Economic Crisis Highlights Risk Management’s Importance to Lifespan of a Business

Risk management is not a flashy business topic – after all, making money is more exciting than saving it. Still, managing risk and avoiding problems is every bit as critical to the health of a business as creating revenue, according to a VCU professor.

Etti Baranoff, associate professor of insurance and finance in the VCU School of Business and the author of the 2003 textbook, “Risk Management and Insurance,” says the current economic turmoil demonstrates the possible consequences of relegating risk management to a place of insignificance in a business culture. Too many businesses and others failed to practice conscientious risk management in recent years, as the economy boomed and the housing market exploded, and the result was what Baranoff calls “a colossal crisis.”

Baranoff, who has completed a new version of her textbook with co-authors Pat Brockett and Yehuda Kahane, says that businesses that lose sight of risk management principles simply will not be sustainable – it is only a matter of time before their behavior catches up with them.

“If you don’t know how to manage risk for your business, then it becomes a case of one day here, one day gone,” Baranoff said.

Baranoff said sturdy risk management is not necessarily complex. It is a matter of practicing basic due diligence. For instance, the many businesses that invested in the various financial instruments built on questionable home loans overlooked something simple: loans should not be given to people who cannot afford to pay them back.

“It’s amazing what some financial institutions ignored,” Baranoff said. The result, she said, was “a party of consumption with no end.”

Baranoff researches the insurance industry and notes the particularly surprising behavior of a number of insurers. In managing risk on the loss side – earthquakes, hurricanes, fires, etc. – insurers use “unbelievable models, fantastically sophisticated models” to predict the potential losses of catastrophes and to be prepared for them. However, she said many insurers did not utilize the same caution and foresight when managing opportunity risk – the risk that their assets carried. Instead, those insurers operated on the assumption that the inventive financial instruments that had been created to produce revenue mitigated risk and did not require the basics of underwriting and risk management.

The insurers were wrong not to understand that “if the models are created on foundations that are faulty – like not having the proper underwriting – then you are negating their ability to make sure a business is sustainable,” Baranoff said.

Baranoff is a five-time winner of the prestigious Shin Research Excellence Award from the International Insurance Society. Her most recent Shin-winning paper, “Mortgage-Backed Securities and the Capital of Life Insurers: Was the Industry prepared for the Credit Crunch of 2007-08?,” was co-authored with Thomas Sager, professor of statistics at the University of Texas at Austin. The paper’s findings indicate that many life insurers were unprepared for the problems that emerged from mortgage-backed securities.

In particular, the award-winning paper demonstrated that some insurers reduced capital as they accumulated mortgage-backed securities, as though acquiring the securities raised the quality of their investment portfolios. This shows that these insurers, who typically engage in risk-reduction measures that would run counter to this, bought into the belief that these securities were of a high quality.

The study, which was released in the summer of 2008, also suggested that the full implications of the mortgage-backed securities problems on the insurance industry had not yet been seen – a view that proved prescient with the high-profile struggles of large life insurers.

Baranoff hopes the lessons of the current economic downturn reverberate and risk management assumes a more prominent place in business boardrooms in the future – as well as in business education.

“When people are taking a very high level of risk, then they must understand that everything could collapse,” Baranoff said.