with the risk response and (3) monitoring these capabilities over time to ensure they perform as intended.
An Effective Policy Structure
Risk ownership is clarified when a policy is written to articulate what people must and cannot do. The actual format and details of the risk policy will vary from one company to the next and depend on the nature of the underlying risks. That said, an effective policy structure often addresses the following:
- Objectives of managing and monitoring risk;
- Roles and responsibilities of operating units and lines of business in managing risk and delineation of responsibilities of risk owners, risk oversight personnel and independent risk and compliance functions;
- Overall enterprise risk appetite assertions linked to established business objectives (e.g., if management’s goals are to earn $6.75 per share and retire $850 million in debt during the coming year, how much exposure to earnings and cash flow variability can the business withstand?);
- Boundary controls and specific limit structures that management has put in place for authorized, potentially risky opportunity pursuits to create enterprise value to specify the company’s “risk tolerance” so it can be deployed at an operational level (i.e., how much risk is the enterprise willing to accept?);
- Authorities empowering specific individuals to commit enterprise resources in conjunction with managing volatile and high-risk activities, and to execute specific risk responses;
- Minimum risk controls (e.g., separation of duties, access limitations, etc.) that need to be in place in specific circumstances; and
- Required risk reporting and the approved methodologies for measuring and valuing risk, including marking-to-market portfolios of financial instruments and commodities.
The policy structure is more effective if it addresses the largest risk exposures that must be managed on a day-to-day basis and defines explicitly the primary risk responses that management has chosen to address those exposures. For example, it might address strategies for managing different exposures, including acceptable or preferred risk management techniques and prescribed tools and practices. If necessary, it might also point out risk response strategies, tools, products and practices that are specifically disallowed.
While the specificity of the enterprise’s policy enables effective accountability, it is only a start. After approving a policy statement, management must ensure, with Board oversight, that established policies are addressed through effectively designed procedures and that implementation of the procedures is monitored and enforced. From an accountability standpoint, the best control procedures and risk information will be worthless if traders, managers, operators and others think they can be ignored. Management must make it clear to everyone that violation of established policies and limits will be subject to disciplinary action and, depending on severity, possible termination. When violations occur, they must not be tolerated. Lessons learned must be shared.
When policy structures dictate behavioral and performance expectations, it is important that the reward system be aligned with those expectations. For instance, compensation for so-called “star performers” should be evaluated carefully to determine whether they incentivize risk taking that is not in the best interests of the organization. Neither senior management nor the Board should want a cavalier and confrontational management style or a “warrior culture” in which operating unit managers or individual employees tend to focus on short-term compensation and, thus, do not think enough – or at all – about the risks their activities may create for the enterprise.
Therefore, executive management must ensure the appropriate incentives and controls are in place to focus responsible individuals on the critical enterprise risks and acceptable – and unacceptable – business behavior. To that end, managers and Boards of Directors should recognize the consequences of too much emphasis on short-term incentives and the benefits of risk-adjusted compensation structures.
When the organization’s policy structure sets clear accountabilities for risk and the compensation system reinforces those accountabilities, there is a positive impact on the organization’s risk awareness and culture. Effectively articulated risk accountabilities lay the groundwork for balancing the entrepreneurial, revenue-generation side of the business and the control, risk oversight side of the business, so that neither one is too disproportionately strong relative to the other. This balance is elusive, which is why a strong foundation of clear accountabilities is vital to any organization.