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Finance 590 Enterprise Risk Management

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Finance 590 Enterprise Risk Management Steve D Arcy Department of Finance Lecture 2 Risk Analytics March 28, 2006 Reference Material Chapters 8 and 9 Enterprise ... – PowerPoint PPT presentation

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Title: Finance 590 Enterprise Risk Management


1
Finance 590Enterprise Risk Management
  • Steve DArcyDepartment of Finance
  • Lecture 2
  • Risk Analytics
  • March 28, 2006

2
Reference Material
  • Chapters 8 and 9 Enterprise Risk Management by
    Lam
  • Overview of Enterprise Risk Management by the
    Casualty Actuarial Society
  • http//www.casact.org/research/erm/overview.pdf
  • Risk and Insurance by Anderson and Brown
  • http//www.soa.org/ccm/cms-service/stream/asset/?a
    sset_id8027034

3
Overview
  • Risk Control Analytics
  • Risk Optimization Analytics
  • Classification of Risk Types
  • Risk Analytics by Risk Type
  • Performance Measures
  • Risk Measures
  • Risk Modeling
  • Risk Integration
  • Characteristics of Hazard Risk
  • Insurance Terminology

4
Risk Control Analytics
  • Scenario Analysis
  • Stress testing
  • Simulation
  • Economic Capital
  • Solvency standards
  • Risk Indicators
  • External
  • Internal

5
Risk Optimization Analytics
  • Return on Capital (Financial Services Industry)
  • Risk-adjusted return on capital (RAROC)
  • Return on risk-adjusted capital (RORAC)
  • Risk-adjusted return on risk-adjusted capital
    (RARORAC)
  • Economic Income Created
  • Risk-adjusted return (Hurdle rate x economic
    capital)
  • Shareholder Value
  • Shareholder value (SHV)
  • Shareholder value added (SVA)

6
Risk Types
  • Hazard or Insurance Risk
  • Financial or Market Risk
  • Credit Risk
  • Operational Risk
  • Strategic Risk

7
Hazard Risk Management Analytics
  • Probable Maximum Loss (PML)
  • Maximum Possible Loss (MPL)
  • Loss Frequency
  • Loss Severity
  • Actuarial Models
  • Loss Distributions

8
Financial Risk Management Analytics
  • Interest Rate Models
  • Equilibrium models
  • Arbitrage free models
  • Value-at-Risk (VaR)
  • Parametric
  • Monte Carlo simulation
  • Historical simulation
  • Asset/Liability Management (ALM)

9
Credit Risk Analytics
  • Credit Scoring Models
  • Credit Migration Models
  • Credit Exposure Models
  • Credit Portfolio Models
  • Financial models
  • Econometric models
  • Actuarial models

10
Operational and Strategic Risk Analytics
  • Top-Down Approaches
  • Analogs
  • Historical loss data
  • Bottom-Up Approaches
  • Self assessment
  • Cash flow model

11
Performance MeasuresGeneral
  • Return on Equity (ROE)
  • Operating Earnings
  • Earnings before interest, dividends, taxes,
    depreciation and amortization (EBITDA)
  • Cash Flow Return on Investments (CFROI)
  • Weighted Average Cost of Capital (WACC)
  • Economic Value Added (EVA)

12
Performance MeasuresInsurance Industry
  • Economic Capital
  • RAROC
  • Expected net income divided by economic capital
  • Embedded value
  • Risk Based Capital (RBC)

13
Risk MeasuresSolvency Related
  • Probability of Ruin
  • Shortfall Risk
  • Value-at-Risk (VaR)
  • Expected Policyholder Deficit (EPD) or Economic
    Cost of Ruin (ECOR)
  • Tail Value at Risk (Tail VaR) or Tail Conditional
    Expectation (TCE)
  • Tail Events

14
Risk MeasuresPerformance Related
  • Variance
  • Standard Deviation
  • Semi-variance and Downside Standard Deviation
  • Below-target-risk (BTW)

15
Risk Modeling
  • Analytic Methods
  • Simulation Methods
  • Statistical Methods
  • Structural Methods
  • Dynamic Financial Analysis (DFA)

16
Risk Integration
  • Covariance
  • Covariance Matrix
  • Structural Simulation Model

17
Characteristics of Hazard Risk
  • Loss/no loss situations (pure risk)
  • Independence of individual exposures
  • Important for risk to be insurable
  • Types of hazard risk
  • Persons
  • Property
  • Liability

18
Insurance Terminology
  • Exposures
  • Deductibles or retentions
  • Policy limits
  • Coinsurance
  • Claims or losses
  • Incurred
  • Paid
  • Loss adjustment expenses
  • Loss frequency and severity
  • Triggers

19
Alternative Risk Transfer (ART) Terminology
  • Captives
  • Finite insurance or reinsurance
  • Insurance-linked bonds
  • Insurance securitization
  • Cat-E-Puts (Catastrophe equity put options)
  • Contingent surplus notes

20
Loss Frequency
  • Number of losses during policy period
  • Often modeled as a Poisson distribution
  • Pr(k) e-??k/k!
  • where Pr probability
  • k number of claims per year (0,1,2,...)
  • ? expected number of claims per year

21
Loss Severity
  • Size of loss given a loss has occurred
  • Variety of potential severity distributions
  • Empirical
  • Exponential (Gamma)
  • Lognormal
  • Pareto
  • Distribution characteristics
  • Non-negative
  • Positively skewed
  • Variance positively correlated with mean

22
Hazard Risk Example
  • Assume independent losses
  • Loss frequency
  • 0 80
  • 1 15
  • 2 5
  • Loss severity
  • 1,000 40
  • 10,000 30
  • 25,000 20
  • 100,000 10

23
Hazard Risk Example (2)
24
Analysis of Potential Losses
  • Expected losses 4,600
  • Maximum possible loss 200,000
  • Maximum probable loss (0.25) 125,000
  • Expected losses excess of a 100,000 retention
    1,084

25
Current State of Hazard Risk Management
  • Insurance industry has developed a high level of
    mathematical sophistication for valuing hazard
    risks
  • Alternative market has also developed for dealing
    with hazard risks
  • Key questions for organizations involve amount of
    risk to retain (deductible) and how much coverage
    to purchase (policy limits)
  • These questions begin to tie hazard risk into
    enterprise risk management

26
Conclusion
  • There is a standard approach for dealing with
    each type of risk
  • Each area has its own terminology and techniques
  • The ERM challenge is to combine these different
    approaches into a common method that can deal
    with risk in an integrated manner
  • The first step is to understand the different
    approaches
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