A better way for boards to manage non-financial risk?

10 minute read  09.04.2019

The Actuaries Institute has released a report outlining a proposed approach for financial services entities to better oversee, document and manage non-financial risk which it suggests may be of particular relevance in light of issues identified by the Financial Services Royal Commission and the CBA Prudential Inquiry.  

Key takeouts

  • 'Pedalling a lot harder' won't work: In light of issues identified by both the Hayne Commission and the CBA Prudential Inquiry, many organisations will be increasing their focus on management of non-financial risk, but doing more of the same thing is unlikely to work.  
  • New approach to identifying, managing and overseeing non-financial risk: The discussion paper outlines a proposed alternative approach to managing and overseeing non-financial risk. 
  • 'a well-produced SCR by an appropriately skilled person' would deliver value to boards and management.

Benefits of the proposed approach?

  1. a means of responding to the issues identified by both the Financial Services Royal Commission and the CBA Prudential Inquiry;
  2. a means of identifying 'root causes' of issues
  3. a means to deliver better information to boards (through a more structured and systematic process)
  4. a means to streamline reporting and risk management processes
  5. potentially benefit regulators in overseeing culture (as well as boards)
  6. potentially of benefit in the context of integrated reporting

The Actuaries Institute has released a discussion paper entitled: The Social Condition Report — A suggestion for Financial Services Businesses making the case for financial services entities to commission annual, internal 'Social Condition Reports' (SCRs).  The report suggests that the adoption of annual SCRs could help boards and management teams to better identify, manage and respond to 'non-financial risks' of the kind identified by the Hayne Royal Commission and the CBA Prudential Inquiry as well as be of potential use for financial regulators in the context of overseeing non-financial risk.

The starting point

'The basic premise underlying this paper is that relationships with key groups in society are so fundamental to the success of a financial services business, and of such great value, that there should be a systematic approach to the management of those relationships, including assessment of their quality, their value, and associated risks. We propose a disciplined and structured ongoing process to report on the business’s social condition, and to recommend actions' the report states.

In addition, the paper suggests that this would be a means of better managing and overseeing non-financial risks of the type identified by both the Australian Prudential Regulation Authority (APRA) CBA Prudential Inquiry and the Hayne Royal Commission.  

What is a Social Condition Report (SCR)?

An SCR would be a comprehensive, internal, annual report to the board about the quality and value of the relationships with key groups in society.  More particularly the report would: 

  • Identify key groups in society with whom the business has a relationship.
  • Assess and measure the quality of the relationships with each key social group and how they have changed.
  • Assess the risks to those relationships, including against the board’s risk appetite.
  • Review the approach taken to manage those relationships and risks.
  • Review social relationship incidents and responses.
  • Review implementation of past SCR recommendations and their success or otherwise.
  • Make new recommendations

The proposed approach envisages use of a number of methodologies (which the writers observe may be new to a organisations) as part of this process to deliver richer information, eg Relational Analytics and Signal Analysis.

[Note: Recommendation 5.6 of Commission Hayne's final report recommended that all 'financial services entities should, as often as reasonably possible, take proper steps to: assess the entity’s culture and its governance; identify any problems with that culture and governance; deal with those problems; and determine whether the changes it has made have been effective'.]

The paper includes an example SCR to illustrate what information might be included/level of detail.  

'Social risk officer' (or other qualified person) should be responsible for the report

  • To ensure adequate time, attention and expertise are brought to bear on the process, the paper envisages that an appropriate skilled person have 'clear and sole ultimate responsibility for the SCR'. 
  • The paper envisages that the SCR would be written by a 'social risk officer' within the organisation, or by another appropriately qualified person eg an actuary.  That is, a person who is 'numerate' with a 'good understanding of the business, its products, strategy, and risk management, and not least the importance of social and cultural issues'.  The paper notes however that it is unlikely that the person initially assigned will have all the skills needed.
  • The paper suggests that were the financial regulators the Australian Securities and Investments Commission (ASIC) or the Australian Prudential Regulation Authority (APRA) to impose a requirement for an SCR, 'one can imagine them specifying the credentials of the person responsible for the SCR'.

Why doing 'more of the same' won't work?  The benefits of adopting SCR reporting

The paper observes that 'Most organisations will be thinking very intently about how to best respond to the Royal Commission and the CBA Inquiry' but expresses doubt about the likely responses, suggesting organisations are likely to continue what they are already doing: 'While it is likely that wide-ranging programs will be implemented, many responses are likely to involve being more diligent, working harder, applying more resources, improving reporting etc – basically pedalling a lot harder. We are sceptical about the effectiveness and efficiency of such approaches'.

In this context, the paper identifies a number of benefits to adopting SCR reporting. These include the following.

  • A means of identifying 'root causes'? The report would function, the paper suggests, as a means of addressing 'root causes of poor behaviour'.  'In the wake of the Royal Commission…because of the discipline and insights the SCR would provide, it could prove of great value to management and boards in identifying and addressing root causes of poor behaviour and unacceptable customer outcomes' the paper states.
  • An antidote to 'flying blind'? Streamline reporting and deliver better information to boards:  The paper observes that management in most companies will be heavily stretched in the current environment and that a fragmented approach, based on present practices will likely be inefficient.  In addition, existing practices have not served boards well. Given recent experiences, it is likely that many boards feel that they are ‘flying blind’ with respect to relationships with various members of society and associated risks.  The paper argues that adoption of the SCR will provide a 'fresh approach built on a disciplined process and new methodologies'. It will provide a 'comprehensive and integrated assessment, and propose specific actions for management, with defined objectives.  In addition, the methodologies proposed will give insights that will never come from existing practices'.
  • It would assist ASIC (as well as the board)? ASIC is being asked to be a much more active regulator, and this suggests a need to closely monitor organisations and their treatment of other parties. This will demand skills and resources which will be difficult to obtain and deploy effectively.  A comprehensive SCR produced by a well-credentialled person and supported by appropriate resources could be of real value to ASIC in identifying issues and areas of regulatory focus – both for the particular institution and for the industry. 'One could imagine ASIC imposing a requirement on financial services businesses for an annual SCR that meets prescribed standards' the paper opines. 
  • Helpful in the context of Integrated Reporting? Though the paper envisages that the SCR would be an internal document, it suggests that is could feed into Integrated Reporting (which is aimed at external reporting) as it would give valuable assessments of Integrated Reporting categories of social and relational capital.
  • The link between relationship management and social licence to operate:  The paper also links relationship management to organisation's 'social licence' which the writers define as 'the idea that certain institutions are effectively given approval to operate by society, with certain expectations being placed on the organisation'.  Though the terminology is controversial, the writers note, at the heart of the concept is the idea of trust, 'the real issue is whether society implicitly trusts the organisation and there is mutual respect in society’s dealings with the organisation' the paper states.  The paper argues that 'it is the quality of relationships that is fundamentally important, and that an organisation should focus on managing its relationships. Any social licence is inevitably a consequence of this. That is, the stronger the relationship – in particular the trust and mutual respect it engenders – the more "licence" society provides'.

The arguments for and against the proposed approach

The discussion paper also anticipates and responds to arguments against the proposed approach, and why, on balance, the paper writers consider 'a well-produced SCR by an appropriately skilled person' would deliver value to boards and management.   

  • The proposed approach is not 'overkill' given that current approaches have failed: In anticipation of the argument that the proposed approach is 'overkill', the authors argue 'that assessment and management of relationships currently is nowhere near adequate for most financial services organisations' as evidenced by both the CBA inquiry and the Financial Services Royal Commission.  Given this, they are, the proposed approach could be a 'very effective and efficient way' of responding and could in time become 'essential work for financial services organisations'.  
  • The proposed approach is not too complex: The writes suggest that some boards may object to the proposed approach on the basis that it is too involved. The writers acknowledge that the SCR as proposed does include multiple new concepts but suggest that 'it would be quite possible to adopt the basic SCR concept and stage the adoption of the more comprehensive approach'.
  • The SCR would not impose undue burden and/or distract management from running the business: The writers anticipate that some boards may object to additional reporting and the associated processes on the basis that it could be a distraction/place additional burden on organisations.  The authors argue that currently businesses are 'primarily focused on their financial profit and loss accounts and their financial capital, and are distracted from understanding the less tangible drivers of long-term value and risk'. As such, the SCR would be a 'foundational step towards correcting the balance of management and board attention'.  They write: 'We believe producing a comprehensive SCR would actually be more efficient and effective over time than a piecemeal approach, and would likely results in better management and board decisions.  Additionally, weak and poorly understood relationships often create friction that diverts management resources. Assuming that the SCR leads to better relationships, this will free up management attention to focus on key issues'.
  • Relationships are already managed using the existing net promoter score (NPS): The authors suggest one objection to the proposed approach may be that the proposed methodologies (Relational Analytics and Signal Analysis) are unproven while the Net Promoter Score (NPS) is already in use and is simple.  They argue that though the NPS is a simple and easy to understand measure, its limitations are being increasingly realised.  For example: a) the fact that it is 'backward looking' is unhelpful in flagging emerging issues; b) the NPS (including the ‘relationship’ NPS measure) is more focused on customer experience and service, rather than the broader underlying foundational conditions of the relationship; and c) NPS is also a 'one-way measure', and therefore ineffective in identifying organisational ‘blind spots’. By contrast, the authors argue that the proposed methodologies address a number of these concerns.  They also note that there are also a variety of other relationship survey methodologies that could be considered.
  • The proposed approach places too much emphasis on the average: The authors note that one criticism that could be made of the proposed approach is that it places excessive emphasis on the 'average' position.  They observe that the Hayne Commission gave 'ample evidence of how poorly some customers can be treated while the average was unremarkable'.  The authors acknowledge that this is a limited in the mock/example SCR but note that 'future work would involve analysis of the distribution of results, including assessment of the weakest relationships'. 
 

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https://www.minterellison.com/articles/overview-actuaries-institute-discussion-paper-the-social-condition-report