TMBUSINESS RISK MODEL
DEFINITION OF BUSINESS RISKS
(OBTAINED FROM THE “UNIVERSAL BUSINESS RISK MODEL” SECTION
TM OF THE BUSINESS RISK MODELKNOWLEDGE BASE)
Competitor Sensitivity Shareholder Relations Capital Availability Catastrophic Loss Sovereign/Political Legal Regulatory Industry Financial Markets
OPERATIONS RISKFINANCIAL RISKEMPOWERMENT RISKCustomer SatisfactionLeadership Interest RatePriceHuman ResourcesAuthority/LimitCurrencyProduct DevelopmentOutsourcingEquityEfficiencyPerformance IncentivesCommodityCapacityChange ReadinessFinancial InstrumentPerformance GapCommunicationsCycle TimeCash FlowLiquiditySourcingINFORMATION PROCESSING/Opportunity CostObsolescence/ShrinkageTECHNOLOGY RISKConcentrationComplianceRelevanceBusiness InterruptionIntegrityDefaultProduct/Service FailureCreditAccessConcentrationEnvironmentalAvailabilitySettlementHealth and SafetyInfrastructureCollateralTrademark/Brand Name Erosion
INTEGRITY RISKManagement Fraud Employee FraudIllegal ActsUnauthorized UseReputation
STRATEGICFINANCIALEnvironmental ScanOPERATIONALBudget and PlanningBusiness PortfolioPricingAccounting InformationValuationContract CommitmentFinancial Reporting EvaluationPerformance MeasurementPerformance MeasurementTaxationOrganization StructureAlignmentPension FundResource AllocationRegulatory ReportingInvestment EvaluationPlanningRegulatory ReportingLife Cycle
c:\convert\temp\52117992.doc Last modified on: 1/98?1999 Arthur Andersen. All rights reserved.
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ENVIRONMENT RISK Competitor Sensitivity Shareholder Relations Capital Availability Catastrophic Loss Sovereign/Political Legal Regulatory Industry Financial Markets
Environment risk arises when there are external forces that could significantly change the
fundamentals that drive a company’s overall objectives and strategies and, in the extreme,
put a company out of business.
Environment risk arises from failure to understand customer wants, failure to anticipate or
react to actions of competitors, overdependence on vulnerable suppliers, etc. As competitive
advantage and the ability to sustain it become increasingly temporary, management's
assumptions about the business environment provide a critical starting point for formulating
and evaluating business strategies. These assumptions include the strategic profile of major
competitors, demographic and social trends, new technologies that provide opportunities for
competitive advantage, and economic, political, and regulatory developments. If key
managers do not have a common understanding of the key environment risks, the company's
strategic objectives will not be focused. The consequences will be severe -- loss of market
share and competitive advantage. Because the high stakes of strategic error, management
must have assurance that the key environmental assumptions on which its strategy is based
are consistent with reality.
Major competitors or new entrants to the market take actions to establish and sustain
competitive advantage over the company or even threaten its ability to survive.
These actions include issuance of new products to market, improving product quality,
increasing productivity and reducing costs, and reconfiguring the value chain in the
eyes of the customer. Superior competitor performance in the marketplace (e.g., in
terms of superior quality, low cost provider capability, or faster response time) will
also result in loss of competitive advantage.
Sensitivity risk results when management commits the company's resources and
expected cash flows from future operations to such an extent that it reduces the
company's tolerance for (or ability to withstand) changes in environmental forces that
are totally beyond its control. For example:
? Unfavorable changes in competitor capabilities, interest rates, currency rates,
inflation, capital markets, international trade and other economic conditions
that are closely tied to the business cycle (e.g., housing starts, consumer
demand for durables, etc.) can adversely affect and even threaten the very
survival of a company that is highly leveraged or has no exploitable
c:\convert\temp\52117992.doc Last modified on: 1/98? A company's strategy to grow rapidly, expand geographically and invest in
significant high risk ventures can increase its sensitivity exposure to
unexpected economic, regulatory and market developments.
? Systemic risk for financial institutions is a form of sensitivity risk. It is the risk
that financial difficulties in one financial institution or a major market
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disruption will cause uncontrollable financial harm to other institutions or
prevent the effective operation of the financial system generally. The result is
financial loss for significant uninsured depositors and other companies that
have a stake in financial institutions that fail as a result of an uncontrollable
chain reaction in financial markets that basically thrives on the expectation of
Sensitivity risk also results when an organization is too inflexible to change in
response to changes in the environment. If a company's business processes cannot be
aligned to satisfy customer wants and meet the challenges of changing technological
advances, unexpected competitor actions or other external environmental changes, its
ability to compete and survive will be significantly affected.
Shareholder Relations Risk
A decline in investor confidence which impairs a company's ability to efficiently raise
capital. Current and prospective investors do not understand the company and its
core messages and strategies. As a result, they do not have the necessary confidence
in the company's potential to provide sufficient returns on their investment. The
consequences can be severe -- the company will not have the same efficient access as
competitors to the capital it needs to fuel its growth, execute its strategies, and
generate future financial returns.
Lower stock valuations can have several consequences:
? Higher cost of capital and lower shareholder wealth. ? Stock options will not provide adequate compensation to executives. ? Stock will not provide an attractive non-cash alternative for acquisitions. ? Increased dilution from stock acquisitions.
? Greater vulnerability to takeovers.
Capital Availability Risk
The company does not have efficient access to the capital it needs to fuel its growth,
execute its strategies, and generate future financial returns. This can result in a
competitive disadvantage if the company is highly leveraged or its major competitors
have larger cash reserves, a lower cost structure, greater market share, or access to
capital through strategic alliances.
Catastrophic Loss Risk
The inability to sustain operations, provide essential products and services, or recover
operating costs as a result of a major disaster. The inability to recover from such
events in a world class manner could damage the company’s reputation, ability to
obtain capital, and investor relationships.
There are two sources of catastrophic losses:
? Uncontrollable -- Disasters from war, terrorism, fire, earthquake, severe c:\convert\temp\52117992.doc Last modified on: 1/98
weather and flooding and other similar events are completely beyond the
control of the company. However, their effect on the company’s assets and
operations can be managed.
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? Controllable -- Environmental disasters, pervasive health and safety violations,
spectacularly large underwater real estate deals, incredibly high litigation
costs, huge losses from derivatives, massive business fraud, and significant
losses in market share because of failure to abandon strategies that no longer
work can be as catastrophic in their effects on a business as an uncontrollable
disaster; however the business activities that contribute to these losses are
within the control of the company.
Catastrophic loss exposure means different things to different industries and
businesses, depending on where the bulk of the exposure is. For example:
? For a fast-foods restaurant, the primary focus is on preventing injuries from
the process of preparing and serving food, because that is where the primary
costs of risk are.
? For an electric utility operating a nuclear power facility, compliance with all
standard plant operating procedures and safety regulations is paramount. ? For an auto manufacturer, product liability claims from exploding fuel tanks,
unpredictable transmissions, and inability to protect occupants from crashes
are key concerns.
? For companies trading in derivatives for profit or to hedge financial risks, fears
of an “Orange County” or “Barings” scenario can create considerable unrest
unless driven out of the organization with effective policies and controls. ? For professional services providers, exposure to professional liability and
“deep pocket” litigation under tort laws are of major concern.
? For health care firms, malpractice claims from pharmaceutical products and
professional services are the primary focus.
? For airlines, aircraft maintenance and pilot competence are significant
priorities because of the concern for passenger safety and the high publicity
given to industry safety records.
? For chemical firms, fire prevention and environmental risks can keep
management awake at night.
Breakdowns in any of these areas can threaten the very survival of the business. The
risk of catastrophic losses occurring overlaps with other business risks that relate
more specifically to the potential for adverse events, i.e., product/service failure,
environmental, health and safety, and derivative risks.
The risk of adverse consequences through political actions in a country in which a
company has made significant investments, is dependent on a significant volume of
business or has entered into an agreement with a counterparty subject to the laws of
that country. For example, possible nationalization, expropriation of assets without
compensation, currency blockage or other restrictions could result in significant losses c:\convert\temp\52117992.doc Last modified on: 1/98
to the company.
Sovereign risk is a reflection of a country's financial standing in the world community
and, to some degree, a function of the country's political stability and historic
performance in meeting its international financial obligations. The greater the
probability a government may impose foreign exchange controls, thus making it
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impossible for a counterparty or foreign subsidiary to honor its commitments, the
greater is the sovereign risk. For example;
? An issuer may be barred by its government from making interest and
principal payments on its debt.
? A counterparty to a derivatives contract (i.e., a swap) is barred by its
government from fulfilling its swap obligations. Legal Risk
The risk that a company's transactions, contractual agreements and specific strategies
and activities are not enforceable under applicable law. Changes in laws and
litigation claims and assessments can also result in increased competitive pressures
and significantly affect a company's ability to efficiently conduct business. For
example, uncontrolled litigation and punitive damages can cause tremendous
uncertainty in decision making and create potentially unacceptable liabilities for
Regulatory Risk Changes in regulations and actions by national or local regulators can result in
increased competitive pressures and significantly affect a company's ability to
efficiently conduct business. For example, regulators can significantly change the
rules of the marketplace and thrust entire industries into a vastly different
competitive environment (e.g., deregulation).
Industry risk is the risk that the industry will lose its attractiveness due to changes in
? Key factors for competitive success within the industry, including significant
opportunities and threats.
? Capabilities of existing and potential competitors. ? Company's strengths and weaknesses relative to present and future
There are also other risks that can be broadly categorized under "industry risk"
because they tend to affect different industries in different ways:
? Demographic Risk -- The risks that demographic trends will affect the
industry's customer base and work force.
? Social/Cultural Risk -- The way people live, work and behave as consumers
can affect the industry's products and services. For example, more women in
the workplace, concerns about drug abuse, increasing crime rate, increased
health consciousness, etc.
? Ecological Risk -- Concerns about acid rain, global warming, recycling, waste
c:\convert\temp\52117992.doc Last modified on: 1/98management, and energy conservation can lead to substantial changes in the
way businesses within an industry operate.
? Natural Disaster Risk -- Severe weather, flooding, earthquakes and other
natural disasters affect most industries, some more directly than others. For
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example, weather affects market demand for gas and electricity. Inclemental
weather that is out-of-season also adversely affects the citrus industry.
Financial Markets Risk
Financial markets risk is defined as exposure to changes in the earnings capacity or
economic value of the firm as a result of changes in financial market variables (e.g.,
currency rates) which affect income, expense or balance sheet values. These variables
(1) The market price of financial instruments (e.g., investment securities, foreign
currency debt instruments, or commodities)
(2) Market rates which influence income and expenses (e.g., interest rates); or
(3) An index (e.g., a stock market index) which can affect either the price of a
financial instrument or the value of a commercial transaction such as export
Financial market exposures can result in substantial losses if the exposures are
unhedged or imperfectly hedged. Financial markets risk can be incurred in a number
of different ways:
? Yield Risk -- Exposure to changes in earnings as a result of fluctuations of
market factors (e.g., interest rate changes, currency fluctuations, etc.) which
affect income from unhedged assets or the cost of unhedged liabilities
(including executory contracts and other contingent exposures).
? Price Risk -- Exposure to changes in earnings or net worth as a result of price
level changes, including:
? Adverse movements in revenues or expenses due to the impact of
financial market factors on prices (e.g., the impact of currency
fluctuations on export sales);
? Adverse changes in competitive position due to changes in financial
market indices (e.g., an uncompetitive cost structure due to high cost
fixed rate debt in a low interest rate environment); and
? Adverse changes in asset or liability values as a result of financial
market fluctuations (e.g., revaluation of overseas subsidiaries). ? Credit Risk -- The exposure to actual loss or opportunity losses as a result of
deterioration in a counterparty’s ability to honor its obligations. Credit risk
? The default (or the failure to perform) by an economic or legal entity
with which the company does business;
? The loss or opportunity cost as a result of the failure of a counterparty
or customer to honor its obligations in a timely manner; and
c:\convert\temp\52117992.doc Last modified on: 1/98? A change in the risk premium on securities issued by an entity due to a
change in the market’s perception of that entity’s creditworthiness.
? Liquidity Risk -- Exposure to loss resulting from the inability to convert assets
(e.g., investment securities, receivables, inventories) to an equivalent cash
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value, or to raise unsecured funding, in a timely and cost-effective manner. It
may arise due to:
? An illiquid or thinly-traded market (e.g., the small size of a securities
? Gaps in price information and/or market participation (e.g.,
unexpected changes in market conditions due to the failure of a large
financial institution); and/or
? Constraints on the organization’s ability to hold and carry an asset
leading to conversion of an investment to cash, divestiture of an asset,
exit from an investment position or execution of an offsetting hedge
under unfavorable market conditions.
? Systemic Risk -- Exposure to loss as a result of a major market disruption
which adversely affects all participants in that market (e.g., the inability to
repatriate funds held in a foreign country due to the failure of its financial
markets and/or banking system).
? Legislative / Regulatory Risk -- Exposure to actions by legislators and
regulators which affect the market value of a financial instrument (e.g.,
changes in tax or accounting treatment of financial instruments).
? Complexity Risk -- Exposure to loss resulting from entering into complex
transactions, the structure and pricing of which are not completely
Financial market exposures are a major risk management concern for company’s with
investment portfolios, such as insurance companies, financial institutions, investment
companies and commercial enterprises with large portfolios.
Process risk is the risk that business processes:
? Are not clearly defined, ? Are poorly aligned with business strategies,
? Do not perform effectively and efficiently in satisfying customer needs,
? Do not add to shareholder wealth or ? Expose significant financial, physical and intellectual assets to unacceptable losses,
risk taking, misappropriation or misuse.
Process risks include:
? Operations Risk -- The risk that operations are inefficient and ineffective in
satisfying customers and achieving the company's quality, cost and time
c:\convert\temp\52117992.doc Last modified on: 1/98? Empowerment Risk -- The risk that managers and employees:
? Are not properly lead,
? Do not know what to do (or how to do it) when they need to do it,
? Exceed the boundaries of their defined authorities,
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? Do not have the resources, training and tools necessary to make
effective decisions, or
? Are given incentives to do the wrong thing.
? Information Processing/Technology Risk -- The risk that the information
technologies used in the business are not efficiently and effectively supporting
the current and future needs of the business, are not operating as intended, are
compromising the integrity and reliability of data and information, are
exposing significant assets to potential loss or misuse, or threaten the
company’s ability to sustain the operation of critical business processes.
? Integrity Risk -- The risk of management fraud, employee fraud, and illegal
and unauthorized acts, any or all of which could lead to reputation
degradation in the marketplace or even financial loss.
? Financial Risk -- The risk that cash flows and financial risks are not managed
? Provide adequate liquidity to meet the firm’s obligations,
? Manage currency, interest rate, credit and other financial risks in a
manner that is consistent with the business objectives of the firm, and
? Move cash funds quickly and without loss of value to wherever they
are needed most.
The interdependencies of processes within a business and with customers and suppliers are a
contributing factor to process risk. Deficient outputs from one business process are deficient
inputs to another.
OPERATIONS RISK Customer Satisfaction Human Resources Product Development Efficiency Capacity Performance Gap Cycle Time Sourcing Obsolescence/Shrinkage Compliance Business Interruption Product/Service Failure Environmental Health and Safety Trademark/Brand Name Erosion
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Customer Satisfaction Risk
The company's processes do not consistently meet or exceed customer expectations
because a lack of focus on the customer. The consequences of dissatisfied customers
are severe -- permanent loss of repeat business, declining revenues, and loss of market
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share. Without a constant drive toward customer satisfaction and continuous
improvement, the company will neither understand nor accept the product
characteristics or service elements necessary to remain competitive and will fail to
improve its products and processes. If a company does not focus on the root causes
of customer dissatisfaction, long-term growth is impossible and survival doubtful.
Human Resources Risk
The personnel responsible for managing and controlling an organization or a business
process do not possess the requisite knowledge, skills and experience needed to
ensure that critical business objectives are achieved and significant business risks are
reduced to an acceptable level.
Product Development Risk
The company's product development process creates products that:
? Customers do not want or need,
? Are priced at a level customers are not willing to pay, or ? Meet a need but are late in reaching the market that a competitor reached first.
The productivity of the product development process is significantly less than more
innovative competitors who are able to achieve higher productivity through a
stronger customer focus, concentrating focused resources and faster cycle time.
The process is inefficient in satisfying valid customer requirements resulting in higher
than competitive costs, e.g., significant gaps are identified when the cost of process
activities is compared with costs incurred by world class performers.
Capacity risk has several dimensions:
? The effective productive capacity of the plant is not fully utilized, resulting in
spreading fixed costs over fewer units and creating higher unit costs and lower
? The effective productive capacity of the plant is not adequate to fulfill
customer needs and demands, resulting in lost business. Performance Gap Risk
A business process does not perform at a world class level because the practices
designed into the process are inferior. When compared to competitors or best of class
performers, there is an unfavorable performance gap because of lower quality, higher
costs, or longer cycle times. When customers discover the alternatives provided by
superior performing competitors, they cease to purchase the company's products.
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Cycle Time Risk
Elapsed time between the start and completion of a business process (or activity
within a process) is too long because of redundant, unnecessary and irrelevant steps.
Cycle time can be measured for all operations, e.g., order entry, production, delivery,
product design, etc.
Cycle time risk has many forms. For example:
? If competitors using time as a strategic weapon can pose a formidable threat if
they significantly alter the cost structure of the value chain to the end user.
Total cycle time reduces the need to tie up cash, liberating funds for growth
opportunities. For example:
? Cutting the cycle time of product design and development by half or
better will double the productivity of research and development
investments and open larger windows of opportunity in the market.
? A company moving to larger machines and facilities to achieve cost
economies may not be able to compete with time-based competitors
that shorten their manufacturing cycle times by using smaller machines
and smaller run sizes that are optimized to fulfill the demands of the
marketplace rather than to achieve full capacity utilization. ? The use of Just-in-Time (JIT) reduces inventory and liquidity risk, e.g., the
amount of cash tied up in procuring, storing, handling and financing raw
materials, work-in-process and finished goods at any point in time.
Compressing the cycle time of ordering, receiving, handling, converting and
shipping inventory reduces liquidity risk.
? Contrary to conventional thinking, time-based competitors believe there is a
link between reducing the number of steps in a process to get the same or
better result with total quality because it reduces the number of things that can
go wrong. The result is elimination of unnecessary and redundant steps,
unneeded precision, excessive materials handling, needless delays and the
automation of as much as possible of what is left. The drive to compress the
time it takes to perform a process or an activity can create a formidable
competitive environment for companies that choose to not focus on time.
The fewer the alternative sources of the energy, metals and other key commodities
and raw materials used in a company's operations, the greater the risks of shortages
and higher costs. These risks can significantly affect the company's capability to
provide competitively priced products and services to customers at the time they are
wanted. For example:
? If the decision is made to source from foreign suppliers, the company will
either assume foreign currency risk if the seller prices in its home currency or
pay a substantial premium if the seller prices in the company's currency. c:\convert\temp\52117992.doc Last modified on: 1/98
? When engineers specify a component that can be sourced from only one
supplier from a foreign country, they expose the company to sourcing risk.
? Fewer suppliers can mean higher costs.
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