ENTERPRISE RISK MANAGEMENT Enterprise risk management (ERM) emerged in the early

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ENTERPRISE RISK MANAGEMENT

Enterprise risk management (ERM) emerged in the early 1990s as an extension of hazard risk management. It argues that an organization should manage enterprise risks in a single, comprehensive program.

RISK VERSUS UNCERTAINTY

Risk. Something that we attach to a probability. In many cases, we can also calculate or estimate the financial cost or benefit.

Uncertainty. Something that can go wrong without an understanding of the consequences, likelihood, or cost or benefit.

ERM raises issues about risk tolerance. How much risk are we willing to take? Which risks are we managing? Which risks are unbearable? Which are important? Which are unimportant? ERM became an organizational priority to identify and manage new exposures. ERM became a buzzword on the lips of CEOs, CFOs, members of boards of directors, and shareholders. Everybody understood that ERM was important. The question confronting organizations was how to get it right.

By 2005, ERM had bogged down. Still, many risk observers pushed a strong ERM agenda. They recognized the logic of coordinating the management of risk. So why did ERM implementation stall? The answer starts with several definitions of ERM.

ERM Defined

Enterprise risk management is a broad and complex concept that reaches into every major area of an organization. As such, it is not surprising that many definitions of ERM have been offered. These definitions fall into three categories. A strategic definition focuses on results, as ERM is expressed in terms of organizational objectives. A functional definition describes ERM in terms of activities that reduce risk. A process definition focuses on actions undertaken by managers to manage risk. A consensus definition might look something like this:

GENERAL MOTORS INVENTORY

As organizations reach maturity, they can no longer depend on a rapidly growing market for goods and the continuation of the business that made them successful. They must seek new approaches to operations to increase their success in managing life cycle risk. The following discussion involves Bo Andersson and his experience at General Motors Corporation. It provides a good story about modern risk management.

In 2001, Bo Andersson became the top purchasing manager at GM. When he arrived, he realized that GM was spending $85 billion on car parts each year, purchased from 3,200 suppliers. He also learned that GM had separate engineering for almost every type of vehicle it produced. Vehicles did not share common parts. Seat frames were an example of a particularly interesting subculture feature. They were expensive, partly because GM had 26 different seat frames. Toyota had only two.

A similar situation existed with V6 engines. Once again, GM had high costs because it had 12 V6 engines, whereas Toyota and Honda had two each. What about fuel pumps? GM had 12. Toyota and Nissan had two.

Moving on, Bo Andersson addressed the rather simple topic of door hinges. He learned that they could be made out of three pieces instead of five. Making the change would save $100 million annually. He had a subculture response. Engineers and designers debated the change for more than three months. Then they reluctantly began a lengthy process of design and testing for the new door hinges.

After studying the situation to be sure he understood it, Bo Andersson identified the design and purchasing problems and brought them to the attention of the engineers who worked in manufacturing. His arguments were carefully framed, but they were not well received. The different units did not support changes, arguing that a change in one component would have ripple effects throughout the entire line of automobiles. In the end, change came slowly over the period from 2001 to 2006 (BusinessWeek, July 31, 2006).

Lessons Learned: GM lacked a modern risk management approach to internal manufacturing. Production efficiency lagged badly while GM failed to make desperately needed changes to be competitive. GM needed ERM.

The Need for ERM

Why do we need to manage risk and pursue opportunity in a single coordinated program?

A few quick answers:

Survival. We want a better chance to identify, mitigate, avoid, and treat risks that could close us down.

Stability. We want reliable and predictable behaviors when creating, distributing, financing, and selling products and services.

Fiduciary Responsibility. ERM helps the board and CEO meet their shareholder, employee, community, social, and ethical responsibilities.

Ethics. ERM helps build good relationships with other parties who expect us to observe legal and ethical behaviors in the conduct of our operations. This affects customers, employees, suppliers, creditors, and regulators.

As we move past the definitions and need for ERM, some heavy hitters have joined the discussion.

TOWERS PERRIN ON ERM Towers, a professional services consulting firm, was an early advocate, believing that ERM is essential to achieve operating stability, build organizational resilience, and increase economic value. As shown in Figure 2-1, Towers Perrin developed a six-stage ERM Road Map to create a customized ERM program.

MOODY’S ON ERM Moody’s was also an early advocate of ERM, using the tool to assess banks. In 2004, the company deployed Risk Management Assessments (RMA) to help it understand exposures facing nonfinancial companies. An RMA is built on four pillars, as shown in Figure 2-2.

STANDARD & POOR’S AND ERM S&P uses ERM in rating financial securities for nonfinancial companies. It acknowledges management’s overall capabilities, quality of strategies, and adaptability to changing conditions. It believes companies with superior ERM should have great stability of earnings and a high likelihood of repaying debt obligations.

FIGURE 2-1. TOWERS PERRIN’S ERM ROAD MAP.

Stage 1. Establish the current state of ERM capability.

Stage 2. Contrast the current state to ERM best practices and produce a gap analysis highlighting areas that need improvement.

Stage 3. Define a target goal for ERM based on organizational strategy and risk profile.

Stage 4. Prepare a formal action plan for implementation. Seek quick wins as well as longer-term ERM objectives.

Stage 5. Implement the ERM vision using timelines, milestones, and assigned responsibilities.

Stage 6. Establish a formal monitoring process with continuous evaluation and reporting and follow-up initiatives.

FIGURE 2-2. MOODY’S PILLARS OF RISK MANAGEMENT ASSESSMENT.

Risk Governance. Are board members engaged in defining and reviewing the company’s risk philosophy and appetite? Does the reporting structure, including budgeting and capital allocation, contain risk considerations?

Risk Management. Does the company have risk control processes with unit- and operating-level reporting lines and risk discipline? Does the company understand its risk appetite and have controls to set limits in portfolio diversification and business decision-making processes? Does the company use risk mitigation, risk control, and risk financing processes and technologies?

Risk Analysis and Quantification. Does the business quantify the level of risk that is acceptable? Does it have effective risk monitoring and reporting?

Risk Infrastructure and Intelligence. Does the company have a risk infrastructure and supporting systems? Is risk intelligence developed with valid risk models and accurate and timely data?

JETBLUE AIRWAYS Standard & Poor’s proposed a unique approach to ERM in 2008. Instead of a specific formula or checklist, S&P believes managing enterprise risk depends largely on the quality of management. Still, even a high-quality management team can stumble if it does not use ERM.

An example came on February 14, 2007, when New York City’s Kennedy Airport was hit by a nasty ice storm. JetBlue Airways, the largest airline at Kennedy, used the airport as the hub of its entire network but was not prepared. Thousands of passengers were trapped in planes on runways for up to eight hours. Aircraft ran out of food. Toilets overflowed. The airline canceled more than 1,000 flights and required six days to get the backlog cleared.

Now suppose JetBlue had had an ERM program that had identified the possibility of such an occurrence. Let us follow this through:

Source of the Risk. The risk stems from disruption of operations at peak flying time. Examples include ice storms, police action, and acts of terrorism. The upside would be a display of JetBlue’s high level of customer service and enhanced reputation. The downside would be a negative public reaction and financial loss.

Risk Owner(s). This scenario is assigned to the senior vice president of operations, who further assigns it to the Kennedy Airport Operations Center.

Frequency. Ice storms hit New York City once every three winters. The likelihood is one chance in three that it will hit at a busy time. A peak-travel disruption is thus likely to happen once every nine years.

Severity. The disruption could be a public relations boon if handled smoothly and a customer relations nightmare if passengers were stranded on planes for long periods of time. It could be financially beneficial if good news attracts new customers or costly if the airline has to reimburse passengers for losses or time spent.

Evaluation. A disruption is a major risk opportunity.

Options. First, JetBlue could arrange to have buses available for an emergency. It could unload passengers stuck in planes sitting on the tarmac when all gates are full. Second, it could provide additional personnel to solve problems, handle luggage, and mitigate discomfort. The company headquarters was a short distance from the airport. The company could train office staff on tasks needed during a crisis. Third, the company could institute rapid-response capabilities for weather or other crises.

Cost-Benefit Analysis. Any approach you use would be good risk management compared to leaving passengers stuck on planes.

Epilogue: Before the incident, a BusinessWeek magazine survey ranked JetBlue Airways fourth in the United States in customer satisfaction. After the incident, the magazine pulled the ranking from its March 5, 2007, edition and reported the failure in considerable detail. Prior to this single event, JetBlue had earned many honors for customer service. It was the top choice in a national airline quality rating four years in a row. It won a readers’ choice award five years in a row from Conde Nast Traveler. It always ranked high in J. D. Power’s quality ratings. Then it stumbled.

Lesson Learned: An ERM program with constant scanning and sharing of risks might have avoided losses that exceeded $30 million. As former JetBlue customers purchase future tickets on other airlines, we will never know the true extent of the loss to JetBlue.

Conclusion The scope of ERM is broad. Therefore, it is important to simplify risk and to get it right in a complex world. We will continue to tell stories of how to do it right and wrong.

APPENDIX 2

GM, FORD, AND THE CHRYSLER BAILOUT

In late 2008, General Motors, Ford, and Chrysler asked the federal government to help them survive a liquidity crisis resulting from the global financial meltdown. The following is a modern risk management analysis of the situation.

The Problems

The Big Three were struggling with a number of issues.

Lagging Sales. GM, Ford, and Chrysler, combined, had less than half the market. Although GM remained number one with 20 percent, Toyota Motor Corp. was a close number two in U.S. market share.

High Costs. The companies had bloated salaried staff, probably 25 percent more than needed. Hourly labor costs were not competitive.

Legacy Costs. The companies provided prohibitively costly retirement and health care benefits, ignored demographic trends on life expectancy, and failed to fund deficiencies in promised benefits.

Dealerships. All three companies had too many dealers. General Motors was in the most trouble. With approximately the same level of U.S. sales as Toyota, GM had 7,000 dealers. Toyota had 1,500.

Contractual Commitments. Agreements with the United Auto Workers were highly punitive to the companies. One example was a program where 90 percent of wages and benefits were paid to laid-off employees. Another financial drain occurred when cities and towns financed facilities by issuing revenue bonds. If a company needed to close an underutilized facility, it could not do so without paying heavy penalties.

Auto Company Management. The companies never seemed to have the ability or the courage to make desperately needed changes. Senior oligarchs were set in their ways, resisted suggestions for change, and stifled dissenting views and innovation.

The Solutions

The companies examined the strategies to fix the problems.

Lagging Sales. The companies needed to become smaller. Too many competitors served the U.S. market. Some brands, such as Chevrolet, Buick, Cadillac, Ford, Chrysler, and Jeep, had considerable loyalty. Even the quality was acceptable. The companies could focus on these brands, update features, and reduce the number of U.S. manufacturing plants. Sales could come into balance with desired vehicles.

High Costs. No genius was needed here. Costs had to be cut. Companies could streamline salaried positions, cut back on hourly workers, and reduce other manufacturing and sales costs.

Legacy Costs. No one wants to fail to deliver on prior promises. At the same time, contractual costs were not affordable. The companies had to modify or break contracts.

Dealerships. Many of the dealerships had to close. This would be horrible for local communities and loyal dealers who had become members of a family. No matter how we now look at this issue, closures were inevitable.

Contractual Commitments. If negotiations to change agreements failed to obtain needed results, the company had to break contracts. Sorry about that. These were tough times.

Management. Personnel changes were needed, starting at the very top. Ford CEO Alan Mulally and Chrysler CEO Robert Nardelli were crisis managers who could be successful if they grabbed the bull by the horns. GM CEO Rick Wagoner was more problematic. He did not show signs of being the right person to change a rigid culture.

Risk Assessment

Now the discussion gets really interesting. The companies apparently had two options to make changes. Negotiations with other parties for concessions could do the job. Alternatively, the companies could reorganize under the U.S. bankruptcy code. Such a filing allows a court to enforce changes that allow a company either to resume viable operations or close down.

Lagging Sales. The strategy is to reduce production, eliminate brands, and close plants. Whoops. The United Auto Workers and municipal contracts would not agree to these steps. Score one for bankruptcy reorganization.

High Costs. We need to reduce the number of salaried and hourly employees—not likely by negotiation. A UAW hourly worker was quoted, “I think we’ve given enough.” The statement clearly reflected the union mood and position. Score two for the legal remedy.

Legacy Costs. The companies needed to reduce the unbearable level of benefits. They were contractual with no sign that workers would give them up easily. Score three for bankruptcy.

Dealerships. State laws made it prohibitively costly to close dealerships. As a political reality, no mayors or other officials could ever agree to provide relief for a car company at the price of a loss of local jobs. Score four for reorganization.

Contractual Commitments. We can only muse about, “Who signed these things?” Never mind. Courts enforce contracts, and lawyers fight to keep them in place. Under U.S. law, only bankruptcy can break the agreements. Score five.

Management. We did not need a “car czar,” a position proposed by the House of Representatives to oversee the U.S. auto industry. It is hard to imagine the government in the business of straightening out carmakers. The industry needed functioning boards of directors and executive leadership operating in a system that works. Fix the management culture. Score six.

Verifying the Choice

Any good risk analysis looks for opposing views. These are opinions expressed at the time of the crisis.

Bankruptcy as an Option. GM’s Mr. Wagoner was quoted as saying, “Bankruptcy is not an option.” As it turned out, he was right. The word “option” implies other choices. If there were none, bankruptcy was not an option. It was an eventuality.

Protecting Dealers. Michael Jackson was the CEO of AutoNation, the largest U.S. retailer of cars. He argued that automakers had improved quality, reduced labor costs, and rationalized production. Does this mean the companies needed all the local dealers included in AutoNation? His point, although correct, was not relevant. The companies had too many dealers.

Labor Costs. What was the UAW view? The quote, “I think we’ve given enough,” captures the hard-line view of the labor force and its leaders. We have no help here.

Likelihood of Change. Mr. Wagoner said he would not resign. That would be taken care of soon enough. The board, perhaps with prodding from the government, would force him out.

Effects of Bankruptcy. A marketing research firm reported that 80 percent of car buyers would not purchase a car from a bankrupt company. Another survey said 51 percent would not buy a car from GM in any case. Bankruptcy may produce a condition where some buyers would take a new look at American products. As it turns out, they did.

Decision Time

Our work is almost done. Are we ready to choose? Bankruptcy reorganization would have negative effects, offset by the possibility of fixing high costs, reducing legacy costs and excessive dealerships, and breaking burdensome contractual commitments. It would be a way to fix the system. Here is what happened.

General Motors. In June 2009, GM filed bankruptcy. On that filing, the U.S. government provided $33 billion in financing. A new General Motors was formed around the four major brands of Chevrolet, Cadillac, GMC, and Buick. The company kept 3,600 of 7,000 U.S. dealerships, shut down 14 of its U.S. plants, and eliminated 20,000 of its 80,000 employees. In 2012, the company earned $4.9 billion in profits and had repaid the government most of the money it borrowed.

Ford. The company was in a stronger financial position than GM or Chrysler in 2008. Starting two years earlier, Alan Mulally had taken aggressive steps to restructure the company. He shed divisions, cut costs, and mortgaged Ford assets to raise $24 billion to modernize the company. He turned Ford around without a government bailout. After losing $30 billion in the period 2006–2008, Ford earned almost all of it back between 2009 and 2012.

Chrysler. The company filed for bankruptcy in 2009, after failing to reach agreement with creditors on a different plan. A court approved the creation of a new entity with 20 percent of the ownership in the hands of FIAT. The U.S. government took 10 percent of the shares and provided financing of $6.6 billion. The new Chrysler dropped contracts with 25 percent of its dealers. The UAW retiree medical fund held two-thirds of the common shares and was the major shareholder of the firm. Free of many obligations, the company reported $1.7 billion in profits in 2012.

QUESTION:

Referring to the General Motors case study above, which of the four reasons (survival, stability, fiduciary responsibility, ethics) that often drive the need to implement Enterprise Risk Management (ERM) did they fail to consider that led them into the situation they now faced?

Be specific and support the answer.

Explanation / Answer

What General Motors(GM ) was desperately needed at that time was survival need. Automobile sector has pure competition and had GM adopted those changes proposed by Bo, the result would have different and sales and revenue of GM could have much more than the present one. Comparing to competitors of GM like Toyota and NIssan, GM lacked in adopting a proper cost optimization plan.

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