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Enterprise Risk Management

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Las Vegas. Moderator. Robert F. Wolf. William M. Mercer Inc/MMC Enterprise Risk. Panelists ... swaps, forwards, options (weather, credit, FX, interest rates, ... – PowerPoint PPT presentation

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Title: Enterprise Risk Management


1

Enterprise Risk Management A Presentation
at Casualty Actuarial Society Ratemaking Seminar
March 13, 2001 Las Vegas
2
Moderator Robert F. Wolf William M. Mercer
Inc/MMC Enterprise Risk
Panelists
Robert Mackay MMC Enteprise Risk
Barry Franklin Aon Risk Consultants
Handouts Available to Download www.casact.org
3
.A decade ago
The Actuary Consulted with the Risk Manager on
Hazard Risks
4
.Today
The Risk Managers 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
5
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
of top 100
Primary Cause of Stock Drop ( of Companies)
Doesnt mean Hazard Risk isnt important.
Its being handled.
Manage-ment ineffective- ness
Competitive Pressure
Mis-aligned Products
Loss of Key Customer
RD Delays
Foreign Macro-Economic Issues
Interest Rate Fluct-uation
High Input Comm-odity Price
Law-suits
Natural Disasters
Cost Overruns
Customer Pricing Pressure
Supplier Problems
Customer Demand Shortfall
Regulatory Problems
MA Integration Problems
Accounting irregularities
Supply Chain Issues
Strategic
Operational
Financial
Hazard
Source Compustat, Mercer Management Consulting
analysis - Period Examined was June 1993 to May
1998 Note There were also 5 stock drops for
which the primary cause could not reliably be
determined. These 5 stock drops are not depicted.
6
What is ERM?
7
What is Enterprise Risk Management?
Corporate Governance?
Establishing a Chief Risk Officer?
Crisis Management?
Integrating Hazard and Financial Risks into a
Single Contract?
Never in all history have we harnessed

such formidable technology. Every
scientific advancement known to man
has been incorporated into its design.
The operational controls are sound and
foolproof.
E.J. Smith Captain, H.M.S. Titanic
8
What is Enterprise Risk Management? - EIU Survey
Selected views of ERM by Senior Management
  • 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, its 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.

EIU survey of Senior Managers conducted in
conjunction with MMC Enterprise Risk
9
So What is ERM All About?
10
ERM Is About all These Things...
  • ...But most of all, its about
  • VALUE

11
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
of top 100
Primary Cause of Stock Drop ( of Companies)
Manage-ment ineffective- ness
Competitive Pressure
Mis-aligned Products
Loss of Key Customer
RD Delays
Foreign Macro-Economic Issues
Interest Rate Fluct-uation
High Input Comm-odity Price
Law-suits
Natural Disasters
Cost Overruns
Customer Pricing Pressure
Supplier Problems
Customer Demand Shortfall
Regulatory Problems
MA Integration Problems
Accounting irregularities
Supply Chain Issues
Strategic
Operational
Financial
Hazard
Source Compustat, Mercer Management Consulting
analysis - Period Examined was June 1993 to May
1998 Note There were also 5 stock drops for
which the primary cause could not reliably be
determined. These 5 stock drops are not depicted.
12
EnterpriseRisk Management- Why?- What?-
How?
13
ERM Is Real But Why is It Timely?
Emerging Need for Enterprise Risk
Management
14
MMCs View of Enterprise Risk ManagementEnterpri
se 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
15
MMC Enterprise Risk Approach
MMC Recommends Starting with an ERM Vision
Workshop to focus an ongoing ERM Process
Identification
Analyses and Quantification
Solution Development/Implementation
ERM Vision Setting

Market Solutions
Integration
Critical Risk Diagnostic
ERM Solution Implementation
Corporate Process Solutions
Risk Management Process Redesign
of risk assessment, strategic planning, capital
allocation, and performance measurement processes
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

16
Organize A Risk Diagnostic Process to Focus on
Critical Issues
Top 10 Critical Risks
Top 10 Firm-Wide Risks
Identifying Broad Risk Issues
Revenue Or Net Income Source
Risk Maps
N A R R O W D O W N T O
Division A or Geography 1
1. 2. 3. 4. 5. 6. 7. 8. 9. 10.
1. Risk A 2. Risk B 3. Risk C 4. 5. 100. Risk
XYZ
Risk 1 Risk 2 Risk 3 Risk 4 Risk 5 Risk 6 Risk
7 Risk 8 Risk 9 Risk 10
1. Risk A 2. Risk B 3. Risk C 4. 5. 100. Risk
XYZ
1. 2. 3. 4. 5. 6.. 7. 8. 9. 10.
Division B or Geograph 2
1. 2. 3. 4. 5. 6.. 7. 8. 9. 10.
1. Risk A 2. Risk B 3. Risk C 4. 5. 100. Risk
XYZ
Division C or Geography 3
17
Analyze and Resolve Critical Risk Issues
Risk Measurement Modeling
Top 10 Firm -Wide Risks
Risk Solutions
Sample Tactics
  • Securitization
  • Sale/Leaseback arrangements
  • Trade finance
  • Asset Backed transactions
  • Project finance/Emerging Market Finance
  • Offshore/special purpose vehicles

Structured Funding
Structuring and placing funding related
products where risk mgmt is an issue
Catastrophe Modeling
Risk 1 Risk 2 Risk 3 Risk 4 Risk 5 Risk 6 Risk
7 Risk 8 Risk 9 Risk 10
  • 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)

Financial Products
Integrated Risk Modeling
Transfer of risk to third party
  • Purchased Materials
  • Labor
  • Hazard
  • Financial
  • Operations
  • Consolidation of placement information
  • Benchmarking studies
  • Risk tranching
  • Indexes for financial products
  • Creation of RMIS
  • Creation of risk banks

Risk Aggregation
Repackaging risk forfinancial products
  • Intellectual property
  • Supply chain/Just-in-Time Inventory analysis
  • Business continuation planning - single
    supplier/ plants
  • Crisis Management
  • Fraud
  • System Breakdowns
  • Unauthorized Trading

Operational Risk
Tort/Liability Modeling
Risk management and mitigation services
People Risk Modeling
  • 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

People Risk
Human capital strategies and tactical plans
  • Value Driven Business Designs
  • Brand vulnerability assessment
  • Supply chain strategy analysis/supply source
    analysis
  • Intellectual property valuation, licensing
    terms, choice analysis
  • Profit Pattern Analysis

Strategic/Brand Risk
Risk Aggregation Analysis
Organization /operational strategies and plans
18
EnterpriseRisk ManagementModeling
19
Relating A Risk Integration Model to Financial
Performance
  • Asset
  • Loss of book value/replacement value of real
    assets used to produce revenues
  • Liabilities
  • Charges for losses/risk liabilities
  • Shareholder Equity

Balance Sheet
  • 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
  • From Operations
  • Impacts on Cash Flows used to fuel business.
    (e.g. Drain other things - RD capital
    investments,...)
  • From Investing
  • From Financing ( e.g., Interest Rates)

Cash Flow
20
Relating A Risk Integration Model to Financial
Performance
Drastic Balance Sheet Impacts 1. Tornado 3. Mass
Torts 4. Accounting Error
Models Can Examine 3 Scenarios
Balance Sheet

Asset
Raw, un-hedged, un-insured exposure

Loss of book value/replacement value of real
assets used to produce revenues
  • Potential Modelling Framework - Considering
  • EPS 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


Liabilities

Charges for losses/risk liabilities

Shareholder Equity
Current set of strategies over layered on top of
exposures What does this strategy do? What is
net effect and the residual volatility?

Revenues
Income Statement

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
Cash Flow

From Operations

Impacts on Cash Flows used to fuel business.
(e.g. Drain other things - RD capital
investments)
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 Investing

From Financing

Interest Rates
We can also consider Cash Flow impacts of 1.
Variable costs 2. Catastrophic Costs
21
Structure of an Integrated Risk Model
  • The common factor model stochastically generates
  • Interest Rates
  • GDP
  • Foreign Exchange
  • Hazard Events
  • Commodity Prices

Common Factors Model
Model Input
Industry/ Company Overrides
Policy Strategy Intervention
In addition to the stochastic model input, other
assumptions and parameters are specified
The individual models calculate the results for
each stochastic trial in the model input
The results from each model are stored in a
database.
The consolidation tool collects results of
individual models to produce an integrated
distribution of results
Consolidation Model
Which is the best program?
Which risk should I manage the most?
22
Some Candidate Models - Random Walk Mean
Reverting
23
Comparison of Price PathsRandom Walk vs. Mean
Reverting Process
RW lnSt - lnSt-1 et
MR lnSt - lnSt-1 .10 ln100 - lnSt-1 et
24
Comparison of End-of-Year Price
DistributionsRandom Walk vs. Mean Reverting
Process
25
Cost Distributions - Example
26
Cost Distributions - Extreme Tail Risk
27
Examining Portfolio Effects -Combined, Summed
and Marginal Cost Distributions
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 clients
combined portfolio at the 95th percentile versus
the commodity portfolios own risk of 462
million at the same percentile. Deviation
Distribution -- shows the distribution of
deviations from budget.
28
Volatility Around Annual Expected Cost
  • Diversification / covariance effect captured
    through integration of financial risks
  • Reduces capital required to manage volatility

29
Financing Risks Via Silo Management
Enterprise Total Risk
. . .
Risk
Risk
Risk
Risk
N
3
2
1
DECISION
Retained Risk unknown
RETAIN

Premium unknown
PREMIUM
Often leads to a sub-optimal enterprise result
  • 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

30
Silo Risk Management as a Portfolio of
Interrelated Decisions
Some risks should stay in silos Some risks should
be split out from silos in which they currently
reside Some risks should be combined in larger
portfolios And, Overlay decisions may be
necessary to produce the desired result.
31
Enterprise Risk Financing - Many Possibilities
Creating Risk Aggregation Centers
Fusing Risk Together
Creating Multiple Triggers to Access Contingent
Capital
Transforming Financial Risk to Insurance Risk
Via A SPV
32
Case Studies
33
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 - RISK
  • ERM influences buyer behavior.

34
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.

35
Risk from the CFOs Perspective
36
General Risk Categories
  • Hazard/Legal Risks
  • Financial Risks
  • Operational Risks
  • Strategic Risks

37
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

38
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)

39
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
  • EO/Professional Liability

40
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

41
Imaginary Motors Risks - III
  • Strategic Risks
  • Model Selection
  • Geographic Expansion
  • Brand Image
  • Product Pricing
  • RD Investments
  • Acquisitions Divestitures

42
Case Study - Hazard Risk
43
Case Study - Hazard Risk
44
Case Study - Financial Risk
45
Case Study - Financial Risk
46
Case Study - Operational Risk
47
Case Study - Operational Risk
48
Case Study - Strategic Risk
49
Case Study - Strategic Risk
50
Case Study - Composite Risk
51
Case Study - Composite Risk
52
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.

53
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.).

54
The Benefits of ERM
55
Enterprise Risk Management Helps Organizations
Better Risk Information and Understanding
BetterRisk Management
Improved Financial Performance
  • 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
  • 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
  • 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

56
Ten Major Take-Aways
  • Be a catalyst. Challenge your management teams
    to think about risk issues impacting the
    organization.
  • Wall Street is unforgiving when your firm misses
    its earnings - Be prepared by knowing how to
    respond to risks when and if they occur.
  • Help your firms management consider and
    establish their risk tolerance for organization.
  • The goal is to avoid a future catastrophic cash
    outflow by balancing short term cash investments
    in risk mitigation financing.
  • Be careful not to shy away from risks that cannot
    be quantified. They are still risks!

57
Ten Major Take-Aways
  • Be leery of a magic black box. Determining
    total risk correlations may not be possible.
  • ERM responses may well be (need to be)
    organizational and strategic responses.
  • Dont look to do this alone. Use other parts of
    your organization.
  • 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!
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