Paul Harwoods article, The Evolution of ERM (The Actuary, June 2015, bit.ly/1QZY73e), discusses how to optimise the second generation of enterprise risk management (ERM), and makes the following statement: In summary, second-generation ERM is about better decision making (BDM ERM), which adds value when its users, primarily boards and managers, are confident that they are overseeing, or making, quality decisions.
This statement resonated strongly with a recent paper of mine, which placed ERM in an optimal stochastic control-theoretic framework. The paper can be found at http://ssrn.com/abstract=2660026 by any who wish to study the detail. However, in broad terms, the reasoning runs as follows:
- Most for-profit organisations operate according to some profit objective that is to be maximised
- But this optimisation will usually be constrained in such a way as to avoid (at least, with high probability) certain undesirable situations - dangerously thin capitalisation, overly volatile business volumes
- The constraints can be interpreted as the embodiment of risk management. The constrained optimisation formulation creates the necessary tension between the profit objective and ERM.
The paper shows how this formulation may be placed in correspondence with an ERM Integrated Framework such as COSO. Many past pronouncements on ERM have been dogged by two criticisms:
- That risk management is essentially negative, a panoply of restrictions that reduce the potential for profit
- That, in delivering quantitative conclusions in only the vaguest form, ERM is of limited value for informing business decisions in the manner contemplated by Paul Harwood's article.
As the third bullet point above makes clear, the first of these criticisms is valid as long as one considers risk management in a vacuum, rather than as a subset of considerations within a larger, profit-orientated system.
My paper endeavoured to add this profit dimension. It endeavours to establish a fully quantitative optimal control model. The practical implementation of this should lead to results that assist in business decision-making.
Adjunct professor, UNSW Business School, Australia
14 January 2016