Risk and Capital Management
Seminar
Washington, DC
July 29, 2003
July 29, 2003
Enterprise Risk Management:
Benefit or Fad?
Scott M. Sanderson
Marsh Advanced Risk Solutions - Minneapolis
Viewpoint of the Non-Financial Company
What is the “cost” of risk

Financial companies have an explicit cost to capital of assuming risk,
others do not

Risk is often viewed in the context of the expectations of the securities
market
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For a private company, there may be no value of risk at all

Measure of success is to maximize income with little regard for
balance sheet and cash flow

Leads to a view that risk is a subjective issue to be considered, but
seldom studied, quantified or managed systematically
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What is Risk?
Essentially, the negative deviation from an expected value
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What is ERM?

Essentially the management of all risks that are embedded within an
organization’s final results

Does the ERM process include:
– Study?
– Modeling?
– Control functions?
– Sarbanes-Oxley compliance?
– A deal structure to manage multiple exposures?
– Change of operational methods?
– Consideration of risk when entering a new business?
– Consideration of risk for all activities?
– Rigorous process for discovery, measurement and management?
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What is ERM?

Essentially the management of all risks that are embedded within an
organization’s final results

Does the ERM process include:
– Study?
– Modeling?
– Control functions?
– Sarbanes-Oxley compliance?
– A deal structure?
– Change of operational methods?
– Consideration of risk when entering a new business?
– Consideration of risk for all activities?
– Rigorous process for discovery and management?
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Does Anyone Really do it?
Why Not?
– Budgets (silos)
– Can’t get blamed for another operation’s failure
– Expense
– People time
– Not important
– Its not what drives organizational value
– No explicit cost to capital
– Hard to prove return on the expenditure
– Requires more rigor than most organizations exhibit
– Too big and amorphous to effectively do anything
– Some elements are impossible to measure
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Perhaps Partial Measures are OK
– Manageable, bite-sized pieces
– Sarbanes-Oxley will be a driver, but slowly
– Easier to execute on the elements that:
Are not part of core business

Are more subject to stochastic approaches

Where there are developed markets already to manage
– The whole is simply too big to tackle and doesn’t lead to actions
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Roadblocks to Managing Enterprise Risk
– Risk are less important when they happened in the distant past
– Operating budgets – assuming that maximizing the outcomes of the parts
maximizes the whole
– Managing the silo, ignoring the farm
– Assuming risk structured can be timed for optimization (in hedging)
– Ignoring the implications of capital charges on volatility assumed
– Ignoring correlation and cause-and-effect relationships - compounding the
outcomes
– Accounting rules
– Modeling sloth – using “feel” rather than objective analysis
– Analysis paralysis
– Assuming buying insurance coverage protects risk
– Belief that future events can be forecasted
– Assumption of mean reversion
– Inability to manage to price elasticity
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Show Me the Money
Value of Covariance
Joint Distribution
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Sum of Individual Risks
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A Single Risk has a Value,
but Multiple Risks are Different
– Aggregating all risks together produce a less volatile outcome than
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the sum of the individual risks - portfolio effect
Correlation decreases the portfolio effect
What happens when an organization transfers risk?

The cost of transfer is higher than the value to the insured, even
in an efficient market

Market for transfer (insurance/hedging, etc.) is not as efficient
as desired, especially where the risk carries a differing view of
possible outcomes

Cost of transfer is therefore not appealing to a rational client
However, client can’t afford to not cover traditional areas management can’t afford to take a hit in a short time frame, even if
transfer is inefficient
Concurrently, many clients will not purchase needed coverage, if
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not a traditional exposure
Client Inefficiencies
– Management driven by:

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Inertia
Silo-centric decision processes
Last year’s and this year’s budget (and bonus formula)

Committee decisions with conflicting interests
Quarterly earnings reporting

Retirement horizon

– Resulting in:
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They are willing to insure or hedge what they have in the past
Won’t consider managing a real exposure if not in last year’s budget
Resistance to change
Won’t cover what impacts other parts of the organization
Must protect short time horizons
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What is Possible and Potentially Efficient
for an Insurer to Provide?
– Non-traded indexes and event observations (parametric
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coverages?) - Example United Grain Growers
Risk integration, like Honeywell (FX and hazard perils)
Multi-peril aggregation exposures without per occurrence
protection
Double triggers
Traditional integrated risk
Outcome guarantees on cash flow streams
Of questionable value:

Finite risk

Contingent capital

Catastrophe bonds
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Impediments for Insurers
– Have their own silos - can’t provide efficient integrated product if
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they disintegrate in the reinsurance placement
Scared of the unknown, even if measurable
Inferiority complex to investment bankers
Actuaries have a limited background in other risk types - no
confidence in the modeling outcomes
Limited understanding of the tradable markets
Limited personnel with broad risk experience beyond traditional
insurance products
Inertia
Budgets
Short time horizon
Not perceived as their business
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Example - Chemical Company
– Make many products
– Largest single product is nylon fiber
– Inputs =
Ammonia

Cyclohexane

Benzene

Propylene

Natural Gas
– No pricing power on selling price - driven by demand based and
competition, not input cost

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Example - Chemical Company
– Correlation's
Ammonia = natural gas

Cyclohexane = crude oil

Benzene = crude oil

Propylene = crude oil (maybe heating oil)

Natural Gas
In proportion, correlation to tradables = 92%
Annual cost to protect the basket = 4.7% of notional
If hedged just as gas and oil, cost to protect > 6% of notional
Client on the edge of losing investment grade credit rating
Public company
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Example - Chemical Company
Outcome
– Studied and worked with commodity buyers, risk manager, treasurer and
senior management for two years to model, quantify and prove
effectiveness
– Quoted in November, 2002 an annual rate of 4.7% on notional
– All parties agreed that this was the most efficient arrangement possible
and would have mitigated prior issues they experienced in a fundamental
way
– CFO and CEO promised the street a certain return for the coming year
– The 4.7% wasn’t in those estimates, therefore, they weren’t going to buy
– Gas and oil both spiked in 1st and 2nd quarter, 2003
– Earnings went massively negative
– Stock price went from $5.00 in October to $1.29 today
– Debt burden increased dramatically,and is now junk quality
– Long run probability of survival low
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Example - Chemical Company
Analysis and Implications
– Client studied but wouldn’t act, even though the event had happened
before. When it happened before, share price was over $15
– Evidence of the client process
– Organizational process change slowly, and the decision-making matches
that speed
– Forecasting to the street was important to management
– Easier to take a risk than to not tell a positive story to analysts
– Some people in the organizations see the value - there are visionaries
– Process didn’t fail from lack of a viable product, but has in many other
cases
– The value was there and was proven.
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Economic Basis for ERM
Modigliani and Miller - 1960’s
Hedging currency has no value - investor will diversify
Froot/Scharfstein/Stein - 1990’s
Managing risk has value by avoiding
the inability to make efficient investments
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Benefit or Fad?
– Risk has a cost and therefore managing it has a corresponding
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benefit
Looking at an organization as a financial system, rather than its
elemental parts, provides a clearer view of the risk within it
Its harder to do and harder to measure, resulting in a tendency to
avoid
Today’s integrated insurance and derivative products remain
inefficient, making the reality difficult to capture
It will be slow to evolve
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Benefit or Fad?
– Risk has a cost and therefore managing it has a corresponding
–
–
–
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benefit
Looking at an organization as a financial system, rather than its
elemental parts, provides a clearer view of the risk within it
Its harder to do and harder to measure, resulting in a tendency to
avoid
Today’s integrated insurance and derivative products remain
inefficient, making the reality difficult to capture
It will be slow to evolve
But it will be the way risk will be managed in the future
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