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MONTE CARLO SIMULATION (STEP 2)

In 2008, Hans introduced Monte Carlo simulation into the process. A mathematician by education (MSc in engineering), he started defining how Monte Carlo simulation could be used in risk management. Now it's being used for three areas:[1]

1. Budget simulation. The business controllers were asked for their input about volatility, which is combined with analyses based on past performance of budget accuracy. Managers said this helped them understand the financial volatility, so it was part of the financial and budget reporting in 2012. In fact, the first analyses directed top management's attention to a sales volatility that was known but that proved to be much more significant than everyone intuitively believed. During the past two years, this approach has been refined as described by Hans: "We actually stopped this. It was found that the volatility of the business is so significant that we have stopped budgeting altogether, as the process took a lot of effort – too little value as conditions changed. Today (2014) we use an estimate process where a small team of lead controllers defines a preliminary estimate for board of directors discussions. In March (each year) we do a detailed estimate on which we base KPIs, targets, bonus criteria, et cetera. Monthly, we then update the estimate, and hence our financial planning process is more dynamic ... and we do not need the budget simulation anymore."

2. Credit risk portfolio. The LEGO Group uses a similar approach to look at its credit risk portfolio so it can have a more professional conversation with a credit risk insurance partner.

3. Consolidation of risk exposure. You could multiply the probability and impact of each risk and add the whole thing up. Risk management isn't about averages (if it were, no one would take out an insurance policy on anything). With a Monte Carlo simulation, the LEGO Group can calculate the 3 percent worst-case loss compared to budget and use that to define risk appetite and risk report exposure vis-a-vis this risk appetite, as shown in Exhibit 6.3.

  • [1] See "Using ERM to Improve Strategic Decisions," CEB Risk Management Leadership Council, Corporate Executive Board, 2013.
 
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