Enterprise Risk Management: Benefit or Fad?

CAS: Risk and Capital Management SeminarJuly 29, 2003

Washington, D.C

Claus S. Metzner, FSA, FCAS, MAAA, Aktuar-SAVEPIC Actuaries, LLC

What is ERM?

Is it a Tool? Is it a Theory?

Is it a way of Managing? Is it a Benefit?

Is it a Fad?

What is ERM?

ERM is: Focusing on all risks

Financial risks Operating risks

Developing appropriate risk constraints Including checks and balances

Assessing risk/return trade-offs Assuring the enterprise is operating within the

predetermined risk constraints

What is ERM?

ERM is Not Modeling

Models can be very helpful in quantification of trade-offs Models can be very helpful in developing a “base case”

Bureaucratic Stifling

ERM: Some Key Concepts

Extreme Events What are they

Severity/frequency

Maximum Possible Loss How defined

Severity/frequency

Price Adequacy Long term/short term

ERM: Some Key Concepts

Balance Sheet “Honesty” Risk Appetite

Level of assessment: Firm wide or subsets? % of Earnings? % of Revenue % of Capital

What fluctuation is “tolerable” What fluctuation is “unacceptable”

RAROC Risk adjusted return on capital

ERM: Time Frame

Is ERM prospective What is the relevant time frame? Does the time frame vary for different risks?

Pricing risk Reserving risk Reputation risk

Considerations When do we know something How long before we can take corrective actions

Key ERM Interrelationships

Asset Risk Liability Risk (including future business) Capital Operating Risks/Constraints

People and processes are important

ERM View

Consider: ERM views the enterprise as a going concern

What are the implications? Capital is not just balance sheet capital Capital includes the franchise value Balance sheet capital (and economic capital)

are important since they serve as possible constraints (insolvency has consequences!)

ERM Open Issues

Asset Risks Current models are tested, in existence Current models seem to work Current models can provide some operating

metrics, e.g. Value at Risk

Cautionary Notes Remember the LTC debacle Who anticipated the drop in equity prices?

ERM Open Issues

Liability Risks Models exist to develop maximum possible

loss (e.g. earthquake, hurricanes) and distribution of outcomes for a portfolio of risks

Output of models is relevant only if appropriate risk control measures are in place (e.g. operational risk management must be in place and effective)

ERM Open Issues

Liability Risks (continued) Models need to consider risks associated with

realizing the value of good will Reputation risk Dynamic responses to pricing/underwriting initiatives

Responses by customers Responses by competitors Political responses

ERM Open Issues

Operational Risk – People and Processes Internal perspective

Underwriting Claims Pricing Marketing Auditing (general financial discipline) Etc, etc

ERM Open Issues

Operational Risk – People and Processes External Perspective

Response of market to internal initiatives Customers Competitors

Response of rating agencies Response of shareholders (publicly traded

companies) Response of regulators Response of Legislators

Enterprise Risk Management: Benefit or Fad?

Answer depends on How well the liability risks and the operational

risks are addressed Consider – we may need to develop day to day

operational metrics Quantification (modeling) comes after, not

before, we understand the risks Holistic view of the risk management process

(RAROC) Many tools are available, but these appear to not yet

be integrated into a cohesive risk management program

Enterprise Risk Management: Benefit or Fad?

Considerations for Improvements Develop Operational Risk Assessment

Function of Management Co-operative Effort across all disciplines

Develop Operational Risk Management Tools Some exist (e.g. underwriting guidelines, etc.)

Develop an Actuarial Control Cycle How do we know if experience is consistent with

assumptions When do we know How do we bring information forward to foster

adjustment to new reality

Enterprise Risk Management: Benefit or Fad?

Let’s take a vote How many believe it is a benefit? How many believe it is a fad?