Enterprise Risk
Management
A Presentation at
Casualty Actuarial
Society
Ratemaking
Seminar
March 13, 2001
Las Vegas
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
….A decade ago
The Actuary Consulted with the Risk Manager on Hazard Risks
Self-Insured Retention Analysis
Considerations
Cost of Capital
Cash Position and Opportunity Costs
Credit Capacity
Need for Admitted Carrier Paper
Cost Predictability/Risk Appetite
Market Premium Assessment
Loss Control Incentives
Propert/Casualty Loss Costs
Alternative Strategies
Risk Retention Levels
•Alternative Risk Financing Techniques
•Hedges
Compliance Issues
IRS Rules
State &/or Domiciliary Laws
Accounting Standards
Actuarial Standards of Practice
Tools
5-10 Year Pro-Forma Models
Dynamic Financial Modeling
Scenario Testing
Conclusions & Recommendations
Estimated Costs/Benefits
Optimum Strategy
Goal is to
optimize risk
retention/cost
benefits
….Today
The Risk Manager’s 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
How Does Risk Manifest Itself?
Fortune 1000 Group Analysis
10% of the Fortune 1000 companies suffered a loss of over 25% of shareholder value within one month
% of top 100
25
24
Primary Cause of Stock Drop (# of Companies)
Doesn’t’ mean
Hazard Risk
isn’t important.
20
15
12
11
10
7
7
6
7
It’s being handled.
6
4
5
2
3
1
1
2
1
1
0
0
0
Competitive
Pressure
Customer
Demand
Shortfall
MisLoss of
R&D
ManageForeign
Cost
aligned
Key
Delays
ment
MacroOverruns
Products
Customer
ineffectiveEconomic
Customer
Regulatory
Supplier
M&A
Accounting ness Supply Issues
Pricing
Problems
Problems
Integration
irregularities
Chain Issues
Pressure
Problems
Strategic
Operational
High Interest
Input
Rate
Comm- Fluctodity uation
Price
Financial
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.
Law- Natural
suits Disasters
Hazard
What is ERM?
What is Enterprise Risk Management?
Corporate Governance?
Gesetz zur Kontrolle und
Transparenz im
Unternehmensbereich- Bill on The
Control And Transparency of
Companies
KonTraG Bill
Cadbury
Commission on Corporate Governance Rutterman
Greenbury
The Stichting Corporate Governance
Hampel
Turnbull
Code of Best Practice
Business Round Table
King Report
Stock Exchange Commission
Stakeholder Communication
Blue Ribbon Commission
Report on Effective Systems of Internal CalpersCorporateGovernanceProgramme
Control
Vienot Committee
Marini Report
Levy-Long Committee
Draghi Commission
Corporate Governance Forum of Japan
Toronto Stock Exchange Committee
Canadian Securities Committee
Allen Committee Report
Canadian Institute of Chartered
Accountants
KPMG Peat Marwick Survey
Blue Book
Company Law Review
Best Practice Statement of
management discussion and analysis
Stock Exchange Listing
New Accounting Standards
Integrating Hazard and Financial Risks
into a Single Contract?
Hazard
Finance
+
Risk Fusion®
Establishing a Chief Risk Officer?
Chief Risk Officer
Oil Trading
Natural Gas
Trading
Risk
Management
Electricity
Trading
Crisis Management?
“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
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, it’s 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
So What is ERM All About?
ERM Is About all These Things...
...But most of all, it’s about
VALUE
How Does Risk Manifest Itself?
Fortune 1000 Group Analysis
10% of the Fortune 1000 companies suffered a loss of over 25% of shareholder value within one month
% of top 100
25
24
Primary Cause of Stock Drop (# of Companies)
20
15
12
11
10
7
7
6
7
6
4
5
2
3
1
1
2
1
1
0
0
0
Competitive
Pressure
Customer
Demand
Shortfall
MisLoss of
R&D
ManageForeign
Cost
aligned
Key
Delays
ment
MacroOverruns
Products
Customer
ineffectiveEconomic
Customer
Regulatory
Supplier
M&A
Accounting ness Supply Issues
Pricing
Problems
Problems
Integration
irregularities
Chain Issues
Pressure
Problems
Strategic
Operational
High Interest
Input
Rate
Comm- Fluctodity uation
Price
Financial
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.
Law- Natural
suits Disasters
Hazard
Enterprise
Risk
Management
- Why?
- What?
- How?
ERM Is Real But Why is It Timely?
New and Larger Risks
• Higher Market Value to Book Value
ratios due to Intangible Assets
• New risks: demand shortfalls,
competitive pressures, etc.
New Risk Products
• Integrated Risk “Books”
Growing Exponentially
• Insurance/Financial
Convergence
Emerging Need for
Enterprise Risk Management
Current Silo-Approach Flawed
• Cross-company Risk
Identification
• Integrated Risk Modeling
• Chief Risk Officers
Increased Management Accountability
• New Regulations: Corporate Governance
• Shareholder Expectations for
Transparency/ Management Process
MMC’s View of Enterprise Risk Management
Enterprise 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:
1. Risk management is a systematic,
critical-risk focused activity
2. Risk is quantified to make
informed business decisions
3. Risk management is an integral part of
strategic planning and budgeting
4. Pricing, capital allocation, performance
measures consider potential risk as well as returns
5. Risk is not automatically avoided, but
weighed against opportunity to optimize risk versus return
6. Risk mitigation/financing focuses on events
and volatilities that could compromise financial
and strategic objectives
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
Integration
Hazard Risk Analysis
Market Solutions
Critical
Financial Risk Analysis
Risk
Corporate
Diagnostic Operational Risk Analysis
Process Solutions
Strategic Risk Analysis
Risk Management Process Redesign
ERM Vision
Setting
ERM
Solution
Implementation
…of risk assessment, strategic planning, capital allocation, and performance measurement processes
Goal:
• High-level
critical risk
assessment
• In-depth
measurement and
modelling of critical
risks
• Understanding
of integrated
effects of risks
• In-depth design and implementation of
solutions to mitigate / finance risks
MMC believes the client should be left wit the ability to independently
conduct Enterprise Risk Management at the completion of the project.
Client Organization
Joint Team
Approach
MMC Enterprise Risk
Client
Organize A Risk Diagnostic Process to
Focus on Critical Issues
Revenue Or Net
Income Source
Identifying Broad
Risk Issues
Uninsured/
Unhedged
Insured/
Hedged
= Single Event
Major Hazard / Operational / Financial Risks
= Aggregate
Can't buy / Choose not to
buy
Excluded Completely
Within Deductible
Subject to sublimits,
exclusions, limits,
coinsurance, deductibles,
or retentions
B13
B6
B15
B17 B9
B17
B18
B4
B10
Severity
B4
B15
$50M
B29
B8
B7
B17
B14
B16
B3
B18
B10
B27
B23
B12
B14
B21
B11
B8
$10M
B16
B17
B3
B24
B20
B11
B22
B21
B27
B12
$2M
B24
B20
Every 20+ to 5 Years
Low
Every 5-3 Years
Low/Medium
Every 3-1 Years
Medium/High
More than Once a Year
Frequency
More likely to occur
More severe
Division B
or
Geograph 2
1. Risk A
2. Risk B
3. Risk C
4.
5.
100. Risk XYZ
5
D
2P T L
F
4
Severity Scale
H
E
A
5 - Catastrophic - $100 million
4 - between $25 - $100 million
3 - Significant - $25 million
2 - between $2 - $25 million
1 - Material - $2 million
W
G 2G
KJ
2C
2E 2KB
3
2
1
Chance this will occur in the
next 3 years:
Probability Scale
1
2
3
4
5
Extremely
Unlikely
Less
than
5%
Unlikely
Occasionally
Regularly
Imminent /
Ongoing
Less
than
25%
50%
75%
Greater
than
75%
5 - Imminent / Ongoing (>75%)
4 - Will Occur Regularly (75%)
3 - Will Occur Occasionally (50%)
2 - Unlikely (<25%)
1 - Extremely Unlikely (<5%)
11
High
13 15 18 35 43
22
26
21
41 1
9
8
20
42 24
31
37
Severity
Division C
or
Geography 3
29
B4
36
19
45
5
6 23
3
32
17 16
44 46
2 4
7
14
B11
33
30
39
B11
34
47 40 27
12 25 38
Low
Low
Moderate
Frequency
High
28
1.
2.
3.
4.
5.
6..
7.
8.
9.
10.
Risk 6
Risk 2
Risk 3
Risk 4
Risk 5
Risk 7
Risk 8
Risk 9
TO
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.
Risk 1
D O W N
$100M
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Top 10
Firm-Wide Risks
N A R R O W
Division A
or
Geography 1
1. Risk A
2. Risk B
3. Risk C
4.
5.
100. Risk XYZ
Top 10
Critical Risks
Risk Maps
Risk 10
Analyze and Resolve Critical Risk Issues
Top 10
Firm -Wide Risks
Risk Measurement
& Modeling
Risk Solutions
Structured Funding
Catastrophe
Modeling
Structuring and placing
funding related products
where risk mgmt is an issue
Risk 1
Risk 2
Integrated
Risk Modeling
Risk 3
Risk 4
Risk 5
Risk 6
Risk 7
•
•
•
•
•
Purchased Materials
Labor
Hazard
Financial
Operations
Tort/Liability
Modeling
Risk 8
Risk 9
Risk 10
People
Risk Modeling
Financial Products
Transfer of risk
to third party
Risk Aggregation
Repackaging risk for
financial products
Operational Risk
Risk management
and mitigation services
People Risk
Human capital strategies
and tactical plans
Risk
Aggregation
Analysis
Strategic/Brand Risk
Organization /operational
strategies and plans
Sample Tactics
•
•
•
•
•
•
Securitization
Sale/Leaseback arrangements
Trade finance
Asset Backed transactions
Project finance/Emerging Market Finance
Offshore/special purpose vehicles
• 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)
•
•
•
•
•
•
Consolidation of placement information
Benchmarking studies
Risk tranching
Indexes for financial products
Creation of RMIS
Creation of risk banks
•
•
•
•
•
•
•
Intellectual property
Supply chain/Just-in-Time Inventory analysis
Business continuation planning - single supplier/ plants
Crisis Management
Fraud
System Breakdowns
Unauthorized Trading
•
•
•
•
•
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
•
•
•
•
Value Driven Business Designs
Brand vulnerability assessment
Supply chain strategy analysis/supply source analysis
Intellectual property valuation, licensing terms, choice analysis
• Profit Pattern Analysis
Enterprise
Risk
Management
Modeling
Relating A Risk Integration Model to Financial Performance
Balance Sheet
• Asset
–Loss of book value/replacement value of “real” assets used to
produce revenues
• Liabilities
–Charges for losses/risk liabilities
• Shareholder Equity
•
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
•
From Operations
– Impacts on Cash Flows used to fuel business.
(e.g. Drain other things - R&D capital investments,...)
•
From Investing
•
From Financing ( e.g., Interest Rates)
Income Statement
Cash Flow
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
– Loss of book value/replacement value of “real”
assets used to produce revenues
• Liabilities
– Charges for losses/risk liabilities
• Shareholder Equity
Income Statement • 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
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?
– 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 - R&D capital investments)
• From Investing
• From Financing
– Interest Rates
• Better understanding of volatility and “worst case”
outcomes considering portfolio effects:
• Does volatility matter? What is the size?
• Dynamics given risk Correlations
We can also consider Cash Flow impacts of
1. Variable costs
2. Catastrophic Costs
Raw, un-hedged, un-insured
exposure
Current set of strategies
over layered on top of
exposures
What does this strategy
do? What is “net” effect
and the residual volatility?
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.
Structure of an Integrated Risk Model
The common factor model stochastically
generates:
• Interest Rates
• GDP
• Foreign Exchange
• Hazard Events
• Commodity Prices
Industry/
Company
Overrides
The individual models
calculate the results for
each stochastic trial
in the model input
LEGEND
Common
Factors
Model
PROCESS
DATA
Policy
Strategy
Intervention
Model
Input
Individual
Models
(HR)
Individual
Models
(Pension)
Individual
Models
(Hazard)
Individual
Models
(Financial)
Result
Data
Result
Data
Result
Data
Result
Data
The consolidation tool collects results of
individual models to produce an
integrated distribution of results
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In addition to the stochastic
model input, other assumptions
and parameters are specified
Which risk should I
manage the most?
Which is the best
program?
The results from each model
are stored in a database.
Some Candidate Models Random Walk & Mean Reverting
“Drift” may be zero,
positive or negative
Arithmetic Random Walk
St = a0 + St-1 + et
Geometric Random Walk
ln= natural
logarithm
lnSt = a0 + lnSt-1 + et
Coefficient of St1 is 1
Et-1 (St) = a0+ St1
•
Simple model for capturing uncertainty.
•
“Best guess” for price tomorrow is price today (plus any drift).
•
Logarithmic form prevents negative prices (or rates); probability
distribution is lognormal.
Arithmetic AR(1)
Geometric AR(1)
•
Widely used for financial time series.
St = a0 + a1 St-1 + et
lnSt = a0 +a1 lnSt-1 + et
•
Underlying “stochastic process” for derivatives valuation, such as BlackScholes and related methods.
•
The First Order Autoregressive or AR(1) process can be written as
a1 < 1
• The price in this model is “mean-reverting”.
Geometric AR(1) can be re-written as
lnSt = (1-a1) [a0/(1-a1) - lnSt-1] + et or
lnSt =  [ lnM - lnSt-1] + et
• When St-1 is below (above) the long-run mean M, the expected price change is positive
(negative).
• Mean reversion is fairly common for commodities and almost always used for interest
rates.
Comparison of Price Paths
Random Walk vs. Mean Reverting Process
Comparison of Sample Price Paths
Random Walk vs. Mean Reverting Process
250
RW: lnSt - lnSt-1 = et
200
MR: lnSt - lnSt-1 = .10 [ln100 - lnSt-1] + et
Price
150
100
50
Week
Random Walk
Mean Reverting Process
51
49
47
45
43
41
39
37
35
33
31
29
27
25
23
21
19
17
15
13
11
9
7
5
3
1
0
Comparison of End-of-Year Price Distributions
Random Walk vs. Mean Reverting Process
End-of-Year Distribution of Price
Random Walk vs. Mean Reverting Process
Random Walk vs. Mean Reverting Process
Distrinution of End-of-Year Price
Name
Random Walk Mean Reverting
Mean =
103.05
100.21
Std Deviation =
26.68
8.19
Coefficient of Variation =
0.26
0.08
5% Perc =
65.75
87.22
95% Perc =
152.05
114.35
45%
40%
35%
Probability %
30%
25%
20%
15%
10%
5%
0%
40
50
60
70
80
90
100
110
120
130
140
150
Price
Random Walk
Mean Reverting Process
160
170
180
190
200
Cost Distributions - Example
Distribution Of Annual Purchase Costs
This table shows the stand-alone cost distributions of 4
commodities. While Commodity 4 has the potential for
generating the greatest extreme cost in this group, in
terms of variation about expected costs, Commodity 3 is,
in one sense, “riskier” than Commodity 4 given its
coefficient of variation (s.d./mean) of 14% compared to 3%
for Commodity 4.
XYZ
Distribution of Annual Purchase Cost ($ MM)
2000
Name
Mean =
Std Deviation =
Coefficient of Variation =
1% Perc =
5% Perc =
95% Perc =
99% Perc =
Comm 1
131.81
10.94
0.08
Comm 2
115.25
10.04
0.09
Comm 3
10.72
1.53
0.14
109.13
114.70
150.73
160.66
93.78
99.52
132.47
141.00
7.67
8.40
13.40
14.86
Comm 4 Combined
173.39
431.17
6.01
18.60
0.03
0.04
159.00
164.10
183.29
189.58
390.73
401.74
462.22
478.31
XYZ
Distribution of Annual Purchase Cost
Combined
2000
Cost Distributions
This shows the commodity risk as a single
portfolio consisting of 4 commodities taking into
account risk reduction due to uncorrelated price
movements in the 4 factors.
25%
Budget
Value
20%
Probability
15%
Mean
10%
5%
5%
Perc
95%
Perc
Annual Cost ($ MM)
520
510
500
490
480
470
460
450
440
430
420
410
400
390
380
370
360
0%
The Budget Value noted is approximately
$20million below the expected value of the
simulated distribution. Values may deviate from
budget due to:
- Coverage in place,
- Result of consensus price forecasts or budget
negotiations.
Cost Distributions - Extreme Tail Risk
95% Tail Distribution Of Annual Purchase Costs
This table shows the 95% tail distribution of the Annual
purchase cost. This distribution describes outcomes in the
right hand tail, which exceed the 95% value of 462.22. The
table shows that for these 500 possible outcomes (5% of
10,000), the mean annual purchase cost is 472.03 and the
95% percentile is 490.45. These statistics better help
define extreme outcomes, than just the 99% percentile for
the annual cost distribution (478.31).
XYZ
XYZ
95% Tail Distribution of 2000 Purchase Costs
Combined
Combined
Name
Mean =
472.03
Std Deviation =
8.87
Coefficient of Variation =
0.02
5% Perc =
463.01
95% Perc =
490.45
XYZ
95% Tail Distribution of Annual Purchase Cost
Combined
2000
35%
The chart on the left shows the skewed
distribution of the 500 highest cost outcomes. The
95% percentile is 490.45 showing that in 25 cases
out of 10,000 (5% of 500) the annual purchase
cost could exceed $490.45 million.
Budget Value = $ 409.88 MM
30%
20%
Mean
15%
10%
5%
95%
Perc
Annual Cost ($ MM)
520
515
510
505
500
495
490
485
480
475
470
465
0%
460
Probability
25%
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 $33
million for the Summed Distribution.
Marginal Distribution - shows the contribution of the
diversified portfolio of commodities to the combined
portfolio of the company.
XYZ
Distribution of Annual Purchase Cost and Cost Deviation
1
on a Combined, Summed, and Marginal Basis ($ MM)
1999
Name
Mean =
Std Deviation =
1% Perc =
5% Perc =
95% Perc =
99% Perc =
1
The commodity portfolio will contribute only $429 million
of risk to the client’s combined portfolio at the 95th
percentile versus the commodity portfolio’s own risk of
$462 million at the same percentile.
Deviation Distribution -- shows the distribution of
deviations from budget.
Combined
431.17
18.60
Summed
431.17
32.54
390.73
401.74
462.22
478.31
361.54
381.12
486.94
517.11
Marginal With Respect to Combined Commodity Annual Purchase Cost.
Combined
Marginal
Deviation
431.17
21.28
0.59
18.60
427.70
429.55
429.40
426.02
-19.15
-8.14
52.34
68.43
Summed
Deviation
21.28
32.54
-48.34
-28.76
77.05
107.23
Volatility Around Annual Expected Cost
• Diversification / covariance effect captured through integration of financial risks
• Reduces capital required to manage volatility
All Risks
Integrated
Risks (1 to 8)
Individual Risks
Currency
Separate
Treatment
Effect of
Integrating
$1.6B
D
E
V
I
A
T
I
O
N
F
R
O
M
$764M
$700m
99%
$500m
90%
$100m
$10m
Mean
- $10m
M
E
A
N
$1M
$173M
$132M
$332M
- $100m
$115
M
$433M
$2.4B
$434M
$4B
$(43)M
$4B
Combined
Risks (1 to8)
Currency
Summed
Total
$4B
Mean
10%
values
1%
-$500m
-$700m
Risk 1
Risk 2
Risk 3
Risk 4
Risk 5
Risk 6
Risk 7
Risk 8
Combined
Total
Financing Risks Via Silo Management
Risk 1 Risk 2 Risk 3
. . . Risk
N
Enterprise
Total Risk
DECISION
RETAIN
Retained Risk
“unknown”
+
PREMIUM
Premium
“unknown”
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
Silo Risk Management as a Portfolio of Interrelated Decisions
Risk 1 Risk 2 Risk 3
...
Risk N
Enterprise
Total Risk
DECISION
RETAIN
Retained Risk
“known”
+
PREMIUM
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.
Premium
“known”
Enterprise Risk Financing - Many Possibilities
Creating Risk Aggregation Centers
Property
Property
Property
Fusing Risk Together
$602.5M
Retention
Retention
$585.3M
Retention
$580.8M
Year 2
Year 1
Retention
Integrated Coverage
Year 3
$200M Limit covers at least 5 Standard Deviations
Creating Multiple Triggers to
Access Contingent Capital
Transforming Financial Risk to
Insurance Risk Via A SPV
Recession
by 10%
Client
Asset
Managers
Financing
P&I
Cash
Payment
Client
Client
Sale of
Experience Account if
losses < Account at the
end of the program
Premium
Lease
Payment
Special
Purpose
Vehicle
Lessees
Lessees
Default
Default
Assets
Assets
NPV of lease less secondary
market sale or Residual Value
Price
above
Index
Insurance
Insurer
Company
Risk Event 1
Machinery
Breakdown
Risk Event 2
Commodity
Prices
Price
below
Index
X Dollar per
Dollar
above the
Index
Risk Event 3
Auto Industry
Growth
by 10%
Recession
by 10%
No Payout
to Client
Payout to
Client
Risk Event 3
Auto Industry
Growth
by 10%
Counterparty
Payout to
Client
No Payout
to Client
Counterparty
X Dollar per
Dollar
above the
Index
Case Studies
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.
“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.
Risk from the CFO’s Perspective
General Risk Categories
•
•
•
•
Hazard/Legal Risks
Financial Risks
Operational Risks
Strategic Risks
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”
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)
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
E&O/Professional Liability
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
Imaginary Motors Risks - III
• Strategic Risks
–
–
–
–
–
–
Model Selection
Geographic Expansion
Brand Image
Product Pricing
R&D Investments
Acquisitions & Divestitures
Case Study - Hazard Risk
Imaginary Motors Hazard Risk
6,000
5,000
Avg. NI
NI (Agg)
$Loss (Sum )
3,000
NI (Sum )
$Loss (Agg)
2,000
Avg. Loss
1,000
Probability of Exceedence
0%
1%
10%
20%
30%
40%
50%
60%
70%
80%
90%
99%
0
100%
$Millions
4,000
Case Study - Hazard Risk
Risk Area
Property Noncat
Wind
EQ
Flood
Automobile Liability
General Liability
Product Liability
Employment Practices
Crime
Directors & Officers
Foreign Liability
E&O/Professional
Hazard Subtotal
Hazard Portfolio
Portfolio Effect
Simulated Loss Amounts (in $Millions)
Min.
Mean
100 Yr.
250 Yr.
Max. St. Dev CV
$
$ 8.54 $
28.19 $
32.20 $
53.23 $ 6.08 0.71
11.76
203.37
268.90
648.96
40.52 3.45
15.35
520.95
903.91
2,570.03
108.63 7.08
5.26
103.35
200.04
820.84
29.40 5.58
4.15
13.92
98.87
159.15
214.85
16.76 1.20
3.90
11.49
38.97
50.50
284.32
8.15 0.71
349.87
572.73
1,232.59
1,284.46
3,301.76
157.74 0.28
1.50
7.72
25.15
29.48
99.92
4.58 0.59
0.06
0.52
4.41
58.29
1.02 16.23
4.63
70.42
159.94
800.08
23.40 5.05
4.03
7.70
11.97
12.81
16.29
1.50 0.19
0.02
0.10
0.37
28.22
0.52 32.76
363.45
659.18
2,334.46
3,106.15
8,896.79
398.30 0.60
395.83
659.18
1,454.98
1,784.28
3,840.32
201.88 0.31
32.38
(0.00)
(879.48) (1,321.88) (5,056.47) (196.42) (0.30)
Case Study - Financial Risk
Imaginary Motors Financial Risk
8,000
6,000
NI (Agg)
4,000
$Loss (Sum )
NI (Sum )
2,000
$Loss (Agg)
Avg. Loss
0
Probability of Exceedence
0%
1%
10%
20%
30%
40%
50%
60%
70%
80%
90%
99%
-2,000
100%
$Millions
Avg. NI
Case Study - Financial Risk
Risk Area
Residual Value
Credit
ERISA/Fiduciary
Financial Subtotal
Financial Portfolio
Portfolio Effect
Simulated Loss Amounts (in $Millions)
Min.
Mean
100 Yr.
250 Yr.
Max. St. Dev CV
$ 86.11 $ 1,341.16 $ 2,794.97 $ 2,901.04 $ 3,316.00 $ 603.18 0.45
(1,907.99)
513.89
1,880.30
2,049.65
2,653.43
619.73 1.21
0.36
3.17
4.45
14.58
0.69 1.91
(1,821.88) 1,855.42
4,678.44
4,955.14
5,984.02 1,223.61 0.66
(883.83) 1,855.42
3,886.43
4,139.83
5,366.54
872.49 0.47
938.05
(0.00)
(792.01)
(815.31)
(617.48) (351.12) (0.19)
Case Study - Operational Risk
Imaginary Motors Operational Risk
20,000
15,000
Avg. NI
10,000
$Loss (Sum )
NI (Sum )
5,000
$Loss (Agg)
Avg. Loss
0
Probability of Exceedence
0%
1%
10%
20%
30%
40%
50%
60%
70%
80%
90%
99%
-5,000
100%
$ Millions
NI (Agg)
Case Study - Operational Risk
Risk Area
Warranty
Strike
Product Recall
Political
Intellectual Property
Operational Subtotal
Operational Portfolio
Portfolio Effect
Simulated Loss Amounts (in $Millions)
Min.
Mean
100 Yr.
250 Yr.
Max.
St. Dev CV
$ 3,157.93 $ 3,596.38 $ 3,864.48 $ 3,902.22 $ 4,030.41 $ 115.40 0.03
288.22
2,609.33
3,230.20
5,551.49
599.07 2.08
5.62
248.84
1,280.31
1,733.32
3,397.26
261.43 1.05
51.89
1,968.22
3,114.63
9,924.05
373.77 7.20
21.26
115.56
170.67
803.63
26.75 1.26
3,163.54
4,206.59
9,837.89 12,151.05 23,706.84 1,376.42 0.33
3,264.95
4,206.59
6,984.44
7,768.32 13,976.52
761.10 0.18
101.41
(0.00) (2,853.45) (4,382.73) (9,730.32) (615.32) (0.15)
Case Study - Strategic Risk
Imaginary Motors Strategic Risk
8,000
Loss ($Millions)
4,000
2,000
0
Probability of Exceedence
0%
1%
10%
20%
30%
40%
50%
60%
70%
80%
90%
99%
-2,000
100%
$Millions
6,000
Avg. NI
NI (Agg)
$Loss (Sum )
NI (Sum )
$Loss (Agg)
Avg. Loss
Case Study - Strategic Risk
Risk Area
Min.
Phase Out Division X
$ 603.92
Invest in Division Y
909.54
Division Y Sales Increase (3,626.97)
Strategic Subtotal
(2,113.51)
Strategic Portfolio
(1,563.68)
Portfolio Effect
549.83
Simulated Loss Amounts (in $Millions)
Mean
100 Yr.
250 Yr.
Max. St. Dev
$ 893.66 $ 1,121.21 $ 1,158.46 $ 1,287.24 $ 893.41
1,340.50
1,681.84
1,737.39
1,945.73 1,340.36
(2,432.76) (1,919.97) (1,858.99) (1,610.99)
893.41
(198.59)
883.07
1,036.86
1,621.98
466.70
(198.59)
449.75
516.08
780.88
293.49
(433.32)
(520.78)
(841.10) (173.20)
CV
1.00
1.00
0.37
2.35
1.48
(0.87)
Case Study - Composite Risk
Imaginary Motors Composite Risk
30,000
25,000
20,000
15,000
NI (Agg)
$Loss (Sum )
10,000
NI (Sum )
$Loss (Agg)
5,000
Avg. Loss
0
-5,000
Probability of Exceedence
0%
1%
10%
20%
30%
40%
50%
60%
70%
80%
90%
99%
-10,000
100%
$Millions
Avg. NI
Case Study - Composite Risk
Risk Area
Hazard Subtotal
Financial Subtotal
Operational Subtotal
Strategic Subtotal
All Risk Subtotal
All Risk Portfolio
Portfolio Effect
Min.
363.45
(1,821.88)
3,163.54
(2,113.51)
(408.39)
3,188.68
3,597.07
Simulated Loss Amounts (in $Millions)
Mean
100 Yr.
250 Yr.
Max.
St. Dev CV
659.18
2,334.46
3,106.15
8,896.79
398.30 0.60
1,855.42
4,678.44
4,955.14
5,984.02 1,223.61 0.66
4,206.59
9,837.89 12,151.05 23,706.84 1,376.42 0.33
(198.59)
883.07
1,036.86
1,621.98
466.70 2.35
6,522.59 17,733.86 21,249.20 40,209.63 3,465.02 0.53
6,522.59 10,151.33 10,988.59 15,602.11 1,229.67 0.19
(7,582.53) (10,260.61) (24,607.52) (2,235.35) (0.34)
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.
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.).
The Benefits of ERM
Enterprise Risk Management Helps Organizations
Better Risk
Information and
Understanding
•
•
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
Better
Risk
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
Improved
Financial
Performance
•
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
Ten Major Take-Aways
1 Be a catalyst. Challenge your management teams to think about
risk issues impacting the organization.
2 Wall Street is unforgiving when your firm misses its earnings - Be
prepared by knowing how to respond to risks when and if they
occur.
3 Help your firm’s management consider and establish their risk
tolerance for organization.
4 The goal is to avoid a future catastrophic cash outflow by balancing
short term cash investments in risk mitigation & financing.
5 Be careful not to shy away from risks that cannot be quantified.
They are still risks!
Ten Major Take-Aways
6 Be leery of a “magic black box”. Determining total risk
correlations may not be possible.
7 ERM responses may well be (need to be) organizational and
strategic responses.
8 Don’t look to do this alone. Use other parts of your organization.
9 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!