7/28/2019 Risk magement
1/48
EnterpriseRisk Management
For Insurers and FinancialInstitutions
David IngramCERA, FRM, PRM
From the International Actuarial Association
7/28/2019 Risk magement
2/48
Course Outline
1. INTRODUCTION - Why ERM?
2. RISK MANAGEMENT FUNDAMENTALS FIRSTSTAGE OF CREATING AN ERM PROGRAM
3. RISK ASSESSMENT AND RISK TREATMENT -ACTUARIAL ROLES
4. ADVANCED ERM TOPICS
7/28/2019 Risk magement
3/48
INTRODUCTION
1. INTRODUCTION - Why ERM?
1.1 Enterprise risk management history
1.2 What is enterprise risk management?
1.3 ERM & the Financial Crisis
1.4 ERM Adoption in the Insurance Industry
7/28/2019 Risk magement
4/48
A Brief History of RiskManagement
1952 Markowitcz Portfolio Theory Risk =variance
1973 Black Scholes Derivative Pricingvariance is key driver
1987 Black Monday Portfolio Insurance
implicated in record 1 day fall in stock market1992 Cadbury (UK) Report urges centralized,
comprehensive corporate RM
1993 First CRO named at GE
7/28/2019 Risk magement
5/48
Current Trends in RiskManagement
1. Dedicated risk management function
- Risk Management decision making
remains largely decentralized2. Risk Aggregation / Economic Capital
- in early stages of development
3. Regulatory practices encourage ERM4. Regulatory Capital Economic Capital
Basel Survey (August 2003)
7/28/2019 Risk magement
6/48
Risk Management Failures
1973: Equity Funding Fraud
1983: Baldwin United Shell Game
1986: The ZZZ Best Carpet Scandal.
1988: Equitable (NY) GIC losses.
1989: The US S&L Crisis.
1991: Salomon Brothers Bond Scandal.1991: BCCI Scandal.
1991: Executive Life / First Capital Life Failures
1991: Mutual Benefit Life Failure
1994: Orange County Default
1994: Kidder Peabody Fiasco.
1994: Confederation Life Failure
1994: Monarch Life Seizure1995: The Barings Derivatives Scandal.
1996: Sumitomo Copper Scandal.
1997: The Natwest Hole.
1997: The Bre-X Mining Scandal.
1997: Smith Barney Investor Fraud.
1997: Bank of Tokyo-Mitsubishi DerivativesLoss.
1997: UBS Derivatives Model Problems.
1997: Prudential Insurance US Market Conduct
1998: Russian Bond Debacle.
1998: The Long-Term Capital ManagementModel Failure.
1999: General American Liquidity Failure1999: Unicover Fiasco
2000: Equitable UK Pension guarantees
2001: American Express CBO Losses
2002: Enron & Worldcom
2003: Parmalat
2003: Allmerica VA reserving
2003: Annuity & Life Re Overgrowth
2004: Marsh Contingent Commissions
2005: AIG Finite Re
2006: Scottish Re Tax Asset
2006: Hurricane Katrina
2007: Countrywide Sub Primes2008: Bear Sterns/ Lehman/ AIG Sub Prime
7/28/2019 Risk magement
7/48
Risk Management Failures
Bank / Financial
BaringsControls Missing, mgt didnt understand risks
LTCM Models inadequate, overleveraging
Northern Rock Excessive Growth
Insurance
Nissan Mutual ALM mismatch, underpricing interest credits
Equitable UK underpriced annuities, poor relationship with regulators
HIH insurance mispricing, underreserving
Confed Life Over-concentration in illiquid investments, shell game
General American ALM mismatch, rating downgrade, downgrade triggeroptions
American International Group Small Financial Group brings down Insurancegiant
7/28/2019 Risk magement
8/48
Barings (UK)
Venerable UK Bank
Trading losses in Singapore
Exceeded value of bank
Problems
Management didnt understand what the trader was doing Trades were not the hedged transactions they were supposed to be
Trader did all reporting of trades
No separation of duties
7/28/2019 Risk magement
9/48
Long Term CapitalManagement (US)
Private Investment Fund
Very highly Leveraged portfolio of investments
Highly sophisticated risk management
Capital was insufficient to withstand market movement
Problems:
Risk Model was inadequate to predict 1998 internationalfinancial problems
Counterparties did not know the extant of their full exposure
7/28/2019 Risk magement
10/48
Northern Rock (UK)
Mortgage lender grew rapidly to become one of the top5 mortgage lenders in the UK
Had used securitization to fund mortgage lendinggrowth
Encountered liquidity problems when mortgagesecuritization markets froze in Aug 2007
Problem:
Request for help with liquidity from Bank of Englandtriggered first run on UK bank in over 100 years
7/28/2019 Risk magement
11/48
Nissan Mutual (Japan)
Savings product guaranteed high interest rates
High sales growth of this product
Investment losses & inadequate yield
200 billion net losses covered by Life Association ofJapan
Problem:
Asset Liability Mismatch
Underpricing (over crediting) of interest
7/28/2019 Risk magement
12/48
Equitable (UK)
Guaranteed payout annuity product sold topension plans
Improvement in mortality & decline in interest rates
Management tried to force solution on regulators
Problem:
Underpricing & poor Asset Liability matching
Poor relationship with regulators lead to companydemise rather than workout
7/28/2019 Risk magement
13/48
HIH (AUS)
Second largest General Insurer suddenly found tobe insolvent
Problem:
Total control failure at all levels
Company, Auditor, Regulator
Ultimate problem was fundamental underpricingand overspending
Hidden by systematic underreserving
7/28/2019 Risk magement
14/48
Confederation Life (Can)
Company invested over 70% of assets in Real Estate
Company failed following valuation and liquidity
crunch Concentration hidden by accounting
Problem:
Lack of Diversification, Liquidity
Limited oversight from regulators, rating agenciesdue to accounting gimmicks
7/28/2019 Risk magement
15/48
General American Life(US)
Funding agreement product sold to banks and mutual funds with 7-day put option
Investments were made in 1 to 2 year maturity securities
Partner handled large share of funds
Downgrade of partner =>triggered downgrade of company =>triggered calls
Company unable to raise cash for multi billion $$ calls
Problem:
Asset Liability Mismatch
High dependency of business on ratings
Huge Counterparty exposure
7/28/2019 Risk magement
16/48
American International Group
In late 2006, AIG claimed to have $16B of excess capital
In early 4th Quarter 2008, AIG needed over $100B of fundsfrom US government to meet obligations
Problem:
Small Financial Products unit has written Trillions of CDS,some on sub prime CDOs
MTM losses lead to downgrade which leads to collateral call
7/28/2019 Risk magement
17/48
Reasons for Current Interestin Risk Management
World Markets Interdependent
Chaos Theory Butterfly Effect
Wide Use of Derivatives
Financial WMD Warren Buffett
Accelerated Pace of Business
Recent Experiences of Losses
1998 International Currency Crisis
2001/2002 Terrorism & Investment Losses
Tsumani and Hurricanes
Financial Crisis
7/28/2019 Risk magement
18/48
Reasons
Tools for Risk Mgt are getting better andbetter
Success of RM in banking over the past
down cycle (view in 2004)
No Major Bank Failures
Insurance Companies in Europe fared much
worse with less Risk Mgt Extreme over exposure to equities
Insurance regulators are getting interested
In many jurisdictions same regulators forbankin & insurance
7/28/2019 Risk magement
19/48
Does the Global
Financial Crisis provethat ERM is Ineffective?
7/28/2019 Risk magement
20/48
Frequently Asked Question. ..
7/28/2019 Risk magement
21/48
Study of 11 majorbanks in 2007
Found differencesin ERM Practices
7/28/2019 Risk magement
22/48
Better Risk Management Practices
Four main differences in practices.
Better-performing banks:
1) Shared risk and exposure information both quickly and broadly
among business unit staff, risk management staff and topmanagement.
2) Used rigorous internal practices and models, consistent across allbusiness units, to evaluate their risk positions.
3) Coordinated cash planning centrally, avoiding or limiting activitiesthat created large contingent liquidity needs and setting incentivesto make such activities unattractive to business unit management.
4) Used multiple risk assessment tools and metrics and generally hadvery adaptive risk models.
7/28/2019 Risk magement
23/48
Insurers should be concerned if:
Business Units are empowered to add significantly to riskconcentrations without frequent disclosures to Top Management
Business Units apply different risk models
Risk sign-off sometimes relies totally on the presumption thatsomeone else is doing good analysis
Contingent risks are not usually identified
Risk models are inflexible, requiring changes to be planned out a
year in advance
Nobody believes those stress tests anyway, so we dont put muchtime into them
7/28/2019 Risk magement
24/48
Insurers should be encouraged if:
Open communications among Business Units, Risk
Management staff and Top Management
Enterprise level decision-making about major riskaccumulations
Systematic internal evaluation of risks
Low reliance on third party risk evaluations
Identification of and plans for contingent risks
Incentives for business units to minimize contingent risks
Multiple risk management tools and metrics
Flexible and adaptive risk models
A re ation of net and ross ex osures in addition to
7/28/2019 Risk magement
25/48
ERM & Seatbelts
They only work if you use them!
http://images.mustangandfords.com/techarticles/mufp_0802_sema_04_z+2007_SEMA_new_products+beams_seatbelts.jpghttp://images.mustangandfords.com/techarticles/mufp_0802_sema_04_z+2007_SEMA_new_products+beams_seatbelts.jpg7/28/2019 Risk magement
26/48
Risk Management is
A. Setting & enforcing limits for all firm risks thatare appropriate for the capital of the firm.
B. Increasing & rewarding activities with superiorrisk adjusted return and fixing or limitingactivities with inferior risk adjusted return.
C. Identifying & preparing for special events thatcould significantly impair the earnings &\or thesolvency of the firm.
7/28/2019 Risk magement
27/48
Benefits of Risk Management(James Lam)
1. Market Value Improvement
Due to decreased volatility
2. Early Warning of Risks
Risk management replaces
Crisis Management
3. Reduction of Losses
4. Rating Agency Capital Relief
5. Risk Transfer Rationalization
Reinsurance cost/benefit
6. Corporate Insurance Savings
ERM F k
7/28/2019 Risk magement
28/48
28
ERM Framework
Strategic
Tactical
Risk controlBalance sheet
protection
Risk/return
optimization
Value creation
Compliance
Loss
minimization
Risk
management
Riskmeasurement
Strategic
integration
Value
optimization
Risk Controlling
Risk Trading
Risk Steering
Change Risk Management
7/28/2019 Risk magement
29/48
29
Scope of ERM
Risk Controlling
Limit exposures and therefore losses
ERM adds Aggregate approach to risk tolerance
Risk Trading
Getting paid for risks taken
ERM adds consistent approach to risk margins
Risk Steering
Strategic choices to improve value
ERM adds risk vs. reward point of view
Change Risk Management
Managing the risks from new projects, products, territories,
ERM adds fitting into the risk profile & ERM program
Potential Benefits of Effective Risk Management
7/28/2019 Risk magement
30/48
Potential Benefits of Effective Risk Management
Reduction inmanagement
time spentfire-fighting
Increasedlikelihood
of changeinitiatives
beingachieved.
PotentialBenefits(ICA)
More focusinternally on
doing the rightthings properly.
Lower costof capital.Better basis for
strategy setting.
Competitiveadvantage.
Fewer suddenshocks andunwelcomesurprises.
Better able totake advantage
of new businessopportunities.
Highershare
price
7/28/2019 Risk magement
31/48
Moodys View of Risk Management
Environment More Risky
More complex products
Higher regulatory scrutiny
Reinsurers leaving markets
Insurers Response
Stress Testing
Risk Management Committee/CRO
7/28/2019 Risk magement
32/48
4/21/2005 32
What is the difference betweenRisk Management and ERM?
An ERM Program comprehensively appliesRisk Management
across ALL of the significant risks of theEnterprise
Consistently across the risks
Consistently with the fundamental objectives of theenterprise
7/28/2019 Risk magement
33/48
4/21/2005 33
Full Benefits of an ERM Program
Once a firms enterprise wide risks are identified and objectives are set,an ERM Program should
Develop and maintain systems to periodically measure the capital needed tosupport the retained risks of the company
Reflect the risk capital in:
strategic decision making,
product design and pricing,
strategic and tactical investment selection
financial performance evaluation
The product of a fully-realized ERM Program is theoptimization ofenterprise risk adjusted return
'
Benefits of Integrated Risk
7/28/2019 Risk magement
34/48
Benefits of Integrated RiskManagement Strategy
Avoid land mines and other surprises
Improve Stability & Quality of Earnings
Enhance growth and shareholder return
By more knowledgeably exploiting risk opportunities
Identify specific opportunities such as natural
synergies & risk arbitrage Reassure stakeholders that the business is well
managed
Life Office Management Association (USA)
7/28/2019 Risk magement
35/48
Management Level 1 Planning
Planning Projection
7/28/2019 Risk magement
36/48
Management Level 2
Scenario Testing
7/28/2019 Risk magement
37/48
Management Level 3
Scenario Analysis
Planning Projection
Average Scenario
Confidence Interval
7/28/2019 Risk magement
38/48
Management Level 4
Risk Management
Planning Projection
Average Scenario
Confidence Interval
7/28/2019 Risk magement
39/48
ERM Benefits & Uses
Insurance = Risk Taking
Risk Management = Management
for Insurance Companies
Risk Management => systematic risk selection
as more insurance companies adopt risk
management they will select the better risks
companies without RM will not know
7/28/2019 Risk magement
40/48
ERM Benefits & Uses
Communicating with Rating Agencies
Risk Management can provide language for
dialogue with RA
Communicating with Board
Markets become more volatile
as more financial institutions use RiskManagement
7/28/2019 Risk magement
41/48
7/28/2019 Risk magement
42/48
Solvency 2 & ERM
Pillar 2
Article 43 requires firms to have an
effective risk management system. Requires firms to consider all risks
Risk management system to be fully
integrated into the organisation
7/28/2019 Risk magement
43/48
GFC & ERM
Progress has been made instrengthening . . . Risk Management
Leaders' Statement from G20 Summit,2009
7/28/2019 Risk magement
44/48
Questions
7/28/2019 Risk magement
45/48
Key Points from Intro
1. Risk Management has evolved overmany years.
2. Learning from Failures.3. Interest in Risk Mgt is increasing.
4. Risk Management is preventing losses
and improving risk adjusted return.5. Risk Management replaces
Crisis Management.
7/28/2019 Risk magement
46/48
7/28/2019 Risk magement
47/48
7/28/2019 Risk magement
48/48