CalPERS Officer and NERA Expert Author Article on Corporate Governance and Risk Management

In this post-Enron business environment, a company's ability to assess and manage risk has never been more important. Identifying and properly managing risk rests with the board of directors, but risk management is not merely a defensive action; it is also a key element in strategic planning, and a proactive means of creating and sustaining shareholder value. Senior management and directors at public companies must therefore ask themselves, "What is the proper balance between risk and return for their business?" NERA Vice President Dr. Cindy Ma and California Public Employees' Retirement System Chief Investment Officer Dr. Mark J.P. Anson join together in this article to discuss the role of boards of directors in managing risk.

NERA Economic Consulting

CalPERS Officer and NERA Expert Author Article on Corporate Governance and Risk Management

Risk Management: A Proactive Strategy for Enhancing Shareholder Value

New York, December 10, 2002 - In a post-Enron business environment where shareholder lawsuits and regulatory scrutiny are ever increasing, a companys ability to assess and manage risk has never been more important. At the same time, new legislation has established strict guidelines for corporate governance and more stringent requirements for financial disclosure. Shareholders, the owners of the company and ultimate bearers of the companys residual risks, cannot systematically oversee the companys risk management. They must delegate this risk to their agents, the board of directors.

In the current issue of Viewpoint, the journal of The Marsh & McLennan Companies, Dr. Mark J.P. Anson, chief investment officer for the California Public Employees Retirement System (CalPERS), and Dr. Cindy W. Ma, National Economic Research Associates (NERA) Vice President argue that it is the responsibility of the board to ensure there is a reliable process to identify significant risks to corporate business objectives, establish accountability and compliance in risk management, ensure up-to-date written risk management policies and procedures, and guarantee to shareholders that a sound internal control system is in place to manage risks.

Despite the challenges and complexities, risk management need not be viewed as a defensive action. In Corporate Governance and Risk Management: What are the Responsibilities of the Board?", the authors contend that risk taking is an essential component of a competitive economy.

Too much risk can be fatal to an enterprise and too little can cause a firm to miss attractive opportunities and reduce the return on economic capital," Dr. Ma said. Running core businesses well in conjunction with proper risk management investments is what creates added value."

What is the proper balance between risk and return for a business? Anson and Ma advise that the central tasks for addressing this question are risk identification, quantification, and implementation. When identifying risks, boards should avoid selecting potential risks from a generic universe. As the authors explain, the risks should be specific to the market sectors in which the business operates, the companys circumstances at a given time, and the anticipated strategic direction of the company.

In terms of risk quantification, Anson and Ma emphasize that good governance demands that boards continually assess the changing business environment through scenario analysis to ensure that the companys strategic business plan can incorporate different competitive pressures." Cash-flow at risk is an effective internal control that allows a board to link management plans and capital position with the companys risk exposure.

Implementation of risk management begins with the board of directors, according to Anson and Ma. Specifically, leadership has to make risk management a priority and adherence to risk policy and procedures a key point for the entire organization," according to Dr. Ma. A companys risk policy should establish the framework within which employees identify, monitor, measure, and report the risk exposures inherent in operations.

Anson and Ma propose that boards have two options for discharging these large responsibilities. First, the board can form a risk management committee to review the corporations primary financial and operational risks and oversee the overall risk associated with the interaction of strategic plans, capital structure, and cash flow volatility. Second, the board can form a risk management committee of senior and executive-level employees that would conduct all of the risk analysis and reporting for the corporation and present this information, along with recommendations, to the corporations board of directors. In either case, the board assumes an active role in the management of the corporations business and financial risk.

Ultimately, the authors conclude, a companys risk appetite originates and continually evolves at the board level. Although not charged with finding the perfect solution, the board is responsible for acting in the best interests of the corporations shareholders.

If you would like to arrange an interview with Dr. Ma or to learn more about NERAs financial risk management practice, please contact us or visit us on the web at www.nera.com.

Contact: Christine Creager (christine.creager@nera.com) or 617.621.2651

About NERA
NERA (www.nera.com) is a leading global economic consulting firm. Founded in 1961, its focus is on the practical application of economics to complex business and legal issues. Under the auspices of parent company Marsh & McLennan Companies, Inc., NERA operates with 500 professionals in 16 offices worldwide.