Post on 20-Jan-2016
Enterprise Risk Management
A Presentation at
Casualty Actuarial Society RatemakingSeminar
March 13, 2001Las Vegas
ModeratorRobert F. Wolf
William M. Mercer Inc/MMC Enterprise Risk
Panelists
Robert MackayMMC Enteprise Risk
Barry FranklinAon Risk Consultants
Handouts Available to Download : www.casact.org
….A decade ago
The Actuary Consulted with the Risk Manager on Hazard Risks
Self-Insured Retention Analysis
ConsiderationsCost of Capital
Cash Position and Opportunity CostsCredit Capacity
Need for Admitted Carrier PaperCost Predictability/Risk Appetite
Market Premium AssessmentLoss Control Incentives
Propert/Casualty Loss Costs
Tools5-10 Year Pro-Forma ModelsDynamic Financial Modeling
Scenario Testing
Conclusions & RecommendationsEstimated Costs/Benefits
Optimum Strategy
Compliance IssuesIRS Rules
State &/or Domiciliary LawsAccounting Standards
Actuarial Standards of Practice
Goal is tooptimize riskretention/cost
benefits
Alternative StrategiesRisk Retention Levels
•Alternative Risk Financing Techniques
•Hedges
….Today
The Risk Manager’s Role expanded beyond that of an insurance buyer,but rather to to optimize/consolidate the risk strategy under one integrated program.
Rise of Chief Risk Officer
24
12
76
4
21 1 1
11
7 76
32
10 0
0
5
10
15
20
25
Cost Overruns
Accounting irregularities
Manage-ment
ineffective-ness Supply
Chain Issues
Competitive Pressure
M&A Integration Problems
Mis-aligned
Products
Customer Pricing Pressure
Loss of Key
Customer
Supplier Problems
R&D Delays
Customer Demand Shortfall
% of top 100
Regulatory Problems
Strategic Operational Financial Hazard
Foreign Macro-
Economic Issues
Interest Rate Fluct-uation
High Input
Comm-odity Price
Law-suits
Natural Disasters
Primary Cause of Stock Drop (# of Companies)
Source: Compustat, Mercer Management Consulting analysis - Period Examined was June 1993 to May 1998Note: There were also 5 stock drops for which the primary cause could not reliably be determined. These 5 stock drops are not depicted.
How Does Risk Manifest Itself?
Fortune 1000 Group Analysis10% of the Fortune 1000 companies suffered a loss of over 25% of shareholder value within one month
Doesn’t’ meanHazard Risk isn’t important.
It’s being handled.
What is ERM?
What is Enterprise Risk Management?
Vienot CommitteeMarini ReportLevy-Long Committee
Corporate Governance Forum of Japan
Code of Best PracticeKing ReportStakeholder CommunicationReport on Effective Systems of InternalControl
Draghi Commission
Toronto Stock Exchange CommitteeCanadian Securities CommitteeAllen Committee ReportCanadian Institute of CharteredAccountantsKPMG Peat Marwick Survey
Gesetz zur Kontrolle undTransparenz imUnternehmensbereich- Bill on TheControl And Transparency ofCompanies KonTraG BillCadburyRuttermanGreenburyHampelTurnbull
Blue BookCompany Law ReviewBest Practice Statement ofmanagement discussion and analysisStock Exchange ListingNew Accounting Standards
Commission on Corporate GovernanceThe Stichting Corporate Governance
Business Round TableStock Exchange CommissionBlue Ribbon CommissionCalpersCorporateGovernanceProgramme
Corporate Governance?
“Never in all history have we harnessedsuch formidable technology. Everyscientific advancement known to manhas been incorporated into its design.The operational controls are sound andfoolproof.”
Crisis Management?
Hazard
+
Finance
=
Risk Fusion®
Integrating Hazard and Financial Risks into a Single Contract?
Chief Risk Officer
Oil TradingRisk
ManagementNatural Gas
TradingElectricityTrading
Establishing a Chief Risk Officer?
E.J. SmithCaptain, H.M.S. Titanic
What is Enterprise Risk Management? - EIU Survey
• “ERM assesses and manages all risks while looking for upsides in identifying risks.”• “The goal of Enterprise Risk Management is to understand all of the risks on a
quantitative and intuitive level and to manage them through a central risk area - to take advantage of the synergies of managing risk in one area.”
• “Enterprise Risk Management is about information and capital management.”• “Good risk management is reflected in share price indirectly, but the market is not
giving a premium for ERM yet, it’s still too new.”• “The ultimate goal of Enterprise Risk Management is preservation of shareholder
value.”• “Managing risk enterprise wide means two things: bringing all the pieces of the
enterprise together to add the exposures, and using the whole enterprise to manage risk - making sure at the corporate level that all the different oversight departments are working together.”
• “The job of Enterprise Risk Management is figuring out where the edge of the cliff is, and making sure the risk takers know where it is.”
Selected views of ERM by Senior Management:
EIU survey of Senior Managers conducted in conjunction with MMC Enterprise Risk
So What is ERM All About?
...But most of all, it’s about
VALUE
ERM Is About all These Things...
24
12
76
4
21 1 1
11
7 76
32
10 0
0
5
10
15
20
25
Cost Overruns
Accounting irregularities
Manage-ment
ineffective-ness Supply
Chain Issues
Competitive Pressure
M&A Integration Problems
Mis-aligned
Products
Customer Pricing Pressure
Loss of Key
Customer
Supplier Problems
R&D Delays
Customer Demand Shortfall
% of top 100
Regulatory Problems
Strategic Operational Financial Hazard
Foreign Macro-
Economic Issues
Interest Rate Fluct-uation
High Input
Comm-odity Price
Law-suits
Natural Disasters
Primary Cause of Stock Drop (# of Companies)
Source: Compustat, Mercer Management Consulting analysis - Period Examined was June 1993 to May 1998Note: There were also 5 stock drops for which the primary cause could not reliably be determined. These 5 stock drops are not depicted.
How Does Risk Manifest Itself?
Fortune 1000 Group Analysis10% of the Fortune 1000 companies suffered a loss of over 25% of shareholder value within one month
EnterpriseRisk
Management- Why?- What?- How?
ERM Is Real But Why is It Timely?
Current Silo-Approach Flawed• Cross-company Risk
Identification• Integrated Risk Modeling• Chief Risk Officers
Emerging Need for Enterprise Risk Management
New and Larger Risks•Higher Market Value to Book Value
ratios due to Intangible Assets•New risks: demand shortfalls,
competitive pressures, etc.
New Risk Products•Integrated Risk “Books”
Growing Exponentially•Insurance/Financial
Convergence
Increased Management Accountability • New Regulations: Corporate Governance• Shareholder Expectations for Transparency/ Management Process
MMC’s View of Enterprise Risk Management
Enterprise Risk Management is a process for identifying and prioritizing critical risks facing an organization, quantifying their impact on financial and strategic objectives, and implementing financial and organizational solutions to address them.
Emerging Best Principles:
1. Risk management is a systematic, critical-risk focused activity
2. Risk is quantified to make informed business decisions
3. Risk management is an integral part of strategic planning and budgeting
4. Pricing, capital allocation, performance measures consider potential risk as well as returns
5. Risk is not automatically avoided, but weighed against opportunity to optimize risk versus return
6. Risk mitigation/financing focuses on events and volatilities that could compromise financial and strategic objectives
MMC Enterprise Risk Approach
Goal: • High-level critical risk assessment
• Understanding of integrated effects of risks
• In-depth design and implementation of solutions to mitigate / finance risks
• In-depth measurement and modelling of critical risks
…of risk assessment, strategic planning, capital allocation, and performance measurement processes
CorporateProcess Solutions
Market Solutions
In
teg
ratio
n
Hazard Risk Analysis
Financial Risk AnalysisOperational Risk Analysis
Strategic Risk Analysis
Critical RiskDiagnostic
Identification Analyses and Quantification Solution Development/Implementation
Risk Management Process Redesign
ERM SolutionImplementation
MMC Recommends Starting with an ERM Vision Workshop to focus an ongoing ERM Process
Client Organization
MMC Enterprise Risk
Client Joint Team Approach
MMC believes the client should be left wit the ability to independently conduct Enterprise Risk Management at the completion of the project.
ERM VisionSetting
Organize A Risk Diagnostic Process to Focus on Critical Issues
Division B or
Geograph 2
Division C or
Geography 3
Risk Maps
Division Aor
Geography 1
Top 10Critical Risks
Top 10Firm-Wide Risks
Identifying Broad Risk Issues
Greaterthan75%
Severity Scale5 - Catastrophic - $100 million4 - between $25 - $100 million3 - Significant - $25 million2 - between $2 - $25 million1 - Material - $2 million
1
2
3
4
5
1 2 3 4 5
Lessthan5%
Lessthan25%
50% 75%Chance this will occur in thenext 3 years:
Probability Scale5 - Imminent / Ongoing (>75%)4 - Will Occur Regularly (75%)3 - Will Occur Occasionally (50%)2 - Unlikely (<25%)1 - Extremely Unlikely (<5%)
2P
More likely to occur
More severe
ExtremelyUnlikely
Unlikely Occasionally Regularly Imminent /Ongoing
T L
FH
E
WG 2G
K J
A
2E2C
2KB
D1. Risk A2. Risk B3. Risk C4.5.100. Risk XYZ
1. Risk A2. Risk B3. Risk C4.5.100. Risk XYZ
1. Risk A2. Risk B3. Risk C4.5.100. Risk XYZ
1. 2. 3. 4. 5. 6.7. 8. 9.10.
Risk 1
Risk 2
Risk 3
Risk 4
Risk 5
Risk 6
Risk 7
Risk 8
Risk 9
Risk 10
Major Hazard / Operational / Financial Risks
Subject to sublimits,exclusions, limits,coinsurance, deductibles,or retentions
Insured/Hedged
Can't buy / Choose not tobuyExcluded CompletelyWithin Deductible
Uninsured/Unhedged
= Single Event
$2M
$10M
$50M
$100M
Low Low/Medium Medium/HighEvery 20+ to 5 Years Every 5-3 Years Every 3-1 Years More than Once a Year
Seve
rity
Frequency
B29
B27
B27
B14
B14
B4
B4
B6B15
B15 B8
B8
B7
B9
B12
B12
B3
B3
B11
B11
B10
B10
B17
B17
B17
B17
B24
B24
B22
B23
B18
B18
B13
B16
B16
B21
B21
B20
B20
= Aggregate
Low
High
Moderate HighLow
Seve
rity
Frequency
B4
B11
B11
1
23
4567
89
10
11
12
13
14
15
1617
18
19
20
2122
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
4445
46
47
1. 2. 3. 4. 5. 6.. 7. 8. 9.10.
1. 2. 3.4. 5. 6.. 7. 8. 9.10.
Revenue Or Net Income Source
N A R R O W
D O W
N T O
Risk Solutions
IntegratedRisk Modeling
CatastropheModeling
Tort/LiabilityModeling
PeopleRisk Modeling
RiskAggregation
Analysis
• Employment related practices - process/coverage• Employee turnover and productivity analysis• External labor market assessment, simulations/projections• Customer loyalty and experience management• High impact award analysis
Structured Funding
Structuring and placing funding related productswhere risk mgmt is an issue
Financial Products
Transfer of riskto third party
Risk Aggregation
Repackaging risk forfinancial products
Operational Risk
Risk managementand mitigation services
• Securitization• Sale/Leaseback arrangements• Trade finance • Asset Backed transactions• Project finance/Emerging Market Finance• Offshore/special purpose vehicles
• Derivatives, swaps, forwards, options (weather, credit, FX, interest rates, commodities)• Non-tradable commodities• New insurance policies - NetSecure for technology• Multi-trigger products• Difficult or non-standard risks (e.g., asbestos)
• Consolidation of placement information• Benchmarking studies• Risk tranching• Indexes for financial products• Creation of RMIS• Creation of risk banks
• Intellectual property• Supply chain/Just-in-Time Inventory analysis• Business continuation planning - single supplier/ plants• Crisis Management• Fraud• System Breakdowns• Unauthorized Trading
• Value Driven Business Designs• Brand vulnerability assessment• Supply chain strategy analysis/supply source analysis• Intellectual property valuation, licensing terms, choice analysis• Profit Pattern Analysis
People Risk
Human capital strategiesand tactical plans
Strategic/Brand Risk
Organization /operational strategies and plans
Sample Tactics Risk Measurement& Modeling
•Purchased Materials•Labor•Hazard•Financial•Operations
Top 10Firm -Wide Risks
Risk 1
Risk 2
Risk 3
Risk 4
Risk 5
Risk 6
Risk 7
Risk 8
Risk 9
Risk 10
Analyze and Resolve Critical Risk Issues
EnterpriseRisk
ManagementModeling
• From Operations– Impacts on Cash Flows used to fuel business.
(e.g. Drain other things - R&D capital investments,...)
• From Investing
• From Financing ( e.g., Interest Rates)
Cash Flow
Balance Sheet• Asset
–Loss of book value/replacement value of “real” assets used to produce revenues
• Liabilities–Charges for losses/risk liabilities
• Shareholder Equity
• Revenues– Risks affecting volume,and price (e.g., interest rates, FX rates,
inflation, recession)
• Operating Costs Fixed Variable– What is expected charge? – What is volatility around expected?
• Net Income– Can we better stabilise to enhance EPS
projections/shareholder value
Income Statement
Relating A Risk Integration Model to Financial Performance
Relating A Risk Integration Model to Financial Performance
Consider Alternative Strategies/Programs
A. To achieve a better “net” effect than current strategy and same volatility.B. To determine ways to improve “net” effect and reduce resulting volatility.
• From Operations– Impacts on Cash Flows used to fuel business.(e.g. Drain other things - R&D capital investments)
• From Investing
• From Financing
– Interest Rates
Cash Flow
Balance Sheet
• Asset
– Loss of book value/replacement value of “real” assets used to produce revenues
• Liabilities
–Charges for losses/risk liabilities
• Shareholder Equity
• Revenues
– Risks affecting volume,and price (e.g., interest rates, FX rates, inflation, recession)
• Operating Costs Fixed Variable– What is expected charge?– What is volatility around expected?
• Net Income
– Can we better stabilise to enhance EPSprojections/shareholder value
Income Statement
Potential Modelling Framework - ConsideringEPS Impacts• Better/enhanced modeling of “expected” variable
costs:• Can we transfer at an efficient price?• Can we mitigate/control/prevent to reduce
charge?
• Better understanding of volatility and “worst case” outcomes considering portfolio effects:
• Does volatility matter? What is the size?• Dynamics given risk Correlations
Drastic Balance Sheet Impacts 1. Tornado3. Mass Torts4. Accounting Error
We can also consider Cash Flow impacts of1. Variable costs2. Catastrophic Costs
Raw, un-hedged, un-insured exposure
Current set of strategies over layered on top of exposuresWhat does this strategy do? What is “net” effect and the residual volatility?
Models Can Examine 3 Scenarios
DATA
PROCESS
LEGEND
IndividualModels(HR)
IndividualModels
(Pension)
IndividualModels
(Hazard)
IndividualModels
(Financial)
ConsolidationModel
CommonFactorsModel
ResultData
ResultData
ResultData
ResultData
ModelInput
Industry/CompanyOverrides
PolicyStrategy
Intervention
Total Cost Deviation Against Total Annual Expected Cost
$700m
-$500m
$100m
PackagingGrains Oils
Sugar MeatsCoffee
CombinedCommodities
Currency CombinedFinancial
DEVIATION
FROM
MEAN
ANNUAL F R E Q U E N C Y
99%
10%
90%
Mean
1%
$10m
$500m
- $10m
- $100m
-$700m
$129m $2,497m$110m$334m$11m $173m $479m $435m $4,169m $214m $4,382mMEANVALUES
CocoaDairy
SummedFinancial
ANNUAL F R E Q U E N C Y
$4,382m
$1,255m
$872m
$709m
Which risk should I manage the most?
Which is the best program?
The common factor model stochastically generates:• Interest Rates• GDP• Foreign Exchange• Hazard Events• Commodity Prices
In addition to the stochasticmodel input, other assumptionsand parameters are specified
The individual modelscalculate the results for each stochastic trialin the model input
The results from each modelare stored in a database.
The consolidation tool collects results of individual models to produce an integrated distribution of results
Kraft Foods North AmericaDistribution of Annual Purchase CostCombined Northfield1999
0%
5%
10%
15%
20%
25%
360370380390400410420430440450460470480490500510520
Annual Cost ($ MM)
5%Perc
95%Perc
Mean
OBValue
CAR = @95%
Structure of an Integrated Risk Model
• Simple model for capturing uncertainty.
• “Best guess” for price tomorrow is price today (plus any drift).
• Logarithmic form prevents negative prices (or rates); probabilitydistribution is lognormal.
• Widely used for financial time series.
• Underlying “stochastic process” for derivatives valuation, such as Black-Scholes and related methods.
Arithmetic Random Walk
St = a0 + St-1 + et
Geometric Random Walk
lnSt = a0 + lnSt-1 + et
“Drift” may be zero,positive or negative
Coefficient of St-
1 is 1
Et-1 (St) = a0+ St-1
ln= naturallogarithm
• The First Order Autoregressive or AR(1) process can be written as
Arithmetic AR(1) Geometric AR(1)
St = a0 + a1 St-1 + et lnSt = a0 +a1 lnSt-1 + et
• The price in this model is “mean-reverting”.
Geometric AR(1) can be re-written as
lnSt = (1-a1) [a0/(1-a1) - lnSt-1] + et or lnSt = [ lnM - lnSt-1] + et
• When St-1 is below (above) the long-run mean M, the expected price change is positive(negative).
• Mean reversion is fairly common for commodities and almost always used for interestrates.
a1 < 1
Some Candidate Models - Random Walk & Mean Reverting
Comparison of Sample Price PathsRandom Walk vs. Mean Reverting Process
0
50
100
150
200
250
1 3 5 7 9 11
13
15
17
19
21
23
25
27
29
31
33
35
37
39
41
43
45
47
49
51
Week
Pri
ce
Random Walk Mean Reverting Process
RW: lnSt - lnSt-1 = et
MR: lnSt - lnSt-1 = .10 [ln100 - lnSt-1] + et
Comparison of Price PathsRandom Walk vs. Mean Reverting Process
End-of-Year Distribution of PriceRandom Walk vs. Mean Reverting Process
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
40 50 60 70 80 90 100 110 120 130 140 150 160 170 180 190 200
Price
Pro
bab
ilit
y %
Random Walk Mean Reverting Process
Name Random Walk Mean RevertingMean = 103.05 100.21Std Deviation = 26.68 8.19Coefficient of Variation = 0.26 0.085% Perc = 65.75 87.2295% Perc = 152.05 114.35
Distrinution of End-of-Year PriceRandom Walk vs. Mean Reverting Process
Comparison of End-of-Year Price DistributionsRandom Walk vs. Mean Reverting Process
Name Comm 1 Comm 2 Comm 3 Comm 4 Combined Mean = 131.81 115.25 10.72 173.39 431.17Std Deviation = 10.94 10.04 1.53 6.01 18.60Coefficient of Variation = 0.08 0.09 0.14 0.03 0.04
1% Perc = 109.13 93.78 7.67 159.00 390.735% Perc = 114.70 99.52 8.40 164.10 401.7495% Perc = 150.73 132.47 13.40 183.29 462.2299% Perc = 160.66 141.00 14.86 189.58 478.31
2000
Distribution of Annual Purchase Cost ($ MM) XYZ
Cost DistributionsThis shows the commodity risk as a single portfolio consisting of 4 commodities taking into account risk reduction due to uncorrelated price movements in the 4 factors.
The Budget Value noted is approximately $20million below the expected value of the simulated distribution. Values may deviate from budget due to:- Coverage in place,- Result of consensus price forecasts or budget negotiations.
Distribution Of Annual Purchase CostsThis table shows the stand-alone cost distributions of 4 commodities. While Commodity 4 has the potential for generating the greatest extreme cost in this group, in terms of variation about expected costs, Commodity 3 is, in one sense, “riskier” than Commodity 4 given its coefficient of variation (s.d./mean) of 14% compared to 3% for Commodity 4.
XYZDistribution of Annual Purchase Cost
Combined2000
0%
5%
10%
15%
20%
25%
360
370
380
390
400
410
420
430
440
450
460
470
480
490
500
510
520
Annual Cost ($ MM)
Pro
bab
ilit
y
5% Perc
95%Perc
Mean
Budget Value
Cost Distributions - Example
The chart on the left shows the skewed distribution of the 500 highest cost outcomes. The 95% percentile is 490.45 showing that in 25 cases out of 10,000 (5% of 500) the annual purchase cost could exceed $490.45 million.
95% Tail Distribution Of Annual Purchase CostsThis table shows the 95% tail distribution of the Annual purchase cost. This distribution describes outcomes in the right hand tail, which exceed the 95% value of 462.22. The table shows that for these 500 possible outcomes (5% of 10,000), the mean annual purchase cost is 472.03 and the 95% percentile is 490.45. These statistics better help define extreme outcomes, than just the 99% percentile for the annual cost distribution (478.31).
XYZ
Name CombinedMean = 472.03Std Deviation = 8.87Coefficient of Variation = 0.025% Perc = 463.0195% Perc = 490.45
95% Tail Distribution of 2000 Purchase CostsCombined
XYZ
XYZ95% Tail Distribution of Annual Purchase Cost
Combined2000
0%
5%
10%
15%
20%
25%
30%
35%
460
465
470
475
480
485
490
495
500
505
510
515
520
Annual Cost ($ MM)
Pro
bab
ilit
y
95%Perc
Mean
Budget Value = $ 409.88 MM
Cost Distributions - Extreme Tail Risk
Name Combined Summed Marginal Combined Deviation
Summed Deviation
Mean = 431.17 431.17 431.17 21.28 21.28Std Deviation = 18.60 32.54 0.59 18.60 32.54
1% Perc = 390.73 361.54 427.70 -19.15 -48.345% Perc = 401.74 381.12 429.55 -8.14 -28.7695% Perc = 462.22 486.94 429.40 52.34 77.0599% Perc = 478.31 517.11 426.02 68.43 107.23
1 Marginal With Respect to Combined Commodity Annual Purchase Cost.
XYZDistribution of Annual Purchase Cost and Cost Deviation
1999
on a Combined, Summed, and Marginal1
Basis ($ MM)
Summed Distribution - not a true probability distribution but a hypothetical one obtained by summing the percentiles across all commodities. Summing ignores diversification created by less than perfect correlation between commodities.
Consider the impact of silo risk management and the cost of risk mitigation. Option premiums vary directly with the standard deviation of the underlying risk. If options were purchased on each commodity, then each premium would reflect individual commodity standard deviation and the sum of the premiums would reflect the Summed standard deviation of $33 million.
Combined Distribution - represents the true risk of the diversified portfolio of commodities. Note the difference in standard deviation of $19 million compared to $33 million for the Summed Distribution.
Marginal Distribution - shows the contribution of the diversified portfolio of commodities to the combined portfolio of the company.
The commodity portfolio will contribute only $429 million of risk to the client’s combined portfolio at the 95th percentile versus the commodity portfolio’s own risk of $462 million at the same percentile.
Deviation Distribution -- shows the distribution of deviations from budget.
Examining Portfolio Effects -Combined, Summed and Marginal Cost Distributions
• Diversification / covariance effect captured through integration of financial risks• Reduces capital required to manage volatility
Volatility Around Annual Expected Cost
All Risks
Currency
$(43)M
Currency
$700m
-$500m
$100m
DEVIATION
FROM
MEAN
Mean$10m
$500m
- $10m
- $100m
-$700m
CombinedTotal
Effect of Integrating
$764M
CombinedRisks (1 to8)
Integrated Risks (1 to 8)
Risk 4Risk 3 Risk 5Risk 2 Risk 6 Risk 7
99%
10%
90%
1%
$132M $115M
$332M$1M $173M
Risk 1 Risk 8
Mean
values
Individual Risks
$2.4B
SummedTotal
$1.6B
Separate Treatment
$4B$433M
$434M $4B $4B
Financing Risks Via Silo Management
• Over insurance/hedging of non-correlated and negatively correlated risks• Under insurance/hedging of positively correlated risks• Higher than understood exposure to event risk• Missed opportunities to place risks in different markets
Often leads to a sub-optimal enterprise result:
Risk NRisk 3Risk 2Risk 1 . . .
DECISION
RETAIN
PREMIUM
+
EnterpriseTotal Risk
Retained Risk“unknown”
Premium“unknown”
Silo Risk Management as a Portfolio of Interrelated Decisions
Risk NRisk 3Risk 2Risk 1 . . .EnterpriseTotal Risk
DECISION
RETAIN
PREMIUM
+
Retained Risk“known”
Premium“known”
Some risks should stay in silosSome risks should be split out from silos in which they currently resideSome risks should be combined in larger portfoliosAnd,“Overlay” decisions may be necessary to produce the desired result.
Enterprise Risk Financing - Many Possibilities
$200M Limit covers at least 5 Standard Deviations
Year 1 Year 2 Year 3
Pro
per
ty
Integrated Coverage
Pro
per
ty
Pro
per
ty
Ret
enti
on
Ret
en
tio
n
Re
ten
tio
n
Ret
en
tio
n$580.8M $585.3M $602.5M
Risk C
enter
Counterparty
Purchase Basket Option
(1) Nets Exposures(2) Retains enterprise based volatility(3) Transfers unacceptable volatility less expensively
Risk CenterAcceptsCommodityVolatility Risk
Individual Risks assumed:$34.5 premium income toRiskCenter
Fusing Risk Together Creating Risk Aggregation Centers
LesseesClient Insurer
P&I
LeasePayment
CashPayment
Sale of
Assets
Experience Account iflosses < Account at theend of the program
PremiumFinancing
Assets
Default
NPV of lease less secondarymarket sale or Residual Value
SpecialPurposeVehicle
AssetManagers
Client Lessees
Client
InsuranceCompany
Default
Transforming Financial Risk to Insurance Risk Via A SPV
Risk Event 1Machinery Breakdown
Risk Event 2Commodity
Prices
PriceaboveIndex
PricebelowIndex
Risk Event 3Auto Industry
Risk Event 3Auto Industry
Recessionby 10%
Growth by 10%
Growth by 10%
Recessionby 10%
Payout toClient
Payout toClient
No Payoutto Client
No Payoutto Client
Counter-party
X Dollar perDollar
above the Index
Counter-party
X Dollar perDollar
above the Index
Creating Multiple Triggers to Access Contingent Capital
Case Studies
Ratemaking?
• More of an account pricing issue than a technical insurance ratemaking issue.
• Of the 18 considerations listed in the CAS SOP Regarding Property & Casualty Ratemaking, ERM really directly impacts only 1 - RISKRISK
• ERM influences buyer behavior.
“Risk” per the Actuarial Statement of Principles
• Random variation from expected cost.– Reflected in cost of capital assumption.– Influences the underwriting profit provision.
• Systematic variation of estimated costs from expected costs.– Reflected in the contingency provision.
CoreBusiness
Strateg
ic
OperationalHazar
d
Financial
Capital
Cap
ital
Cap
ital
Capital
Risk from the CFO’s Perspective
General Risk Categories
• Hazard/Legal Risks• Financial Risks• Operational Risks• Strategic Risks
Case Study - Imaginary Motors
• Based on composite and rescaled individual “Big 3” data, industry information, recent press releases and some pure “guestimates”
• Quantify risks individually and aggregate• Measure “untreated” earnings impact• Determine theoretical risk capital for selected level of
earnings “protection”
Imaginary Motors -Assumptions
• Market Cap = $42.8 Billion• Net Income = $5.45 Billion (ttm)• EPS = $4.72 (ttm); Share Price = $38.12• Effective Tax Rate = 35%• Protect against the “1 in 100 year event”• Exposures can be transferred at pretax nominal cost
(expenses offset PV factor)
Imaginary Motors Risks - I
• Hazard/Legal Risks– Property
– Business Interruption
– Cargo/Marine
– Workers’ Compensation
– Automobile Liability
– General Liability
– Product Liability
– Employment Practices
– Crime
– Boiler & Machinery
– Directors & Officers
– Intellectual Property
– Product Recall
– Foreign Liability
– E&O/Professional Liability
Imaginary Motors Risks - II
• Financial Risks– Credit
– Residual Value
– ERISA/Fiduciary
– Foreign Exchange
– Commodity Prices
– Energy Prices
– Interest Rates
• Operational Risks– Warranty
– Product Recall
– Contingent Business Interruption
– Political
– Intellectual Property
– E-Commerce
– Strike/Labor Relations
Imaginary Motors Risks - III
• Strategic Risks– Model Selection
– Geographic Expansion
– Brand Image
– Product Pricing
– R&D Investments
– Acquisitions & Divestitures
Imaginary Motors Hazard Risk
0
1,000
2,000
3,000
4,000
5,000
6,000
100% 99%
90%
80%
70%
60%
50%
40%
30%
20%
10% 1% 0%
Probability of Exceedence
$Mil
lio
ns
Avg. NI
NI (Agg)
$Loss (Sum)
NI (Sum)
$Loss (Agg)
Avg. Loss
Case Study - Hazard Risk
Case Study - Hazard Risk
Risk Area Min. Mean 100 Yr. 250 Yr. Max. St. Dev CVProperty Noncat -$ 8.54$ 28.19$ 32.20$ 53.23$ 6.08$ 0.71 Wind - 11.76 203.37 268.90 648.96 40.52 3.45 EQ - 15.35 520.95 903.91 2,570.03 108.63 7.08 Flood - 5.26 103.35 200.04 820.84 29.40 5.58 Automobile Liability 4.15 13.92 98.87 159.15 214.85 16.76 1.20 General Liability 3.90 11.49 38.97 50.50 284.32 8.15 0.71 Product Liability 349.87 572.73 1,232.59 1,284.46 3,301.76 157.74 0.28 Employment Practices 1.50 7.72 25.15 29.48 99.92 4.58 0.59 Crime - 0.06 0.52 4.41 58.29 1.02 16.23 Directors & Officers - 4.63 70.42 159.94 800.08 23.40 5.05 Foreign Liability 4.03 7.70 11.97 12.81 16.29 1.50 0.19 E&O/Professional - 0.02 0.10 0.37 28.22 0.52 32.76 Hazard Subtotal 363.45 659.18 2,334.46 3,106.15 8,896.79 398.30 0.60 Hazard Portfolio 395.83 659.18 1,454.98 1,784.28 3,840.32 201.88 0.31 Portfolio Effect 32.38 (0.00) (879.48) (1,321.88) (5,056.47) (196.42) (0.30)
Simulated Loss Amounts (in $Millions)
Imaginary Motors Financial Risk
-2,000
0
2,000
4,000
6,000
8,00010
0% 99%
90%
80%
70%
60%
50%
40%
30%
20%
10% 1% 0%
Probability of Exceedence
$Mil
lio
ns
Avg. NI
NI (Agg)
$Loss (Sum)
NI (Sum)
$Loss (Agg)
Avg. Loss
Case Study - Financial Risk
Risk Area Min. Mean 100 Yr. 250 Yr. Max. St. Dev CVResidual Value 86.11$ 1,341.16$ 2,794.97$ 2,901.04$ 3,316.00$ 603.18$ 0.45 Credit (1,907.99) 513.89 1,880.30 2,049.65 2,653.43 619.73 1.21 ERISA/Fiduciary - 0.36 3.17 4.45 14.58 0.69 1.91 Financial Subtotal (1,821.88) 1,855.42 4,678.44 4,955.14 5,984.02 1,223.61 0.66 Financial Portfolio (883.83) 1,855.42 3,886.43 4,139.83 5,366.54 872.49 0.47 Portfolio Effect 938.05 (0.00) (792.01) (815.31) (617.48) (351.12) (0.19)
Simulated Loss Amounts (in $Millions)
Case Study - Financial Risk
Imaginary Motors Operational Risk
-5,000
0
5,000
10,000
15,000
20,00010
0% 99%
90%
80%
70%
60%
50%
40%
30%
20%
10% 1% 0%
Probability of Exceedence
$ M
illi
on
s
NI (Agg)
Avg. NI
$Loss (Sum)
NI (Sum)
$Loss (Agg)
Avg. Loss
Case Study - Operational Risk
Risk Area Min. Mean 100 Yr. 250 Yr. Max. St. Dev CVWarranty 3,157.93$ 3,596.38$ 3,864.48$ 3,902.22$ 4,030.41$ 115.40$ 0.03 Strike - 288.22 2,609.33 3,230.20 5,551.49 599.07 2.08 Product Recall 5.62 248.84 1,280.31 1,733.32 3,397.26 261.43 1.05 Political - 51.89 1,968.22 3,114.63 9,924.05 373.77 7.20 Intellectual Property - 21.26 115.56 170.67 803.63 26.75 1.26 Operational Subtotal 3,163.54 4,206.59 9,837.89 12,151.05 23,706.84 1,376.42 0.33 Operational Portfolio 3,264.95 4,206.59 6,984.44 7,768.32 13,976.52 761.10 0.18 Portfolio Effect 101.41 (0.00) (2,853.45) (4,382.73) (9,730.32) (615.32) (0.15)
Simulated Loss Amounts (in $Millions)
Case Study - Operational Risk
Imaginary Motors Strategic Risk
-2,000
0
2,000
4,000
6,000
8,00010
0% 99%
90%
80%
70%
60%
50%
40%
30%
20%
10% 1% 0%
Probability of Exceedence
$Mil
lio
ns
Lo
ss (
$Mil
lio
ns) Avg. NI
NI (Agg)
$Loss (Sum)
NI (Sum)
$Loss (Agg)
Avg. Loss
Case Study - Strategic Risk
Case Study - Strategic Risk
Risk Area Min. Mean 100 Yr. 250 Yr. Max. St. Dev CVPhase Out Division X 603.92$ 893.66$ 1,121.21$ 1,158.46$ 1,287.24$ 893.41$ 1.00 Invest in Division Y 909.54 1,340.50 1,681.84 1,737.39 1,945.73 1,340.36 1.00 Division Y Sales Increase (3,626.97) (2,432.76) (1,919.97) (1,858.99) (1,610.99) 893.41 0.37 Strategic Subtotal (2,113.51) (198.59) 883.07 1,036.86 1,621.98 466.70 2.35 Strategic Portfolio (1,563.68) (198.59) 449.75 516.08 780.88 293.49 1.48 Portfolio Effect 549.83 - (433.32) (520.78) (841.10) (173.20) (0.87)
Simulated Loss Amounts (in $Millions)
Imaginary Motors Composite Risk
-10,000
-5,000
0
5,000
10,000
15,000
20,000
25,000
30,00010
0% 99%
90%
80%
70%
60%
50%
40%
30%
20%
10% 1% 0%
Probability of Exceedence
$Mil
lio
ns
Avg. NI
NI (Agg)
$Loss (Sum)
NI (Sum)
$Loss (Agg)
Avg. Loss
Case Study - Composite Risk
Risk Area Min. Mean 100 Yr. 250 Yr. Max. St. Dev CVHazard Subtotal 363.45 659.18 2,334.46 3,106.15 8,896.79 398.30 0.60 Financial Subtotal (1,821.88) 1,855.42 4,678.44 4,955.14 5,984.02 1,223.61 0.66 Operational Subtotal 3,163.54 4,206.59 9,837.89 12,151.05 23,706.84 1,376.42 0.33 Strategic Subtotal (2,113.51) (198.59) 883.07 1,036.86 1,621.98 466.70 2.35 All Risk Subtotal (408.39) 6,522.59 17,733.86 21,249.20 40,209.63 3,465.02 0.53 All Risk Portfolio 3,188.68 6,522.59 10,151.33 10,988.59 15,602.11 1,229.67 0.19 Portfolio Effect 3,597.07 - (7,582.53) (10,260.61) (24,607.52) (2,235.35) (0.34)
Simulated Loss Amounts (in $Millions)
Case Study - Composite Risk
Imaginary Motors - Implications
• To protect against earnings volatility at the “1 in 100 year” level on a pretax basis:– finance $11.2 B if risks treated individually;– finance $3.6 B if risks treated as a portfolio.
• Risk finance cost difference of $76 Million.– $0.04 in after-tax EPS.– Almost $400 M in market capitalization at current P/E
multiple.
Imaginary Motors - Caveats
• Not all risks to Net Income are included.– WC, cargo, etc. due to lack of data;– general economic risks - interest rates, etc.
• “Portfolio Effect” potentially overstated– not all correlations reflected (warranty, recall and product
liability, for example);– companies may look at some risks in portfolios (integrated
insurance programs, combined aggregate excess programs, etc.).
The Benefits of ERM
Enterprise Risk Management Helps Organizations
• Quantification of risks on an integrated basis
– Examines integrated effects, especially across operating and decision silos
– Considers risks encountered by peers and by other industries
• Identification and prioritization of top critical risks
– Better manages investments and capital structures
– Focuses on business management, not crisis management
Better Risk Information and Understanding
BetterRisk
Management
• Improved risk management framework
– Controls existing risks– Helps identify and manage
changing risk profiles
• Better allocation of resources– Focuses risk management
resources on the right risks
• Improved decision making– Improves cross-functional
communication regarding risk
– Considers risks in capital budgeting and strategic planning process more effectively
– Allows cost/benefit analysis of alternative risk financing and mitigation strategies
Improved Financial
Performance
• Better avoidance and mitigation of threats to value
• Reduction of total volatility of cash flow and earnings
– Ensures sufficient internal funds for strategic investments
– Reduces likelihood of financial distress and thus the cost of financing
– Minimizes surprises for shareholders and stakeholders
• Enhanced stakeholder confidence– Improves understanding of risks
Ten Major Take-Aways
1 Be a catalyst. Challenge your management teams to think about risk issues impacting the organization.
2 Wall Street is unforgiving when your firm misses its earnings - Be prepared by knowing how to respond to risks when and if they occur.
3 Help your firm’s management consider and establish their risk tolerance for organization.
4 The goal is to avoid a future catastrophic cash outflow by balancing short term cash investments in risk mitigation & financing.
5 Be careful not to shy away from risks that cannot be quantified. They are still risks!
Ten Major Take-Aways
6 Be leery of a “magic black box”. Determining total risk correlations may not be possible.
7 ERM responses may well be (need to be) organizational and strategic responses.
8 Don’t look to do this alone. Use other parts of your organization.
9 As Plato said, “The first and best victory is to conquer self”– If you understand your company better, you have a better state of
readiness
10 ERM should exercise senior managements’ minds and make them more agile in responding to risk surprises!