OCCA Presentation
Enterprise Risk Management
Pierre Laurin
December 6, 2006
© 2005 Towers Perrin
There are four phases of ERM
Financial
Market
Political
Operational
Regulatory
Enterprise Risks
Human Assets
Hazard
Legal Liability
ERM Framework and Processes
Compliance and
Governance
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Diagnostics and
Analytics
Solution Analysis
and Review
Transaction
Execution / Risk
Mitigation
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ERM Value
Framework
Value
Creation
Maximize value by
relating a firm’s
decisions on the
risks it takes to
decisions on the
capital it uses to
finance its business
Capital
Costs
Return
on Risk
Value
Management
Portfolio of
Enterprise
Risks
Capital Adequacy
Portfolio of
Capital
Resources
Risk and Capital
Management
Capital
Structure
Risk
Structure
How much
capital do I
need?
What type
of capital do I
need?
Economic
Capital
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Specific Tasks under Enterprise Risk Management
 Economic Capital
 Reinsurance Optimization
 Asset Allocation
 Portfolio Optimization
 Economic Capital Model Building/Parameterization Database
 Operational Risk Management
 ERM Governance/Function Design
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Why is Economic Capital economic?
 Based on economic, rather than accounting, balance sheet
 Market value of assets
 Expected economic cost of liabilities
 Also reflects distribution of economic, rather than accounting, profits (losses)
 Actual ultimate economic cost of liabilities
 Set to maintain a selected defined level of policyholder security
 Economic cost of ruin
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Percent Change in Economic Capital
What is Economic Capital?
0%
Economic Capital covers the downside
scenarios in all but the most extreme scenarios
-100%
Policyholder/depositor security risk
relates to insolvency and non-performance
Cumulative probability
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From a corporate finance perspective,
reinsurance should be viewed as a form of capital
Debt
Conventional
approach
Debt
Net
Risks
Equity
Reinsurance
Gross
Risks
Debt
Equity
Framework
approach
Gross
Risks
Equity
Reinsurance
Strategic: Should I change the
mix between paid up capital
and contingent capital?
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Tactical: Given the amount of
paid up capital, how much
contingent should I buy?
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The ERM value framework can be used to
evaluate reinsurance and other portfolio hedging strategies
 Reinsurance can also create value when the cost of reinsurance
is offset by a reduction in the required rate of return
Market Consistent
Required-Rate-of-Return
(Opportunity Cost of Capital)
Return
Expected cost of reinsurance
With
reinsurance
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Without
reinsurance
Risk
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Summary
 ERM:
 is an important process
 requires significant resources
 touches all aspects of the entreprise
 is an on-going process
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