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Enterprise Risk Management and Business Continuity

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Different corporate situations may indeed lead to different capital investment decisions ... Recognizes interdependencies corporate, financial, and ... – PowerPoint PPT presentation

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Title: Enterprise Risk Management and Business Continuity


1
Enterprise Risk ManagementandBusiness Continuity
  • Rick Gorvett, FCAS, MAAA, ARM, FRM, Ph.D.
  • Actuarial Science Professor
  • Departments of Mathematics and Finance
  • University of Illinois at Urbana-Champaign
  • Crisis Management Business Continuity Seminar
  • Bloomington, IL
  • October 10, 2003

2
Agenda
  • About me
  • A risky world
  • Broadening our perspective
  • Enterprise risk management (ERM)
  • Evolution
  • Current state
  • Relationship to Business Continuity
  • Conclusion

3
Who am I? Why am I here?
- Admiral James Stockdale, 1992
  • Currently
  • Professor, Depts. of Mathematics and Finance
  • University of Illinois at Urbana-Champaign
  • Prior
  • Senior Vice President
  • Director of Internal Audit Risk Management
  • Internal Audit
  • Corporate Investigations
  • Risk Management
  • Enterprise Risk Management
  • Business Continuity

4
A Risky WorldAnd it just seems to be getting
riskier!
  • Whats getting riskier about our world?
  • What isnt ?
  • Perhaps aspects of technology, medical care,?
  • Evidence of riskiness
  • Catastrophic events in a more crowded world with
    greater vulnerabilities
  • Current events
  • Books e.g., Safe Food Eating Wisely in a
    Risky World
  • Financial markets

5
Why Worry AboutInterest Rate Risk? (cont.)
Data per FRED II, St. Louis FRB, for 3-Month
T-Bills, Secondary Market
6
Why Worry AboutInterest Rate Risk? (cont.)
Data per FRED II, St. Louis FRB
7
Why Worry About FX Risk?
8
Steps in theRisk Management Process
  • Determine the corporations objectives
  • Identify the risk exposures
  • Quantify the exposures
  • Assess the impact
  • Examine alternative risk management tools
  • Select appropriate risk management approach
  • Implement and monitor program

9
The Bottom LineIt All Boils Down to Capital
  • Capital
  • Assets less liabilities owners equity net
    worth
  • Support for (riskiness of) operations
  • Thus, supports profitability and solvency of firm
  • Capital Management
  • Determine need for and adequacy of capital
  • Plans for increasing or releasing capital
  • Strategy for efficient use of capital

10
Why Do We Care About Managing Capital?
  • Leads to solvency and profitability
  • Benefits of solidity and profitability
  • Higher company value
  • Happy claimholders
  • Better ratings
  • Less unfavorable regulatory treatment
  • Ability to price products competitively
  • Customer loyalty
  • Potentially lower costs

11
The Problem With Capital
  • A certain amount of capital is needed in order to
    promote solvency
  • Thus, we need to be able to raise capital
  • But.... If there is too much capital,
    profitability (as measured by return on equity)
    will suffer
  • Thus, we need to be able to efficiently deploy
    capital

12
What Does Capital Management Entail?
Product Pricing
Financial Risk Mgt.
Raising Capital
Capital Management
Setting Objectives
Strategic Planning
Liability Valuation
Risk Management
Asset Allocation
13
Financial Theory andCapital Management
  • Why bother to worry about financing or FRM (or
    any risk management activity), in light of the
    capital structure irrelevance proposition?
  • Modigliani-Miller (1958) if financing does
    matter, it must be because of one or more of
  • Tax effects convex tax function
  • Financial distress / bankruptcy costs
  • Effects on future investment decisions

14
Capital Structure - Reality
  • Modigliani-Miller Proposition capital structure
    decision is irrelevant to firm value, under
    certain friction-free assumptions (e.g., no
    taxes)
  • But in reality, there are taxes
  • There are also costs associated with financial
    distress
  • Different corporate situations may indeed lead to
    different capital investment decisions

15
Post-FRM
Pre-FRM
16
Enterprise Risk Management
  • Or Enterprise Risk and Assurance Management
  • What is ERM?
  • Concerned with a broad financial and operating
    perspective
  • Recognizes interdependencies corporate,
    financial, and environmental factors
  • Strives to determine and implement an optimal
    strategy to achieve the primary objective
    maximize the value of the firm

17
Goals of ERM
  • Ensure business continuity
  • Enhance opportunities for the company to achieve
    its objectives
  • Create and increase company value
  • Make risk management more cost-efficient
  • Stabilize earnings

18
Evolution of ERM
  • Historically risk silo mentality
  • Mid-1990s
  • First Chief Risk Officer
  • First use of ERM terminology
  • Late-1990s
  • Risk-related regulatory requirements (e.g.,
    Turnbull)
  • Earnings protection insurance debuts
  • 2001
  • September 11
  • Corporate scandals
  • Beginning of efforts to improve corporate
    governance

19
Current State
  • Findings from various surveys
  • An acknowledged need to improve risk management
  • A recognition that a holistic approach is
    appropriate and preferable
  • ERM can improve overall capital management and
    thus enhance corporate value and competitiveness
  • A variety of approaches to improving risk
    management
  • There are still problems to overcome

20
A Paradigm Shift
  • Traditional
  • Risks managed in silos
  • Concentrates on physical hazards and financial
    risks
  • Insurance orientation
  • Ad hoc / one-off projects
  • Emerging
  • Centralized mgt., with exec-level coordination
  • Integrated consideration of all risks, firm-wide
  • Opportunities for hedging, diversification
  • Continuous and embedded

21
Types of Risks
  • Operational
  • Hazard
  • Physical
  • Strategic
  • Capital / resource allocation
  • Industry / competitors
  • Technological
  • Databases
  • Security
  • Confidential information
  • Stakeholder
  • Legal
  • Compliance
  • Regulatory
  • Financial
  • Capital markets
  • Credit risks
  • Taxes
  • Human capital
  • Retention
  • Training
  • Reputational

22
Issues in ERM Implementation
  • Different corporate cultures require different
    ERM approaches
  • Who is going to be the ERM champion within the
    company
  • Among senior executives
  • Among departments / functions
  • How to embed a risk management culture and
    responsibilities throughout the firm

23
Components of the ERM Process
  • Determine corporate objectives
  • Risk identification
  • Goal comprehensiveness
  • E.g., self-assessment
  • Risk measurement
  • Volatility measures
  • Value at Risk (VaR)

Likelihood
Impact
Likelihood
Size of loss
24
Components of ERM (cont.)
  • Assessing the impact
  • Stress or scenario testing
  • Stochastic simulation
  • Examine and select alternative risk management
    tools and techniques
  • Traditional risk transfer
  • Natural hedging / diversification
  • Integration of risks

E.g., dynamic financial analysis
25
An Analytic TechniqueDynamic Financial Analysis
  • Dynamic
  • Stochastic / variable not fixed / static
  • Reflects uncertainty
  • Financial
  • Integration of financial, operational, etc.,
    factors
  • Assets and liabilities
  • Analysis
  • An examination of a complex, its elements and
    their relations
  • Complex a whole made up of complicated or
    interrelated parts

26
Definition of DFA
  • Dynamic Financial Analysis is the process by
    which an actuary analyzes the financial condition
    of an insurance enterprise. Financial condition
    refers to the ability of the companys capital
    and surplus to adequately support the companys
    future operations through an unknown future
    environment.
  • The process of DFA involves testing a number of
    adverse and favorable scenarios regarding an
    insurance companys operations. DFA assesses the
    reaction of the companys surplus to the various
    selected scenarios. -- CAS DFA Handbook

27
Key Ideas in this DFA Definition
  • Financial condition
  • Specifically, capital and surplus
  • Future operations
  • Going concern
  • Unknown future environment
  • Uncertainty / stochastic
  • Testing a number of.... scenarios
  • Analysis across different environments
  • Assesses the reaction of.... surplus
  • Analyze acceptability of results

28
Types of DFA
  • Scenario testing
  • Projects results under specific conditions
  • Catastrophe, interest rate shift
  • Used for cash flow or stress testing
  • New York Life Insurance Regulation 126
  • Stochastic simulation
  • Models uncertainty components by distributions
  • Uses randomly selected values to calculate a
    large number of outcomes
  • Evaluate risk by proportion of unacceptable
    outcomes

29
Sample DFA Model Output
30
Keys to Success in ERM
  • Senior management commitment and sponsorship
  • Embed a risk management culture in the
    corporation at the operational level
  • Provide for accountability, both specific and
    widespread
  • Clearly defined responsibilities for coordination
    and maintenance
  • Adequate communication

31
Keys to Success inBusiness Continuity Planning
  • Senior management commitment and sponsorship
  • Provide for accountability, both specific and
    widespread
  • Clearly defined responsibilities for coordination
    and maintenance
  • Adequate communication
  • Differentiate BCP from technology disaster
    recovery

32
Conclusion
  • The revolutionary idea that defines the boundary
    between modern times and the past is the mastery
    of risk
  • - Peter Bernstein, Against the Gods
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