7 Components to an Enterprise Risk Management Framework
The 7 Pieces of an ERM Framework
After the 2008 housing market crash, the management board of large enterprises needed a better way to manage operational risk and understand risk tolerance. As a result, the RMA ERM council created a set of guidelines to help each business create its own risk mitigation strategy. The council refers to it as enterprise risk management.
Enterprise risk management is an organization's ability to handle and respond to risk. Successful businesses utilize a risk management framework to optimize decision-making, identify risks, implement a business strategy, and meet business objectives.
Now, companies can use an ERM program to monitor their risk appetite, internal controls, and conduct an internal audit. Before any potential problem turns into a larger concern, companies have the knowledge and tools to eliminate it. Furthermore, they know which risks to take to increase profits and grow their market share.
1. Business Strategy and Risk Response
Before an organization embarks on a strategic risk policy, executives should know what its current plans are to mitigate risk. It's critical to identify the company's goals before anyone defines a risk appetite. Questions to ask include
- What does the organization want to achieve in the next 3-5 years?
- What markets does it want to tap into?
- What areas of the country should the company capture?
- What is the demographic of customers?
- How much does the organization want to earn?
2. Risk Appetite
Risk appetite refers to the amount of risk a business can take on without losing too much money. The board of directors needs to recognize how strategy and risk relate before they determine what the company's risk appetite is. The final risk appetite statement will reaffirm this connection. Without a clear understanding of risk appetite, a company cannot know which endeavors to embark on and which to hold back from.
3. Governance, Policies/Procedures
An ERM framework cannot survive without a company culture that values it. Individuals from all sectors of the organization must involve themselves in the risk management process. Leaders and board members need to oversee a risk strategy and consider risk assessment within each business decision.
In other words, an ERM program needs to be an integrated framework across the organization. Policies include all of the procedures and strategies that the management board delivers to external stakeholders. This may include investors, customers, or the media.
4. Enterprise Risk Management Infrastructure
Risk managers need to thoroughly understand the organization's risk profile to carry out a risk response and management strategy. The way that a company collects risk data, integrates it, analyzes it, and explains it are all part of the risk data and infrastructure.
This is a very challenging task for most risk managers. A successful ERM enterprise invests in a high-level information system as part of a risk strategy. This will help protect risk data and prepare the organization for risk responses.
5. Internal Controls
Every management system needs strong internal controls to carry out an ERM program. Internal controls minimize the number of avoidable risks so it is manageable to the leadership team. Controls may refer to the company culture, procedures, and preparation for different situations.
This helps an organization handle residual risk and keep it at a manageable level. Effective ERM programs understand the importance of strong internal controls so risk managers aren't overwhelmed by risk.
6. Evaluation of Risk Program and Risk Response
The board of directors must document all of the various risks and determine which ones are significant and which aren't. Documentation will also help to know how much time and energy to spend on mitigating risk.
Many businesses use a color rating system to measure and evaluate their risk portfolio. The size and scope of the organization will determine the type of methodology and documentation system to use.
7. Planning for Scenarios in an Objective Setting
ERM allows a business to identify where a risk response went wrong in the past and how to fix it in the future. This process requires leaders to address and document even the most inconsequential risks.
While it may be tedious to plan for scenarios for risks that probably won't happen, it's better than to leave it up to chance. Stress testing and scenario planning ensure a company can address each problem and capitalize on valuable opportunities.
Key Takeaways of a Risk Management Framework
In conclusion, here is what to know about a risk management framework
- A risk framework requires management to understand its business strategies and capacity to handle risk. It's also critical to define the company's risk appetite and financial capital.
- Governance, policies, and procedures refer to the company's culture and the policies an organization communicates to outside stakeholders. The risk infrastructure is the system in place to collect risk data, analyze it, and capitalize on it. An information system can help to optimize a risk strategy.
- Internal controls minimize the number of risks so risk managers don't become overwhelmed. An evaluation requires documentation and organization, along with a methodology.
- It's critical to plan for scenarios in an objective setting, even if there is a low likelihood of a risk occurring. Stress testing can ensure an organization has what it needs to manage risks.