The Role of the ENTERPRISE in Risk Management
Richard Goldfarb, FCAS
Ernst & Young
Casualty Actuaries in Reinsurance Seminar
New York, NY
June 1-2, 2006
Discussion Outline
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What is Enterprise Risk Management?
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Alternative Views of Enterprise Risk Management
Alternative Balance Sheets
– GAAP
– Fair Value
– Market Value
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How an Enterprise Approach Can Impact Risk Management Strategies
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Three Examples
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Interest Rate Risk Management Strategy
Determining Optimal Capital Levels
Risk-Based Capital Allocation
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What is Enterprise Risk Management?
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Traditional Risk Management
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Identification
Measurement
Monitoring
Hedging and Risk Transfer
Enterprise Risk Management (ERM)
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How is this different from traditional risk management?
What is the role of the enterprise?
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Alternative Views of the Role of the Enterprise
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View #1: Wider Perspective
Applies risk management principles throughout the organization.
management” applied throughout the enterprise.

It is “risk
View #2: More Comprehensive Perspective
Ensures that risk measurements reflect all sources of exposure to a given risk.
It is “risk management” applied at an aggregate level within risk categories.
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View #3: Portfolio Perspective
Emphasizes the interactions of risks.
aggregate level across risk categories.
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It is “risk management” applied at an
View #4: Total Firm Perspective
Emphasizes the total value of the firm to the shareholders. It is “risk
management” of the shareholders’ total interest in the enterprise as a going
concern.
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How Does a “Going Concern” Perspective Differ from the Others?
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Traditional Perspectives Focus Only on the GAAP Balance Sheet
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Assets
Liabilities
Book Value of Equity
Going Concern Perspective Incorporates Franchise Value
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Total Firm Value = Book Value + Franchise Value
–
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Reflects the value of the firm to its shareholders
Franchise Value = Value of future business not yet written
Includes renewals and “new” business
Three Balance Sheets
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US GAAP
US GAAP
GAAP Assets
GAAP Liabilities
Book Value Equity
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Fair Value
Fair Value
Market Value Assets
Fair Value Liabilities
Fair Value Equity
Market Value
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Market Value
Market Value Assets
Fair Value Liabilities
Franchise Value
Market Value Equity
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How Does a Going Concern Perspective Impact Risk Management?

Emphasizes Effect of Risk and Risk Reduction on the Shareholders
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What impact does the risk have on the value of the firm?
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Measures, Manages and Hedges the Risks that Affect Shareholders
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In some cases, the shareholder perspective can lead to decisions that are not
even directionally the same as when only the balance sheet is taken into
account.
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Three Examples To Demonstrate This Point:
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Interest Rate Risk Management
Identifying Optimal Capital Levels
Risk-Based Allocation of Capital
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Interest Rate Risk Management (“ALM”) – Background
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Interest rate risk commonly measured using duration (and other related measures)
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Duration measures the sensitivity of the value of a series of cash flows to (small) changes in interest
rates and is expressed relative to the value of the cash flows.
Denoting the value of a bond as V, duration is calculated as:
D
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Example:
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dV 1
dy V
5 year bond
6% annual coupon bond
Principal of $1000
Continuously compounded interest rates are 4%
Value = $1,085.23
.04(1)
 60 e .04( 2)  60 e .04(3)  60 e .04( 4)  1060 e .04(5) 1
Duration: D   dV 1   d 60 e

dy V

dy

V
  (1)60 e .04(1)  (2)60 e .04( 2)  (3)60 e .04(3)  (4)60 e .04( 4)  (5)1060 e .04(5)
10851 .23
 4.49
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Related to the “weighted average time to payment” (exact in the case of continuously compounded
interest rates)
For small increase in yield, say .2%, duration indicates the change in value of the bond:
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Change in Value = - D * (Change in Yield) = -4.49*.2% = -0.89%
Actual Change in Value = (1075.54 – 1085.23)/1085.23 = -0.89%
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Different Perspectives on ALM
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Narrowest Perspective
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More Comprehensive Perspective
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Considers only the bond portfolio
Sets target duration of bond portfolio to DT.
DT selected judgmentally
Incorporates all invested assets with interest rate sensitivity – not just bonds.
Aggregates interest rate risk measure, duration, across all assets
Wider Perspective
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Incorporates duration of liabilities.
Naïve Rule of Thumb: Set DA = DL
Ignores the dollar value of the assets and liability, assumes they are equal
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Different Perspectives on ALM (Cont.)
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Portfolio Perspective
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Emphasizes duration of surplus, DS, taking into account the value of the assets, A, and
the value of the liabilities, L.
Dollar Duration of Assets = Dollar Duration of Liabilities + Dollar Duration of Surplus
A*DA = L*DL + (A-L)*DS
DS = (A/S)*(DA - DL) + DL
Setting, DS = 0  DA = L/A* DL < DL
Naïve Rule of Thumb: Asset duration must be lower than liability duration to immunize
the surplus against changes in interest rates.
Enterprise Perspective
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See Next Slide
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How the Enterprise View Affects Interest Rate Risk Management

Managing duration of surplus ignores the interest sensitivity of franchise value:
Market Value
Market Value Assets (MVA)
Fair Value Liabilities (FVL)
Franchise Value
Fair Value Surplus = MVA - FVL
Franchise Value
Market Value of Equity
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Market Value of Equity (MVE) = Fair Value Surplus (S) + Franchise Value (FV)
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Dollar Duration of MV Equity = Dollar Duration of Surplus + Dollar Duration of FV
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$DMVE = $DS + $DFV
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Setting $DS = 0  $DMVE  0
Market Value of Equity will be sensitive to interest rates.
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Magnitude and sign depend on duration of franchise value, DFV
DFV is very complex, but note that it will reflect the net effect of the following:
– duration of future premiums
– duration of future claims and expenses
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Duration of Franchise Value
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Consider Simple P&C Insurance Company Example
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Fixed Premiums
Claims not interest sensitive
Premiums collected before claims are paid, therefore duration of future premiums is
less than duration of future claims
As rates rise, value of future premiums falls by less than the value of the future claim
payments and so the FV rises. This is negative duration!
DPremium < DClaims  DFV < 0
Supposes the goal is to set Duration of MVE = 0
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MVE “immunized” against changes in interest rates
$DMVE = $DS + $DFV
Therefore, with $DFV < 0, would need $DS > 0
Asset duration must be larger than the case where FV was ignored.
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Duration of Franchise Value (continued)
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More Interesting Case:
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Premiums = Present Value of Expected Claims (+ Risk Margin)
Premiums are now interest sensitive
DFV will depend on pricing strategy
Simple Model (Panning, Managing Interest Rate Risk: ALM, Franchise Value and Strategy)
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P = Written premium each year, collected at beginning of year
E = Expenses, paid when premium is written = 25
L = Expected claims and expenses, paid at end of year = 75
y = risk free discount rate = 5%
S = Company’s surplus, assumed constant each year = 50
k = firm’s target return on surplus
– Pricing Policy: k = a + by
– e.g. if b = 0, then k is constant; if b <> 0, then k varies with interest rates
– Assume a = 15%, b = 0
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cr = client retention (% of policies that renew each year) = 90%
Ignoring risk premiums, P = [S*(k-y) + L]/(1+y) + E
Franchise Value = Present value of all future premium, loss and expense cash flows
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Duration of Franchise Value – Example Continued
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Duration of Franchise Value
DFV 
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Notice that when premiums were not interest sensitive, DFV < 0
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To immunize the market value, needed higher asset duration compared to “balance
sheet” approach that ignored franchise value
With interest sensitive premiums, DFV > 0
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a  b 1
1

 17 .62
(1  y )( a  by  y ) 1  y  cr
To immunize the market value, now need lower asset duration compared to “balance
sheet” approach that ignored franchise value
Interesting side note (see Panning paper for discussion)
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Lowering the asset portfolio duration may be costly
Lowering it “enough” may not even be possible – or may need the use of complex
derivative instruments with more perceived risk
May be able to use pricing strategy (b <> 0) to manage this risk more effectively than
altering asset portfolio composition.
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Key Insight from Interest Rate Risk Management Example
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Assuming that interest rate risk management is one of the firm’s priorities, the
first step is to determine what to immunize:
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One reasonable approach – focus on the enterprise and manage the interest
rate risk that affects all components of this value.
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The Portfolio?
The (GAAP, Stat or Fair Value) Surplus?
The Value of the “Enterprise”?
Ignoring franchise value, one could reasonably conclude that the “optimal” investment
strategy is to have DA < DL.
Including franchise value, but with fixed premiums and expected claims, optimal asset
duration is higher
In more general case, with interest sensitive premiums, duration decisions depend on
much more complex factors such as the firm’s pricing strategy.
Other Examples
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Determining Optimal Capital Levels
Risk-Based Capital Allocation
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Determining Optimal Capital Levels
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Current “Economic Capital” models consider only those assets and liabilities
currently on the balance sheet (or perhaps, at most, one year of new business).
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Naïve view – “Minimize capital so that return on capital can be maximized.”
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But this ignores the franchise value, a significant portion of the market value of
the firm’s equity.
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Franchise value depends on survival
Survival is affected by “tail events” that make it impossible to pay all claims
But survival is also affected by more routine events that destroy a large portion of the
company’s surplus
Optimal capital levels must be set so as to ensure survival, not just pay current claims!
Ignoring the franchise value makes it impossible to determine capital required to
maximize shareholder value.
•
See Panning (2006) Managing the Invisible: Measuring Risk, Managing Capital and
Maximizing Value, CAS/SOA ERM Symposium Call for Papers for details.
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Risk-Based Capital Allocation
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Traditional Capital Allocation
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Enterprise Approach
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Measures “economic capital” based on tail measures of risk (VaR, CTE, etc.)
Allocates capital to business units that most contribute to these “tail” events
Recognize that “routine” losses could materially impact surplus
Capital allocation should reflect all scenarios where franchise value is impacted – not
just tail scenarios
Suggests that allocation should be based on risk measures at significantly lower
percentiles
Potential Impact
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Some business units are not inherently volatile, but have tremendous uncertainty about
the mean of the distribution
Tail risk measures tend to heavily discount this uncertainty
Risk measures at lower percentiles recognize that large and frequent deviations from
the mean can lead to loss of surplus, loss of credit rating and significant loss in
shareholder value
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Summary
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Enterprise Risk Management
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Should go beyond the balance sheet
Focuses on the total firm value to its shareholders – the total enterprise, including
Franchise Value
Measures and manages the risk to the enterprise
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Implications for Risk Management Strategy Can Be Significant
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Three Examples:
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Interest Rate Risk Management
Recognizing that the firm’s franchise value itself is sensitive to interest rate changes
could lead to different choices in asset portfolio.
Determining Optimal Capital Levels
Recognizing that the firm’s franchise value depends on retaining a given rating
suggests that more capital is needed than simply that which limits the risk of
insolvency.
Risk-Based Capital Allocation
Recognizing that the firm’s franchise value can be destroyed by events that are not “in
the tail” could shift attention to sources of risk that are less extreme, but still significant
to the shareholders.
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References

Panning, William H. 2006. Managing the Invisible: Measuring Risk, Managing
Capital, Maximizing Value. SOA/CAS 2006 ERM Symposium Call for Papers.

Panning, William H. 2006. Managing Interest Rate Risk: ALM, Franchise Value
and Strategy. Willis Re White Paper. Presented to the International Conference
of Actuaries, May 2006.
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Panning, William H. 1994. Asset-Liability Management for a Going Concern. In
Edward Altman and Irwin Vanderhoof, eds. Financial Dynamics of the Insurance
Industry. Dow Jones-Irwin.
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