Consolidated risk management, which is also called enterprise-wide risk management, refers to synchronized management of total pool of risk in the enterprise. Consolidation of risks became possible due to advances in financial engineering and information technology.
Consolidation of risks is important for 5 main reasons:
- Consolidation of risks allows management to see the big picture of risk. Management able to see what is happening to the total pool of risk in the enterprise. Management can analyze if risks are increasing or decreasing and why such changes occur. Moreover, management is able to compare how such changes relate to the risk tolerance level of the enterprise.
- Since management is able to see the big picture, it is in a better position to make decisions on risk management which lead to improved performance of the enterprise risk management process.
- Improved performance of the enterprise risk management process leads to improved performance of the enterprise and enhanced owner’s wealth maximization, which is the ultimate objective of the enterprise.
- Consolidation of risks involves letting go of some particulars and allows to present risks in a straightforward and uncomplicated manner which facilitates effective management throughout the enterprise.
- Consolidation of risks involves analysis of the relationships between different risks. Thereafter, risks are categorized. This enhances quality of risk reporting, which in turn improves decisions associated with allocation of capital.
Approaches to consolidation of risks
Risks should be categorized into appropriate categories. If risks have the same drivers than risks are positively or negatively correlated. If risks do not have the same drivers than such risks are uncorrelated.
When risks are categorized, appropriate methods should be chosen to manage each category. Methods for managing categories of consolidated risks include:
- Managing it as a portfolio of risks
- Obtaining insurance for entire category or for each individual risk within category, whichever is less costly. Transfer costs for entire category will be more cost effective in cases when risks have low or negative correlation and high when risks have positive correlation.
- Using “natural hedges”. As an example, in 1984 a German airline Lufthansa signed a contract with American Boeing committing company to buy aircraft for $3 billion. The organization took forward contract for half of the amount (1.5 billion) to hedge itself against possible currency fluctuations. However, what was not taken into account is that Lufthansa’s cash flow was also essentially dollar-denominated. Therefore, Lufthansa had a “natural hedge” in this situation. Incidentally, the dollar depreciated by 30 percent in 1985 and Lufthansa incurred sizable foreign-exchange loss due to the forward contract which was unnecessary due to “natural hedge” that company had and which was overlooked.