Talking about risk
The UK Financial Reporting Council wants business to get serious in its conversation with investors about business risk. Vijay Krishnaswamy and Jon Hatchett tell Stephen Bouvier what these changes mean
The Financial Reporting Council, the UK’s watchdog for quoted companies, is out to raise the bar on risk management. On 6 November last year it released, for a final round of public comment, a series of tweaks to its UK Corporate Governance Code. The revamped code, it hopes, will “raise the bar for risk management by boards and communication to the providers of capital about the risks faced by companies in which they invest and how they are managed or mitigated”.
Read alongside the shake-up of disclosure requirements under IAS 19 Employee Benefits, the new FRC code is a game changer, says Vijay Krishnaswamy, head of enterprise risk management at Hymans Robertson LLP: “The FRC has proposed a number of steps for companies, their boards and auditors to take. Many of these measures are in place in financial institutions but not in corporates. In brief, the FRC wants companies to be able to identify the risks they face, articulate their risk appetite for each of them and manage them accordingly.
“So, from that starting point, companies must assess the risks that they are facing in their business model and take steps to mitigate or manage that risk in line with stated risk appetite. In particular, stress testing and scenario and sensitivity analyses can prove useful to measure the impact of risks and prioritise management attention.” Closing the circle, he adds, is a culture of risk-reporting to the company’s board. This is intended to enable management to both monitor risks and refine the company’s business model as necessary.
Krishnaswamy notes that his experience of banks has shown that rather than technical issues, it is the cultural change brought about by breaking down silos, performance measurement, incentivisation and communication of risk that has thrown up the greatest obstacles to change.
As for the 2011 amendments to IAS 19, these changes take effect for annual reporting periods beginning on or after 1 January 2013. In place of a tick-box approach to disclosure, the new reporting regime forces defined-benefit sponsors to think about risk. IAS 19 now articulates three disclosure principles. These call on sponsors to:
• Explain the characteristics of their plans and the risks they pose;
• Identify and explain how the amounts in the financial statements arising from the DB plans have emerged;
• Describe how each DB plan might affect the amount, timing, and uncertainty of the reporting entity’s future cash flows.
Jon Hatchett, a partner and head of corporate consulting with Hymans, agrees that both developments signal a move away from the traditional accounting perspective of a backward-looking, single-time-point estimate going hand-in-glove with boilerplate disclosures.
“I think the FRC document is about quantifying these risks in a clearer and more forward-looking way. This feels well aligned to the IAS 19 changes. Most analysts understand that a fall in interest rates is damaging to pension schemes, but some schemes have largely insulated themselves from this risk through their asset strategy and the current disclosures don’t bring this out.”
And the challenge of meeting those disclosures requirements is, he says, a frequent year-end conversation with clients: “There is an opportunity for companies that are managing risks actively to demonstrate that and give analysts greater clarity, insight and ultimately comfort that pensions are under control,” he says.
“In the accounts there are a lot of backward-looking numbers and very little forward-looking information over timescales relevant for pensions about issues such as how much cash the company will have to put into plan and how variable that amount could be. Where a pension scheme is material, companies ought to be disclosing the key risks to the funding position. Those risks have remained the same – interest rates, equity risk, inflation and how long people are living – but the interesting part is what companies are doing about it.
“Many companies are seriously tackling the risks by buying in liabilities to insure them, engaging in LDI strategies to manage interest and inflation risk and engaging in more active financial management. The changes to IAS 19 give companies a route to tell investors about the good things they’ve been doing; market announcements along these lines have had a positive share price impact for some already.”
As for the impact of the increased focus on risk management, both Krishnaswamy and Hatchett agree that it will be most keenly felt among outlier companies. Hatchett says: “Both the IAS 19 changes and the latest FRC proposals are going in the same direction and encouraging boards to spend more time thinking about and quantifying risk. For most FTSE 350 companies, pensions can be a financial drain but they aren’t going to bankrupt the company.
“For the vast majority of finance directors, it is simply annoying that they are having to divert serious amounts of cash to their scheme but ultimately they are affordable; a typical FTSE 350 company has a pension deficit of just one percent of its market cap.
“But there are some schemes where, if things go badly wrong, the company cannot afford to dig itself out of the hole. That is where the two changes come together, as, for these companies, pensions are a real issue in the context of their on-going solvency. The FRC proposals are about encouraging people to think about what could happen in future and paint a more vivid picture of risks.”
And Vijay Krishnaswamy warns that the increased emphasis on risk management, means companies must focus on what matters: “In my experience, people are still paying attention to the accounting. Certainly, the recent changes from the FRC and IAS 19 force boards to think about their risk appetite.
So, if you take a large industrial company as an example, some of these have huge pensions funds. But does this mean that if you make high tech gadgets you should have a high appetite for pension fund risk?
“No, because it’s not your core business. The boards of these companies should be focusing on strategic risk, or business risk (competition and prices), foreign exchange risks, reputational and operational risks. They are unlikely to want to have a high appetite for pension fund risk.” But any business that opts to de-risk, he adds, must also consider how much de-risking it can afford, as well as the timeframe over which that de-risking will happen.
Ultimately, says Krishnaswamy, companies can expect to have a much tougher conversation with investors in future: “Companies can expect investors to benchmark them against their peers, and so if one of their peers is doing something and the other isn’t, I think they have to explain why not.
“This is going to be a real wake-up call when you go beyond the story telling and put in some hard numbers. And there will be a lot more richness to these numbers than the single-time-point backward-looking estimates that we see in accounts today.”