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Enterprise Risk Management

Enterprise Risk Management (ERM)

Definition

Enterprise Risk Management (ERM) — a holistic approach to identifying, defining, quantifying, and treating all of the risks facing an organization, whether insurable or not. Unlike traditional risk management, ERM deals with all types of risk, such as hazard or event risk, operational risk, credit risk, and financial risk.

Related Terms

Risk Management

The practice of identifying and analyzing loss exposures and taking steps to minimize the financial impact of the risks they impose. Traditional risk management, sometimes called "insurance risk management," has focused on "pure risks" (i.e., possible loss by fortuitous or accidental means) but not business risks (i.e., those that may present the possibility of loss or gain). Financial institutions also employ a different type of risk management, which focuses on the effects of financial risks on the organization. For example, interest rate risk is a bank's most important financial risk, and various hedging tools and techniques such as derivatives are used to manage banks' exposure to interest rate volatility.

Event Risk

Risk of loss associated with fortuitous occurrences (e.g., fires, hurricanes, tortuous conduct). Event risk, which is synonymous with pure risk, hazard risk, or insurance risk, presents no chance of gain, only of loss. The perils covered by traditional property-casualty (P&C) insurance products are within the realm of event risk.

Interest Rate Risk

Interest rate risk is the risk associated with any contractual agreement or financial transaction wherein interest income on liquid assets (1) is critical to the success of the transaction and (2) the future value of which is not known or guaranteed. Interest rate risk may be borne by one or both counterparties to a transaction. In some transactions, the seller of the service assumes the interest rate risk but charges the customer a fee based on some estimate of the degree of risk assumed. Banks are subject to severe interest rate risk since the slightest movement in critical rates can produce significant gains or losses. Banks often use derivative hedges to limit the volatility of interest rates, thus mitigating the risk (by removing or diminishing the second definition above).

Operational Risk

The risk of loss from everything other than credit, market, and interest rate risks. It is the risk of human, process, system, or technological failure as well as risks from external events (i.e., event risk).

Risk Management Process

The process of making and implementing decisions that will minimize the adverse effects of accidental business losses on an organization. Making these decisions involves a sequence of five steps: identifying and analyzing exposures to loss, examining feasible alternative risk management techniques to handle exposures, selecting the most appropriate risk management techniques to handle exposures, implementing the chosen techniques, and monitoring the results. Implementing these decisions requires performing the four functions of the management process: planning, organizing, leading, and controlling resources.

Tradable Risk

A wide array of risks that share one fundamental characteristic—transparency. Transparency is the term of art used to describe the degree to which the majority of market participants can readily understand the relative value of a financial transaction. For example, public companies' equity, whether traded on an exchange or over-the-counter, is extremely transparent; the company must report significant financial data to the Securities and Exchange Commission (SEC), and those data are readily available to any investor. Barring corporate malfeasance, all of the risks associated with any publicly traded equity may be known and therefore factored into the share price. All of these risks (there are way too many to list) are considered tradable risks because they are understood and priced by the market participants.

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