Casualty Actuarial Society
Seminar on Ratemaking
Tampa
March 7-8, 2002
Risk Quiz
On some questions, there are multiple
right answers
On all questions, there’s multiple wrong
answers
Write in answers are fine and may garner
extra credit (or a debit)
Choose the Best Phrase for your
View on Risk Management
A. Risk can be assessed and managed through mathematical
techniques. I think math is fun; my friends find me geeky
and I have a difficult time interacting with “normal” people
B. I find trading to be the essence of risk management. I trade
to make a profit and enhance my bonus. I can always make
a profit if my employer would just remove all trading constraints
C. Risk goes away over time. I just need to be able to get around
the accounting rules. Using financial engineering tools is
fundamentally stupid, as they cost money to trade over time.
D. Producing and selling product is all that matters. Price volatility
is the shareholders problem.
E. ____________________________________________________
Risk Quiz
Risk is:
A-m
B-s
C - Mostly m but with an element of s
D - Mostly s but modified by m
E - What the _____ is m and s and
why should I care?
The Most Important Aspect of Risk
Management is:
A.
B.
C.
D.
E.
Protecting the outcomes of my operation
Protecting market share
Creating the opportunity for trading profits
Making sure my bonus formula is achieved
Enhancing shareholder value through maximized
income at a lower volatility
What is a Garch Model
A. Used in thermodynamics and measures the movement
of heat through a semi-permeable metalic membrane
B. Uses a physical theory of random movement of a molecule
in a vacuum to simulate random motions of financial variables
C. Measures and simulates outcomes for interest rate movements
D. Captures financial volatility that demonstrates heteroskedastic
properties
E. None of the above
F. C&D
A Naked Straddle is:
A. An interesting way to ride a horse
B. Concurrently selling a put and a call
C. The part the director eliminates from a movie so
people 18 and under can gain admission
D. Not something polite people would put in a quiz
E. A & C
F. A, B & C
G. All of the above
H. None of the above
I. I don’t know, I don’t care but I’m willing to give it a try
Match the Formula and the Description
1. Bayes Rule for
Conditional Probability
A.
S(X i- X)(Yi -Y)
n-1
1
2. Sample Covariance
3. Density of Normal Distribution
4. Circumference of a circle
B.
C.
D.
f(x)=
2ps 2
2
2
e -(x-m)/2s
C = 2pR
P(A&B)
P(A|B) =
P(B)
Your View on Risk Management
Answer
 Requires analysis and understanding of the
analysis - being modeling conversant is an
asset, but social oddness is not
 Trading is fine if it’s the organizational strategy
but don’t confuse trading with risk
management
 True - volatility over time matters relatively
little, but does impact business operations
 Good to keep sight of the objectives of the
organization - but the shareholder issues are
your issues
Risk Quiz
Risk is:
A-m
B-s
C - Mostly m but with an element of s
D - Mostly s but modified by m
E - What the _____ is m &s and why should
I care?
The Most Important Aspect of Risk
Management Answer:
A.
B.
C.
D.
E.
Protecting the outcomes of my operation
Protecting market share
Creating the opportunity for trading profits
Making sure my bonus formula is achieved
Enhancing shareholder value through maximized
income at a lower volatility
A Naked Straddle is:
A. An interesting way to ride a horse
B. Concurrently selling a put and a call
C. The part the director eliminates from a movie so
people 18 and under can gain admission
D. Not something polite people would put in a quiz
E. A & C
F. A, B & C
G. All of the above
H. None of the above
I. I don’t know, I don’t care but I’m willing to give it a try
What is a Garch Model
A. Used in thermodynamics and measures the movement
of heat through a semi-permeable metalic membrane
B. Uses a physical theory of random movement of a molecule
in a vacuum to simulate random motions of financial variables
C. Measures and simulates outcomes for interest rate movements
D. Captures financial volatility that demonstrates heteroskedastic
properties
E. None of the above
F. C&D
Extra Credit - GARCH stands for Generalized Auto - Regressive
Conditional Heteroskedactic model
Match the Formula and the Description
1. Bayes Rule for
Conditional Probability
A.
S(X i- X)(Yi -Y)
n-1
D.
1
2. Sample Covariance
B.
f(x)=
2ps 2
2
A.
3. Density of Normal Distribution
C.
C = 2pR
B.
4. Circumference of a circle
C.
D.
2
e -(x-m)/2s
P(A&B)
P(A|B) =
P(B)
Write Down as Many Risks as Possible based
on The Following Exposure
Jack and Jill went up a hill to fetch a pail of water,
Jack fell down and broke his crown
and Jill came tumbling after.
Jack and Jill Scenario
 J & J sue landowner for slick surface and failure to warn of
dangerous conditions
 Jill sues Jack for encouraging her to climb an unsafe hill
 Purchaser of water sue J & J for non-delivery
 J & J sue purchaser of water for encouraging them to perform
an inherently unsafe act
 J & J sue maker of pails for creating unbalanced pail system
 J&J sue shoemakers for unsafe sole pattern
 J&J sue school system for not teaching hill-climbing dangers
 Price spikes on water, compounding J&J’s spillage loss
 J&J sue ambulance company for failure to render adequate
care and to safeguard the water supply
 Jill sues Jack for sexual harassment for the implication that
she couldn’t climb the hill because “she was just a girl”
Risk and Why We Care
Impacts stock price
Impacts ability to make future
investments
Impacts business decisions and
willingness to enter a business
Impacts cash flows and earnings from
non-core activities
Defines the potential deviations from
expectations of the company
Enterprise Risk Management
 Clients changing their view of risk to encompass many areas
 Risk is no longer defined by the products the insurance industry sells
 Measurement is defined by what the client thinks it is
–
–
–
–
EVA
CFaR
Internally created metrics
Stock price movements
Generally: Risk can be defined as a deviation from an
expected outcome
Traditional View of Risk
 Clients have traditionally viewed their risks as a series of single
elements
 Each risk stood alone - assumed one wasn’t related to another
 Optimized silos meant optimized risk management
 Insurance risk management wasn’t a problem
 Cheap insurance was an effective tool with these assumptions
 Derivatives allowed other risks (FX, commodity, interest rates) to
be managed with their unique set of tools
 Assumes that management can deal with other non-tradable,
non-insurable risks in their role of managing the business effort
Issues
 Ignores portfolio effect
 Human beings are extremely bad at dealing with things that have not
happened to them recently
 People assume mean reversion in short time periods
 Ignores possibility of related events (embedded, unrecognized correlation)
 Budgets are silo based and drive individual behaviors, even though the
true outcomes are inherently intertwined
 Management of enterprise wide risk is perceived as complex
 The tools to manage enterprise risk are in their infancy
0%
0%
97
5%
91
5%
85
10%
79
10%
72
15%
66
15%
60
20%
54
20%
48
25%
42
25%
36
30%
30
30%
24
PROBABILITY
Portfolio Effect
Impact of Portfolio Effect
Apparent Silo Volatility vs. Real Portfolio Volatility
1,200,000
1,000,000
Auto Liability
General Liability
Volatility
800,000
Workers Comp
Property
600,000
Foreign Exchange
Portfolio
400,000
200,000
0
Silo Management
Actual Portfolio
Client Issues
Budgets and Silos
Organizations seldom take an overall
view
– Budgets drive behaviors
– Assumed that the sum of optimized
elements optimizes the whole
How do you split an integrated outcome?
How to retain an entrepreneurial spirit
How to reward and punish
Client Issues
Trading Mentality
Current purchasing/treasury functions
attempt to optimize timing
Beating the market goes into the budget
of the department, working against the
desire to integrate
People like to trade - its fun
Client Issues
Understanding the Cost of Volatility
Unlike banks and insurers, non-financial
companies have no explicit cost to take
risk
Hard to know the impact to the stock
price if an unforeseen event does occur
Not particularly concerned with things
that haven’t happened recently
Little concept of scope of volatility or
correlation in the organization
Client Issues
Organizational Dynamics
 Decision process is inherently across a diverse
group of managers
 Each member views in the context of their role
 Inertia
 Communication
 Difficult explanation to most senior
management - too complex to show in three
slides
 How many others have done this; “We don’t
want to be first”
Client Issues
Economic Foundations
 Never really considered or modeled the
volatility of the exposures, thus never
concerned with risks not actually experienced
 Difficult to determine price elasticity questions
on commodities and other economic indicators
 Underlying belief that economic elements can
be forecasted with adequate certainty
 Mean reversion assumption and ability to view
whether something is expensive or cheap
 It’s a lot of work and most organizations don’t
have people with the skills
Client Issues
Market Pricing Inefficiency
 Complex structures lack transparency
 Differing view of modeling processes, resulting
in differing view on value
 Markets have their own silos that have to be
circumvented to capture portfolio pricing
 Lack of depth of people with multiple
experience
 Lack of integrated reinsurance marketplace
Is there a Future in Managing Risk together?
There are rational economic foundations
Marketplace for insurers and banking is
overlapping, encouraging organizations
to use the talents of each
Will be slow to take off, but will fly
The logical extension to Enterprise Risk
Management approaches - why study
something if there is no intent to
manage?
Evolving Tools
 Application of simulation modeling for single and multivariant exposures is being slowly accepted as a tool to
measure risk
 The models are being taken from a combination of actuarial
and econometric modeling processes
 May haven’t done it yet, but are interested in pursuing the
subject
 There is a broadening of the insurance market to include
derivative-like exposures for
– Commodities that don’t trade
– Exposures that trade, but may be illiquid
– Correlation proxy opportunities
 A realization that risk is risk and should be treated
consistently
Risk Example
 Client makes nylon based products
 In their processes, they use
–
–
–
–
–
Ammonia
Cyclohexane
Benzene
Propylene
Natural gas (fuel and input)
 Product pricing presumed to be inelastic to input costs
How do you manage this?
Understand the risk
 All commodities are oil or natural gas based
 Can we model the inputs?
 Compare to proxy basket of oil and natural gas?
 Measure the volatility of the correlation?
 Structure an arrangement with and insurer where
– they provide the client a cover for what they purchase
– trade out the proxy basket
– Charge for the volatility of the exposure
 Outcome - a synthetic derivative with excellent
margins for the insurer that solves the client
problem
Optimized correlation
$90,000,000
$80,000,000
$70,000,000
Optimized oil/gas w absorber
Client Basket
$60,000,000
$50,000,000
$40,000,000
$30,000,000
$20,000,000
$10,000,000
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$-
Annual Volatility of Correlation
Volatility of Correlation
3
2.5
X <=-0.19
5%
X <=0.25
95%
Mean = -3.601814E04
2
1.5
1
0.5
0
-30.00%
-2.50%
25.00%
52.50%
80.00%
Enterprise Risk Management
 Its coming - slowly
 Actuary’s opportunity - to understand and
support modeling and understanding of the
opportunity
 Provides an opportunity to increase insurer’s
results while concurrently providing valuable tool
for clients
 Not yet everyday - but will be
 The way risks will be managed tomorrow