In the current economy, companies are under pressure to justify all major investments, including enterprise risk management (ERM). In this article, published by KPMG, KPMG provides some common approaches for valuing ERM programs or ERM components. Placing a value on ERM can help companies realize the return of their investment through reduced costs, increased reputation, and improved decision-making.
KPMG discusses six different components that can affect the value of ERM. Four of these components lead to improved cash flows: reduced capital costs, reduced ERM program costs, reduced hedging and insurance costs, and improved investments or avoided losses. The remaining two components, reduced volatility and improved reputation, lead to a reduced discount rate. KPMG suggests an ERM framework which discounts the improved cash flows at the new reduced rate, leading to the enhanced value of the company.
Improved Cash Flows
A company with an effective ERM system often experiences a lower cost of capital, leading to improved cash flows and enhanced value. The cost of capital is affected because many rating agencies have begun to consider ERM in their overall rating assessments. With the economic downturn, many companies are facing less access to capital, meaning that any impact on a company’s ability to borrow is critical.
An effective ERM program can also improve cash flows through reducing compliance costs by streamlining risk assessment, risk monitoring, risk assurance and reporting. An inventory of existing activities and costs allows a company to uncover redundancies, which can be eliminated to reduce costs and enrich cash flows.
Many companies take advantage of ERM to reduce hedging and insurance costs. The primary goal of ERM is to identify key risks and mitigate their impact. By identifying the key risks that are addressed by insurance and hedging activities, a company can determine if these activities are a good match with the underlying risk exposure. These policies and activities can also be integrated with ERM assessment and reporting activities to achieve additional cost savings.
Ideally, management should not just seek to eliminate risks, but also to identify risks that will lead to opportunities. First, a company must determine its risk appetite, or how much risk it is willing to take to earn a return. ERM can then help identify opportunities that a company should take within its risk appetite. Companies should also consider a standard process to track financial losses resulting from risk events. This will lead to improved processes that can further reduce event-related losses. Through making better investments and avoiding losses, companies will find themselves experiencing improved cash flows and increased value.
Reduced Discount Rate
KPMG has found that the rate at which cash flows are discounted by investors is directly affected by reduced earnings volatility. To measure earnings variability, companies can review past results, conduct stress testing, and review future plans using simulations or forecasts. By measuring earnings variability before and after ERM risk mitigation activities, management will also have better information for decision-making.
In addition, the discount rate is affected by a company’s reputation within the investment community. Reputation is difficult to value because various individuals can perceive it differently and it is formed by many sources. Reputation is affected by market branding, customer outreach, and proactive risk management. Despite the difficulty in valuing reputation, KPMG implies that an ERM system that provides the benefits previously discussed will also lead to improved company reputation through enhanced value.
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