What is Enterprise Risk Management (ERM)? Explained by Digimagg

Understanding Enterprise Risk Management (ERM)

Enterprise risk management (ERM) is a strategic approach to risk management that examines risks across an entire organization. It involves identifying, evaluating, and preparing for potential threats and hazards that could impact an organization's operations, objectives, or result in losses.

Comprehending Enterprise Risk Management (ERM)

Enterprise Risk Management (ERM) adopts a comprehensive approach that prioritizes management-level decision-making over individual business units or segments. Instead of each unit managing risks independently, ERM emphasizes organization-wide oversight. This strategy often involves including risk management plans in annual reports accessible to all stakeholders. Various industries, from aviation to finance, have embraced ERM to mitigate overall risks and identify broader opportunities. Effective ERM implementation requires strong communication and coordination across business units, as decisions from upper management may differ from local assessments. Organizations employing ERM typically establish dedicated teams to oversee these efforts.

Taking a comprehensive approach to risk management

Modern businesses encounter a wide range of risks and potential threats. Historically, companies managed these risks through individual divisions handling their own operations. Enterprise risk management (ERM) requires corporations to comprehensively identify all risks they face and actively decide which ones to address. Unlike isolated risk management within departments, ERM provides a holistic view across the organization.

ERM treats each business unit as a component of the overall corporate portfolio, examining how risks within each unit interact and overlap. It also uncovers potential risks that may not be apparent to individual units.

While companies have long managed risks independently within each unit, there is a growing recognition of the need for a unified approach. For instance, the role of a Chief Risk Officer (CRO) has become crucial in ERM frameworks. The CRO oversees identifying, analyzing, and mitigating internal and external risks that affect the entire corporation. They also ensure compliance with regulatory requirements like Sarbanes-Oxley (SOX) and evaluate factors that could impact investments or business units. The CRO's responsibilities are defined in collaboration with top management, the board of directors, and other stakeholders.

Core elements of enterprise risk management framework

The COSO framework for enterprise risk management outlines eight fundamental components that guide how a company should develop its practices for ERM.

Internal environment

The internal environment of a company encompasses the atmosphere and corporate culture shaped by its employees. It establishes the company's risk appetite and management's philosophy on risk-taking. This environment is typically influenced by upper management or the board and permeates throughout the organization, often reflected in the actions of all employees.

Objective setting

When a company defines its purpose, it must establish objectives that align with its mission and goals. These objectives should also be consistent with the company's risk tolerance. For instance, a company pursuing ambitious strategic plans should anticipate potential internal or external risks that accompany these goals. Accordingly, the company can implement measures that align with its objectives, such as hiring regulatory staff to support expansion into unfamiliar areas.

Event identification

Positive occurrences can significantly benefit a company, whereas negative events can severely hinder its operations. Enterprise Risk Management (ERM) advises companies to identify critical areas and events that could lead to serious consequences. These high-risk events might impact operations, such as natural disasters necessitating temporary office closures, or strategic aspects like regulatory changes that could outlaw a company's primary product line.

Risk assessment

In addition to anticipating potential events, the ERM framework emphasizes the importance of assessing risks by evaluating their likelihood and financial impact. This involves not only the immediate risk, such as a natural disaster rendering an office unusable, but also residual risks, like employee safety concerns upon returning to work. While challenging, ERM encourages companies to quantify risks by assessing the probability of occurrence and the financial implications in dollars.

A company can respond to risks in the following ways

• Avoidance: The company chooses to eliminate the risk by discontinuing the activity that poses the risk. For example, a company may stop selling a specific product line to prevent associated risks.
• Reduction: The company remains engaged in the activity but takes actions to decrease the likelihood or impact of the risk. For instance, investing in quality control or consumer education to improve product safety.
• Sharing: The company retains the current risk exposure but transfers some of the potential losses to a third party in exchange for a fee. An example includes purchasing an insurance policy to mitigate financial losses from certain risks.
• Acceptance: The company acknowledges the risk and decides to proceed without taking further action to mitigate it. This may involve analyzing potential outcomes and determining that the benefits outweigh the risks, opting to continue operations as usual.

Implementing Enterprise Risk Management (ERM) practices can be tailored based on a company's size, risk preferences, and business goals.

Here are recommended steps for implementing effective ERM strategies

• Define Risk Philosophy: Begin by establishing the company's stance on risk and its overall strategy. This involves strategic discussions among management to assess the entire risk profile.
• Create Action Plans: Based on the risk philosophy, develop detailed action plans outlining steps to protect assets and ensure organizational resilience post-risk assessment.
• Think Creatively: Consider a broad spectrum of potential risks, even those that may seem unlikely. This proactive approach helps in devising comprehensive risk response strategies.
• Communicate Priorities: Clearly identify and communicate high-priority risks that must be mitigated for the company's continuity. Ensure all stakeholders understand these critical risks and corresponding response plans.
• Assign Responsibilities: Delegate specific tasks outlined in the action plans to responsible employees. Ensure clear ownership and accountability, even considering contingency plans in case key personnel change.
• Maintain Flexibility: Adapt ERM practices to evolving risks and organizational changes. Anticipate and prepare for new and future risks while executing current strategies.
• Utilize Technology: Leverage ERM digital platforms to centralize risk data, monitor performance against ERM objectives, and implement internal controls effectively.
• Continually Monitor: Regularly review and monitor adherence to ERM practices. Track progress towards goals, ensure risk mitigation efforts are effective, and confirm employees are executing assigned tasks.
• Use Metrics: Develop measurable metrics (SMART goals) to evaluate the effectiveness of ERM strategies. Use these metrics to assess whether objectives are achieved and to refine strategies as needed.

By following these best practices, companies can enhance their ability to manage risks effectively, safeguard assets, and maintain resilience in a dynamic business environment.

Pros and cons of ERM

Enterprise Risk Management (ERM) addresses various types of risks that can impact a company's operations and sustainability.

Here are the key types of risks commonly managed through ERM

Compliance Risk: This involves the risk of failing to comply with laws, regulations, or standards. For instance, not meeting deadlines for financial reporting as per GAAP can lead to compliance issues.

Legal risk: Legal risks arise from potential lawsuits, disputes, or penalties due to contractual breaches or regulatory non-compliance. An example is a company facing litigation over a billing dispute with a major client.

Strategic risk: Strategic risks affect a company's long-term goals and competitive position. This includes risks associated with market shifts, technological changes, or new competitors disrupting the market.

Operational risk: Operational risks pertain to disruptions in daily business activities. Examples include supply chain interruptions, equipment failures, or natural disasters impacting operations.

Security risk: Security risks involve threats to a company's physical or digital assets. This includes breaches in cybersecurity leading to unauthorized access or data breaches compromising sensitive information.

Financial risk: Financial risks relate to the company's financial health and stability. Examples include currency fluctuations affecting profitability or high levels of debt impacting financial solvency.

ERM frameworks are designed to identify, assess, and manage these diverse risks to mitigate their potential impact on the company's performance and sustainability.

Ideal entities for ERM systems

Ideal entities for Enterprise Risk Management (ERM) systems include large corporations operating in complex and diverse environments. These companies typically manage risks across multiple business units, regions, and functions, making ERM crucial for systematic risk identification, assessment, and management at both operational and strategic levels.

Specific industries benefit greatly from ERM, such as financial institutions like banks, insurance companies, and investment firms. These sectors operate in highly regulated and volatile markets, facing risks such as compliance, legal, operational, and financial risks. ERM integration helps these institutions enhance risk management practices, optimize capital allocation, and bolster resilience against economic fluctuations.

Multinational corporations and global enterprises also find ERM invaluable due to their expansive operations across various countries and jurisdictions. These companies encounter diverse risks including geopolitical instability, currency risks, supply chain disruptions, and regulatory challenges in different regions. Implementing ERM frameworks enables global enterprises to effectively monitor and mitigate risks across their diverse operations, ensuring robust risk management tailored to specific regional and departmental challenges.

ERM vs. ERP

Enterprise Risk Management (ERM) primarily focuses on identifying, assessing, managing, and mitigating risks throughout an organization. It addresses risks across all functions and departments, aiming to protect assets, ensure sustainability, and minimize disruptions. In contrast, Enterprise Resource Planning (ERP) tools concentrate on integrating and optimizing core business processes such as finance, manufacturing, sales, and marketing. ERP systems prioritize operational efficiencies and real-time insights rather than comprehensive risk management. Implementing ERM involves collaboration among stakeholders like risk managers, compliance officers, executives, and board members to establish risk frameworks. ERP implementations, on the other hand, often require coordination among IT teams, department heads, and end-users, emphasizing technical integration and operational efficiency. While ERM strategies safeguard long-term sustainability, ERP systems align with strategic goals by enhancing productivity and reducing costs. They may sometimes present growth opportunities that ERM would identify as risky, illustrating how the two frameworks complement each other.

ERM vs. CRM

Customer Relationship Management (CRM) systems are designed to manage interactions with customers and prospects through technology and processes. Their main purpose is to organize, automate, and synchronize sales, marketing, customer service, and support activities. CRM aims to enhance customer relationships, streamline business operations, and boost profitability by understanding and meeting customer needs effectively.

In contrast, Enterprise Risk Management (ERM) systems focus on identifying, assessing, managing, and mitigating risks across an organization. ERM consolidates data related to risks across various functions and departments within the company. Unlike CRM, which prioritizes customer data, interactions, and insights to improve customer engagement and satisfaction, ERM is inward-looking and concerned with operational risks, compliance, and strategic threats. It serves operational teams such as risk management, insurance, operations, and finance.

While CRM systems concentrate on external factors and enhancing customer relationships, ERM systems handle internal risks comprehensively to protect organizational assets, ensure sustainability, and minimize disruptions. Thus, CRM and ERM serve distinct purposes within an organization, with CRM focusing outward on customer-centric activities and ERM focusing inward on holistic risk management.

Example of ERM

ExxonMobil provides a robust example of how Enterprise Risk Management (ERM) is implemented within a large multinational company operating in the oil and gas sector. Their ERM strategy spans all organizational levels to identify, assess, manage, and mitigate risks that could impact business operations and performance. The approach integrates core elements such as risk organization, rigorous identification practices, prioritization methods, risk management systems, and comprehensive governance.

ExxonMobil utilizes advanced data and computer modeling before embarking on new projects to evaluate potential environmental, socioeconomic, and health risks associated with construction and operations. Engagement with communities and collaboration with regulators ensure transparent communication and adherence to regulatory standards, minimizing future risks. This systematic ERM process enables ExxonMobil to implement tailored measures to prevent or mitigate various risks, including environmental impacts from factors like weather changes, sea level rise, seismic activity, and geological conditions, across both offshore and onshore facilities.