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A steep climb for FRC guidelines

Much like his own hill walking adventures, Colin Ledlie outlines how the Financial Reporting Council’s UK Corporate Governance Code guidance is driven by cutting-edge thinking in enterprise risk management

5 FEB 2015 | COLIN LEDLIE

Colin Ledlie
It’s Saturday morning and I’m about to head off to bag my 60th Munro. “Goodbye,” I say to my wife. “I should be home by eight in the evening. But, please note, hill walking is an inherently dangerous activity. Weather conditions can change suddenly, snow and ice can be perilous, human error and poor judgment could lead to adverse outcomes. I can offer no guarantee that I will return safely.”

“OK, have a nice day,” she replies as I head out of the door.

That doesn’t sound like the right dialogue to be having about risk, but it is the type of conversation many UK listed companies have with their shareholders through the risk disclosures in their annual report and accounts. All too often, companies highlight the existence of a wide range of risks but give little indication of the current level of exposure, how material the risks are and what the company is doing to mitigate them.

If I were better at my personal risk disclosures, I might add that the weather forecast is positive, with an expectation of clear skies and warm temperatures. The hill I am climbing is straightforward and I will be well equipped with map, compass, adequate clothing for all conditions and a mobile phone to seek assistance in the unlikely event I need it.

The Financial Reporting Council (FRC) issued a major update to the UK Corporate Governance Code in September. They also updated the ‘Turnbull’ Guidance on Risk Management and Internal Control.

This substantially raises the bar on risk management and disclosure practices. If the old guidance was rooted in the accounting world of systems and controls, the new guidance is very much driven by cutting-edge thinking in enterprise risk management.

Out on the hills I have an extremely low risk appetite. This isn’t the case for everyone. I’ve just watched Scottish trials cyclist Danny MacAskill traversing the Cuillin Ridge on the Isle of Skye on a mountain bike. I’m a wimp as far as danger is concerned. If light is fading fast or I’m not comfortable with icy conditions underfoot I will turn back, even if 50 metres from the summit – I’ve done so several times. My behaviour is risk aware with a strong foundation in being prepared with the right equipment for the conditions and thinking through the risks I might be exposed to.

The new guidance from the FRC has greatly increased expectations for the disclosure of risk appetite and risk culture. Meaningful disclosures of risk appetite are extremely rare in current corporate disclosures. This is surprising given the level of insight that a clear and honest disclosure can give to investors.

Corporate culture

Directors are being asked not just to determine the business culture they would like to see but also to ensure it is actually in place. They need to consider the behaviour that permeates their organisation and have the means to assess it.

It isn’t easy to quantify the level of risk associated with walking in the hills, but there are some statistics to work with. In Scotland, in 2012, there were 543 incidents that required mountain rescue support and 25 deaths. In an earlier study, the top causes of incidents were poor navigation (23%), bad planning (18%) and inadequate equipment (11%). How many people go out to the hills each year is difficult to tell. My guess is 1,500,000 individual mountain journeys. I’d love to hear other views on this, but on this basis that makes a death rate of around 0.002%. Another way to put the number of deaths into context is a comparison with road fatalities (172) and murders (62). The quantification is imperfect but I certainly find it helpful and it increases my understanding of the risk.

The level of quantification of risk in current corporate disclosures is minimal, but the FRC wants to see more. It will now require a longer-term statement of viability from companies. Stretching my analogy a little far, this is equivalent to asking me to disclose whether I will be an active hill walker throughout the next five years. The short answer is ‘yes’, but the FRC expects a range of scenarios to be considered and for any qualifications or assumptions to be disclosed. Hence, I would need to disclose my expectation as having ongoing good health, not sustaining any serious injuries, and continuing to reside in Scotland.

So, how well prepared are companies for the new FRC regime? The IFoA recently conducted research with key decision makers in firms subject to the FRC code and guidance. The majority are starting their preparations but roughly a quarter of firms haven’t started or understood the implications of the guidance. They need to take action now to get up to speed. Many firms were underestimating the amount of work required to meet the new guidelines.

When asked what the most important aspects of the new guidance were, companies listed the following:

  • integration of risk management with considerations of strategy, capital and business planning processes;
  • defining risk appetite;
  • quantification of risks;
  • production of longer-term viability statement.

Figure 1: Most important elements of the revised guidance
Figure 1: Most important elements of the revised guidance
It is interesting that these are all areas where actuaries have substantial experience gained through preparations for Solvency II and development of their Own Risk and Solvency Assessments.

For most companies, the new guidance is already in force. For insurers, for the most part, the implementation challenges won’t be too onerous given their investment in risk management in recent years. However, there will be increased expectations on what is disclosed to the market, and getting these external disclosures right is never easy.

For businesses in other sectors, the work required could be substantial. Some 64% of firms surveyed indicated they were likely to require some external assistance. This must represent a great opportunity for actuaries to share their skills and experiences.

Colin Ledlie is chief executive of Argyle Chalmers

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