Actuarial Notes

Risk Management Objectives

Study guide: Exam DISC-RM

Risk management objectives are the goals an organization sets for its risk management program. They are usually split into pre-loss objectives, which the program pursues before any loss happens (economy, reduction of anxiety and meeting externally imposed obligations), and post-loss objectives, which it must be able to meet after a loss (survival, continued operation, stable earnings, continued growth and social responsibility). The objectives tie the program to the organization's own goals, and they are what the benefits of risk management are measured against.

V = m \times \bar{\pi}

\bar{\pi} = R - C_{\text{rm}} - W - I

  • Symbols: In this simple valuation, V is the value of the organization, \bar{\pi} is its expected annual profit, and m is the multiple the owners apply to it. A constant profit valued as a perpetuity at a 10% return gives m = 10. R is revenue, C_{\text{rm}} is the cost of the risk management program (safety spending or insurance premiums), W is salaries and I is interest on debt.
  • Why the formula matters: Spending on risk management adds C_{\text{rm}} to the costs, so with everything else fixed it lowers profit and value. It raises value only by changing the other terms: customers who prefer a secure supplier buy more (R rises), employees accept less to work for a safer firm (W falls), lenders charge less (I falls), and owners may accept a higher multiple m for a less risky firm. This is the sense in which risk management benefits stakeholders other than the owners.
  • Economy: Before a loss, the organization should prepare for potential losses in the most economical way. That means comparing the cost of safety programs, insurance premiums and the other techniques for handling losses, rather than buying every protection available.
  • Reduction of anxiety: Some exposures, such as the chance of a major lawsuit, cause more worry for the risk manager, executives and owners than others. A pre-loss objective is to reduce that anxiety to a tolerable level, which can justify protection that economy alone would not.
  • Externally imposed obligations: Laws and regulations impose obligations that must be met whatever they cost, such as installing safety devices to protect workers, disposing of hazardous materials properly and labeling consumer products.
  • Survival and continued operation: The first post-loss objective is survival: after a loss, the organization can resume at least partial operation within a reasonable time. For some organizations, the ability to keep operating after a severe loss is itself an extremely important objective, a stricter goal than survival.
  • Stability of earnings and continued growth: After a loss, the organization wants to maintain its earnings, such as earnings per share, and to continue growing, so the risk manager considers how a loss would interrupt both.
  • Social responsibility: The organization seeks to limit the effect a loss has on other people and on society, such as employees who lose work, customers who lose a supplier and a community that loses a major employer.
  • Benefits beyond the objectives: The enterprise risk management framework of COSO (2017) lists the benefits an organization can realize by integrating risk management throughout the entity: a wider range of opportunities, risks identified and managed entity-wide, more positive outcomes and fewer negative surprises, less variability in performance, better deployment of resources, and greater resilience (Organizational Resilience). These extend the traditional objectives, which concern pure loss exposures, to risks with an upside as well.
  • Objectives can conflict: Economy pulls toward retaining losses and spending little, while reduction of anxiety and the post-loss objectives pull toward more protection. Stating the objectives in a risk management policy statement lets the organization resolve these conflicts in advance and communicate them consistently, and the risk management process starts from them.

Sorting a Manufacturer's Risk Management Goals A furniture manufacturer's board approves a risk management policy that lists these goals:

  1. Choose among sprinklers, a larger deductible and higher insurance limits by comparing their costs over five years.
  2. Be able to restart at least one production line within 30 days of a fire.
  3. Comply with the state's workplace safety rules on machine guarding.
  4. Keep earnings per share within 10% of plan in a year with a major loss.
  5. Keep supplying the two hospitals that depend on its beds, even if a plant is damaged.
  6. Limit the effect of a plant closure on the town where the plant is the largest employer.

Classify each as a pre-loss or a post-loss objective and name it.

Answer

  • 1. Pre-loss, economy: The firm is preparing for potential losses in the most economical way by comparing the costs of the techniques.
  • 2. Post-loss, survival: Resuming at least partial operation within a reasonable time is the survival objective.
  • 3. Pre-loss, externally imposed obligation: The rule applies whether or not a loss ever happens.
  • 4. Post-loss, stability of earnings: Steady earnings after a loss is a goal for the period following it.
  • 5. Post-loss, continued operation: The goal is to keep operating through the loss, which is more demanding than partial resumption within a reasonable time.
  • 6. Post-loss, social responsibility: The goal is to limit the loss's effect on people outside the firm.

The goals also show a conflict to resolve. Goal 1 looks for the cheapest protection, while goals 4 and 5 may require backup capacity or insurance that costs more than the cheapest option.

How a Risk Management Program Changes Firm Value With illustrative figures, a firm has revenue of $2,000, salaries of $800 plus other operating costs of $700 (so $1,500 in total), and interest of $200, all in thousands a year, and its owners value it at 10 times profit. It adopts a safety and insurance program costing $60 a year. Customers buy more, so revenue rises to $2,040. Employees accept $30 less in total pay, and lenders cut interest by $10. Find the firm's value before and after, and after if the owners also accept a multiple of 11 for the more secure firm.

Answer

\begin{align*}
\bar{\pi}_{\text{before}} &= 2{,}000 - 1{,}500 - 200 \\
&= 300 \\
V_{\text{before}} &= 10 \times 300 \\
&= 3{,}000
\end{align*}
\begin{align*}
\bar{\pi}_{\text{after}} &= 2{,}040 - 60 - 1{,}470 - 190 \\
&= 320 \\
V_{\text{after}} &= 10 \times 320 \\
&= 3{,}200
\end{align*}

With a multiple of 11, V = 11 \times 320 = 3{,}520. The program costs $60 a year but raises value, because customers, employees and lenders all respond to a more secure firm. Judged by its cost alone, the program would look like a $600 loss in value (10 \times 60).

How it appears on the exam

  • DISC-RM: The introduction to risk management covers the objectives and benefits of risk management. Questions describe a goal in an organization's risk management policy and ask whether it is a pre-loss or post-loss objective and which one, or ask which objective a decision serves.
  • Benefits: Questions ask how risk management benefits the organization, its stakeholders and society, for example why a lender or an employee gains from a firm's safety program.
  • Conflicts: Short cases set economy against another objective, such as survival or reduction of anxiety, and ask which consideration should prevail or how the policy statement resolves it.

Exam traps

  • Survival versus continued operation: Survival means resuming at least partial operation within a reasonable time. Continued operation is the stricter goal of keeping the organization operating after a severe loss.
  • Legal obligations are pre-loss: Meeting safety and labeling laws is a pre-loss objective because it applies whether or not a loss occurs. Classifying it as post-loss because the law exists to prevent losses is a common slip.
  • Cost is not the whole answer: Economy is one objective among several. A choice that minimizes cost but leaves the firm unable to survive a large loss fails the post-loss objectives.
  • Benefits reach other stakeholders: The value created by risk management often shows up in revenue, wages and borrowing costs, not in lower insured losses. An answer that counts only the owners' savings misses how the benefit arises.