Firms may have reason to consider that a liability is emerging, but don’t have to recognise it in the accounts unless:
- a present obligation (legal or constructive) has arisen as a result of a past event (the obligating event),
- payment is probable (‘more likely than not’), and
- the amount can be estimated reliably.
Every firm will have its own method of making these judgements. This in turn will be influenced by their risk management philosophy. They should offer these judgements to the auditor for an independent view.
As an emerging risks regime is put in place and develops experience, there will be false positives which would show up on the bottom line. This would tend to lead to marginal judgements becoming hardened into “not yet, if ever”. A conservative view of emerging liabilities is entirely justifiable. Over time, money tied up by false positives would be released, again a matter of judgement and strategy.
While it therefore seems unlikely that major corporates and their insurance brokers would as a norm enthusiastically invest in identifying and evaluating emerging liability risks, their insurers would do so. Better for the insurers to know and take steps before the loss manifests.
Shareholders might want their corporate to take a more reasoned line: deciding what to do about a risk only after it has been identified and evaluated, not as a result of some default conservative response. They should express their view of risk tolerance and risk appetite.
As with all things, there will be an optimum degree of searching for emerging risks. Corporate systems should be designed so that they seek feedback and respond to it. False positives and false negatives would be quite normal but risk appetite should be the deciding factor in determining the right balance between them.
One of the weak points in the above approach is the requirement that the amount of any liability be estimated reliably. Most such estimates are based on an experience system. If there is no experience then traditional actuarial approaches cannot be used. Other methods would be needed. Fortunately for many forms of emerging risk there are adequate methods. The shareholders should specify the acceptable precision of all estimation methods.