ENTERPRISE RISK MANAGEMENT Enterprise risk management (ERM) emerged in the early 1990s asan extension of hazard risk management. It argues that anorganization 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 orbenefit. Uncertainty. Something that can go wrong without anunderstanding of the consequences, likelihood, or cost orbenefit. ERM raises issues about risktolerance. How much risk are we willing to take? Which risks are wemanaging? Which risks are unbearable? Which are important? Whichare unimportant? ERM became an organizational priority to identifyand manage new exposures. ERM became a buzzword on the lips ofCEOs, CFOs, members of boards of directors, and shareholders.Everybody understood that ERM was important. The questionconfronting organizations was how to get it right. By 2005, ERM had bogged down. Still,many risk observers pushed a strong ERM agenda. They recognized thelogic of coordinating the management of risk. So why did ERMimplementation stall? The answer starts with several definitions ofERM. ERM Defined Enterprise risk management is a broadand complex concept that reaches into every major area of anorganization. As such, it is not surprising that many definitionsof ERM have been offered. These definitions fall into threecategories. A strategic definition focuses on results, as ERM isexpressed in terms of organizational objectives. A functionaldefinition describes ERM in terms of activities that reduce risk. Aprocess definition focuses on actions undertaken by managers tomanage risk. A consensus definition might look something likethis: GENERAL MOTORSINVENTORY As organizations reach maturity, theycan no longer depend on a rapidly growing market for goods and thecontinuation of the business that made them successful. They mustseek new approaches to operations to increase their success inmanaging life cycle risk. The following discussion involves BoAndersson and his experience at General Motors Corporation. Itprovides a good story about modern risk management. In 2001, Bo Andersson became the toppurchasing manager at GM. When he arrived, he realized that GM wasspending $85 billion on car parts each year, purchased from 3,200suppliers. He also learned that GM had separate engineering foralmost every type of vehicle it produced. Vehicles did not sharecommon parts. Seat frames were an example of a particularlyinteresting subculture feature. They were expensive, partly becauseGM had 26 different seat frames. Toyota had only two. A similar situation existed with V6engines. Once again, GM had high costs because it had 12 V6engines, whereas Toyota and Honda had two each. What about fuelpumps? GM had 12. Toyota and Nissan had two. Moving on, Bo Andersson addressed therather simple topic of door hinges. He learned that they could bemade out of three pieces instead of five. Making the change wouldsave $100 million annually. He had a subculture response. Engineersand designers debated the change for more than three months. Thenthey reluctantly began a lengthy process of design and testing forthe new door hinges. After studying the situation to besure he understood it, Bo Andersson identified the design andpurchasing problems and brought them to the attention of theengineers who worked in manufacturing. His arguments were carefullyframed, but they were not well received. The different units didnot support changes, arguing that a change in one component wouldhave ripple effects throughout the entire line of automobiles. Inthe end, change came slowly over the period from 2001 to 2006(BusinessWeek, July 31, 2006). Lessons Learned: GM lacked a modernrisk management approach to internal manufacturing. Productionefficiency lagged badly while GM failed to make desperately neededchanges to be competitive. GM needed ERM. The Need for ERM Why do we need to manage risk andpursue 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 whencreating, distributing, financing, and selling products andservices. Fiduciary Responsibility. ERM helps the board and CEO meet theirshareholder, employee, community, social, and ethicalresponsibilities. Ethics. ERM helps build good relationships with other partieswho expect us to observe legal and ethical behaviors in the conductof our operations. This affects customers, employees, suppliers,creditors, and regulators. As we move past the definitions andneed for ERM, some heavy hitters have joined the discussion. TOWERS PERRIN ON ERM Towers, aprofessional services consulting firm, was an early advocate,believing that ERM is essential to achieve operating stability,build organizational resilience, and increase economic value. Asshown in Figure 2-1, Towers Perrin developed a six-stage ERM RoadMap to create a customized ERM program. MOODY’S ON ERM Moody’s was also anearly advocate of ERM, using the tool to assess banks. In 2004, thecompany deployed Risk Management Assessments (RMA) to help itunderstand exposures facing nonfinancial companies. An RMA is builton four pillars, as shown in Figure 2-2. STANDARD & POOR’S AND ERM S&P uses ERM in ratingfinancial securities for nonfinancial companies. It acknowledgesmanagement’s overall capabilities, quality of strategies, andadaptability to changing conditions. It believes companies withsuperior ERM should have great stability of earnings and a highlikelihood 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 andproduce a gap analysis highlighting areas that needimprovement. Stage 3. Define a target goal for ERM based on organizationalstrategy and risk profile. Stage 4. Prepare a formal action plan for implementation. Seekquick 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 continuousevaluation and reporting and follow-up initiatives. FIGURE 2-2. MOODY’S PILLARS OF RISK MANAGEMENT ASSESSMENT. Risk Governance. Are board members engaged in defining andreviewing the company’s risk philosophy and appetite? Does thereporting structure, including budgeting and capital allocation,contain risk considerations? Risk Management. Does the company have risk control processeswith unit- and operating-level reporting lines and risk discipline?Does the company understand its risk appetite and have controls toset limits in portfolio diversification and businessdecision-making processes? Does the company use risk mitigation,risk control, and risk financing processes and technologies? Risk Analysis and Quantification. Does the business quantify thelevel of risk that is acceptable? Does it have effective riskmonitoring and reporting? Risk Infrastructure and Intelligence. Does the company have arisk infrastructure and supporting systems? Is risk intelligencedeveloped with valid risk models and accurate and timely data? JETBLUE AIRWAYS Standard & Poor’s proposeda unique approach to ERM in 2008. Instead of a specific formula orchecklist, S&P believes managing enterprise risk dependslargely on the quality of management. Still, even a high-qualitymanagement team can stumble if it does not use ERM. An example came on February 14, 2007, when New York City’sKennedy Airport was hit by a nasty ice storm. JetBlue Airways, thelargest airline at Kennedy, used the airport as the hub of itsentire network but was not prepared. Thousands of passengers weretrapped in planes on runways for up to eight hours. Aircraft ranout of food. Toilets overflowed. The airline canceled more than1,000 flights and required six days to get the backlog cleared. Now suppose JetBlue had had an ERM program that had identifiedthe possibility of such an occurrence. Let us follow thisthrough: Source of the Risk. The risk stems from disruption of operationsat peak flying time. Examples include ice storms, police action,and acts of terrorism. The upside would be a display of JetBlue’shigh level of customer service and enhanced reputation. Thedownside would be a negative public reaction and financialloss. Risk Owner(s). This scenario is assigned to the senior vicepresident of operations, who further assigns it to the KennedyAirport Operations Center. Frequency. Ice storms hit New York City once every threewinters. The likelihood is one chance in three that it will hit ata busy time. A peak-travel disruption is thus likely to happen onceevery nine years. Severity. The disruption could be a public relations boon ifhandled smoothly and a customer relations nightmare if passengerswere stranded on planes for long periods of time. It could befinancially beneficial if good news attracts new customers orcostly if the airline has to reimburse passengers for losses ortime spent. Evaluation. A disruption is a major risk opportunity. Options. First, JetBlue could arrange to have buses availablefor an emergency. It could unload passengers stuck in planessitting on the tarmac when all gates are full. Second, it couldprovide additional personnel to solve problems, handle luggage, andmitigate discomfort. The company headquarters was a short distancefrom the airport. The company could train office staff on tasksneeded during a crisis. Third, the company could instituterapid-response capabilities for weather or other crises. Cost-Benefit Analysis. Any approach you use would be good riskmanagement compared to leaving passengers stuck on planes. Epilogue: Before the incident, a BusinessWeek magazine surveyranked JetBlue Airways fourth in the United States in customersatisfaction. After the incident, the magazine pulled the rankingfrom its March 5, 2007, edition and reported the failure inconsiderable detail. Prior to this single event, JetBlue had earnedmany honors for customer service. It was the top choice in anational airline quality rating four years in a row. It won areaders’ choice award five years in a row from Conde Nast Traveler.It always ranked high in J. D. Power’s quality ratings. Then itstumbled. Lesson Learned: An ERM program with constant scanning andsharing of risks might have avoided losses that exceeded $30million. As former JetBlue customers purchase future tickets onother airlines, we will never know the true extent of the loss toJetBlue. Conclusion The scope of ERM is broad. Therefore, it is importantto simplify risk and to get it right in a complex world. We willcontinue 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 thefederal government to help them survive a liquidity crisisresulting from the global financial meltdown. The following is amodern 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 remainednumber one with 20 percent, Toyota Motor Corp. was a close numbertwo in U.S. market share. High Costs. The companies had bloated salariedstaff, probably 25 percent more than needed. Hourly labor costswere not competitive. Legacy Costs. The companies providedprohibitively costly retirement and health care benefits, ignoreddemographic trends on life expectancy, and failed to funddeficiencies in promised benefits. Dealerships. All three companies had too manydealers. General Motors was in the most trouble. With approximatelythe same level of U.S. sales as Toyota, GM had 7,000 dealers.Toyota had 1,500. Contractual Commitments. Agreements with theUnited Auto Workers were highly punitive to the companies. Oneexample was a program where 90 percent of wages and benefits werepaid to laid-off employees. Another financial drain occurred whencities and towns financed facilities by issuing revenue bonds. If acompany needed to close an underutilized facility, it could not doso without paying heavy penalties. Auto Company Management. The companies neverseemed to have the ability or the courage to make desperatelyneeded changes. Senior oligarchs were set in their ways, resistedsuggestions for change, and stifled dissenting views andinnovation. The Solutions The companies examined the strategies to fix the problems. Lagging Sales. The companies needed to become smaller. Too manycompetitors served the U.S. market. Some brands, such as Chevrolet,Buick, Cadillac, Ford, Chrysler, and Jeep, had considerableloyalty. Even the quality was acceptable. The companies could focuson these brands, update features, and reduce the number of U.S.manufacturing plants. Sales could come into balance with desiredvehicles. High Costs. No genius was needed here. Costshad to be cut. Companies could streamline salaried positions, cutback on hourly workers, and reduce other manufacturing and salescosts. Legacy Costs. No one wants to fail to deliveron prior promises. At the same time, contractual costs were notaffordable. The companies had to modify or break contracts. Dealerships. Many of the dealerships had toclose. This would be horrible for local communities and loyaldealers who had become members of a family. No matter how we nowlook at this issue, closures were inevitable. Contractual Commitments. If negotiations tochange agreements failed to obtain needed results, the company hadto 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 CEORobert Nardelli were crisis managers who could be successful ifthey grabbed the bull by the horns. GM CEO Rick Wagoner was moreproblematic. He did not show signs of being the right person tochange a rigid culture. Risk Assessment Now the discussion gets really interesting. The companiesapparently had two options to make changes. Negotiations with otherparties for concessions could do the job. Alternatively, thecompanies could reorganize under the U.S. bankruptcy code. Such afiling allows a court to enforce changes that allow a companyeither to resume viable operations or close down. Lagging Sales. The strategy is to reduceproduction, eliminate brands, and close plants. Whoops. The UnitedAuto Workers and municipal contracts would not agree to thesesteps. Score one for bankruptcy reorganization. High Costs. We need to reduce the number ofsalaried and hourly employees—not likely by negotiation. A UAWhourly worker was quoted, “I think we’ve given enough.” Thestatement clearly reflected the union mood and position. Score twofor the legal remedy. Legacy Costs. The companies needed to reducethe unbearable level of benefits. They were contractual with nosign that workers would give them up easily. Score three forbankruptcy. Dealerships. State laws made it prohibitivelycostly to close dealerships. As a political reality, no mayors orother officials could ever agree to provide relief for a carcompany at the price of a loss of local jobs. Score four forreorganization. Contractual Commitments. We can only museabout, “Who signed these things?” Never mind. Courts enforcecontracts, 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,” aposition proposed by the House of Representatives to oversee theU.S. auto industry. It is hard to imagine the government in thebusiness of straightening out carmakers. The industry neededfunctioning boards of directors and executive leadership operatingin a system that works. Fix the management culture. Score six. Verifying the Choice Any good risk analysis looks for opposing views. These areopinions expressed at the time of the crisis. Bankruptcy as an Option. GM’s Mr. Wagoner wasquoted as saying, “Bankruptcy is not an option.” As it turned out,he was right. The word “option” implies other choices. If therewere none, bankruptcy was not an option. It was an eventuality. Protecting Dealers. Michael Jackson was the CEOof AutoNation, the largest U.S. retailer of cars. He argued thatautomakers had improved quality, reduced labor costs, andrationalized production. Does this mean the companies needed allthe local dealers included in AutoNation? His point, althoughcorrect, 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 thelabor force and its leaders. We have no help here. Likelihood of Change. Mr. Wagoner said he would not resign. Thatwould be taken care of soon enough. The board, perhaps withprodding from the government, would force him out. Effects of Bankruptcy. A marketing researchfirm reported that 80 percent of car buyers would not purchase acar from a bankrupt company. Another survey said 51 percent wouldnot buy a car from GM in any case. Bankruptcy may produce acondition where some buyers would take a new look at Americanproducts. As it turns out, they did. Decision Time Our work is almost done. Are we ready to choose? Bankruptcyreorganization would have negative effects, offset by thepossibility of fixing high costs, reducing legacy costs andexcessive dealerships, and breaking burdensome contractualcommitments. It would be a way to fix the system. Here is whathappened. General Motors. In June 2009, GM filedbankruptcy. On that filing, the U.S. government provided $33billion in financing. A new General Motors was formed around thefour major brands of Chevrolet, Cadillac, GMC, and Buick. Thecompany kept 3,600 of 7,000 U.S. dealerships, shut down 14 of itsU.S. plants, and eliminated 20,000 of its 80,000 employees. In2012, the company earned $4.9 billion in profits and had repaid thegovernment most of the money it borrowed. Ford. The company was in a stronger financialposition 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 withouta government bailout. After losing $30 billion in the period2006–2008, Ford earned almost all of it back between 2009 and2012. Chrysler. The company filed for bankruptcy in2009, after failing to reach agreement with creditors on adifferent plan. A court approved the creation of a new entity with20 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 ofits dealers. The UAW retiree medical fund held two-thirds of thecommon shares and was the major shareholder of the firm. Free ofmany obligations, the company reported $1.7 billion in profits in2012. QUESTION: Referring to the General Motors case study above, whichof the four reasons (survival, stability, fiduciary responsibility,ethics) that often drive the need to implement Enterprise RiskManagement (ERM) did they fail to consider that led them into thesituation they now faced? Be specific and support the answer. Attached