Risk Management Reports

May, 1996

Volume 23, No. 5

Holy Cow!

It is a classic example of risk mis-management. I'm referring to the "mad cow" disease (BSE - bovine spongiform encephalopathy) scare that surfaced in Great Britain in mid-March, just when I happened to be in London. The EU banned British beef. The "beefeaters" reluctantly flocked to chickens and fish. The Conservative government dithered and dallied, reinforcing the public's lack of confidence in government's ability to understand the degree of risk, much less solve it. Wild solutions surfaced. Some Cambodians suggested that English cows be shipped to that country where they could be used to help explode still buried land-mines. Still others proposed sending 4.6 million cattle to India where the Hindus revere rather than eat them. The Economist indulged in its normal quota of punning headlines for the story: "Silence of the Calves," and "Cowed."

Scientific research indicates a possible linkage between BSE, a fatal disease to cattle, and a human counterpart, Creutzfeldt-Jakob disease (CJD), but the connection remains unproved. A new strain of CJD has been identified in England in about 12 recent cases among younger people from farming communities, but a cross-species infection is still doubtful. BSE, believed to be related to scrapie in sheep, has existed for centuries. Why hasn't there been previous evidence of transmittal to humans?

While scientists ponder these questions, politicians and business people must take action. It is a classic situation of managing risk, which hinges on the critical element of the public's perception of that risk.

Just as the British government first argued that British beef was perfectly safe, following an earlier outbreak of BSE in 1989 and the decision to ban the mixture of beef offal in cattle feed, and then procrastinated when the possible connection to CJD surfaced earlier this year, other organizations quickly recognized the risk implications and took immediate responsive action. McDonald's, within days of the new announcement, dropped all English beef from its 660 outlets in Britain, replacing it with chicken, fish and vegetarian burgers, and later with beef from safe sources. It took out full page ads in English papers. It wasn't a question about the relatively remote risk of contracting CJD, judged to be about the same as winning the lottery, but about public perception and what an adverse reaction could do to both income and reputation.

McDonald's contingency planning is an example to both governments and other corporations. Competitive chains delayed and may have lost some market share as a result.

All of this has re-focused attention on the question of the relative riskiness of various products and the reactions to new problem areas. We face a continuing battle among the scientific "experts," many of which disagree among themselves, government regulators, charged with protecting the public, and the public whose perceptions are so easily influenced by the press. How and when should an organization respond to a new crisis? The BSE affair shows that rebuilding and maintaining public confidence, particularly in consumer products, probably takes precedence over other considerations, ranging from this quarter's earnings per share to re-election prospects.

Saying that, we must recognize the potential for future unintended consequences. Mass panic is contagious, requiring swift and recognizable action, so beware of the results of those actions. Woodrow Wyatt, writing in The Times (London) on March 26, 1996, at the height of the crisis, argued that the "herd instinct" be resisted, since life consists of risk. "Flight from risk is a fantasy," he suggested. It would be impossible to eliminate, for example, the 3,650 road deaths each year in Britain and the 18,000 deaths from influenza. His coldly rational conclusion about BSE and a possible CJD connection: "The disease may be horrible for the sufferers and their relatives, but the risk is too small to justify the destruction of the cattle industry." I disagree, for this same industry is just as quickly destroyed if consumers in Britain and abroad decide to forego English beef or are prevented by regulators from consuming it .

I agree with Mr. Wyatt in his warning about possible new risk consequences: "Banning marginally risky products frequently has unintended consequences. The late Lord Rothschild, in his remarkable lecture, 'Risk' in 1978, cited the banning of DDT by Sri Lanka in the early 1960s, induced by an emotional book, Silent Spring, by Rachel Carson. Sri Lanka endured a virulent epidemic of malaria spread by mosquitoes, which could have been eliminated by DDT."

Using the BSE situation as an example, risk managers should understand the importance of the public's perception of risk, the volatility of that perception, the need for rapid contingency responses, and the possibility that unintended consequences may occur.

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It seems to me that humanity has always been tottering on the edge of an abyss, perpetually looking back to happier generations, when people knew how to build, paint and write, when children sat up at table, mute and never touching the backs of their chairs. I view the present with distress, but not with despair."

Patrick O'Brien, "The Art of Fiction," The Paris Review,

No. 135, Summer 1995

Building Bridges

Risk management is a process of building communications bridges among various components of an organization. In 1993, in the course of a consulting project, I heard the treasurer of a large chemical company complain that too many of his company's staff seemed to be isolated in their own "silos." Their work was first-rate but they had not integrated their specialties to maximum benefit. I used this metaphor first in Risk Management Reports (Vol. 20, No. 6) and later in a series of speeches, in which I argued that these "silos" must be broken down in order for risk management to flourish.

When I took the message to Europe, I recognized that silos, being an agricultural term more familiar in the United States, might be confusing to European audiences, and I changed the metaphor to "castles." The diagram with this piece is the result. Risk management too often consists of relatively isolated staff and line specialists, each secure within individual "castles," surrounded by moats and crocodiles. The mini-fiefdoms are jealously protected, often by jargon unintelligible to the uninitiated. The result: lack of coordination and integration when cross-fertilization is essential.

Today's risk manager should be building bridges to the other related risk management specialties: public policy and compliance, environmental protection, personnel health and safety, security, insurance, quality assurance and financial and investment controls. It's not easy. New languages have to be learned. Job security is threatened. External working relationships are challenged. By working together, rather than separately, risk managers can provide a dramatic and broader understanding of the inter-relationships of all risks and the opportunities that may be found in many responses.

Have you been bridge-building yet this year?

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The only perfect hedge is in an English garden"

Halsey Balleu, Financial Accounting Standards Board

The Social Scene

Why are we, especially in the United States, so down on ourselves? We live in a vibrant economy, filled with material ease unimagined forty years ago (for those of you have memories that long). Our political system works reasonably well. The world is in relative peace, following decades of great power standoffs. We are, in the words of George Will, "richer, freer and healthier." But we don't seem to be happier!

Perhaps the problem comes from the entitlement mentality that has infiltrated so much of our daily lives, not only in North America but also in other developed countries.

Look at our sports. Professional players have adopted the "free agent" mentality - go where the reward is greatest; forget loyalty to team or town. Employees treat corporations the same way, and employers respond by sacking thousands when times get tough. Their stock prices then rise and executives reward themselves with enormous bonuses, further justifying the cynicism of employees.

The incredible rise of gambling (no, it's not called "gaming") in the last forty years has fostered a "jackpot" mentality of "winner take all." Perhaps this led to Peter Middleton's abrupt departure from Lloyd's to join an investment banking firm, saying "It's an offer I'd be foolish to turn down." I've seen too many younger people rush to grab the short-term promise of a pot of gold, ruthlessly and thoughtlessly kicking over long-standing working relationships, obligations, and future potential. It hasn't surprised me to see these same migrants ceaselessly moving on, unable to find satisfaction.

George Will suggested that "we," in the form of government, may ultimately be responsible: "the illusion that government is the source of economic growth and is responsible for the 'fair' allocation of wealth encouraged a sensibility demanding the ultimate entitlements - to security and peace of mind." It is just those "entitlements" that we cannot find.

The good news is that we are beginning to realize that we cannot depend on government to undertake what we should be doing ourselves. We must take more personal responsibility for both risk and reward. One of the positive signs of risk management is that a refreshing new mentality is beginning to attach itself to the social scene. With luck and a re-defined focus, we may find that combination of personal and group responsibility that will make us happier.

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As the struggle against inflation was the main macroeconomic task for governments in the 1980s, so controlling public debt could be their main challenge over the next decade. Rightly so; for excessive debt may now be the developed world's biggest obstacle to sustained prosperity.

"House of Debt," The Economist, April 1, 1995

The Hamilton Awards

This past February, the first Alexander Hamilton Awards for Treasury Excellence were made at the Global Treasury Summit in Palm Beach, Florida. These awards, jointly offered by Treasury & Risk Management magazine and the National Association of Corporate Treasurers (NACT), included two for risk management: Operational & Liability Risk Management and Financial Risk Management. I had the privilege of serving as one of the award judges and was impressed by the quality and scope of the competition.

The Summit was an intellectually challenging event, emphasizing many of the major risk issues facing organizations today. I drew some key ideas from the two days of presentations:

o Business is global: from the large to the small company, all agreed that a narrow or provincial market focus invites obsolescence. (On my return to Connecticut I checked my own records and found that my non-US subscribers are 30% of the total. RMR is more global than I had imagined.)

o Because of this global approach, organizations are constructing global risk analyses, ranging from credit, currency, interest rate and political, to legal liability and operational risks. More sophisticated information is given to shareholders and other stakeholders on these risks and their responses.

o US exports are shifting gradually from industrialized to developing nations.

o The trend toward privatization of once-public industries is growing, especially in South America and Europe.

o Nationalism continues its resurgence. Many corporations now use joint venture partnerships as techniques to reduce local risk. One treasurer, Pedro Reinhard of Dow Chemical, suggested that all risk financing for such entities be separate and independent.

o De-conglomeration is also occurring, witness Hansons and Daimler-Benz.

o Finance functions, once de-centralized, are being re-centralized. Two proponents of this approach, made possible by new technology and global communications systems, were Malcolm Macdonald, the treasurer of Ford and Krister Willgren, the treasurer of Siemens. Risk financing will have a single global focus, occasionally with regional support centers.

These developments have major implications for the management of risk, and every presentation implicitly or explicitly acknowledged the importance of risk management.

The two risk management awards were made to corporations that are clearly in the vanguard of the new "integrated" approach to the discipline. Although these awards were split into "Operational and Liability" and "Financial" risk management, their winners used similar processes to achieve their results.

Eli Lilly won the Operational and Liability Risk Management Gold Medal for a project of increased risk retention and reduced reliance on conventional insurance. More important than the $5 million in annual savings and limiting its retention to $30 million, or $.07 per share, was the process employed by Edwin Miller, Lilly's vice president and treasurer and Donald Arbogast, its risk manager. It started with senior management support for the project, a clear , realistic target of cost competitiveness, reducing cost-of-risk by at least $5 million, and keeping loss costs within $.07 per share, and partnership with business units. The project team set up a new corporate risk management committee, composed of the treasurer as chairman, representatives of each business unit, and staff from health services, legal, treasury, facilities, and manufacturing/environmental. This brought business unit ownership of both the risks and the planned responses. The new financing techniques included an aggregate stop loss, Lilly's Bermuda-based captive insurer, Elco Insurance Limited, finite risk insurance, quota share participations and partnerships with risk financing organizations. Miller reported that initially Lilly's insurance brokers and markets reacted negatively, believing that the new approach might threaten their livelihood. They were brought on as members of the team, however, and eventually supported the concept. Finally, the entire process was communicated to those affected, including a formal presentation of the plan at Kinsale, Ireland, in the fall of 1994.

The Financial Risk Management Gold Medal went to Lukens Steel. Its CFO and treasurer, John van Roden, Jr. and its cash and risk manager, Henry Graef, used a process similar to Lilly in developing a program to manage its hedging risks. This began with a risk management team that included the CFO, VP Purchasing, Director of Materials Management, Manager of Corporate Accounting, and the Risk Manager. A Risk Management Policy was drafted and approved by the Finance Committee of the Board. The process was developed and reviewed by Arthur Andersen, serving as the external consultant. The risks to be managed were nickel, energy, insurance, aluminum, carbon scrap, pension, foreign exchange and interest rates. It's interesting to note that insurance and pension risks are included. As Graef noted in his presentation to the Summit in Florida, while Lukens continues separate strategies for each exposure, the entire process is coordinated for the first time. The new process is:

o Team based,

o Cross-functional,

o Subject to approved policy with limitations,

o Integrated with physical purchase processes,

o Subject to frequent communication of positions and risks,

o Based on data-driven risk evaluations, and.

o Subject to annual review

The Alexander Hamilton Awards are a welcome addition to benchmarking tools for risk managers. I encourage those interested to put forward their own entries for the 1997 awards. Full information on the 1996 awards can be found in the March-April issue of Treasury & Risk Management. Write to Ms. Maile Hulihan at the magazine, 111 W. 57th Street, New York, NY 10019 for entries for the 1997 awards.

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Now that the baseball season is with us again . . .

Baseball in its many aspects mirrors the American character with astonishing fidelity: in its individualism (so far resistant to the Cult of the Coach, which has ruined football), in its capacity for spontaneity and even limited anarchy within a structured form, in its magical blend of lazy insouciance and artfully channeled exertion, in its boundless obsession with averages, records, and other statistical desiderata, and, finally, in its stubborn, workmanlike beauty. Just as faithfully, the game's history mirrors many of those struggles within the republic's history that have pitted our "better angels" against our worst, notably the saga of race and integration. In short, baseball is us.

Jay Tolson, Editor's Comment, Wilson Quarterly, Autumn 1994

NOVA's Annual Report

Last July (RMR Vol. 22, No. 7) I commented on the inclusion of a full page on "risk management" in the 1994 Annual Report of NOVA Corporation, in Calgary, Alberta, Canada. NOVA is one of the most far-sighted organizations globally in its development of risk management and treatment of risk.

Its new 1995 Annual Report comments on the creation of a new Safety, Health, Environment and Risk (SHER) management system, independently ranked in the top quartile of North American businesses in 1994. Each year some 40 independent audits are made of NOVA's operating businesses to assess the effectiveness of its coordinated efforts to address operational, legal liability and regulatory risks.

While financial and market risks are still managed independently from SHER, NOVA's Annual Report includes detailed information on interest rate, commodity, credit, price, and foreign exchange risk management, all under the heading "Derivatives and Other Hedging Instruments." NOVA notes that it has already met 13 of the 14 guidelines published by the Toronto Stock Exchange (see the Dey Report article in RMR No. 4, April 1996). Its total risk management program reports to a Board Committee on Public Policy, Risk and Environment, chaired by an external director.

NOVA continues to lead in strategic risk management.

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He has no faith that justice will be done. That's why he is a lawyer.

Thomas Berger, Killing Time, Delta Publishing, New York 1967

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