Seizing opportunity - Linking risk and performance

Thought Leadership Institute Seizing opportunity Linking risk and performance Table of contents The heart of the matter 2 Global business volatility seems more extreme than ever. How will your company manage the risks and rewards of doing business in unprecedented times? The time to link risk and corporate performance management is now 3 An in-depth discussion 4 Uncovering the connections between risk and performance reveals a fuller view of your company’s strategy and operations. Business as usual is a riskier proposition 5 Siloed approaches to risk management create dangerous blind spots for business 6 Closer alignment of risk and performance management has become a business imperative 8 An integrated approach to risk and performance management leads to smarter risk taking 12 Moving toward an integrated approach to risk and performance management 15 What this means for your business 16 Build the foundation for a more stable future: Start with a deeper assessment of risk and reward across your organization. Start at strategy setting 18 Doing more with less: Honing your arsenal of business metrics 20 Transforming disparate data into meaningful information 23 Creating accountability and incentives for integrating risk and performance management 26 A call to action 28 July 2009 The heart of the matter Global business volatility seems more extreme than ever. How will your company manage the risks and rewards of doing business in unprecedented times? 2 The time to link risk and corporate performance management is now The origins of the financial crisis will be debated for some time, but the fallout exposed one clear shortcoming: inadequate risk assessment practices. Too many companies took on excessive risk with too little regard for reasonable, realistic long-term performance expectations. The debacle is focusing minds on more robust approaches to risk management, with a new imperative to keep pace with financial innovation, performance incentives, and business goals. Reforms will stretch risk management across the organization and involve systematically linking risk and corporate performance management, leading to an informed view of reward. Extreme volatility, even financial crisis, isn’t new to US business. Companies that keep their proverbial eyes on the ball—on improving performance, both financially and operationally— will emerge from these trying times better positioned to take advantage of opportunities. However, conducting business as usual is in itself a risky proposition. Compliance-driven approaches to managing risk no longer suffice in an increasingly volatile, interconnected business environment. Approaches to risk management need to provide business leaders and their boards of directors with an integrated view of risk and performance that defines how rapidly emerging events will impact operations, quality, and, ultimately, shareholder value. Recent research shows that many companies fail to connect risk and performance in the course of basic performance management. Just 37 percent of nearly a hundred senior executives at US-based multinationals surveyed by PricewaterhouseCoopers in 2008 said their companies link key risk indicators to corporate performance indicators. External stakeholders are already motivating companies to take a fresh approach to aligning their risk appetites and performance objectives in a smarter, more systematic way. Company directors, credit rating agencies, and institutional investors alike are scrutinizing the risk- reward relationship and formalizing their own linkages between risk and performance, creating new expectations and market demands for businesses. A further inducement is being crafted by the Obama Administration, which has telegraphed its clear intent to more closely tether compensation in financial services to long-term performance, through either regulatory or legislative action. The bonus culture has been a hallmark of Wall Street, but it’s not entirely unique to the big banks. The reforms to compensation and incentives that emerge on Wall Street will likely have an influence on the wider American business community. There is no handbook for integrating risk and performance management, but it should be understood at the start that this is not merely a defensive response to greater uncertainty in the business environment and, for some, to pending regulation. Companies are recognizing that the same drivers of increased volatility—capital mobility, rapid innovation, and the development of new business models—also offer opportunities that they must exploit to increase revenue, improve shareholder value, and satisfy evolving customer demands. With an integrated, principled approach to managing risk and business performance, companies can seize with greater confidence the opportunities that an interconnected economy presents. The process of connecting risk and reward starts at strategy setting. When company leaders understand the greatest sources of value creation and destruction across their organizations, when they assign clear accountability for risk management and performance management, and when they systematically quantify the rewards associated with the risks, they change the decision-making game for their managers. PricewaterhouseCoopers 3 An in-depth discussion Uncovering the connections between risk and performance reveals a fuller view of your company’s strategy and operations. 4 Business as usual is a riskier proposition According to the 2008 World Economic Forum Global Risks report, while the financial conditions of the past decade allowed for an exceptional period of economic growth and stability worldwide, the interconnected global business environment also presents new sources of increased volatility, including systemic financial risk, skyrocketing food prices, rapidly extending supply chains, and a looming energy crisis.1 From Wall Street to Main Street, and now around the world, the effects of that systemic financial risk are being harshly realized. Still, financial shocks aren’t new: A recent PricewaterhouseCoopers analysis revealed that the international mobility of capital has, over the last two centuries, repeatedly produced financial crises by freeing large amounts of capital to swell local markets. In today’s networked world, such bubbles inflate faster than ever.2 Whether or not one subscribes to the argument that current levels of economic volatility are cyclical, one thing is certain: the pace of change and business innovation over the last decade has been unprecedented. And it has dramatically increased the frequency—and scale—of economic disruptions. Put into historical perspective, just one financial crisis affected the US in all of the 18th century (perhaps unsurprisingly, as the US was in its infancy), and five financial panics occurred in the US over the next hundred years. In the course of the 20th century, the US saw 11 major economic disruptions, and in just the first decade of the new millennium, the US has experienced two financial crises.3 In times of economic instability, the natural tendency among business leaders is often to batten down the hatches, shy from increased risk, and ride out the storm. In fact, some 80 percent of 101 senior executives at US-based multinationals surveyed by PricewaterhouseCoopers in 2009 said they’re likely to be more cautious about spending and investing over the next 12 to 18 months.4 However, the ability to take smart, strategic, frequently large risks is becoming increasingly important not just to business growth but also to sustainability and continuous operational improvement. Berkshire Hathaway CEO Warren Buffett’s insights on taking risk in volatile times offer a case in point. In 2007, Buffett expressed uncertainty about the road ahead for his company’s core insurance businesses but seemed confident in the organization’s ability to effectively manage risk and performance. In a letter to shareholders, he said the investment vehicle hadn’t lost its taste for risk, yet added: “We remain prepared to lose $6 billion in a single event, if we have been paid appropriately for assuming that risk. We are not willing, though, to take on even very small exposures at prices that don’t reflect our evaluation of loss probabilities. Appropriate prices don’t guarantee profits in any given year, but inappropriate prices most certainly guarantee eventual losses.”5 In many regards, increased risk is a cost of market entry. Take the case of home furnishings retailer IKEA, which, out of necessity, maintains a fundamental acceptance of, and appetite for, the increased risks associated with supporting a global operating model. 1. World Economic Forum, Global Risks 2008: A Global Risk Network Report (January 2008). 2. PricewaterhouseCoopers, American Perspectives (October 2008). 3. Ibid. 4. PricewaterhouseCoopers, 2009: Q1 Management Barometer (2009). 5. Warren Buffett, Berkshire Hathaway Annual Report 2006 (February 2007). PricewaterhouseCoopers 5 The company sources its products from business risks is behind rapid declines in 1,600 suppliers in 55 countries.