Building risk: The ERM or CRO has to keep all company buildings safe and operational. Most, if not all, companies carry insurance on all real property. We will discuss the reasons later in the text. However, this represents only part of the CRO’s activities. The risk management manual should give directions for how to take care of weather-related potential damages, or losses from fires or other perils. Furthermore, the risk manager should be involved in any discussions of how to convert some building parts into income–producing opportunities. This will entail carefully assessing potential cash flow streams from reliable and careful tenants, not only from their capacity to pay potential, but also from their capacity to keep losses at an absolute minimum. The CRO or ERM takes on the capital budgeting function and computes net present values with the appropriate risk factors, as shown in Chapter 4, Evolving Risk Management: Fundamental Tools with the example of the safety belts. They need to include some risk factors to measure tenant quality in terms of both paying the rent and maintaining the properties properly.

Accounts Receivables and Notes Due: ERMs and CROs must create procedures to ensure that the accounts receivables can be collected and remain in good standing. This is key to sustainability—the ability to maintain expected cash flows. In addition, since the Fashion Apparel’s customers are from other countries, the decision of what currency to use is very important. As far as currency risk is concerned, the risk officer must negotiate with the suppliers and designers to set a mutually beneficial currency. This mutually beneficial currency will provide a very important means to pay the firm’s suppliers and global designers. The risk manager can use currency derivatives to hedge/mitigate the currency risk. Also, if the company uses credit to maintain inventory for the long term, the ERM procedures should include ways to handle interest rate risk on both sides. Such interest rate risk would affect both receivables and payments to vendors, designers, and suppliers. To ensure liquidity, many companies create interest-bearing credit lines from banks—as long as the interest rates are in line with what can be collected in the accounts receivable. The firm has to borrow money to create the cash flows to pay salaries and buy new inventory. At the same time, the firm receives interest from clients. These transactions create a need for interest-rate management while it is receiving interest from clients, there needs to be interest risk management, such as using swaps, which is explained in detail with an example in the next section of this chapter.

If used correctly, the swap derivative can act as insurance to mitigate interest rate risk. The interest rate used for borrowing and lending must make sense in terms of the management of accounts receivable and notes due on the liabilities side of the balance sheet. See Figure 5.1, “The Links to ERM with Opportunities and Risks” showing the gains and losses that can occur because of interest rate and currency risks. They can also provide opportunities if handled with appropriate risk management. Note that the ability to obtain lines of credit from banks and suppliers and extend credit to customers is an integral part of the working of the cash flow of the firm. Indeed the credit crisis of 2008–2009 occurred in part because banks and other creditors lost confidence in the counterparty’s ability to pay, and the credit markets “froze.” This led to insolvencies, declines in stock value, and a general recession.

Tools, furniture, and inventory: ERMs must take account of the traffic flow in the show room because they will want to establish sustainability and opportunities to make money. They must ensure that halls provide safety designs as well as fashion statements and innovative and creative designs to enhance visibility of the merchandise. Thus, while the risk manager is involved in avoiding or reducing losses, he/she is also involved in the opportunities. For example, it may be risky to hang some of the merchandise from the ceilings with wind tunnels that accentuate the flow of the fabrics, but it may also increase sales dramatically if the right effects are achieved. CROs must manage the opportunity risk (the chance to make money) with the appropriate risk factors as they compute the capital budget.

Accounts Payable including the Mortgage on the Buildings → Capital Structure: Until the real estate crisis of 2008, real estate investments were stable. However, the CRO, working with other managers, must decide whether to purchase large assets with debt or equity from investors. The financing method is very important and it is regarded as the capital structurecapital structureA firm’s choice between debt and equity. of the firm—the choice between debt and equity. In this company, the Apparel Designer, the building was purchased with a large mortgage (debt). The mortgage amount due is not subject to reduction unless paid. But, the buildings can decline in value, and at the same time the company’s net worth can be in jeopardy, with potentially catastrophic consequences. If our hypothetical example was a publicly traded company, it would have to show at the end of each year the true value of buildings—the market value. Under this scenario, with so much debt and so little owner’s equity, the balance sheet can show the firm as insolvent. The CRO or risk manager must address the company’s capital structure issue and point out the risks of taking large mortgages on buildings, since the properties may lose their value. The capital structure decision creates a need for managers to choose between financing property with debt versus equity. This tradeoff is a tricky one to negotiate. If the firm uses equity, it may be underinvested. If it uses debt, it runs the risk of insolvency. For example, we know that before the 2008 financial crisis, many firms used too much debt, leading to sustainability issues and liquidation, such as Circuit City.^[67]

Risks from the liabilities: The liabilities comprise mostly reserves for claims on the products sold by the life insurer. The products here are life and annuities (this insurance company does not sell health insurance). Most of the reserves are for these products. The reserves are computed by actuariesactuariesIndividuals who specialize in forecasting the losses and developing the losses’ potential future impact on the insurers., who specialize in forecasting the losses and developing the losses’ potential future impact on the insurers. Actuaries use mortality tables and life expectancy tables to estimate the future losses that the insurer must pay. Mortality tablesmortality tablesTables that indicate the percent of expected deaths for each age group. indicate the percent of expected deaths for each age group. Life expectancylife expectancyMeasure of the length of life expected for people born in each year. shows the length of life expected for people born in each year. Chapter 1, The Nature of Risk: Losses and Opportunities delves into this topic in detail. Usually, life insurance firms maintain a high level of expertise in selling products to people and categorizing them in similar risk levels. Insurance underwriters develop specialized expertise to ensure that the insurer does not sell the products too cheaply for the risks that the insurer accepts. As such, the enterprise risk manager depends on the actuarial and underwriting expertise to ensure the liabilities side of the business is well managed. If the reserve calculations miss the mark, the insurer can become insolvent very quickly and lose the capital and surplus, which is its net worth.^[68]

Risks from the asset mix: The enterprise risk manager or CRO should ensure that the insurer’s investment portfolio or asset mix can perform and sustain its value. Our hypothetical life insurer posted $1,800 million in bonds. The mix of these bonds is critical, especially during the recent 2008–2009 global crisis (described in Chapter 1, The Nature of Risk: Losses and Opportunities). The amount of mortgage-backed securities (MBS) within the bonds is very critical, especially if these MBS are nonperforming and lose their value. As it turns out, the balance sheet we provided above represents a time before the credit crisis of 2008. This hypothetical insurer held 10 percent of its bonds in MBS and half of them turned into nonperforming assets by the end of 2008. This translates into $90 million of lost assets value in 2008. In addition, the stock market collapse took its toll and the 2008 market value of the stocks decreased by 30.33 percent. Investment professionals worked with a CRO to ensure a much lower decrease than the market indexes. They ensured that the stock portfolio was more conservative. If we assume that all other liabilities and assets did not suffer any additional loss, the capital and surplus of this hypothetical insurer will be almost wiped out at the end of 2008.^[69]