ERM-6 Risk Integration, Aggregation, and Correlation Robert F. Wolf, FCAS, MAAA Principal, William M. Mercer Inc./MMC Enterprise Risk Consulting Copies

ERM-6 Risk Integration, Aggregation, and Correlation

Robert F. Wolf, FCAS, MAAAPrincipal, William M. Mercer Inc./MMC Enterprise Risk Consulting

Copies of Presentation Available at www.casact.org

MMC Enterprise Risk 2

Correlation

What is Correlation?

– Two variables tending to move in the same direction e.g Commercial Building Fires and Employee Injuries

When Risk is Managed in Silos, a potential domino effect can be missed

1998 Mercer Management Consulting, Inc. Study

– Reasons for Major Stock Price Declines from Fortune 1000 Companies over a 5 year period

Often Multiples Reasons Seldom a Single Cause Unanticipated Correlated Impacts


MMC Research

Mercer Management Consulting Research– Investigated risk factors behind the 100 largest one month drops in

shareholder value amongst Fortune 1000 companies between 1993-98

Found top 100 stock drops Identified triggering event Determined causes of triggering event Categorized primary cause Analyzed results and implications


Methodology – Stock Selection

Selected the largest 100 one-month percentage stock price drops among Fortune 1000 between June 1993 to May 1998.

1. Compustat database. The monthly stock prices were adjusted for stock splits.

100

31131

Largest one-month

share price drops

Capital Restructuring

• Identified each company's worst one-month percent share price drop between June 1993 and May 1998

• Selected 131 companies with the largest share price drops

Stock Selection1

(Fortune 1000 group)Preliminary Causal Screening

(Fortune 1000 group)

• Selected companies with market value/book value>1 and with at least one year of positive earnings over the past five years to reduce the bias caused by fundamentally unsound companies.

• Eliminated the share price drops caused by capital restructuring, such as spin offs, split offs, and discontinued operations

Fortune1000

Mkt Value<Book Value

Private No positiveannual

earnings

1000 5578

54813

Final selection of

top 100

# of companies

# of companies

All the top 100 drops were over one-quarter of shareholder’s value, in a generally strong U.S. stock market and U.S. economy.

• June 93 to May 98 was selected because the overall market was performing well, and thus share price drops should reflect company-specific problems


2

5

13

24

53

100

202

392

674

0 100 200 300 400 500 600 700 800

-50%

-45%

-40%

-35%

-30%

-25%

-20%

-15%

-10%

Worst-month stock drops

Percentage drop in stock price during

worst calendar month

Number of Fortune 1000 Companies

Number of companies with worst-month stock drops greater than... (Between June 1993 and May 1998)

Source. Compustat database. Data is adjusted for stock splits. Note: the monthly stock prices beyond the top 100 were not adjusted for capital restructurings, etc.

During their worst calendar month between June 1993 and May 1998, 100 of the Fortune 1000 companies lost over 25% of their shareholder.

MMC Enterprise Risk 6Source: Fortune, Mercer Analysis.

Industry breakdowns

34%

21%20%

16%14%

11%10%

6%

1%0%

0%

5%

10%

15%

20%

25%

30%

35%

40%

Health Care(12/32)

CommunicationsInformation &Entertainment

(29/137)

Services (7/35) Retail (20/122) Wholesale &Miscellaneous

(9/66)

Food (7/61) Transportation(3/31)

Manufacturers(11/198)

Financial Services(14/195)

Energy & P rocess(0/155)

Percentage of Companies Experiencing a Top 100 Share Price Drop by Industry

(Number of top 100 Drops / Number of Fortune 1000 Companies)

Industry (Number of top 100 Drops / Number of Fortune 1000 Companies)

CIE, Services, and Retail companies particularly need enterprise-wide risk management.

Percentage within an

industry of companies

with a top 100 drop

With the exception of energy and process companies, companies in all industry groups have suffered major stock drops.


After the Stock DropThe 100 companies studied never recovered relative to the rest of the market over a 24 month period.

60

70

80

90

100

110

120

130

140

150

160

Source: Compustat, Mercer analysisNote: 1S&P 500 index is the sum of the S&P indexes corresponding to time period for each of the 100 cos. suffering stock drops.2Data was not available for all companies for all 24 months after the stock drop (e.g., for stock drops in the last two years. Where data was not available, companies were excluded from that month for both the 100 cos. index and the S&P 500 index.

Index of growth in

stock price

Months after Initial Drop

Growth in Stock Price relative Growth in S&P 500(Indexed percent change in stock price)

S&P 5001

100 Cos. Suffering drops2


Revenue breakdowns

Revenue Classifications

Number of Companies in top 100 Stock

Drops 31

69

0

20

40

60

80

Fortune Rank 1-500 Fortune Rank 501-1000

Source: Fortune, Mercer Analysis.

The second tier Fortune 1000 companies have the most to gain from enterprise-wide risk management.

Major stock drops happen to companies of all sizes in the Fortune 1000 companies, but twice more often to the Fortune 501-1000.


Triggering event

3%8%

11%

17%

61%

Triggering Event

Company announcement about earnings

shortfall

7

4

11

7 7

15

3

6

17

67

10

0

5

10

15

20

25

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Major stock drops usually occur in months when quarterly earnings are announced

Month of Drop

# o

f C

om

pan

ies

By implication, how a company releases negative earnings results to the financial community is important in influencing the volatility of stock market reactions.

Other company

announcement

Discovery of Accounting Irregularities

Unknown

External Market Forces

the apparent triggering event for a major stock drop is usually a company announcement of disappointing current quarter earnings or expected future disappointments in earnings.


Methodology – Causal determination

Relied upon writings from the time of the stock drop to explain the causes

– Investment bank analyst reports

– Newspaper and magazine articles

Focused on what new or unexpected events caused investors to drop the price of the stock–usually a surprise earnings shortfall relative analyst expectations

Most earnings shortfalls resulted from multiple causes, but for classification purposes a primary cause was always selected.

In five cases, a primary cause could not be determined

Since most earnings drops result from multiple causes, by implication only an integrated approach to risk assessment, quantification, and management can prevent these drops.

Because the stock market consists of millions of individual decision makers, “causes” of stock drops must be inferred but cannot be observed directly

Analyzing the cause of earnings shortfalls is equally difficult, given the complexity of business economics

Ultimately, selecting a primary cause of a stock drop is an art, not a science

A Note About Causation

To determine the causes of stock drops, we researched analyses written by market observers just after each stock drop.


Methodology – Categorization of causes

The implied causes behind the stock drops were grouped into four different areas: hazard,

financial, operational, and strategic risks. • Lawsuits – Lawsuits that are not related to accounting

practices

• Natural Disaster – Act of God and other natural phenomena

Hazard

• Accounting irregularities – Misrepresentation of financial statements and/or fraud

• Cost overruns – Higher than expected overhead or other operating costs, extraordinary charges, and/or heavy investment

• Ineffective Management – Poor operating decisions made by executives within the company leading to an earnings shortfall

• Supply chain issues – Problems with the inventory and delivery systems leading to revenue shortfalls or cost overruns

• Foreign Macro-economic – Changes in foreign interest rates and/or currency exchange rates which affects a company’s earnings

• High input commodity price – Significant increase in commodity price of a major input causing an earnings decrease

• Interest rate fluctuation - Changes in interest rates negatively affect company’s earnings

• Competitive pressure – Loss of revenue due to pricing and/or volume pressures from competitors

• Customer demand shortfall – Lower than expected industry-wide demand from customers

• Customer pricing pressure – Strong customers negotiate price discounts

• Loss of key customer – Loss or major reduction of business from key customers

• Misaligned Products/Channels – Product selection/design does not meet customer requirements

• M&A integration problems – M&A activities viewed unsound by investors; cost savings and/or synergies from M&A not achieved

• Regulatory problems – Regulatory changes affect long-term earnings potential

• R&D Delays – Problems with research and development

• Supplier Problems – Suppliers oppose company’s strategy

Financial

Operational Strategic


Causes for stock drops – Fortune 1000 Group1993-1998

.

24

12

76

4

21 1 1

11

7 76

32

10 0

0

5

10

15

20

25

Cost Overruns

Accounting irregularities

Manage-ment

ineffective-ness Supply

Chain Issues

Competitive Pressure

M&A Integration Problems

Mis-aligned

Products

Customer Pricing

Pressure

Loss of Key

Customer

Supplier Problems

R&D Delays

Customer Demand Shortfall

% of top 100

Regulatory Problems

MMC Research

• Primarily Due to Strategic and Operational Risks

Strategic Operational Financial Hazard

Foreign Macro-

Economic Issues

Interest Rate Fluct-uation

High Input

Comm-odity Price

Law-suits

Natural Disasters

58% 31% 6% 0%

Risk Event Precipitating Stock Drop (# of Companies)


Risk Management can protect shareholder value

31

100

6

7

77

Fortune 1000

Companies losing over

25% of value in a

month

Financial Risks


AccountingIrregularities

Supply ChainProblems

Other Risks

# of Companies

Risk Category and Possible Mitigation for 100 Major Stock Drops

30

12

Customer Risks

CompetitivePressure

Financialderivativescould transfer Customer

research could anticipate

Scenario Planning & Game Theory could anticipate

Up-front integration planning could prevent Proper audit

process could prevent Effective supply

chain strategy could prevent

Hazard Risks

0

Success Story: Insurance has successfully transferred

Risks causing major Fortune 1000 stock drops

• Foreign exchange

• Interest Rate• Commodity

Prices

• MisalignedProducts / Channels

• Demand Shortfall

OOver two-thirds of these risks could have been anticipated and ver two-thirds of these risks could have been anticipated and mitigated / transferred using existing tools and techniques.mitigated / transferred using existing tools and techniques.


Implications from the Study

The typical Fortune 1000 company has a 10% chance of losing at least 1/4 of their value in a month due to company specific problems– Healthcare, CIE and Services companies are particularly prone to drops

– Smaller Fortune 1000 companies are more likely to drop

The primary causes of major stock drops cannot be traditionally insured but almost two-thirds can be mitigated– Strategic risks can be anticipated by spotting emerging profit patterns in an

industry; once anticipated these risks can be mitigated or prevented

– Research, analysis, and scenario planning can be used to think through potential operational and strategic risks; which can be prepared for once considered

– Well structured processes and contingency plans can lessen the effect of operations and strategic risks which are not prevented

Companies should explore enterprise-wide risk management to assess, mitigate and if possible transfer, all of their risks

Enterprise-wide risk management can mitigate large drops in a company’s share price.


XYZ Company

Exposed to many insurable risks

– Substantial Annual Costs Deductible or Retained Losses Insurance Premiums Collateral Costs

Goal- Optimal Insurance Structure

Actuary can be a valuable resource in bridging the communications gap between the risk manager and the CEO/CFO/Treasurer


Example: ABC Airlines

Rise in Jet Fuel Deemed to correlate and causative with certain events

– Increases Expense Raising Fares

– Bonuses Cut for Employees

– Stock Price Drops

– Fewer Passenger Miles

– Decreased Maintenance Expense

– Decreased Advertising

– Employees Layoffs

– Workers Compensation Costs Up

– Lower Levels of Space Needed

– Prices Fall on Rental Space


Consider Correlated Events not Causative to Jet Fuel

– Rise in Jet Fuel Correlated with cost of Oil and Natural Gas

Strategy

– Purchase a Call Option on Crude Oil

– Sell Calls on the Stock

– Negotiate for future aircraft when prices are at their highest

– variable contract with advertisers

– Workers Compensation Retention Inversely Related to Fuel Prices

– Tie Lease Negotiations to Fuel Prices


Challenges

Difficulty in Measuring Correlation

– Attempts to isolate relationships between variables such that historical relationships will continue into the future

Corporate Constraints to Integrating Risk

– Budgets Drive Corporate Behavior

– Trading Mentality

– Not particularly concerned with things that haven’t happened recently

– Static Inertia

– Risk Manager still seen as insurance buyer


Bridge in Organizational Communication-Speak same Language

How much capacity does XYZ Corp have to bear risk?

Within the above capacity, how desirable is it for XYZ Corp to retain/bear additional risk?

XYZ not in the business to just merely survive, but rather to thrive


The Goal of Optimizing XYZ’s risk retention alternatives is to…..

“Go Northwest”

Figure - The Efficient Frontier and Preference Indifference (Utility)

0%

5%

10%

15%

20%

25%

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

Risk = Standard Deviation of Return Distribution

Retu

rn = M

ean Value of R

eturn Distribution

The Efficient Frontier ofOptimal Retentions

A guaranteed cost policy transfersall losses to the insurer andcarries no retention: depictedhere in the space of risk andreturn, this insurance optionresides at the origin where riskand return are both zero.

As retentions are increased, bothrisk and return should increase.Programs that offer only highercosts with higher risks areidentified as sub-optimal.

NWA B

C

D

• Option A is Better than Option B because for the same return (I.E. cost savings), option A has less risk (more West).

• Option D is a better alternative than Option C, because for the same amount of risk, D has a greater return (I.E. more savings;more North)


Figure 3 - The Efficient Frontier and Preference Indifference (Utility)

0%

5%

10%

15%

20%

25%

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%


Retu

rn =

Mean V

alue of Return D

istribution

Each point represents an alternative portfolio of risk financing/transfer strategies.

Return = Savings from Guaranteed Cost



0%

5%

10%

15%

20%

25%

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%


Retu

rn =

Mean V

alue of Return D

istribution

Efficient Frontier

Markets have hardened - going Southeast



Optimum Portfolio

Utility

Curv

e

0%

5%

10%

15%

20%

25%

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%


Retu

rn =

Mean V

alue of Return D

istribution

Utility Curve represents XYZ’s levels of indifference to cost savings/risk retention alternatives

Current Structure


Two Questions

Does the benefit of reduced costs given additional risk enhance or destroy XYZ’s shareholder value?

Does the benefit of reduced costs given the additional risk increase or destroy shareholder value?

In theory, shareholder value is enhanced if the Risk Adjusted Return on additional (marginal) capital at risk (by raising retention) exceeds XYZ’s marginal cost of capital.


When retaining risk, XYZ is notionally committing capital at risk. When viewed this way, the insurance and or risk-financing decision is essentially equated to an investment decision, and hence, the goal of the retention decision becomes maximizing return while minimizing risk.



Optimum Portfolio

Utility

Curv

e

0%

5%

10%

15%

20%

25%

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%


Retu

rn =

Mean V

alue of Return D

istribution

The Goal is to reach the Tangent of the Market Efficient Frontier and XYZ Indifference Curves. This point represents the best of all available alternatives per the corporation’s risk/reward appetite.


A simple numerical example

Marginal Cost of Capital = 15%

Option 2 Option 3 No Insurance

retention 5,000,000 10,000,000 <null>

Inputs

expected retained losses 8,635,183 11,960,949 23,095,332measure of tail losses 21,845,362 33,260,552 138,078,729

market premium 16,000,000 10,750,000 0

Total Cost Of Risk

discounted retained losses 7,553,364 10,462,476 20,201,939TCOR 23,553,364 21,212,476 20,201,939


Option 2 Option 3 No Insurance

retention 5,000,000 10,000,000 <null>

Inputs

expected retained losses 8,635,183 11,960,949 23,095,332TVaR 21,845,362 33,260,552 138,078,729

market premium 16,000,000 10,750,000 0

Total Cost Of Risk

discounted retained losses 7,553,364 10,462,476 20,201,939TCOR 23,553,364 21,212,476 20,201,939

SavingMarginal Approach Current 2,340,887 3,351,424Option 2 is current Program Program 8,089,424 101,773,218

28.9% 3.3%Better Deal Worse Deal

Marginal Approach -2,340,887 Current 1,010,537Option 3 is current Program -8,089,424 Program 93,683,794

28.9% 1.1%Marginal Return Marginal ReturnGiven Up

Marginal Approach -3,351,424 -1,010,537 CurrentNo insurance is Current -101,773,218 -93,683,794 Program

3.3% 1.1%Best Deal


The frontier of integrating risk is including operational and strategic risks

24

12

76

4

21 1 1

11

7 76

32

10 0

0

5

10

15

20

25

Cost Overruns

Accounting irregularities

Manage-ment

ineffective-ness Supply

Chain Issues

Competitive Pressure


Mis-aligned

Products

Customer Pricing

Pressure

Loss of Key

Customer

Supplier Problems

R&D Delays

Customer Demand Shortfall

% of top 100

Regulatory Problems

Strategic Operational Financial Hazard

Foreign Macro-

Economic Issues

Interest Rate Fluct-uation

High Input

Comm-odity Price

Law-suits

Natural Disasters

58% 31% 6% 0%

Primary Cause of 25%+ Stock Drops for 100 of Fortune 1000 Companies

Source: Compustat, Mercer Management Consulting analysis

What Risks Impact Shareholder Value


“….We don’t do things because they are easy. We do them because they are hard.”

….John F. Kennedy

…….Significant Opportunities Casualty Actuaries in servingas the bridge between hazard and operational/strategic risks.

Documents

ERM-6 Risk Integration, Aggregation, and Correlation Robert F. Wolf, FCAS, MAAA Principal, William M. Mercer Inc./MMC Enterprise Risk Consulting Copies