“How can you be better than us to understand our business risk?" This is a question we often hear and the simple answer is that we don’t! But by using our methods and models we can utilize your knowledge in such a way that it can be systematically measured and accumulated throughout the business and be presented in easy to understand graphs to the management and board. The main reason for this lies in how we can treat uncertainties 1 in the variables and in the ability to handle uncertainties stemming from variables from different departments simultaneously.

1. “How can you be better than us to understand our business risk?"
This is a question we often hear and the simple answer is that we don’t! But by using our
methods and models we can utilize your knowledge in such a way that it can be
systematically measured and accumulated throughout the business and be presented in
easy to understand graphs to the management and board.
The main reason for this lies in how we can treat uncertainties 1 in the variables and in the
ability to handle uncertainties stemming from variables from different departments
simultaneously.
Risk is usually compartmentalized in “silos” and regarded as proprietary to the department
and - not as a risk correlated or co-moving with other risks in the company caused by
common underlying events influencing their outcome:
When Queen Elizabeth visited the London School of Economics in autumn 2008 she asked
why no one had foreseen the crisis. The British Academy Forum replied to the Queen in a
letter six months later. Included in the letter was the following:
“One of our major banks, now mainly in public ownership, reputedly had 4000 risk
managers. But the difficulty was seeing the risk to the system as a whole rather than
to any specific financial instrument or loan (...) they frequently lost sight of the
bigger picture.” 2
1
Variance is used as measure of uncertainty or risk.
2
The letter from the British Academy to the Queen is available at: http://media.ft.com/cms/3e3b6ca8-7a08-
11de-b86f-00144feabdc0.pdf
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2. To be precise we are actually not simulating risk as such, risk just is a bi-
product from simulation of a company’s financial and operational
(economic) activities. Since the variables describing these activities - and
their forecasts – is of stochastic nature, which is to say contains uncertainty,
all variables in the P&L and Balance sheet will contain uncertainty. They can
as such best be described by the shape of their frequency distribution – after
thousands of simulations -and it is the shape (tails) of these distributions
that describe the uncertainty in the variables.
Most ERM activities are focused on changing the left or downside tail - the tail that
describes what normally is called risk.
We however are also interested in the right tail or upside tail, the tail that describes possible
outcomes increasing company value.
S@R thus treats company risk holistic by modeling risks (uncertainty) as parts of the overall
operational and financial activities, thus being able to “add up” the risks - to a consolidated
level. Since this can’t be done with ordinary addition3 (or subtraction) we have to use Monte
Carlo simulation.
The value added by this are:
1. A method for assessing changes in strategy; investments, new markets, new
products etc.
2. A heightening of risk awareness in management across an organization’s diverse
businesses
3
The variance of the sum of two stochastic variables is the sum of their variance plus the covariance between
them.
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3. 3. A consistent measure of risk allowing executive management and board reporting
and response across a diverse organization
4. A measure of risk (including credit and market risk) for the organization that is able
to be compared with capital required by regulators, rating agencies and investors
5. A measure of risk by organization unit, product, channel and customer segment
which allows risk adjusted returns to be assessed, and scarce capital to be rationally
allocated
6. A framework from which the organization can determine its risk mitigation
requirements rationally
7. A measure of risk versus return that allows businesses and in particular new
businesses (including mergers and acquisitions) to be assessed in terms of
contribution to growth in shareholder value
The independent risk experts are often essential for consistency and integrity. They can also
add value to the process by sharing risk and risk management knowledge gained both
externally and elsewhere in the organization. This is not just a measurement exercise, but
an investment in risk management culture.
Forecasting
All business planning are built on forecasts of market sizes, market shares, prices and costs.
They are usually given as low, mean and high scenarios without specifying the relationship
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4. between the variables. It is easy to show that when you combine such forecasts you can end
up very wrong4. However the 5 %, 50 % and 95 % values from the scenarios can be used to
produce a probability distribution for the variable and the simultaneous effect of these
distributions can be calculated using Monte Carlo simulation, giving for instance the
probability distribution for profit or cash flow from that market. This can again be used to
consolidate the company’s cash flow or profit etc.
Controls & Insurance Mitigation
Controls and insurance play a significant part in reducing the likelihood of a risk event or the
amount of loss should one occur. They also have a material cost. One of the drivers of
measuring risk is to support a more rational analysis of the costs and benefits of controls
and insurance.
The mathematics of the mitigation offered by controls is not straightforward. A distinction
needs to be made between those controls that reduce the likelihood of occurrence (such as
segregation of duties) and those that minimize the impact should the event occur (such as
business continuity planning). These need to be adjusted for separately. The precise
mathematics will vary with the underlying risk distributions.
The result after mitigation for controls and insurance becomes the final or residual risk
distribution for the particular risk for the organization.
Distributing Diversification Benefits
At each level of aggregation within a business diversification benefits accrue, representing
the capacity to leverage the risk capital against a larger range of non-perfectly correlated
risks. How should these diversification benefits be distributed to the various businesses?
This is not an academic matter, as the residual risk capital attributed to each business
segment is critical in determining its shareholder value creation and thus its strategic worth
to the enterprise. Getting this wrong could lead the organization to discourage its better
value creating segments and encourage ones that dissipate shareholder value.
The simplest is the pro-rata approach which distributes the diversification benefits on a pro-
rata basis down the various segment hierarchies (organizational unit, product, customer
segment etc.).
A more accurate approach that can be built into the Monte Carlo simulation is the
contributory method which takes into account the extent to which a segment of the
organization’s business is correlated with or contrary to the major risks that make up the
Group's overall risk. This rewards countercyclical businesses and others that diversify the
Group's risk profile.
4
http://www.strategy-at-risk.com/2009/05/04/the-fallacies-of-scenario-analysis/
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5. The S@R Process
Implementation
Problem Creation of of the S&R Simulation and
Description Framework model software Reporting
Definition of Time frame Systemic EBITDA model
value and cost Implementation P&L and Balance
drivers and Quantification: of EBITDA model model
their
distributions Opening balance Data entry Valuation
Inventories template for simulation
Dependencies Taxes, etc. EBIDA model
("Correlations")
Forecasts and
between cost Legal requirements Data for balance distributions
and value drivers model template
Company Interest rates Evaluation and
environment: (yield curves) treatment of
taxes, Exchange rates Results
interest rates Financial strategy
etc etc.
Aggregation with market & credit risk
For many parts of an organization there may be no market or credit risk - for these areas,
such as sales and manufacturing, operational and business risk covers all of their risks.
But at the Group level the operational and business risk measure needs to be integrated
with market and credit risk to establish an overall measure of risk being run by the
organization. And it is this combined risk capital measure that needs to be apportioned out
to the various businesses or segments to form the basis for risk adjusted performance
measures.
It is not sufficient just to add the operational, credit and market risks together. This would
over count the risk - the risk domains are by no means perfectly correlated, which a simple
addition would imply. A sharp hit in one risk domain does not imply equally sharp hits in the
others.
Yet they are not independent either. A sharp economic downturn will affect credit and
many operational risks and probably a number of market risks as well.
The combination of these domains can be handled in a similar way to correlations within
operational risk, provided aggregate risk distributions and correlation factors can be
estimated for both credit and market risk.
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6. Correlation risk
Markets that are part of the same sector or group are usually very highly correlated or move
together. Correlation risk is the risk associated with having several positions in too many
similar markets. By using Monte Carlo simulation as described above this risk can be
calculated and added to the company’s risks distribution that will participate in forming the
company’s yearly profit or equity value distribution. And this is the information that the
management and board will need.
Decision making
The distribution for equity value (see above) can then be used for decision purposes. By
making changes to the assumptions about the variables distributions (low, medium and high
values) or production capacities etc. this new equity distribution can be compared with the
old to find the changes created by the changes in assumptions etc.:
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7. A versatile tool
This is not only a tool for C-level decision making but also for controllers, treasury,
budgeting etc.
The results from these analyses can be presented in form of B/S and P&L looking at the
coming one to five (short term) or five to fifteen years (long term); showing the impacts to
e.g. equity value, company value, operating income etc. With the purpose of:
• Improve predictability in operating earnings and its’ expected volatility
• Improve budgeting processes, predicting budget deviations and its’ probabilities
• Evaluate alternative strategic investment options at risk
• Identify and benchmark investment portfolios and their uncertainty
• Identify and benchmark individual business units’ risk profiles
• Evaluate equity values and enterprise values and their uncertainty in M&A processes,
etc.
If you always have a picture of what really can happen you are forewarned and thus
forearmed to adverse events and better prepared to take advantage of favorable events.
Many examples of this are given on our home page: www.strategy-at-risk.com.
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