Enterprise
Risk Management
For Insurers and Financial
Institutions
David Ingram
CERA, FRM, PRM
From the International Actuarial Association
1
Course Outline
1. INTRODUCTION - Why ERM?
2. RISK MANAGEMENT FUNDAMENTALS – FIRST STAGE
OF CREATING AN ERM PROGRAM
3. RISK ASSESSMENT AND RISK TREATMENT - ACTUARIAL
ROLES
4. ADVANCED ERM TOPICS
2
Risk Assessment &
Risk Treatment
Actuarial Roles
3.1 Types of Risks
3.2 Risk Models
3.3 Risk Treatment Options – ALM
3.4 Risk Treatment Options – Hedging
3.5 Risk Treatment Options – Reinsurance
3.6 Risk Treatment Options – Capital Markets
3.7 Risk Treatment Options – Risk Design
3.8 Risk Treatment Options – Diversification
3.9 Risk Treatment Options – Avoid/Retain
3.10 Choosing a Primary Risk Metric
3.11 Uses of multiple Risk Models
3.12 Using Economic Capital for ERM
3.13 Capital Management & Allocation
3
3.1 Types of Risks
Systematic v. Specific
Traded v. Non-Traded
Paid to Take v. Not Paid to Take
Market, Credit, Insurance, Operational
4
Systematic Risk vs. Specific Risk
•
Flood – Systematic Risk -everyone gets wet
•
Bucket of water thrown by your brother –
Specific risk – only you get wet
•
Insuring one House – Systematic or Specific?
•
Insuring thousands of houses – Systematic or
Specific?
5
What are risk management
Techniques for Specific Risk?
1)
_____________
2)
_____________
3)
_____________
6
What are Risk Management
Techniques for Systematic Risk?
1)
_____________
2)
_____________
3)
_____________
7
What happens with a group of
specific risks?
8
3.2 Risk Models
Cause / Effect - Outcome
Outcome – Frequency/Severity
Closed Form v. Single Scenario v. Monte Carlo
Stress v. Scenario
Sensitivity
9
Cause Effect - Outcome


Typical Life Insurance Actuarial Model
Model follows the steps taken over the life of
an insurance contract following a tree
branching logic

Policy Issue, continue to next year (1 – q - w)


10
Death & Claim in first year (q)
Lapse or surrender the contract (w)

Repeat – year after year

Outcome = PV of three paths for each year
Outcome – Frequency/Severity
•
Model commonly used for non-life insurance and for
financial market instruments
•
Past observations of frequency and severity of
outcomes used to parameterize statistical models of
future outcomes
11
Closed Form v. Single Scenario v. Monte Carlo
•
•
•
12
Close Form models
–
one step calculations
–
usually depend upon assumption of distribution of outcomes
(normal or log normal) that have formulaic outcomes
–
Black Sholes
Single Scenario
–
Also one step (the one scenario)
–
Using either CEO or OFS
Monte Carlo (stochastic) model
–
Multi scenario
–
Often do not presume to know distribution of outcomes
Stress v. Scenario
•
Stress Test
–
•
13
Redo calculation changing one parameter
Scenario Test
–
Adjust all parameters to reflect a fictional total
world
–
Includes interactions of factors and
dependencies in the assumed situation
3.3.0 Risk Treatment Process
•
May vary significantly with each major risk
category
•
Depending on Nature of Risk
14
–
Assessment Capabilities
–
Relationship with Risk Takers
–
Knowledge & Experience of Staff
Components of
Risk Treatment Process
–
–
–
–
Risk Identification
Measuring & Monitoring System
Risk Assessment & Communication
Establishment of Risk Limits &
Standards
– Risk Treatments
– Enforcement of Limits & Standards
– Risk Learning
15
Risk Identification
•
Within a broad category
•
Need to know which sub categories of
the risk can be treated together
– And which need to be treated
separately
16
Measuring & Monitoring System
•
Measures of risk v. Key Risk Indicators
•
Existing v. Future
•
Manual v. Automated
•
Quantitative v. Qualitative
17
Risk Assessment & Communication
•
Need to establish regular schedule of
assessment
•
Assessments must be communicated at
several levels in the organization
•
18
– Operational Levels
– Management levels
Management MUST have discussions
with subordinates about the risk positions
Establishment of Risk Limits &
Standards
•
•
Limits = How large, How much, How
many, Authorities
– Limits must be quantitative
– Also may use Checkpoints
Standards
– For how things are to be done
– Treatments permitted/ required
19
Risk Treatments
•
Avoid
•
Reduce
•
Offset
•
Transfer
•
Retain & Provision
20
To set Standards
•
Ask the best person in a function what
needs to be done to “get it right”
•
Ask supervisors what information that
they need to be able to tell that things
are being done “right”
•
Standards also apply to documentation
and recordkeeping
21
Enforcement of Limits & Standards
•
•
Assessment & Communication systems need
to include comparison of risk positions to limits
– And adherence to standards
Must clearly establish what will happen if limit
or standard is violated
– Might depend on seriousness of breach
– Hard limits v. Soft Limits
22
Risk Learning
•
About Losses, Risk Assessment, Risk
Treatment Processes
–
–
–
–
23
Internal
External
Backwards
Forward
Credit Risk Treatment
Traditional Credit Risk Treatment
•
Standards for
– Underwriting
– Authorities
– Collateral, Coverage
•
Limits & Enforcement
– Limits by credit quality, Size of Position
– Authority Limits
•
24
Active Workout with Risk Learning
“Modern” Credit Risk Treatment
• Credit VaR risk model & Aggregate
limits
– Gives aggregate portfolio view of
Credit Risk
– Allows trade-offs within aggregate
limits
• Use of credit derivatives to offset
excessive specific or aggregate risk
levels
25
Insurance Underwriting
Traditional Risk Control Mechanism for Insurance
Standards for
•
Underwriting
•
Authorities
•
Insurable Interest
Limits & Enforcement
•
Limits by quality, Amount of Coverage
•
Authority Limits
Active Claims management with Risk Learning
26
3.3 Risk Treatment Options – ALM
Interest Rate Risk Treatment
•
Crediting Rate Matching
•
Cashflow Matching
•
Duration Matching
•
Advanced ALM
•
Economic Capital
Limits & Reporting
27
Crediting Rate Matching

Portfolio Rate

New Money Rate

Investment Year Rates
Mismatched crediting rates can lead to large
harmful cashflows
28
Cashflow Matching
1) Project out expected cashflows from liabilities
2) Project out expected cashflows from assets
3) Identify major gaps where there is a large
difference between the projected cash outflow
and inflow in a future year
4) Make plans to fill those gaps (usually on asset
side for insurers)
29

Targeting future asset purchases

Targeting asset sales & repurchases
Duration Matching


Duration is sensitivity of value to a change in
interest rate
Also equal to PV of time weighted cashflows
Sum of PV(t x Cft)
 Focus on D v. D
A
L

Set Limit for abs(DA – DL)
–
30
Usually ½ to 1 year
Duration Matching
•
Most Insurers adjust assets to match duration
of liabilities
•
First step is to assess expected DL for a new
product
–
•
31
Set DA target for new cashflow
Second step is to set schedule for assessment
of portfolio DA & DL
Duration Matching
If assessment reveals excessive abs(DA – DL)
gap then will plan to:
•
–
Adjust DA target for future cashflows
–
Sell some assets and purchase others to
change DA
–
Purchase derivatives
•
32
Macro or Micro Hedge
ALM – Advanced
•
•
33
Duration matching only works well if interest
rate moves are
–
Small
–
Similar for all durations
Advanced methods take care of:
–
Larger movements (Convexity)
–
Non-parallel shifts (Key Rate Durations)
Convexity
•
Change in Duration with change in interest
rates
–
•
Duration measures slope of the value plot
–
34
Second derivative of value with respect to a
change in interest
If Value Plot is a curve, then slope is only
accurate measure for very small moves
Key Rate Durations
•
Change in value with change in rate at a
specific duration
–
•
35
For example, 5 year rate only
Matching Key Rate Durations allows
protection against yield curve twists
3.4 Risk Treatment Options –
Hedging
Financial Market Risk Treatment
•
•
Derivative Instruments used for Hedging
–
Futures
–
Put & Call Options
–
Swaps
Derivatives are often low cash outlay
–
36
Usually means that derivatives involve significant
leverage
Example of Financial Market Risk
Product – Index Annuity
–
Feature – Product promises the greater of
•
•
80% of stock market growth
Floor interest Rate on 90% of funds
On a specified maturity date
To match without derivatives would require insurer to invest twice
37
–
80% In Stock Fund
–
90% in Bonds
–
For a total of 170% of deposit
Hedging Methods
•
•
Cashflow Hedging
–
Works like Cashflow matching in ALM
–
Purchase derivatives that have strike dates where there
are potential cash mismatches
Most firms use this method to manage Index Annuities
–
Invest 90% of deposit in fixed income
–
Use other 10% to buy Option contracts tied to Equity
market
•
38
•
•
Adjust participation percentage (80%) based upon
cost of Options
Strike Date3 for Options is maturity date
Of Index Annuity Contract
Hedging Methods
•
Delta Hedging
–
Is fundamentally the same idea as Duration
Matching
–
Delta is change in price (value) per change in an
underlying (usually a market index)
–
Delta hedging often uses derivatives with extremely
different term to hedge obligations
•
•
39
Delta hedges are only good for a very short
time period (usually a day)
Delta Hedges must be rebalanced every day
Delta Hedging Index Annuity
•
Buy bonds to cover interest guarnatees
–
•
Then determine Delta of liabilities
–
•
40
Delta hedging ignores interest rate risk
Plus Delta of existing hedges
Purchase new derivatives that will bring Delta
of assets + hedges to be within tolerance for
difference from liabilities
Hedging Methods
•
Greeks
–
Greeks are partial derivatives of Prices with
change in various factors
•
•
•
Gamma
Vega
Tau
Get Definitions
41
Hedging Index Annuity with
Greeks
•
Investments can be any mixture of bonds and
stocks
•
Greeks will determine adjustments needed
with derivatives to match all of the risk
characteristics
42
Custom Hedging
•
Can purchase custom hedge contracts from a
bank that have terms tailored to your specific
need
•
If using custom hedges, would expect very low
amount of rebalancing needed
•
Hedges are tied to market indices – not to
actual liabilities
43
Hedging Programs
Favorable
Unfavorable
Cashflow
Hedging
Easy to understand &
Control
Inflexible
Delta Hedging
Lock in protection
Can produce low cost
hedging program
Single Metric – easy to
control
Difficult to adjust
Can be costly
Requires sophisticated
models & derivative trading
abilities
Requires that derivatives
are always available and
Works well in normal market always reasonably priced
conditions
Ignores risk of jump and
other risks
Greeks
Custom
44
Can provide
protection that is
effective in normal &
abnormal markets
Requires highly
sophisticated models and
derivative trading
capabilities
One step hedging
process
May not work as
expected
Can result in high amount of
trading to balance many
Greeks
3.5 Risk Treatment Options –
Reinsurance
Insurance & Financial Market Risk Treatment
Reinsurance is broadly similar to Custom hedges just described
Usually much more customized than Custom hedges
Reinsurers will usually promise to offset some portion of an
insurers exact claims experience
45
Types of Reinsurance
•
Facultative v. Treaty
•
Proportional v. Non-Proportional
•
Per Risk v. Per Occurrence v. Aggregate
Facultative v. Treaty
•
“Facultative” reinsurance applies to a single
insurance contract
•
“Treaty” reinsurance applies to all contracts in
a defined block
Proportional v. Non-Proportional

Proportional reinsurance: the reinsurer takes a
defined percentage of all losses

Non-proportional reinsurance: the reinsurer
only takes losses that exceed some threshold
 Almost always subject to a maximum limit
 Threshold may be on per risk, per occurrence, or
aggregate basis
Per Risk v. Per Occurrence v. Aggregate

Types of loss threshold for non-proportional
reinsurance
 Per Risk: threshold applies to losses from each
insurance policy
 Per Occurrence: threshold applies to total loss from
each specific event (for example, each hurricane or
earthquake)
 Aggregate: threshold applies to total loss from a
specific time period
Reinsurance
• Advantages:
– Customized to take exact aspect of risk that insurer
wants to lay off
– Available through a market of 50-100 firms globally
• Disadvantages
– Cost and availability of specific covers varies widely
– Need to be concerned about credit quality of
reinsurer
• Sometimes for many, many years
Actuarial Analysis of Reinsurance
Decision
 Quantify frequency & severity of insurance
losses
 Apply terms of various reinsurance options
 Compare cost / benefit and Risk/Reward
tradeoffs
 Evaluate options in light of company goals in
order to determine best strategy
51
Strategies for Managing
Underwriting Risk
• Remove
– Cancel policy or exit LOB
• Pro: eliminates future risk
• Con: also eliminates
opportunity for profit
• Reduce
– Stringent UW & claims
management
• Pro: leverage company
expertise
• Con: competitive forces are
outside company control
52
• Reinsure
– Purchase reinsurance
• Pro: customized hedge
• Con: cost of risk transfer
• Retain
– Live with the risk
• Pro: retain profit opportunity
• Con: risky; requires supporting
capital
Determining Reinsurance Needs
Growth
Business
Strategy
Provide
Increase
Risk
Capacity
Stability
X
X
X
X
X
X
X
X
X
Provide
Provide U/W
Surplus
53
Withdrawal from
Expertise
Relief
Business
LOB
Focus
Financial
Position
Facilitate
Limited
Asset
Liquidity
Limited
Surplus
X
X
X
Functions Served by Different
Types of Reinsurance
Increase
Provide
Provide
Risk
Provide U/W
Surplus
Stability
Capacity
54
Facultative
X
Proportional
Treaty
X
NonProportional
Treaty
X
Facilitate
Withdrawal from
Expertise
Relief
Business
X
X
X
X
X
Reinsurance
•
•
Advantages:
–
Customized to take exact aspect of risk that
insurer wants to lay off
–
Available through a market of 50 to 100 firms
globally
Disadvantages
–
Cost and availability of specific covers varies
widely
–
Need to be concerned about credit quality of
reinsurer
•
Sometimes for many, many years
3.6 Risk Treatment Options – Capital
Markets
Securutization of Firm Risks
Use of General Capital Markets products (ILW)
56
Capital Markets Options for
Insurance Risks
•
57
Two broad Capital Markets Solutions to Risk
–
Securitize & Sell your own risk on the Capital
Markets
–
Buy Capital Markets Instruments that offset a
risk that you have
Securitize your Risk
Advantages:
•
Covers your exact risk
•
Pricing may be better than reinsurance
•
Capacity can be higher than reinsurers
Disadvantages
•
Market might balk at any non-standard
aspects of your risk
•
Large fixed cost of securitization
•
Market appetite varies widely for insurance
58
Buy Capital Markets instruments
to offset your risk
•
There are some instruments – usually related
to insurance cats that have been created by
banks or (re)insurers
–
Mortality Cat Bonds
–
Industry Loss Warrents
•
Usually, these are bonds where principle is not
repaid if trigger event occurs
•
Trigger event is usually very large catastrophe
59
3.7 Risk Treatment Options – Risk
Design
Life Insurance
Annuities
Health Insurance
Property Insurance
Casualty Insurance
60
Risk Design – Life Insurance
•
Increasing Insurance Amount
–
•
•
61
To limit underwriting anti-selection
High Premium Levels
–
For Guaranteed Options
–
Assumed high degree of anti-selection
Offsetting Insurance & Investment Risks
–
If investments perform poorly, must buy more
insurance
–
Explicit in UL product
Risk Design - Annuities
•
•
Deferred Annuities
–
Surrender Charges
–
Market Value Adjustments (fixed)
–
Investment restrictions (variable)
Immediate Annuities
–
62
Limited or no Withdrawal options
Health Specific ERM Concerns
Underwriting controls-- centralized authorizations
required for larger cases
Avoiding Anti-Selection--being one of several health
options offered by employer could invite anti-selection
Experience monitoring--ability to slice and dice claim
experience and trend, monthly, down to
segment/geography/product
Diversification—(Large Accounts, small accounts, by
location, public/private).
Provider contract renewal (for example – staggering
renewals).
Assessing counterparty credit risk of providers,
especially those accepting capitated risk.
63
Stress scenario modeling: Bioterrorism, Pandemic
POLICY CONTRACTS
As Risk Treatment Tool
ELEMENTS OF AN INSURANCE POLICY –
64
Declarations Page(s)
Coverage Part(s)
Definitions
General Provisions
Exclusions – General 
Additional Coverages 
Conditions 
Duties After an Accident or Loss
Excluded Property 
Excluded Perils 
POLICY CONTRACTS …
OCCURRENCE & CLAIMS-MADE
Policies written to cover losses two ways:
Occurrence Basis – Pays for losses that occur
during the policy period.
Claims Made – Pays for losses reported during
the policy period
Due to nature of Claims Made policies, they are written
with either:
65
Extended Reporting Provision, or
Retroactive Date Provision
Both extend the “period” during which losses may be
reported and covered
BASIC Reinsurance CONTRACT
TYPES
Facultative or Treaty
Individual Risk
Entire Book of Business
Excess or Pro Rata
Limit and Retention
Proportional Sharing of Loss
66
66
“BUSINESS” PROVISIONS
Business Covered
Line(s) of business
In force, new and renewal
Exclusions
What isn’t covered
Territory
Where can the risks be located or policies written
67
67
COVERAGE PROVISION
“Coverage” Article establishes the Reinsurer’s
liability to the Company for the subject
business:
Excess – Retention and Limit
Quota Share or other Pro Rata – Percentage of
Cession
The Basis of Coverage is defined. For example,
on an XOL contract the Basis of Coverage is
“each loss occurrence” or “each risk,” etc.
68
68
COVERAGE PROVISIONS
Commencement and Termination
Definitions – Excess vs. Pro Rata
ECO/XPL
LAE/DJ
UNL – excess only
Loss Occurrence – Property vs Casualty
69
69
COVERAGE PROVISIONS
Other Reinsurance – Inuring vs Underlying
Reinstatement
Warranties
Notice Of Loss and Loss Settlements
70
70
“MONEY” PROVISIONS
Three Types of Accounting Basis
1. Accident Year
2. Calendar Year
3. Underwriting Year
71
71
3.8 Risk Treatment Options –
Diversification
Diversification among risks
Diversification between risks
Correlations v. Dependencies
72
Diversification of Like
Independent risks
•
If rate of claim is q, amount of claim is C,
number of insured is N
•
Expected claims = NqC
•
Standard Deviation of Claims amount is
–
73
Square Root {Nq(1-q)}C
Independent Like Risks
•
74
N
Expected
Std Dev
COV
1
10
99
995%
5
50
222
445%
10
100
315
315%
50
500
704
141%
100
1,000
995
99%
500
5,000
2,225
44%
1,000
10,000
3,146
31%
5,000
50,000
7,036
14%
10,000
100,000
9,950
10%
50,000
500,000
22,249
4%
q=.01 C=1000
Combining Unlike Risks
•
Dependent = Add Ranked Values
•
Fully independent = Square Root(A2 + B2) if
both are Normally distributed
75
Unlike Risks
76
Risk
1
Risk Dependent
2
Independent
5%
-6
-18
-24
-19
15%
-0
-6
-6
-6
25%
3
2
5
4
35%
6
7
13
10
45%
9
12
21
15
55%
11
18
29
21
65%
14
23
37
27
75%
17
28
45
33
85%
20
36
56
41
95%
26
48
74
55
Correlation v. Dependencies
•
Correlation is a mathematical term
–
•
Dependency is a statement about the
fundamental relationship between things
–
•
77
Can calculate correlation between finger length
and car ownership
Net Wealth and Car ownership
Correlations can be found for things with no
conceivable dependency
Copulas
General Mathematical technique for combining
two random variables that are partially
dependent
• Gaussian Copula
• Non-Gaussian Copula
– Some non-Gaussian Copulas will allow higher
dependence in the tails of the distribution
– Which is popular to more closely fit with reality
78
3.9 Risk Treatment Options –
Avoid/Retain
Operational Risks
Holding Capital for Retained Risks
79
Operational Risks
•
Usually a firm is not paid to take Operational
Risks
•
So most firms will choose to avoid Operational
Risks
80
–
If unavoidable, to minimize them
–
Using cost benefit to choose how to lminimize
Operational Risk
Definition
Identifying Risks
Assessing Risks
Risk Control
Risk Transfer & Reduction
Case Studies
81
Operational Risk
“the risk of loss, resulting from inadequate or failed
internal processes, people and systems, or from
external events”. Basel
82
Operational Risks
(a partial listing)
•
•
•
•
•
•
•
•
•
83
Regulatory Changes
Tax Changes
Governance Problems
Industry reputation
Company reputation
Information systems risks
Legal risks
Financial Reporting Risk
Outsourcing
•
•
•
•
•
•
•
•
•
Inadequate Controls
Process inefficiencies
Business strategy risks
Political risk
Terrorism
Natural Catastrophe
Misselling
Fraud
Insourcing
Operational Risk Measurement
Measurement is not the most important aspect of
operational risk management
Operational Risk Management Process:
Identify Risks
Classify risks by frequency and severity
Develop plans and strategies for controlling high
frequency and high severity risks
84
Risk Management Continuum
(Harvard University)
Proactive Management
Anticipate Risks
• Central Oversight / Assurance
Active Management
Timely Response
• Governance / Compliance Standards
• Understanding and Evaluation
of Risks
Reactive
Crisis Management
• Protection of Reputation
• Decreased Crisis Response
• Improved Services
• Improved Work Place
85
Compliance Paradigm Shift
(Harvard University)
From
• Informal Policies
• Limited Oversight
• Reactive
• Fragmented
• Limited Involvement
• People Orientation
• Ad Hoc
86
To
• Formal Policies
• Senior Level Oversight
• Anticipate, Prevent, Monitor
• Focused, Coordinated
• Everyone is Involved
• Process Orientation
• Continuous Activity
Basel Prescribed Methodology
Banks should implement a sound process to identify in
a consistent manner over time the events used to set
up a loss database and to be able to identify which
historical loss experiences are appropriate for the
institution and represent the current and future
business activities.
Banks should develop rigorous conditions under which
internal data would be supplemented with external
data, as well as the process of ensuring relevance of
this data for their business environment.
87
Operational Risk Tracking
Need Standard List of Risks
Need to Track
Losses
Exposures
Process should be similar to mortality studies for
Life Insurers
88
Operational Risk Management
Control Systems
Internal audit
Back-up and Redundancy
Insurance
Compliance monitoring
Process improvement
89
Categories of Operational Risk
1. Clients, Products &
Business Practices
2. Fraud, Theft,
Unauthorized Activity
3. Execution &
Processing Errors
4. Employment & Safety
5. Physical Asset
90
 Suitability, breach of fiduciary duties,
sales practices
 Unauthorized transactions, money
laundering, fraud
 Execution errors & systems failures
 Wrongful dismissal, harassment, workers
comp & related legal liability
 Natural Disasters and human-instigated
acts of damage
Case Study
Misselling Risk
Risk Description
Occurs during Sales Process
Improper Illustrations
Misrepresentation of Policy Provisions
Misrepresentation of Company intentions regarding non-guaranteed
elements
Loss occurs when
Incorrect expectations are not met by company
policyholder obtains redress via regulator or courts
91
Misselling Risk
Risk Assessment
Isolated cases
Frequency – Low to Medium
Severity – Low to Very Low
Systematic Misselling
Frequency – based on economic & competitive conditions
Severity – Very High
92
Misselling Risk
Risk Management Options
Transfer – Insurance Coverage?
Offset – Not Applicable
Manage - Controls
Avoid – Improve Procedures
93
Misselling
Controls & Improved Procedures
Culture
Training
Clear Marketing Materials, Illustrations &
Contracts
Supervision
Monitoring
In Depth Review
Random
Triggered
Complaints
94
Turnover
Spot Checking
Case Study
Equity Linked Product Execution
Risk Description
Occurs with client directed transactions
processing lags corrected with backdating of transactions
company has gain or loss with each backdated transaction
Original thinking – gains & losses would cancel
Actual findings – direction of client fund movement tends to create
more losses than gains
with extreme market movements volumes increase, delays increase and
losses increase
95
Equity Linked Product Execution
Risk Assessment
Frequency – Very High
Severity – Low
96
Equity Linked Product Execution
Risk Management Options
Transfer – Insurance, Hedging
Offset – Possibly
Manage – Controls
Avoid – Improve Procedures
97
Equity Linked Product Execution
Insurance Option
Insurer will require improvement in procedures &
controls
Hedging Option
buy hedge contracts to offset losses from late
processing
may want to use if cost of improved processing & controls is
very high
98
Equity Linked Product Execution
Controls & Improved Procedures
Monitoring processing lag
Set targets for max daily lag
Review cases with longest lags
Monitoring losses
Review losses with supervisors
Review Processes
look for avoidable delays in processing
enhance technology & training
Special attention to larger transactions
Develop standards for overtime vs. delays
empower management to make decisions
99
Risks to Avoid
•
Most firms will have certain risks that they will
always AVOID
•
Important to explicitly document these
–
100
Either in Standards or Limits
Retained RIsks
•
Insurers and Banks are usually in the
business of retaining some risks as their
primary business
•
Important for each to appropriately provision
for the risks that are retained
•
Reserves + Capital
101
Total Asset Requirement (TAR)
approach to provisioning
•
Risk area calculated the Total amount of
assets needed to pay off risks with desired
confidence interval (for example 99.5% under
Solvency 2) – This is TAR
•
Reserves are held for expected losses plus
prudent margin (as required)
•
Capital requirement is then TAR - Reserves
102
3.10 Choosing a Primary Risk Metric
Ruin v. Volatility
Short Term v. Long Term
Other Risk Aspects
103
Ruin v. Volatility
•
Ruin = Large and usually unlikely loss
potential
–
•
104
99.5%tile loss – Solvency 2
Volatility = Fluctuations in earnings
–
Standard Deviation of distribution of probable
earnings or
–
90%tile loss
Ruin v. Volatility
Reasons to Choose Ruin
105
Reasons to Choose Volatility
Short Term v. Long Term
•
Short Term
–
•
106
1 year – Solvency 2
Long Term
–
Multi Year
–
Until finall run-off of liabilities - US
Short Termv. Long Term
Reasons to Choose ST
107
Reasons to Choose LT
Other Aspects of Risk
108
109
3.11 Uses of multiple Risk Models
Risk & Light
Full Risk Profile
110
Law of Risk & Light
There is a danger that whatever risks you ignore
will accumulate in your firm.
111
Full Risk Profile
Risk Profile is your distribution of Risks
A) By Risk Type
B) By Business Area
C) By Region
D) With Other important risk aspects
112
Other Risk Aspects
•
Can determine Risk Profile by Measurement
•
Or by Queary
–
Ask Underwriter to note whether each case has
•
113
High, Medium, Low data integrity risk
3.12 Using Economic Capital for ERM
Loss Controlling
•
EC Provides common metric for exposures & Limits
Risk Trading
•
EC Provides common standard for risk margins
Risk Steering
•
114
EC provides common metric for macro risk reward
115
116
3.13 Capital Management &
Allocation
Risk Steering
•
Overall Capital Target
•
Capital Allocation (retrospective)
•
Capital Budgeting Process (prospective)
117
Capital Target
Base Target plus
Security
118
Base Target
DIRECT REFERENCE TO RATING AGENCY
Target the level of capital that supports the desired rating
according to the exact rating agency capital model.
Advantages
• Rating agency model widely used / thoroughly vetted
• Offers greater certainty on capital portion of the rating
Disadvantages
• Uses broad industry average risk factors
• Inaccurate unless firm replicates industry average risk per
exposure
• Actual capital held by similar firms with target rating may
vary from Rating Agency guidelines; adjustments reduce
this to a modified peer comparison method
119
Base Target
INDIRECT REFERENCE TO RATING AGENCY
Using an internal company risk model, target Economic Capital level at
an exceedence probability consistent with default rate for desired
rating.
Advantages
• Reflects management knowledge of the risks of the firm
• At least one rating agency (S&P) has stated that it will eventually
incorporate internal capital models into ratings decisions
Disadvantages
• Effort of developing a full internal risk model
• Work required to validate the model to the satisfaction of both
internal and external users
• Probabilities related to A and AA rating levels are extremely low
(0.02% and 0.008% per one Moody's study); in almost no case is
there enough data to reliably calibrate a model to those probability
levels
120
BUFFER CAPITAL
There are often dire circumstances associated with failure to
maintain minimum rating agency capital; therefore, most firms
establish a safety buffer.
At one extreme is a firm that plans to maintain its rating through a
1-in-500-year catastrophe loss scenario (99.8th percentile).
In contrast, another firm believes it will be possible to access the
capital markets about once every five years to replenish capital
after moderate losses, and therefore sets a buffer at the 80th
percentile loss.
Most firms, whether they directly calculate a buffer or not, fall
somewhere in the 1-in-10 to 1-in-20 range (90th to 95th
percentile).
121
Capital
Economic Risk Capital
Amount needed to support particular probability of loss
event over a time period
i.e. 95% probability of maintaining solvency over 5 years
Face Capital
Additional amount needed to satisfy regulators, rating
agencies, board and stock analysts
Free Capital
Actual capital in excess of above
122
Reasons for Allocating Capital
Pricing
Reflecting cost of capital in premiums, expense charges and
interest rates
Financial Reporting
Determining ROE (RAROC)
Capital Budgeting
Determining who gets the scarce resource
123
Allocating Risk Capital
Total Firm Risk Capital is usually less than
total risk capital for each unit
Diversification Benefit
Correlation Benefit
How can the overlap be allocated?
124
Allocating Risk Capital
First, calculate Risk Capital for each unit
separately
Three general methods for allocating overlap:
Proportionate
Marginal
Corporate
125
Proportionate Allocation
Multiply each unit’s separate Risk Capital
Calculation by
ratio of overlap to sum of separate risk capital
calculations
126
Marginal Allocation
Order of calculation is key
“Base” Unit gets overlap
“Other” Units get overlap
Marginal Factors by risk category
127
Corporate
Each unit holds full separate Risk Capital
Corporate unit “holds” the overlap
(Could be coordinated with Face Capital and Free Capital)
128
Proportionate Allocation
Pros
• Easy to explain &
understand
• Easy to calculate
• Can be seen as fair /
impartial
129
Cons
• No recognition of source
of correlations
Marginal Allocation
“Base” Unit gets overlap
Pros
Cons
• Helps to “feed the
• Makes it difficult for
franchise”
new Unit to get started
• Recognizes that “Base” • Ignores fact that “Other”
unit creates the
units are necessary for
opportunity for overlaps
overlap to exist
130
Marginal Allocation
“Other” Units get overlap
Pros
Cons
• May give newer units a • Is another way that the
pricing advantage
“Other” units are
subsidized by “Base”
• Recognizes that “Other”
unit
units create the new
situations that lead to
• Encourages shift of
overlaps
business to the new unit
131
Marginal Allocation
Marginal Factors by Risk
Pros
Cons
• Allocates some of
• Difficult to explain
overlap to each business • Factors difficult to
unit that contributes
develop
132
Face Capital Allocation
Methods of Allocations
Offset against “Overlap” and use overlap
allocation techniques
Corporate keeps Face Capital
133
Free Capital
Retained Earnings approach
Units keep what they earn
regardless of short term needs
usually a long term expectation of need
Sometimes followed by international firms
where moving capital is difficult
Profits Released approach
all free capital flows to corporate for reallocation
134
Investing Capital
Many firms let unit management determine investment
strategy for assets backing capital
Firm can use investment strategy as a major Risk
Management tool
Can be especially effective if all capital is used
may want to use a “transfer pricing” approach to allocate investment
results back to units
135
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