What is Enterprise Risk Management, and Why is It Critical for Proper Corporate Governance?

Historically, most organizations and their stakeholders have vehemently pursued business and financial growth while taking a reactive approach to risk management.

Although facilitating business growth will remain at the top of organizational leaders’ priority list, companies can no longer afford to be defensive regarding risk management.

Forward-thinking decision-makers are keenly aware of this fact, which is why countless entities have embraced the enterprise risk management (ERM) framework. This approach seeks to align a company’s pursuit of acceptable returns and its desire to manage risks within its appetite.

Enterprise risk management is essential to corporate governance. It enables business leaders to protect their brands from reputational damage, avoid costly fines from regulatory entities, and minimize their exposure to civil litigation, which are vital to ensuring long-term success.

What is Enterprise Risk Management?

In simplistic terms, enterprise risk management is the process of identifying events that have the potential to threaten the entity and endanger business continuity.

ERM is also designed to “provide reasonable assurance” to stakeholders that the entity will achieve its objectives. Businesses leveraging ERM use a top-down approach that includes its board of directors, decision-makers, and management personnel across the organization.

Enterprise risk management transitions away from compartmentalized risk assessment, which has long been the standard approach for many industries.

ERM is a more holistic approach that breaks away from defensive-minded risk management strategies. The latter focuses on mitigating and avoiding risks rather than proactively eliminating roadblocks and potential vulnerabilities.

The ERM philosophy permits business leaders to identify, prepare for, and remove hazards that arise within a company’s key departments, including finance, legal, and HR.

Enterprise risk management also eliminates information silos by shifting the risk management burden away from division heads and into the hands of C-suite decision-makers.

Organizational leaders can leverage their high-level business overview to mandate specific departments to engage in or stop certain activities.

Core Components of Enterprise Risk Management

The Committee of Sponsoring Organizations (COSO) created the enterprise risk management framework. In this framework, COSO identified eight critical components of ERM:

Internal environmental factors

The internal environment of an organization includes its corporate culture and the overall business ecosystem.

Culture plays a key role in creating the company’s risk appetite and influences management’s attitude toward incurring risks. Although the C-suite creates expectations for the internal environment, one should look at employees’ behavior to assess a business’s culture.

Objective setting

When setting objectives, organizational leaders must remain aware of the company’s overall risk appetite. For instance, a company with a low-risk tolerance should avoid setting overly ambitious objectives. Achieving lofty goals requires a company to take on much higher risk exposure, which may not sit well with stakeholders.

Identification of events

Organizational leaders must identify events that have the potential to negatively impact business continuity. As part of these efforts, decision-makers need to identify incidents that can threaten the business from both a strategic and operational perspective.

An operational risk, for example, could be a natural disaster that disrupts production. Conversely, a strategic risk could come from a government regulation that imposes a new tax on one of your manufacturing materials.

Risk assessment

Under the COSO model, events should be classified based on their likelihood of occurring and their potential to impact the business.

Naturally, business leaders should prioritize preventing or preparing for an event that’s both highly likely to occur and very damaging to the business. Business leaders must consider direct and indirect impacts on the company when assessing risks.

Response

In terms of risk response, businesses have four primary options:

• Risk avoidance
• Risk reduction
• Risk sharing (i.e. purchasing insurance)
• Risk acceptance

When determining which response strategy to use, decision-makers should consider how likely the event is to occur, what financial impacts it could have on the business, and whether taking on said risk will move it closer to a critical objective.

Control

More commonly referred to as “internal controls,” control activities enable businesses to mitigate risks by implementing standardized policies and procedures.

Controls typically fall into one of two categories: preventive and detective.

As their name suggests, preventive controls are designed to mitigate risk by preventing specific events from occurring. Detective activities reveal risky activities that are currently occurring so management can take action.

Information gathering and communication

Gathering information requires you to implement the right entity management systems. When businesses rely on antiquated manual processes, they can’t effectively capture data, much less distribute it to decision-makers.

Reliable and easily accessible access to your corporate data is essential for risk management and corporate governance. By centralizing information on all entities, organizations can track and manage entity data, including corporate filings, ownership structure, and compliance obligations.

These advanced reporting features help organizations to identify and mitigate risks across entities, ensuring compliance with regulations and reducing the risk of penalties.

Disseminating information to managers and C-suite executives is critical, as doing so informs decision-making processes and promotes buy-in across the organization.

Monitoring

Businesses with successful ERM strategies conduct regular audits to assess their performance. Organizations can leverage an internal committee or hire an external auditor.

The latter approach is often preferred, as an objective third party can deliver a more nuanced perspective of a company’s enterprise risk management strategy.

Why is Enterprise Risk Management Necessary?

Individual business units and their managers often view a business through a limited lens.

For instance, the head of the accounting department will have a strong understanding of risks as they pertain to the organization’s finances. However, they’ll be far less conscious of other risk types, such as compliance challenges that arise during legal entity management.

While narrowing its focus is necessary for each business unit to fulfill its responsibilities, it must lend itself better to holistic enterprise risk management.

Transitioning toward a holistic enterprise risk management approach serves two essential purposes. First and foremost, ERM enables an organization to minimize risk and pursue goals while staying within its risk appetite. Secondarily, an enterprise risk management strategy can reveal opportunities to reduce risk and pursue business goals.

Consequently, your business should embrace a strategy focused on organization-wide risk monitoring, management, and mitigation. Doing so will insulate you from undue risk and empower you to push toward key organizational objectives without inadvertently undermining business continuity.

Additional Resources

Analyzing Growth Drivers & Business Risks Course

Enterprise Risk Management for Financial Institutions

See all risk management resources