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Owning the Right Risks - Kevin Buehler, Andrew Freeman and Ron Hullme

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In the paper, "Owning the right risks", the authors, Kevin Buehler, Andrew Freeman and Ron Hullme , state that for the first 70 years of the twentieth century, corporate risk management was largely about buying insurance. There has been seen a new revolution since 1970 which has brought a drastic change in the way corporate houses approach risk management. The first of these changes occurred when companies' focus shifted from owning the most profitable or fastest-growing businesses to owning those in which they had a competitive advantage. The second change was the development of models that were able to put a value on risk transfer, changing how companies could buy, sell, and understand risk. Now these two revolutions are coming together to trigger a third in the corporate approach to risk management. These concepts have allowed the evolution of the current corporate approach to risk management in which companies are able to identify and focus on risks for which they have a competitive advantage using their knowledge of the value of different risks. The authors state that managing a company's risk portfolio in this manner can make it possible for a company to generate higher returns on their equity and use capital far more efficiently.

The approach to corporate risk management involves a five-step process that forms a dynamic cycle, as the cycle begins anew with recognized changes in risk profiles. When companies focus on the risks for which they are naturally advantaged, they can typically support higher debt levels and save on operating costs. McKinsey's Buehler, Freeman, and Hulme describe five steps to help corporate managers adjust to the third revolution which should begin at the enterprise level but is also applicable within business units. A corporation cited in the article is TXU Corporation, an electric utility in northern Texas. TXU applied this process by embracing risks for which it was competitively advantaged, actively mitigating all other risks, and dynamically managing risk capacity. Following the 2002 deregulation of wholesale and retail electricity markets in the U.S. state of Texas, TXU embarked on an ambitious risk-return restructuring program that relied on sophisticated risk-management tools to quantify its risk capacity. Over a period of about three years, TXU realized an increase of more than $32 billion in equity value and estimated that its risk-return restructuring process contributed about 75% of that value before the company was taken private in the largest leveraged buyout in history.

Step 1: Identify and Understand Your Major Risks: A company must identify its risks and gain some understanding of how those risks might work for or against it. Different people might have different opinion but it is important to focus on the handful of key risks in a company and consider the full range of outcomes and probabilities of those outcomes in order to ascertain a company's vulnerability to different risks. For most companies, there are four to six key risks that typically account for the majority of cash-flow volatility e.g. demand risk, commodity risk, country risk, operational risk, and foreign-exchange risk. Companies should be able to analyze those extreme events that, while rare, could have major impacts and identify risks that can be reassigned within a company rather than transferred to external markets.

Step 2: Decide Which Risks Are Natural: Assessing which risks are naturally owned by a company provides a clear risk strategy. If a company has a natural advantage for a given risk, it should retain that risk and possibly even acquire more, because it can create superior returns. However, risks for which a company does not have an advantage should be mitigated if there are reasonably efficient risk-transfer markets or transferred if those markets are not available.

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