February 20, 2018
How Risk Produces Financial Success
by Kieran Stack
The implementation of enhanced risk management practices represents a tremendous opportunity, while lowering D&O premiums.
The evolving environment across economics, demographics and geopolitics, paired with the continuing pace of technological change, is creating an increasingly complex risk landscape for all types of businesses.
We are continuing to witness increased connections of potential risk impact on organizations. Never has it been more critical for organizations to consider the relationship between building sustainable competitive advantages and adopting risk management best practices.
It is incumbent on organizational executives and key leaders to take steps to increase their understanding of the risks they face to adapt to the changing environment. In addition, technology offers tremendous growth opportunities in the form of operational performance, automation, new products and services, new and enhanced distribution channels and improved business intelligence. However, the use of technology also increases exposure to cyber risk, which is a key concern.
The impact of connected risk has been felt by many organizations. Increasingly, boards are being obligated, in the case of regulated entities, or challenged to be acutely aware of and understand the key risks their organizations face and how they are being managed. The ability to understand, manage and develop effective organizational governance and processes that encourage improved risk-based decision-making is imperative to an organization’s financial and operational well-being.
In pursuit of the strategic objective to deliver value back to stakeholders, most organizations seek to grow their revenue or drive operational performance and efficiencies within their operating model. Invariably, in today’s complex and evolving environment, there is a level of uncertainty created in the tactical pursuit of such initiatives. Understandably, a greater level of uncertainty equates to a greater level of volatility in financial performance.
See also: How to Use Risk Maturity Models
Researchers at Aon continue to identify correlations between advanced risk management capabilities and higher stock price performance for publicly traded organizations. Reducing volatility via the implementation of robust risk management practices should be a core objective for organizational leaders, as research repeatedly shows that higher levels of risk maturity correlate to lower stock price volatility.
Factors That Distinguish Organizations With Higher Levels of Risk Maturity
Risk professionals have long recommended a structured enterprise-wide risk identification and assessment process for organizations to tackle current and emerging risks. The Aon Risk Maturity Index Insight Report, developed by Aon in close collaboration with the Wharton School of the University of Pennsylvania, identifies three key factors to successfully understanding and managing risk:
- Awareness of the complexity of risk
- Agreement on strategy and action
- Alignment to execute
Increasing performance along these dimensions requires a robust process that focuses on:
- the identification of strengths and weaknesses
- strong communication of risks and risk management across functions and at all levels of the organization
- building consensus regarding the steps to be taken
Having different functions and levels involved and integrated into an organization’s risk maturity assessment process provides the foundation for determining an organization’s current status along these dimensions and provides the foundation for identifying continuing improvement activities.
Aon and Wharton researchers found continued positive impacts on stock price performance and company profitability from higher risk maturity, underscoring the positive internal and external benefits that a robust and sustainable risk management program can deliver.
In addition to a cross-functional understanding of risk, the use of sophisticated quantification methods is another key characteristic exhibited by organizations with advanced risk maturity. Aon and Wharton research shows that organizations with higher levels of risk maturity successfully integrate the use of advanced risk quantification techniques and the utilization of those outputs in the risk decision-making process.
The Relationship Between Risk Maturity and Directors and Officers (D&O) Insurance Premium
Reductions in insurance premiums are another potential financial benefit from more mature risk management processes. This can occur through two channels. First, insurance providers are likely to lower insurance premiums for firms they view as less risky, as reflected in lower volatility. Second, better understanding of risk exposures and their drivers, together with the consistent development and application of risk appetite and risk tolerance concepts to decision-making, provides the information needed to make more informed decisions about which risks to avoid, mitigate or accept and which risks to insure.
By optimizing their insurance portfolio through more mature application of risk management processes, firms can potentially reduce premiums by avoiding or mitigating the most costly risks, choosing only the level of coverage that is necessary given the firm’s risk appetite and tolerances, and improving its bargaining position with insurers.
What’s more, Aon and Wharton research finds that firms with higher overall risk maturity scores paid significantly lower premiums for D&O insurance. Just a 10% increase in overall risk maturity scores is associated with D&O premiums that are 2.6% lower than the premiums paid by similar firms. This direct benefit does not take into account the indirect premium benefits that also arise from lower volatility — and thus lower premiums in firms with higher risk maturity. When we calculate the total effects of higher risk maturity on D&O premiums, including the benefits from lower volatility, the premium reduction associated with a 10% improvement in risk maturity scores increases to 3.9%.
The implementation of enhanced risk management practices represents a tremendous opportunity for all types of businesses to reduce the volatility associated with the evolving risk landscape while also leveraging the associated benefits to their D&O insurance programs.