ERMetrics, LLC, is a consultancy that helps managers and quants use Enterprise Risk Management (ERM) to measurably increase the value of their firm.
Here is a simplified example, based on past engagements:
- An insurer expects future annual earnings (cash flow) of 100. The current interest rate is 5%.
- The firm has a yearly 2% probability of experiencing losses large enough to lose its financial strength rating, which is indispensable for retaining its clients.
- The firm can reduce this annual risk to 0.5%, at an annual cost of 10. Should it do so?
Tradeoffs between earnings and risk, like this one, are difficult because they lack a common metric. Earnings are measured in dollars, and risks in probabilities. (Value at Risk is expressed in dollars, but the amount varies with the probability level one selects.)
At ERMetrics, we construct a valuation model that incorporates a firm's future earnings (cash flow) and its risks, as measured by its ERM process. Earnings determine the level of future cash flows, and risks affect their longevity. Value is measured by discounting future cash flows.
In this example, the increased longevity of future cash flows outweighs the reduction in earnings. Lowering the firm's risk increases the value of the firm by 12%.
To learn more, email me at Bill@ERMetrics.com.
Tags: Enterprise Risk Management; Valuation; Quant Gap; Value Metrics;