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.
(shaded box)
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?
(shaded box)
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.
(shaded box)
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.
(shaded box)
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.
(shaded box)
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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