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Enterprise Risk Management: Hollow Tree or Giant Redwood?


Enterprise Risk Management: Hollow Tree or Giant Redwood? Midwestern Actuarial Forum Chicago March 7, 2008 Rick Gorvett, FCAS, MAAA, ARM, FRM, PhD – PowerPoint PPT presentation

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Title: Enterprise Risk Management: Hollow Tree or Giant Redwood?

Enterprise Risk Management Hollow Tree or Giant
  • Midwestern Actuarial Forum
  • Chicago
  • March 7, 2008
  • Rick Gorvett, FCAS, MAAA, ARM, FRM, PhD
  • Director, Actuarial Science Program
  • State Farm Companies Foundation Scholar in Act.
  • University of Illinois at Urbana-Champaign

  • ERM in general
  • Observations from the CAS ERM Online Course
  • Issues in advancing ERM
  • ERM as complex systems analysis
  • ERM as an evolutionary process
  • ERM as subject to behavioral patterns
  • Conclusion

Who am I? Why am I here? - Admiral
Stockdale, 1992
  • Currently
  • Director, Actuarial Science Program
  • State Farm Companies Foundation Scholar in
    Actuarial Science
  • Professor, Depts. of Mathematics, Statistics
  • 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

ERM General Thoughts
Steps in the Risk 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

An Initial ERM Comment
  • You dont become a famous writer by
  • Reading a book
  • Reading about other authors
  • Watching someone else write
  • Similarly, you dont become an Enterprise Risk
    Manager by
  • Reading a book
  • Taking a course
  • Listening to a presentation

Rather, ERM is
  • A complex process
  • involving broad-based and in-depth
    knowledge and understanding
  • requiring an appropriate corporate culture,
  • and creativity
  • born of a variety of experiences
  • and insatiable curiosity.

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

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

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.,
  • Earnings protection insurance debuts
  • 2001
  • September 11
  • Corporate scandals
  • Beginning of efforts to improve corporate

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
  • There are still problems to overcome

A Paradigm Shift
  • Traditional
  • Risks managed in silos
  • Concentrates on physical hazards and financial
  • 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

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

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

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

Size of loss
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
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
  • Clearly defined responsibilities for coordination
    and maintenance
  • Adequate communication

ERM Tries to Avoid
  • A failure of imagination.
  • - Frank Borman, in testimony to Congress,
  • responding to a question regarding the real
  • cause of the Apollo 1 fire and the resulting
  • three astronaut deaths, as dramatized in
  • HBOs series From the Earth to the Moon

Observations from the CAS ERM Online Course
CAS Online Courses
  • Originally, four modules in a Financial Risk
    Management series
  • Newest course Intro to ERM
  • First offering October 2006
  • Fourth offering January 2008
  • Course components
  • 12 lectures (PPT with voiceovers)
  • Readings, and case studies
  • Discussion forum
  • Final exam

Titles of Lectures
  • Introduction to ERM
  • ERM in Context
  • ERM in Practice
  • ERM Framework
  • Hazard Risk
  • Financial Risk
  • Operational Risk
  • Strategic Risk
  • Risk Metrics
  • Application of ERM
  • COSO Pros and Cons
  • Conclusion

Some Preliminary Observations
  • Significant But Most Difficult Risk to Quantify
  • Reputational risk
  • Quantification suggestions e.g., event study
  • Human capital
  • Operational risk
  • Strategic risk

Some Preliminary Observations (cont.)
  • Status of ERM at Company
  • Many companies have moved in the direction of ERM
  • Some are well along
  • CROs, risk committees
  • Some have a long way to go
  • Still some silo mentality
  • Focus on more immediate issues (e.g., SOX)
  • Question ERMs staying power

Some Preliminary Observations (cont.)
  • Risk Measures Alternatives to VaR
  • Economic capital
  • Measures relating risk and return (e.g., RAROC)
  • Probability of ruin
  • A few thought VaR and TVaR are reasonable and

Some Preliminary Observations (cont.)
  • Greatest Risks Faced
  • Hazard risks (particularly catastrophe and
    terrorism risks)
  • Reputational risks
  • Operational risks
  • Pricing reserving risks
  • Financial risks
  • Strategic risks

Issues in Advancing ERM
(1) Complex Adaptive System
  • A system of individual agents which interact
    and adapt / evolve to changing conditions
  • Characteristics
  • Not reducible
  • Self-organized emergence, exhibiting
  • Bottom-up rather than top-down
  • Some examples
  • Economies
  • Ecologies
  • Consciousness
  • Organizations

Complex Social Systems
  • One must study the laws of human action and
    social cooperation as the physicist studies the
    laws of nature.
  • - Human Action, Ludwig von Mises, 1949

Historical Recognition
  • He intends only his own gain, and he is in this,
    as in many other cases, led by an invisible hand
    to promote an end which was no part of his
  • - An Inquiry into the Nature and Causes of
  • the Wealth of Nations, Adam Smith, 1776

(2) Evolutionary Process
  • There are several important parallels between
    economic systems and biological evolutionary
  • Complex systems
  • Self-organized agents / individuals
  • Adaptation / natural selection
  • Emergence of order
  • Understanding the historical process helps to
    explain behavior

Biology and Economics
  • The precise mathematical relationship which
    describes the link between the frequency and size
    of the extinction of companies, for example, is
    virtually identical to that which describes the
    extinction of biological species in the fossil
    record. Only the timescales differ.
  • - Why Most Things Fail Evolution, Extinction
  • Economics, Paul Ormerod, 2005

(3) Behavioral Concerns
  • Various well-documented fallacies can cause
    inaccurate or biased estimates of values,
    probabilities, etc. E.g.,
  • Anchoring fallacy bias toward an initial value
  • Inattentional blindness concentrating in one
    area can induce blindness to other events
  • Availability fallacy immediately-available
    examples have a perhaps undue influence on our

Evaluating Probabilities
  • The information provided by advocacy groups is
  • Y-Me states that breast cancer is the overall
    leading cause of death in women between the ages
    of 40 and 55. It adds In the United States, 1
    in 8 women will develop breast cancer in her
    lifetime. This year, breast cancer will be newly
    diagnosed every three minutes and a woman will
    die of breast cancer every 13 minutes.
  • CapCure, the organization founded by Michael
    Milken to fight prostate cancer, states similar
    statistics In 2002, an estimated 189,000 men
    will be diagnosed with prostate cancer. This
    represents one new case every three minutes.
  • While the figures are accurate, some medical
    researchers are concerned by the messages they
    convey. Such statements, they say, may lead
    people to exaggerate their chances of getting and
    dying from a fearsome disease.
  • - Experts Strive to Put Diseases in Proper
    Perspective, by Gina Kolata, New York Times,

Evaluating Probabilities (cont.)
  • Even concerns about real dangers, when blown out
    of proportion, do demonstrable harm. Take the
    fear of cancer. Many Americans overestimate the
    prevalence of the disease, underestimate the odds
    of surviving it, and put themselves at greater
    risk as a result. Women in their forties believe
    they have a 1 in 10 chance of dying from breast
    cancer, a Dartmouth study found. Their real
    lifetime odds are more like 1 in 250. Womens
    heightened perception of risk, rather than
    motivating them to get checkups or seek
    treatment, can have the opposite effect. A study
    of daughters of women with breast cancer found an
    inverse correlation between fear and prevention
    the greater a daughters fear of the disease the
    less frequent her breast self-examination.
    Studies of the general population-both men and
    women-find that large numbers of people who
    believe they have symptoms of cancer delay going
    to a doctor, often for several months. When asked
    why, they report they are terrified about the
    pain and financial ruin cancer can cause as well
    as poor prospects for a cure.
  • - The Culture of Fear Why Americans are Afraid
    of the Wrong Things, Barry Glassner, 2000, Basic

  • New undergraduate research initiative at the
    University of Illinois
  • Current research projects
  • Agent-based modeling
  • Predator prey models
  • Power laws and their applications
  • Neuroeconomics and behavioral economics

ERM Predictions Lam
  • ERM will become an industry standard
  • CRO position will be prevalent
  • Audit committees will become risk committees
  • Economic capital will replace VaR
  • Enterprise-level transfer of risk
  • Impact of advanced technology
  • Measurement standard for operational risk
  • Mark-to-market accounting
  • Risk education will grow
  • Salary gap between risk professionals will widen

Enterprise Risk Management From Incentives to
Controls, James Lam, 2003
Personal Conclusions
  • ERM is a giant redwood
  • However, lets not underestimate how big a
    challenge it is
  • Even in a frictionless world, quantifying and
    codifying a holistic approach to risk management
    is an enormous task
  • Real-world realities make it even more difficult
  • But its worth the effort

Concluding Quotation
  • 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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