Capital Optimization through Enterprise Risk Management

Capital Optimization through Enterprise Risk Management

Return on capital is the motive behind investor’s putting their money into the business else they could earn risk-free rate investing in government securities. By investing in the business, the investor needs risk premium over the risk-free rate to compensate for taking higher risks. What are the risks to the investors in investing in a business? The actual return on investment could be lower than the return they could earn from directly investing market or the capital infused could be insufficient to run the business needing call for money at a higher cost. How could these risks be addressed using Enterprise Risk Management (ERM)?

Return on capital is a prime concern of the investors while strong capital adequacy of a business concern customers, regulators and investors. Thus, owners are interested in expected returns and the minimisation of the volatility of returns. For this purpose, a process is required that assesses risks, determines necessary capital based on risk levels and required returns, looks at volatility, and figures out how to minimise volatility.

The first step in this direction is to identify key risks and prioritise them between the material and immaterial risk and focus on material risk, and determine how to model and quantify those key risks. This could be performed using stochastic modelling. One of the methods often used for risk assessment is Value at Risk (VaR) which gives rise to economic capital for each risk pre-diversification and allows diversification effect to arrive at company level economic capital. The value at risk is calculated as a maximum loss that a company can face at a given confidence level (99%) within a certain time frame (a day or a year).

Once the capital is allocated, there is a need to look at the return on capital. The shareholder’s interest is to minimise the variance of the return to stay ahead in the capital market. For this purpose, the Board must define and pre-fix the risk appetite (the standard deviation on the return) to maximize the return on the portfolio for the management to focus on. The expected return on the portfolio can be found from capital market line given the risk appetite (σ (A) on the portfolio as

E (P) = r+ [E(m)-r)/ σ(m)]* σ(A)

r is the risk free rate and E(m) and σ(m) is the mean and standard deviation on the market.

Using this risk and return trade-off at an enterprise level helps in taking the decision on which projects/products to allocate capital and on which ones not to.

So, the objective is achieving the return on the capital as E(P), given the risk appetite σ(A) in making the decision at the company level for different jobs and projects within the company, which may be broken down into small projects such that the weighted return is E(P) and overall risk is σ(A).

Essentially, while the management is focusing on the upside opportunity, Chief Risk Officer is focusing on σ(A) and tail risk. Any return over and above the E (P) while staying within the risk appetite is the value added to the shareholders. Risk management comes handy here in enhancing the shareholder value addition by helping in deciding which projects, which products, which decisions to make and accept the risk. In the absence of such a tool, the year-on-year variability on the return on company’s price would be very high making its share suspect in the capital market.

While accepting the risk within an organisation, the ERM framework provides a working model of risk identification, risk measurement, risk management, risk monitoring and risk reporting so that overall risk remain within σ(A). The ERM further provides a tool for risk acceptance, risk transfer, risk avoidance and risk management. Risk governance is, therefore, important for smooth functioning of the ERM framework and taking informed decisions. Risk governance cannot be successful without a good risk culture.

So ERM, on the one hand, helps in reducing the economic capital due to lower risks through risk management, on the other hand, it helps in maximising the shareholder value by keeping the company within σ(A).

Therefore, Solvency-II and Basel-II/III for insurance and banking institutions are based on three-pillar approach. Pillar-1 is responsible for economic capital calculation, pillar-2 for risk management and pillar-3 is responsible for disclosure. When all the three pillars groove well within an organisation, it helps in improving solvency, optimising profit and minimising capital.

Development of ERM

The ERM is a companywide approach to risk management as opposed to silo approach where risks are managed by only a few functions. This allows integration of risk management from the origination, right from Board across the company to the last employee. It was realised that fragmented approach to risk management does not work as the risks are highly interdependent and cannot be segmented and managed independently. The cost of management of risk is also higher if handled in silos as the benefit of diversification does not come into force.

For example, in the insurance business, lapse rate and interest rate have a correlation. Lapse rate is defined as the number of customers who stop paying a premium in subsequent years which leads to loss to the business due to non-recovery of fixed expenses.

When interest rate moves up, the customers will get a higher return on their premium if they invest their money in the market outside insurance company and may tend to lapse their policy. While on the other hand, if the interest rate goes down, a number of customers may continue paying a premium to life insurance policy as their return on premium is higher compared to that in the market.

Both the situations could be bad for the insurance companies. In the first case, the insurance company may not able to recover its fixed expenses if lapse increases; while in the second case, higher return is to be given to more number of customers than they assumed in the pricing, which means the cost of guarantee increases for an insurance company.

This exercise is a combination of retention team for collection of premium, investment team and treasury team for assets and liability management. If silo approach is used in risk management, the risks may not be addressed totality, if retention team and investment function in isolation. In such a case, the volatility of the portfolio may increase impacting shareholder’s return.

About the author

Sonjai Kumar, CMIRM, Certified Member of IRM, Ambassador in India of Institute of Risk Management (IRM), Professional Member of Institute of Operational Risk, UK.

(The views expressed in this write-up are solely mine and in no way representing my current employer’s view.)