Risk Quantification

Any intelligent fool can invent further complications, but it takes a

genius to retain, or recapture, simplicity. E.F. Schumacher
THE RISK QUANTIFICATION ERM process step is the lynchpin of the ERM
process cycle. It enhances the key risk ranking and prioritization
performed in the prior ERM process steprisk identificationand it also
provides the information necessary to perform the next ERM process step
risk decision making. The key linkage performed in this step is the
connection of risk and value by quantifying risk in terms of its value
impact. This is the bridge between risk and return.
PRACTICAL MODELING
The single most important characteristic of the value-based ERM model is
that it is practical. All aspects of the modelinputs, calculations, and
outputsare kept simple, with the sole purpose, constantly in mind, of
supporting decision making.

Input of Data and Assumptions

The data and assumptions needed to calculate the enterprise baseline
value include the following three items:
1. Strategic plan financial projection. The first item needed as input
for the calculation of the baseline company value is the strategic plan
financial projection. This is a financial projection that extends out to the
end of the formal planning period; for example, a three-year period. This
should include the latest version of the official strategic plan projection as
well as any detailed supporting documents. This should also include any
information
available internally regarding projections or expectations beyond the
formal planning period; this is often limited to additional revenue growth,
expense reduction, and known or scheduled changes in investments.
Recent financials. The second item needed as input for the calculation
of the baseline company value is recent financial results that are
normalized for any one-time or anomalous items. This includes the
income statement, balance sheet, cash flow statement, and, for financial
services companies, required capital calculations. In addition, this
includes the detailed data supporting the construction of the financials;
for example, rates of returns on invested assets, tax rates, and so forth

Discount rate. The third item needed as input for the calculation of the
baseline company value is the discount rate, or cost of equity capital. This
is the rate that will be used to discount all future distributable cash flows
back to the present time in the calculation of company value. This is the
return on investment assumed to be demanded by the collective
shareholders. This is based on the long-term average required return. For
a discussion on determining an appropriate discount rate, see Setting
the Discount Rate.

Input of Data and Assumptions Last year, Pear had 5,000 salespeople,
each selling an average of 750 units annually, based on a $250 purchase
price per unit. The purchase price is expected to remain constant in the
future. Pear tends to lose 15 percent of its salespeople each year. Last
year, Pear hired 1,000 new salespeople. Starting this year, Pear plans to
grow more aggressively. Each year going forward, Pear plans to hire 100
more new
salespeople than the year before. Pear earns net investment income at
an earned rate of 4.5 percent on invested assets of $150 million. Pears
variable costsits costs of goods sold (COGS)are equal to 67 percent of
sales. Last year, research and development costs (R&D)
were $50 million, and this is expected to remain constant in the future.
Last year, Pears fixed expensesits selling, general, and administrative
(SG&A) expenseswere $35 million, and are expected to increase with
an annual inflation rate of 3.5 percent. Pear pays interest expense of6
percent on long-term debt of $150 million. Pears effective tax rate is
35 percent.
Pear uses a discount rate of 13 percent for internal valuations, believing
that this fairly represents the long-term average required return of the
collective shareholders.
Pear has 200 million shares outstanding. The current stock price is $8.75
per share, resulting in a market capitalization of $1.75 billion.

At this point, all we have done is individually quantify the risk scenarios.
We have not yet calculated any interactivity between risk scenarios, which
is part of the next risk quantification activitycalculating enterprise risk
exposure.
Yet, this is still quite valuable information, and it immediately spurs
management action. Once management sees the potential impact to
company value, they take actions. These actions are further informed by
the attribution information discussed next. In addition, several case studies
illustrating this point are presented later.
Attribution of Shocks
By itself, calculating the shock impact of individual risk scenarios on
company value is powerful information. It shows management the
connection of risk to value, focusing priorities and clarifying a business
case for decision making involving mitigation. However, specific mitigation
actions are further informed by calculating an attribution of the individual
risk scenario shocks to company value. This reveals how much each
component risk driver contributes to the overall shock to company value.
For example, assume a risk scenario includes two component driversone
being a reduction in revenues and another being an increase in variable
expenses. The attribution would show how much of the total value shock
was separately caused by each component driver: the value shock from
therevenue decrease and, separately, the value shock from the variable
expense increase.

Method #1. Each component driver can be introduced, by itself, into the
baseline model, and the value shocks recorded separately; if the
component value shocks do not add up to the total value shock (due to
interactivity) then the remainder is allocated to the drivers, in proportion
to the magnitude of each component driver. Some component drivers
may be judiciously excluded when it is clear that allocation to those
drivers is not warranted.
Method #2. Each component driver can be cumulatively introduced into
the model, one at a time, in some chosen order, with each marginal value