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ERM - Enterprise Risk Management.ppt

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					 Enterprise Risk Management
            Stephen P. D’Arcy
 Fellow of the Casualty Actuarial Society
           Professor of Finance
          University of Illinois

UNSW Actuarial Studies Research Seminar
             3 July 2007
         Sydney, Australia
              What is ERM?
ERM is the application of the basic risk
management principles to all risks facing an
organization
Other names for ERM
     Enterprise-wide risk management
     Holistic risk management
     Integrated risk management
     Strategic risk management
     Global risk management
          Genealogy of ERM
• Risk Management – 1960s
• Financial Risk Management – 1980s
• Enterprise Risk Management – 1990s
Basic Risk Management Principles
1. Identifying loss exposures
2. Measuring loss exposures
3. Evaluating the different methods for
   handling risk
  •   Risk assumption      •    Risk transfer
  •   Risk reduction        •   Hedging
4. Selecting a method
5. Monitoring results
               Why Manage Risk?
Diversifiable risk argument
• Shareholders are diversified investors
• They will not pay a premium to reduce unsystematic risk
How risk management can add value
• Decreasing taxes
• Decreasing the cost of financial distress
   – Customers
   – Employees
   – Suppliers
• Facilitating optimal investment
Helpful Reference
   ERM: Theory and Practice by René Stulz and Brian Nocco
   http://papers.ssrn.com/sol3/papers.cfm?abstract_id=921402
    Traditional Risk Management
• Formally developed as a field in the 1960s
  – Pioneers were two insurance professors at the
    University of Illinois
     • Bob Mehr and Bob Hedges
     • Risk Management in the Business Enterprise, 1963
• Focused on “pure” risks
  – Loss/no loss situation
• Often could be insured
• Managing risk involved reducing frequency or
  severity of losses
   New Elements of Risk – 1970s
Foreign exchange risk
  End of Bretton Woods agreement in 1972
Commodity price risk
  Oil price fluctuations of the 1970s
Equity risk
  Development of option markets - 1973
Interest rate risk
  U. S. Federal Reserve Board policy shift – 1979
  Similar changes worldwide
 Failure to Manage Financial Risk
• Foreign exchange risk
   – Laker Airlines – 1970s
      • Borrowing in dollars
      • Revenue in pounds
• Interest rate risk
   – U. S. Savings and Loans – 1980s
      • Borrowing short
      • Lending long
• Commodity price risk
   – Continental Airlines – 1990
      • Fuel costs not hedged
      • Oil price doubled with Gulf War
The “New” Risk Management -1980s
Financial risk management
  Dealt with financial risk
     Foreign exchange risk
     Interest rate risk
     Equity risk
     Commodity price risk
  Use derivatives to hedge financial risk
      Financial Risk Management
                Toolbox
•   Forwards
•   Futures
•   Options
•   Swaps
     New Elements of Risk – 1990s
•   Failure to manage derivatives appropriately
•   Financial model failures
•   Improper accounting for derivatives
•   Operational risk failures
Mismanagement of Financial Risk
• Mismanagement of derivatives
  – Proctor and Gamble
  – Barings Bank
  – Orange County
• Model failure
  – Long Term Capital Management
• Accounting improprieties
  – Enron and Arthur Andersen
• Foreign exchange rates
  – East Asia currency crisis
The “New” Risk Management - 1990s
           and beyond
• Enterprise Risk Management
    – Initial focus on avoiding derivative disasters
    – History of managing risk, not managing performance
    – Slowly developing into optimizing firm value
•   Chief Risk Officer
•   Sarbanes-Oxley Act – 2002
•   Basel II
•   Solvency II
•   Increased focus on risk models
The Problem With “Risk Management”
 • Risk Management
   – Focus was on pure risk (insurable, hazard)
 • Financial Risk Management
   – Value-at-Risk – measure of certain percentile loss
 • Enterprise Risk Management
   – Incorporates all risks facing an organization
   – Name suggests focus still on managing downside risk
       Need for New Emphasis
     (and Perhaps a New Name)
• ERM is not just managing downside risk
• More on the lines of risk-return tradeoff
• Incorporate portfolio theory
• Combine risk reduction (insuring, traditional
  risk management) with investing for expected
  gain
• Need consistent approach for addressing both
  aspects of financial decision making
         ERM Risk Categories
Common risk allocation
• Hazard risk
• Financial risk
• Operational risk
• Strategic risk
Bank view – New Basel Accord
• Credit risk
  – Loan and counterparty risk
• Market risk (financial risk)
• Operational risk
                   Hazard Risk
•   “Pure” loss situations
•   Property
•   Liability
•   Employee related
•   Independence of separate risks
•   Risks can generally be handled by
    – Insurance, including self insurance
    – Avoidance
    – Transfer
                 Financial Risk
• Components
  –   Foreign exchange rate
  –   Equity
  –   Interest rate
  –   Commodity price
• Correlations among different risks
• Use of hedges, not insurance or risk transfer
• Securitization
      Operational Risk Definition
• Per Basel II:
  – “Operational risk is defined as the risk of loss resulting
    from inadequate or failed internal processes, people and
    systems or from external events. This definition includes
    legal risk, but excludes strategic and reputational risk.”
• S&P 2005 “Insurance Criteria” document:
  – Operational risk includes “Distribution, process and people,
    fraud and internal control, outsourcing, reputational,
    information technology, human resources, regulatory and
    compliance, change management, and business continuity”
      Operational Risk Definition.
                (cont.)
• Per Casualty Actuarial Society:
• Risks from
  –   Business operations
  –   Empowerment (leadership, preparation for change)
  –   Information technology
  –   Information / business reporting
     Operational Risk Examples
• HIH Insurance
  – Under pricing and under reserving
  – Unfamiliar with new markets
• Backdated options
  – over 130 public companies
  – options with exercise prices below market value
• Meijer price discount (May 2007)
  – 50% discount meant to apply to one item
  – applied to everything sold in every store for 1 hour
  – estimated loss $750,000
      Operational Risk References
• “The Market Value Impact of Operational Risk
  Events for U.S. Banks and Insurers” by Cummins,
  Lewis and Wei
 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=640061
• “Introduction to Operational Risk” by Mango and
  Venter
  http://www.actuaries.org/ASTIN/Colloquia/Orlando/Papers/Mango3.pdf
       Strategic Risk Definitions
• A strategic risk is a risk a company takes to
  fulfill its objectives
  – www.harperrisk.com
• Risks that arise in pursuit of business objectives
  – Emblemsvag and Kjelstad (2002)
• Stategic objectives ... relating to high level goals
  – COSO Integrated Framework (2004)
• Helpful reference
  – Mango (2007)
  – http://www.actuaries.org/ASTIN/Colloquia/Orlando/Papers/Mango1.pdf
         Strategic Risk Examples
•   Competition
•   Regulation
•   Technological innovation
•   Political impediments
             Examples of ERM - 1
Michelin – contingent capital
• Issued by Swiss Re New Markets and Societe Generale
• Option to draw on subordinated long-term bank credit
  facility
• Option to issue subordinated debt at fixed spread
   – This option can only be exercised if GDP growth falls below a
     trigger (1.5% 2001-03, 2.0% 2004-05)
         Examples of ERM - 2
United Grain Growers – risk integration
• Issued by Swiss Re
• Grain volume coverage
• Integrated with other property/liability coverages
• Three year policy
• Annual aggregate retention
• $35 million annual limit
• $80 million policy limit
         Examples of ERM - 3
RLI Corporation – Cat-E-Puts
• Arranged by Aon, issued by Centre Re
• Three year term
• Provided an option to issue $50 million in
  convertible preferred shares
• Trigger was major California earthquake
• Subject to minimum capital requirements
         Examples of ERM - 4
• Honeywell – 1997
• Old approach
  – Separate annual insurance policies for each hazard
  – Options used to hedge FX risk
• New approach
  – Multiyear combined hazard and FX risk policy
  – $30 million annual retention based on simulation
    model
        Current Status of ERM
• Starting to put ERM framework together
• Forming committees to deal with risk
  consistently
• Starting to integrate risk management across
  silos
• Developing lists of top risks (downside) the
  organization faces
• Often rating agency driven
               Future of ERM
• ERM will continue as risk consolidation and
  aggregation
• Process increases value of risk management skills
• Management is concerned with risk control issues
• Chief Risk Officer will be a visible figure in an
  organization
• Need for consulting help to get process started
• ERM’s role in optimization has a long way to go
• Potential benefit is worth pursuing for pioneers

				
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