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Corporate Risk: What Does Management Really Know?

A short list of questions that every board member and senior manager should be able to answer.

Fortnightly Magazine - February 2005

following results and show that the insurance policy represents a more efficient form of risk reduction than the credit default swap:

Risk charges and an integrated approach to risk management allow management to assess which transaction delivers the best risk-management bang for the buck. Further, it shows analysts and rating agencies that the company is taking a proactive, rather than a reactive approach to risk management.

5. What is the right benchmark to use in evaluating performance, and are we beating the benchmark?

Once a company has an appropriate risk management framework and the ability to charge for risk as described above, the purpose of risk management can change from one of risk avoidance and control to the optimization of return on risk. This raises the question: What is an appropriate return on risk?

While simple in concept, this can become complex in execution. At least three methods can be used to answer this question:

1. The return on risk of current operations;

2. Competitor's return on risk;

3. Return on risk of alternate investments.

Method 1, return on risk of current operations, requires the company to look at its investments and risks historically to determine both the level of return and the level of risk taken. While this method is helpful in determining how various initiatives have performed, it provides little insight as to how the company's operations compare with those of their peers.

Method 2, competitor's returns on risk, can be gleaned from several sources of publicly available data, including annual and quarterly SEC filings, public plant information, and public auction results. This information can give management important benchmarks with which to compare their own performance to that of their competitors, just as P/E and other financial ratios do. Risk management activities can be adjusted accordingly, based on the results. Like any analysis based on publicly available data, the quality of the results rely on the accuracy of the reported data. Recent power and gas industry earnings restatements would skew analysis results.

Method 3, return on risk of alternative investments, allows management to benchmark their projects' returns on risk versus other investments such as corporate bonds, equities, or commodity investments.

Return on risk benchmarks are necessary to judge how efficiently the company is taking risk relative to its peers, and can be a valuable piece of competitive information used to position the company favorably in the eyes of lenders, shareholders, and analysts.

Once the organization's risk tolerance and appetite have been established, an appropriate governance structure must exist to support and control the risk-taking activities of the firm.\

6. Is our risk management organizational structure adequate to control the firm's risks?

Effective risk management demands the respect and cooperation of traders and commercial managers. Organizations may be designed to aid that process. An effective structure ensures the independence of the risk function while at the same time keeping it involved in day-to-day activities. Most utilities have an insufficient level of communication among risk management, senior management and the board. The most effective way to remedy this problem is to appoint