Enterprise Risk Management

A Presentation at

Casualty Actuarial Society RatemakingSeminar

March 13, 2001Las Vegas

ModeratorRobert F. Wolf

William M. Mercer Inc/MMC Enterprise Risk

Panelists

Robert MackayMMC Enteprise Risk

Barry FranklinAon Risk Consultants

Handouts Available to Download : www.casact.org

….A decade ago

The Actuary Consulted with the Risk Manager on Hazard Risks

Self-Insured Retention Analysis

ConsiderationsCost of Capital

Cash Position and Opportunity CostsCredit Capacity

Need for Admitted Carrier PaperCost Predictability/Risk Appetite

Market Premium AssessmentLoss Control Incentives

Propert/Casualty Loss Costs

Tools5-10 Year Pro-Forma ModelsDynamic Financial Modeling

Scenario Testing

Conclusions & RecommendationsEstimated Costs/Benefits

Optimum Strategy

Compliance IssuesIRS Rules

State &/or Domiciliary LawsAccounting Standards

Actuarial Standards of Practice

Goal is tooptimize riskretention/cost

benefits

Alternative StrategiesRisk Retention Levels

•Alternative Risk Financing Techniques

•Hedges

….Today

The Risk Manager’s Role expanded beyond that of an insurance buyer,but rather to to optimize/consolidate the risk strategy under one integrated program.

Rise of Chief Risk Officer

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

Strategic Operational Financial Hazard

Foreign Macro-

Economic Issues

Interest Rate Fluct-uation

High Input

Comm-odity Price

Law-suits

Natural Disasters

Primary Cause of Stock Drop (# of Companies)

Source: Compustat, Mercer Management Consulting analysis - Period Examined was June 1993 to May 1998Note: There were also 5 stock drops for which the primary cause could not reliably be determined. These 5 stock drops are not depicted.

How Does Risk Manifest Itself?

Fortune 1000 Group Analysis10% of the Fortune 1000 companies suffered a loss of over 25% of shareholder value within one month

Doesn’t’ meanHazard Risk isn’t important.

It’s being handled.

What is ERM?

What is Enterprise Risk Management?

Vienot CommitteeMarini ReportLevy-Long Committee

Corporate Governance Forum of Japan

Code of Best PracticeKing ReportStakeholder CommunicationReport on Effective Systems of InternalControl

Draghi Commission

Toronto Stock Exchange CommitteeCanadian Securities CommitteeAllen Committee ReportCanadian Institute of CharteredAccountantsKPMG Peat Marwick Survey

Gesetz zur Kontrolle undTransparenz imUnternehmensbereich- Bill on TheControl And Transparency ofCompanies KonTraG BillCadburyRuttermanGreenburyHampelTurnbull

Blue BookCompany Law ReviewBest Practice Statement ofmanagement discussion and analysisStock Exchange ListingNew Accounting Standards

Commission on Corporate GovernanceThe Stichting Corporate Governance

Business Round TableStock Exchange CommissionBlue Ribbon CommissionCalpersCorporateGovernanceProgramme

Corporate Governance?

“Never in all history have we harnessedsuch formidable technology. Everyscientific advancement known to manhas been incorporated into its design.The operational controls are sound andfoolproof.”

Crisis Management?

Hazard

+

Finance

=

Risk Fusion®

Integrating Hazard and Financial Risks into a Single Contract?

Chief Risk Officer

Oil TradingRisk

ManagementNatural Gas

TradingElectricityTrading

Establishing a Chief Risk Officer?

E.J. SmithCaptain, H.M.S. Titanic

What is Enterprise Risk Management? - EIU Survey

• “ERM assesses and manages all risks while looking for upsides in identifying risks.”• “The goal of Enterprise Risk Management is to understand all of the risks on a

quantitative and intuitive level and to manage them through a central risk area - to take advantage of the synergies of managing risk in one area.”

• “Enterprise Risk Management is about information and capital management.”• “Good risk management is reflected in share price indirectly, but the market is not

giving a premium for ERM yet, it’s still too new.”• “The ultimate goal of Enterprise Risk Management is preservation of shareholder

value.”• “Managing risk enterprise wide means two things: bringing all the pieces of the

enterprise together to add the exposures, and using the whole enterprise to manage risk - making sure at the corporate level that all the different oversight departments are working together.”

• “The job of Enterprise Risk Management is figuring out where the edge of the cliff is, and making sure the risk takers know where it is.”

Selected views of ERM by Senior Management:

EIU survey of Senior Managers conducted in conjunction with MMC Enterprise Risk

So What is ERM All About?

...But most of all, it’s about

VALUE

ERM Is About all These Things...

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

Strategic Operational Financial Hazard

Foreign Macro-

Economic Issues

Interest Rate Fluct-uation

High Input

Comm-odity Price

Law-suits

Natural Disasters

Primary Cause of Stock Drop (# of Companies)

Source: Compustat, Mercer Management Consulting analysis - Period Examined was June 1993 to May 1998Note: There were also 5 stock drops for which the primary cause could not reliably be determined. These 5 stock drops are not depicted.

How Does Risk Manifest Itself?

Fortune 1000 Group Analysis10% of the Fortune 1000 companies suffered a loss of over 25% of shareholder value within one month

EnterpriseRisk

Management- Why?- What?- How?

ERM Is Real But Why is It Timely?

Current Silo-Approach Flawed• Cross-company Risk

Identification• Integrated Risk Modeling• Chief Risk Officers

Emerging Need for Enterprise Risk Management

New and Larger Risks•Higher Market Value to Book Value

ratios due to Intangible Assets•New risks: demand shortfalls,

competitive pressures, etc.

New Risk Products•Integrated Risk “Books”

Growing Exponentially•Insurance/Financial

Convergence

Increased Management Accountability • New Regulations: Corporate Governance• Shareholder Expectations for Transparency/ Management Process

MMC’s View of Enterprise Risk Management

Enterprise Risk Management is a process for identifying and prioritizing critical risks facing an organization, quantifying their impact on financial and strategic objectives, and implementing financial and organizational solutions to address them.

Emerging Best Principles:

1. Risk management is a systematic, critical-risk focused activity

2. Risk is quantified to make informed business decisions

3. Risk management is an integral part of strategic planning and budgeting

4. Pricing, capital allocation, performance measures consider potential risk as well as returns

5. Risk is not automatically avoided, but weighed against opportunity to optimize risk versus return

6. Risk mitigation/financing focuses on events and volatilities that could compromise financial and strategic objectives

MMC Enterprise Risk Approach

Goal: • High-level critical risk assessment

• Understanding of integrated effects of risks

• In-depth design and implementation of solutions to mitigate / finance risks

• In-depth measurement and modelling of critical risks

…of risk assessment, strategic planning, capital allocation, and performance measurement processes

CorporateProcess Solutions

Market Solutions

In

teg

ratio

n

Hazard Risk Analysis

Financial Risk AnalysisOperational Risk Analysis

Strategic Risk Analysis

Critical RiskDiagnostic

Identification Analyses and Quantification Solution Development/Implementation

Risk Management Process Redesign

ERM SolutionImplementation

MMC Recommends Starting with an ERM Vision Workshop to focus an ongoing ERM Process

Client Organization

MMC Enterprise Risk

Client Joint Team Approach

MMC believes the client should be left wit the ability to independently conduct Enterprise Risk Management at the completion of the project.

ERM VisionSetting

Organize A Risk Diagnostic Process to Focus on Critical Issues

Division B or

Geograph 2

Division C or

Geography 3

Risk Maps

Division Aor

Geography 1

Top 10Critical Risks

Top 10Firm-Wide Risks

Identifying Broad Risk Issues

Greaterthan75%

Severity Scale5 - Catastrophic - $100 million4 - between $25 - $100 million3 - Significant - $25 million2 - between $2 - $25 million1 - Material - $2 million

1

2

3

4

5

1 2 3 4 5

Lessthan5%

Lessthan25%

50% 75%Chance this will occur in thenext 3 years:

Probability Scale5 - Imminent / Ongoing (>75%)4 - Will Occur Regularly (75%)3 - Will Occur Occasionally (50%)2 - Unlikely (<25%)1 - Extremely Unlikely (<5%)

2P

More likely to occur

More severe

ExtremelyUnlikely

Unlikely Occasionally Regularly Imminent /Ongoing

T L

FH

E

WG 2G

K J

A

2E2C

2KB

D1. Risk A2. Risk B3. Risk C4.5.100. Risk XYZ

1. Risk A2. Risk B3. Risk C4.5.100. Risk XYZ

1. Risk A2. Risk B3. Risk C4.5.100. Risk XYZ

1. 2. 3. 4. 5. 6.7. 8. 9.10.

Risk 1

Risk 2

Risk 3

Risk 4

Risk 5

Risk 6

Risk 7

Risk 8

Risk 9

Risk 10

Major Hazard / Operational / Financial Risks

Subject to sublimits,exclusions, limits,coinsurance, deductibles,or retentions

Insured/Hedged

Can't buy / Choose not tobuyExcluded CompletelyWithin Deductible

Uninsured/Unhedged

= Single Event

$2M

$10M

$50M

$100M

Low Low/Medium Medium/HighEvery 20+ to 5 Years Every 5-3 Years Every 3-1 Years More than Once a Year

Seve

rity

Frequency

B29

B27

B27

B14

B14

B4

B4

B6B15

B15 B8

B8

B7

B9

B12

B12

B3

B3

B11

B11

B10

B10

B17

B17

B17

B17

B24

B24

B22

B23

B18

B18

B13

B16

B16

B21

B21

B20

B20

= Aggregate

Low

High

Moderate HighLow

Seve

rity

Frequency

B4

B11

B11

1

23

4567

89

10

11

12

13

14

15

1617

18

19

20

2122

23

24

25

26

27

28

29

30

31

32

33

34

35

36

37

38

39

40

41

42

43

4445

46

47

1. 2. 3. 4. 5. 6.. 7. 8. 9.10.

1. 2. 3.4. 5. 6.. 7. 8. 9.10.

Revenue Or Net Income Source

N A R R O W

D O W

N T O

Risk Solutions

IntegratedRisk Modeling

CatastropheModeling

Tort/LiabilityModeling

PeopleRisk Modeling

RiskAggregation

Analysis

• Employment related practices - process/coverage• Employee turnover and productivity analysis• External labor market assessment, simulations/projections• Customer loyalty and experience management• High impact award analysis

Structured Funding

Structuring and placing funding related productswhere risk mgmt is an issue

Financial Products

Transfer of riskto third party

Risk Aggregation

Repackaging risk forfinancial products

Operational Risk

Risk managementand mitigation services

• Securitization• Sale/Leaseback arrangements• Trade finance • Asset Backed transactions• Project finance/Emerging Market Finance• Offshore/special purpose vehicles

• Derivatives, swaps, forwards, options (weather, credit, FX, interest rates, commodities)• Non-tradable commodities• New insurance policies - NetSecure for technology• Multi-trigger products• Difficult or non-standard risks (e.g., asbestos)

• Consolidation of placement information• Benchmarking studies• Risk tranching• Indexes for financial products• Creation of RMIS• Creation of risk banks

• Intellectual property• Supply chain/Just-in-Time Inventory analysis• Business continuation planning - single supplier/ plants• Crisis Management• Fraud• System Breakdowns• Unauthorized Trading

• Value Driven Business Designs• Brand vulnerability assessment• Supply chain strategy analysis/supply source analysis• Intellectual property valuation, licensing terms, choice analysis• Profit Pattern Analysis

People Risk

Human capital strategiesand tactical plans

Strategic/Brand Risk

Organization /operational strategies and plans

Sample Tactics Risk Measurement& Modeling

•Purchased Materials•Labor•Hazard•Financial•Operations

Top 10Firm -Wide Risks

Risk 1

Risk 2

Risk 3

Risk 4

Risk 5

Risk 6

Risk 7

Risk 8

Risk 9

Risk 10

Analyze and Resolve Critical Risk Issues

EnterpriseRisk

ManagementModeling

• From Operations– Impacts on Cash Flows used to fuel business.

(e.g. Drain other things - R&D capital investments,...)

• From Investing

• From Financing ( e.g., Interest Rates)

Cash Flow

Balance Sheet• Asset

–Loss of book value/replacement value of “real” assets used to produce revenues

• Liabilities–Charges for losses/risk liabilities

• Shareholder Equity

• Revenues– Risks affecting volume,and price (e.g., interest rates, FX rates,

inflation, recession)

• Operating Costs Fixed Variable– What is expected charge? – What is volatility around expected?

• Net Income– Can we better stabilise to enhance EPS

projections/shareholder value

Income Statement

Relating A Risk Integration Model to Financial Performance

Relating A Risk Integration Model to Financial Performance

Consider Alternative Strategies/Programs

A. To achieve a better “net” effect than current strategy and same volatility.B. To determine ways to improve “net” effect and reduce resulting volatility.

• From Operations– Impacts on Cash Flows used to fuel business.(e.g. Drain other things - R&D capital investments)

• From Investing

• From Financing

– Interest Rates

Cash Flow

Balance Sheet

• Asset

– Loss of book value/replacement value of “real” assets used to produce revenues

• Liabilities

–Charges for losses/risk liabilities

• Shareholder Equity

• Revenues

– Risks affecting volume,and price (e.g., interest rates, FX rates, inflation, recession)

• Operating Costs Fixed Variable– What is expected charge?– What is volatility around expected?

• Net Income

– Can we better stabilise to enhance EPSprojections/shareholder value

Income Statement

Potential Modelling Framework - ConsideringEPS Impacts• Better/enhanced modeling of “expected” variable

costs:• Can we transfer at an efficient price?• Can we mitigate/control/prevent to reduce

charge?

• Better understanding of volatility and “worst case” outcomes considering portfolio effects:

• Does volatility matter? What is the size?• Dynamics given risk Correlations

Drastic Balance Sheet Impacts 1. Tornado3. Mass Torts4. Accounting Error

We can also consider Cash Flow impacts of1. Variable costs2. Catastrophic Costs

Raw, un-hedged, un-insured exposure

Current set of strategies over layered on top of exposuresWhat does this strategy do? What is “net” effect and the residual volatility?

Models Can Examine 3 Scenarios

DATA

PROCESS

LEGEND

IndividualModels(HR)

IndividualModels

(Pension)

IndividualModels

(Hazard)

IndividualModels

(Financial)

ConsolidationModel

CommonFactorsModel

ResultData

ResultData

ResultData

ResultData

ModelInput

Industry/CompanyOverrides

PolicyStrategy

Intervention

Total Cost Deviation Against Total Annual Expected Cost

$700m

-$500m

$100m

PackagingGrains Oils

Sugar MeatsCoffee

CombinedCommodities

Currency CombinedFinancial

DEVIATION

FROM

MEAN

ANNUAL F R E Q U E N C Y

99%

10%

90%

Mean

1%

$10m

$500m

- $10m

- $100m

-$700m

$129m $2,497m$110m$334m$11m $173m $479m $435m $4,169m $214m $4,382mMEANVALUES

CocoaDairy

SummedFinancial

ANNUAL F R E Q U E N C Y

$4,382m

$1,255m

$872m

$709m

Which risk should I manage the most?

Which is the best program?

The common factor model stochastically generates:• Interest Rates• GDP• Foreign Exchange• Hazard Events• Commodity Prices

In addition to the stochasticmodel input, other assumptionsand parameters are specified

The individual modelscalculate the results for each stochastic trialin the model input

The results from each modelare stored in a database.

The consolidation tool collects results of individual models to produce an integrated distribution of results

Kraft Foods North AmericaDistribution of Annual Purchase CostCombined Northfield1999

0%

5%

10%

15%

20%

25%

360370380390400410420430440450460470480490500510520

Annual Cost ($ MM)

5%Perc

95%Perc

Mean

OBValue

CAR = @95%

Structure of an Integrated Risk Model

• Simple model for capturing uncertainty.

• “Best guess” for price tomorrow is price today (plus any drift).

• Logarithmic form prevents negative prices (or rates); probabilitydistribution is lognormal.

• Widely used for financial time series.

• Underlying “stochastic process” for derivatives valuation, such as Black-Scholes and related methods.

Arithmetic Random Walk

St = a0 + St-1 + et

Geometric Random Walk

lnSt = a0 + lnSt-1 + et

“Drift” may be zero,positive or negative

Coefficient of St-

1 is 1

Et-1 (St) = a0+ St-1

ln= naturallogarithm

• The First Order Autoregressive or AR(1) process can be written as

Arithmetic AR(1) Geometric AR(1)

St = a0 + a1 St-1 + et lnSt = a0 +a1 lnSt-1 + et

• The price in this model is “mean-reverting”.

Geometric AR(1) can be re-written as

lnSt = (1-a1) [a0/(1-a1) - lnSt-1] + et or lnSt = [ lnM - lnSt-1] + et

• When St-1 is below (above) the long-run mean M, the expected price change is positive(negative).

• Mean reversion is fairly common for commodities and almost always used for interestrates.

a1 < 1

Some Candidate Models - Random Walk & Mean Reverting

Comparison of Sample Price PathsRandom Walk vs. Mean Reverting Process

0

50

100

150

200

250

1 3 5 7 9 11

13

15

17

19

21

23

25

27

29

31

33

35

37

39

41

43

45

47

49

51

Week

Pri

ce

Random Walk Mean Reverting Process

RW: lnSt - lnSt-1 = et

MR: lnSt - lnSt-1 = .10 [ln100 - lnSt-1] + et

Comparison of Price PathsRandom Walk vs. Mean Reverting Process

End-of-Year Distribution of PriceRandom Walk vs. Mean Reverting Process

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

40 50 60 70 80 90 100 110 120 130 140 150 160 170 180 190 200

Price

Pro

bab

ilit

y %

Random Walk Mean Reverting Process

Name Random Walk Mean RevertingMean = 103.05 100.21Std Deviation = 26.68 8.19Coefficient of Variation = 0.26 0.085% Perc = 65.75 87.2295% Perc = 152.05 114.35

Distrinution of End-of-Year PriceRandom Walk vs. Mean Reverting Process

Comparison of End-of-Year Price DistributionsRandom Walk vs. Mean Reverting Process

Name Comm 1 Comm 2 Comm 3 Comm 4 Combined Mean = 131.81 115.25 10.72 173.39 431.17Std Deviation = 10.94 10.04 1.53 6.01 18.60Coefficient of Variation = 0.08 0.09 0.14 0.03 0.04

1% Perc = 109.13 93.78 7.67 159.00 390.735% Perc = 114.70 99.52 8.40 164.10 401.7495% Perc = 150.73 132.47 13.40 183.29 462.2299% Perc = 160.66 141.00 14.86 189.58 478.31

2000

Distribution of Annual Purchase Cost ($ MM) XYZ

Cost DistributionsThis shows the commodity risk as a single portfolio consisting of 4 commodities taking into account risk reduction due to uncorrelated price movements in the 4 factors.

The Budget Value noted is approximately $20million below the expected value of the simulated distribution. Values may deviate from budget due to:- Coverage in place,- Result of consensus price forecasts or budget negotiations.

Distribution Of Annual Purchase CostsThis table shows the stand-alone cost distributions of 4 commodities. While Commodity 4 has the potential for generating the greatest extreme cost in this group, in terms of variation about expected costs, Commodity 3 is, in one sense, “riskier” than Commodity 4 given its coefficient of variation (s.d./mean) of 14% compared to 3% for Commodity 4.

XYZDistribution of Annual Purchase Cost

Combined2000

0%

5%

10%

15%

20%

25%

360

370

380

390

400

410

420

430

440

450

460

470

480

490

500

510

520

Annual Cost ($ MM)

Pro

bab

ilit

y

5% Perc

95%Perc

Mean

Budget Value

Cost Distributions - Example

The chart on the left shows the skewed distribution of the 500 highest cost outcomes. The 95% percentile is 490.45 showing that in 25 cases out of 10,000 (5% of 500) the annual purchase cost could exceed $490.45 million.

95% Tail Distribution Of Annual Purchase CostsThis table shows the 95% tail distribution of the Annual purchase cost. This distribution describes outcomes in the right hand tail, which exceed the 95% value of 462.22. The table shows that for these 500 possible outcomes (5% of 10,000), the mean annual purchase cost is 472.03 and the 95% percentile is 490.45. These statistics better help define extreme outcomes, than just the 99% percentile for the annual cost distribution (478.31).

XYZ

Name CombinedMean = 472.03Std Deviation = 8.87Coefficient of Variation = 0.025% Perc = 463.0195% Perc = 490.45

95% Tail Distribution of 2000 Purchase CostsCombined

XYZ

XYZ95% Tail Distribution of Annual Purchase Cost

Combined2000

0%

5%

10%

15%

20%

25%

30%

35%

460

465

470

475

480

485

490

495

500

505

510

515

520

Annual Cost ($ MM)

Pro

bab

ilit

y

95%Perc

Mean

Budget Value = $ 409.88 MM

Cost Distributions - Extreme Tail Risk

Name Combined Summed Marginal Combined Deviation

Summed Deviation

Mean = 431.17 431.17 431.17 21.28 21.28Std Deviation = 18.60 32.54 0.59 18.60 32.54

1% Perc = 390.73 361.54 427.70 -19.15 -48.345% Perc = 401.74 381.12 429.55 -8.14 -28.7695% Perc = 462.22 486.94 429.40 52.34 77.0599% Perc = 478.31 517.11 426.02 68.43 107.23

1 Marginal With Respect to Combined Commodity Annual Purchase Cost.

XYZDistribution of Annual Purchase Cost and Cost Deviation

1999

on a Combined, Summed, and Marginal1

Basis ($ MM)

Summed Distribution - not a true probability distribution but a hypothetical one obtained by summing the percentiles across all commodities. Summing ignores diversification created by less than perfect correlation between commodities.

Consider the impact of silo risk management and the cost of risk mitigation. Option premiums vary directly with the standard deviation of the underlying risk. If options were purchased on each commodity, then each premium would reflect individual commodity standard deviation and the sum of the premiums would reflect the Summed standard deviation of $33 million.

Combined Distribution - represents the true risk of the diversified portfolio of commodities. Note the difference in standard deviation of $19 million compared to $33 million for the Summed Distribution.

Marginal Distribution - shows the contribution of the diversified portfolio of commodities to the combined portfolio of the company.

The commodity portfolio will contribute only $429 million of risk to the client’s combined portfolio at the 95th percentile versus the commodity portfolio’s own risk of $462 million at the same percentile.

Deviation Distribution -- shows the distribution of deviations from budget.

Examining Portfolio Effects -Combined, Summed and Marginal Cost Distributions

• Diversification / covariance effect captured through integration of financial risks• Reduces capital required to manage volatility

Volatility Around Annual Expected Cost

All Risks

Currency

$(43)M

Currency

$700m

-$500m

$100m

DEVIATION

FROM

MEAN

Mean$10m

$500m

- $10m

- $100m

-$700m

CombinedTotal

Effect of Integrating

$764M

CombinedRisks (1 to8)

Integrated Risks (1 to 8)

Risk 4Risk 3 Risk 5Risk 2 Risk 6 Risk 7

99%

10%

90%

1%

$132M $115M

$332M$1M $173M

Risk 1 Risk 8

Mean

values

Individual Risks

$2.4B

SummedTotal

$1.6B

Separate Treatment

$4B$433M

$434M $4B $4B

Financing Risks Via Silo Management

• Over insurance/hedging of non-correlated and negatively correlated risks• Under insurance/hedging of positively correlated risks• Higher than understood exposure to event risk• Missed opportunities to place risks in different markets

Often leads to a sub-optimal enterprise result:

Risk NRisk 3Risk 2Risk 1 . . .

DECISION

RETAIN

PREMIUM

+

EnterpriseTotal Risk

Retained Risk“unknown”

Premium“unknown”

Silo Risk Management as a Portfolio of Interrelated Decisions

Risk NRisk 3Risk 2Risk 1 . . .EnterpriseTotal Risk

DECISION

RETAIN

PREMIUM

+

Retained Risk“known”

Premium“known”

Some risks should stay in silosSome risks should be split out from silos in which they currently resideSome risks should be combined in larger portfoliosAnd,“Overlay” decisions may be necessary to produce the desired result.

Enterprise Risk Financing - Many Possibilities

$200M Limit covers at least 5 Standard Deviations

Year 1 Year 2 Year 3

Pro

per

ty

Integrated Coverage

Pro

per

ty

Pro

per

ty

Ret

enti

on

Ret

en

tio

n

Re

ten

tio

n

Ret

en

tio

n$580.8M $585.3M $602.5M

Risk C

enter

Counterparty

Purchase Basket Option

(1) Nets Exposures(2) Retains enterprise based volatility(3) Transfers unacceptable volatility less expensively

Risk CenterAcceptsCommodityVolatility Risk

Individual Risks assumed:$34.5 premium income toRiskCenter

Fusing Risk Together Creating Risk Aggregation Centers

LesseesClient Insurer

P&I

LeasePayment

CashPayment

Sale of

Assets

Experience Account iflosses < Account at theend of the program

PremiumFinancing

Assets

Default

NPV of lease less secondarymarket sale or Residual Value

SpecialPurposeVehicle

AssetManagers

Client Lessees

Client

InsuranceCompany

Default

Transforming Financial Risk to Insurance Risk Via A SPV

Risk Event 1Machinery Breakdown

Risk Event 2Commodity

Prices

PriceaboveIndex

PricebelowIndex

Risk Event 3Auto Industry

Risk Event 3Auto Industry

Recessionby 10%

Growth by 10%

Growth by 10%

Recessionby 10%

Payout toClient

Payout toClient

No Payoutto Client

No Payoutto Client

Counter-party

X Dollar perDollar

above the Index

Counter-party

X Dollar perDollar

above the Index

Creating Multiple Triggers to Access Contingent Capital

Case Studies

Ratemaking?

• More of an account pricing issue than a technical insurance ratemaking issue.

• Of the 18 considerations listed in the CAS SOP Regarding Property & Casualty Ratemaking, ERM really directly impacts only 1 - RISKRISK

• ERM influences buyer behavior.

“Risk” per the Actuarial Statement of Principles

• Random variation from expected cost.– Reflected in cost of capital assumption.– Influences the underwriting profit provision.

• Systematic variation of estimated costs from expected costs.– Reflected in the contingency provision.

CoreBusiness

Strateg

ic

OperationalHazar

d

Financial

Capital

Cap

ital

Cap

ital

Capital

Risk from the CFO’s Perspective

General Risk Categories

• Hazard/Legal Risks• Financial Risks• Operational Risks• Strategic Risks

Case Study - Imaginary Motors

• Based on composite and rescaled individual “Big 3” data, industry information, recent press releases and some pure “guestimates”

• Quantify risks individually and aggregate• Measure “untreated” earnings impact• Determine theoretical risk capital for selected level of

earnings “protection”

Imaginary Motors -Assumptions

• Market Cap = $42.8 Billion• Net Income = $5.45 Billion (ttm)• EPS = $4.72 (ttm); Share Price = $38.12• Effective Tax Rate = 35%• Protect against the “1 in 100 year event”• Exposures can be transferred at pretax nominal cost

(expenses offset PV factor)

Imaginary Motors Risks - I

• Hazard/Legal Risks– Property

– Business Interruption

– Cargo/Marine

– Workers’ Compensation

– Automobile Liability

– General Liability

– Product Liability

– Employment Practices

– Crime

– Boiler & Machinery

– Directors & Officers

– Intellectual Property

– Product Recall

– Foreign Liability

– E&O/Professional Liability

Imaginary Motors Risks - II

• Financial Risks– Credit

– Residual Value

– ERISA/Fiduciary

– Foreign Exchange

– Commodity Prices

– Energy Prices

– Interest Rates

• Operational Risks– Warranty

– Product Recall

– Contingent Business Interruption

– Political

– Intellectual Property

– E-Commerce

– Strike/Labor Relations

Imaginary Motors Risks - III

• Strategic Risks– Model Selection

– Geographic Expansion

– Brand Image

– Product Pricing

– R&D Investments

– Acquisitions & Divestitures

Imaginary Motors Hazard Risk

0

1,000

2,000

3,000

4,000

5,000

6,000

100% 99%

90%

80%

70%

60%

50%

40%

30%

20%

10% 1% 0%

Probability of Exceedence

$Mil

lio

ns

Avg. NI

NI (Agg)

$Loss (Sum)

NI (Sum)

$Loss (Agg)

Avg. Loss

Case Study - Hazard Risk

Case Study - Hazard Risk

Risk Area Min. Mean 100 Yr. 250 Yr. Max. St. Dev CVProperty Noncat -$ 8.54$ 28.19$ 32.20$ 53.23$ 6.08$ 0.71 Wind - 11.76 203.37 268.90 648.96 40.52 3.45 EQ - 15.35 520.95 903.91 2,570.03 108.63 7.08 Flood - 5.26 103.35 200.04 820.84 29.40 5.58 Automobile Liability 4.15 13.92 98.87 159.15 214.85 16.76 1.20 General Liability 3.90 11.49 38.97 50.50 284.32 8.15 0.71 Product Liability 349.87 572.73 1,232.59 1,284.46 3,301.76 157.74 0.28 Employment Practices 1.50 7.72 25.15 29.48 99.92 4.58 0.59 Crime - 0.06 0.52 4.41 58.29 1.02 16.23 Directors & Officers - 4.63 70.42 159.94 800.08 23.40 5.05 Foreign Liability 4.03 7.70 11.97 12.81 16.29 1.50 0.19 E&O/Professional - 0.02 0.10 0.37 28.22 0.52 32.76 Hazard Subtotal 363.45 659.18 2,334.46 3,106.15 8,896.79 398.30 0.60 Hazard Portfolio 395.83 659.18 1,454.98 1,784.28 3,840.32 201.88 0.31 Portfolio Effect 32.38 (0.00) (879.48) (1,321.88) (5,056.47) (196.42) (0.30)

Simulated Loss Amounts (in $Millions)

Imaginary Motors Financial Risk

-2,000

0

2,000

4,000

6,000

8,00010

0% 99%

90%

80%

70%

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50%

40%

30%

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10% 1% 0%

Probability of Exceedence

$Mil

lio

ns

Avg. NI

NI (Agg)

$Loss (Sum)

NI (Sum)

$Loss (Agg)

Avg. Loss

Case Study - Financial Risk

Risk Area Min. Mean 100 Yr. 250 Yr. Max. St. Dev CVResidual Value 86.11$ 1,341.16$ 2,794.97$ 2,901.04$ 3,316.00$ 603.18$ 0.45 Credit (1,907.99) 513.89 1,880.30 2,049.65 2,653.43 619.73 1.21 ERISA/Fiduciary - 0.36 3.17 4.45 14.58 0.69 1.91 Financial Subtotal (1,821.88) 1,855.42 4,678.44 4,955.14 5,984.02 1,223.61 0.66 Financial Portfolio (883.83) 1,855.42 3,886.43 4,139.83 5,366.54 872.49 0.47 Portfolio Effect 938.05 (0.00) (792.01) (815.31) (617.48) (351.12) (0.19)

Simulated Loss Amounts (in $Millions)

Case Study - Financial Risk

Imaginary Motors Operational Risk

-5,000

0

5,000

10,000

15,000

20,00010

0% 99%

90%

80%

70%

60%

50%

40%

30%

20%

10% 1% 0%

Probability of Exceedence

$ M

illi

on

s

NI (Agg)

Avg. NI

$Loss (Sum)

NI (Sum)

$Loss (Agg)

Avg. Loss

Case Study - Operational Risk

Risk Area Min. Mean 100 Yr. 250 Yr. Max. St. Dev CVWarranty 3,157.93$ 3,596.38$ 3,864.48$ 3,902.22$ 4,030.41$ 115.40$ 0.03 Strike - 288.22 2,609.33 3,230.20 5,551.49 599.07 2.08 Product Recall 5.62 248.84 1,280.31 1,733.32 3,397.26 261.43 1.05 Political - 51.89 1,968.22 3,114.63 9,924.05 373.77 7.20 Intellectual Property - 21.26 115.56 170.67 803.63 26.75 1.26 Operational Subtotal 3,163.54 4,206.59 9,837.89 12,151.05 23,706.84 1,376.42 0.33 Operational Portfolio 3,264.95 4,206.59 6,984.44 7,768.32 13,976.52 761.10 0.18 Portfolio Effect 101.41 (0.00) (2,853.45) (4,382.73) (9,730.32) (615.32) (0.15)

Simulated Loss Amounts (in $Millions)

Case Study - Operational Risk

Imaginary Motors Strategic Risk

-2,000

0

2,000

4,000

6,000

8,00010

0% 99%

90%

80%

70%

60%

50%

40%

30%

20%

10% 1% 0%

Probability of Exceedence

$Mil

lio

ns

Lo

ss (

$Mil

lio

ns) Avg. NI

NI (Agg)

$Loss (Sum)

NI (Sum)

$Loss (Agg)

Avg. Loss

Case Study - Strategic Risk

Case Study - Strategic Risk

Risk Area Min. Mean 100 Yr. 250 Yr. Max. St. Dev CVPhase Out Division X 603.92$ 893.66$ 1,121.21$ 1,158.46$ 1,287.24$ 893.41$ 1.00 Invest in Division Y 909.54 1,340.50 1,681.84 1,737.39 1,945.73 1,340.36 1.00 Division Y Sales Increase (3,626.97) (2,432.76) (1,919.97) (1,858.99) (1,610.99) 893.41 0.37 Strategic Subtotal (2,113.51) (198.59) 883.07 1,036.86 1,621.98 466.70 2.35 Strategic Portfolio (1,563.68) (198.59) 449.75 516.08 780.88 293.49 1.48 Portfolio Effect 549.83 - (433.32) (520.78) (841.10) (173.20) (0.87)

Simulated Loss Amounts (in $Millions)

Imaginary Motors Composite Risk

-10,000

-5,000

0

5,000

10,000

15,000

20,000

25,000

30,00010

0% 99%

90%

80%

70%

60%

50%

40%

30%

20%

10% 1% 0%

Probability of Exceedence

$Mil

lio

ns

Avg. NI

NI (Agg)

$Loss (Sum)

NI (Sum)

$Loss (Agg)

Avg. Loss

Case Study - Composite Risk

Risk Area Min. Mean 100 Yr. 250 Yr. Max. St. Dev CVHazard Subtotal 363.45 659.18 2,334.46 3,106.15 8,896.79 398.30 0.60 Financial Subtotal (1,821.88) 1,855.42 4,678.44 4,955.14 5,984.02 1,223.61 0.66 Operational Subtotal 3,163.54 4,206.59 9,837.89 12,151.05 23,706.84 1,376.42 0.33 Strategic Subtotal (2,113.51) (198.59) 883.07 1,036.86 1,621.98 466.70 2.35 All Risk Subtotal (408.39) 6,522.59 17,733.86 21,249.20 40,209.63 3,465.02 0.53 All Risk Portfolio 3,188.68 6,522.59 10,151.33 10,988.59 15,602.11 1,229.67 0.19 Portfolio Effect 3,597.07 - (7,582.53) (10,260.61) (24,607.52) (2,235.35) (0.34)

Simulated Loss Amounts (in $Millions)

Case Study - Composite Risk

Imaginary Motors - Implications

• To protect against earnings volatility at the “1 in 100 year” level on a pretax basis:– finance $11.2 B if risks treated individually;– finance $3.6 B if risks treated as a portfolio.

• Risk finance cost difference of $76 Million.– $0.04 in after-tax EPS.– Almost $400 M in market capitalization at current P/E

multiple.

Imaginary Motors - Caveats

• Not all risks to Net Income are included.– WC, cargo, etc. due to lack of data;– general economic risks - interest rates, etc.

• “Portfolio Effect” potentially overstated– not all correlations reflected (warranty, recall and product

liability, for example);– companies may look at some risks in portfolios (integrated

insurance programs, combined aggregate excess programs, etc.).

The Benefits of ERM

Enterprise Risk Management Helps Organizations

• Quantification of risks on an integrated basis

– Examines integrated effects, especially across operating and decision silos

– Considers risks encountered by peers and by other industries

• Identification and prioritization of top critical risks

– Better manages investments and capital structures

– Focuses on business management, not crisis management

Better Risk Information and Understanding

BetterRisk

Management

• Improved risk management framework

– Controls existing risks– Helps identify and manage

changing risk profiles

• Better allocation of resources– Focuses risk management

resources on the right risks

• Improved decision making– Improves cross-functional

communication regarding risk

– Considers risks in capital budgeting and strategic planning process more effectively

– Allows cost/benefit analysis of alternative risk financing and mitigation strategies

Improved Financial

Performance

• Better avoidance and mitigation of threats to value

• Reduction of total volatility of cash flow and earnings

– Ensures sufficient internal funds for strategic investments

– Reduces likelihood of financial distress and thus the cost of financing

– Minimizes surprises for shareholders and stakeholders

• Enhanced stakeholder confidence– Improves understanding of risks

Ten Major Take-Aways

1 Be a catalyst. Challenge your management teams to think about risk issues impacting the organization.

2 Wall Street is unforgiving when your firm misses its earnings - Be prepared by knowing how to respond to risks when and if they occur.

3 Help your firm’s management consider and establish their risk tolerance for organization.

4 The goal is to avoid a future catastrophic cash outflow by balancing short term cash investments in risk mitigation & financing.

5 Be careful not to shy away from risks that cannot be quantified. They are still risks!

Ten Major Take-Aways

6 Be leery of a “magic black box”. Determining total risk correlations may not be possible.

7 ERM responses may well be (need to be) organizational and strategic responses.

8 Don’t look to do this alone. Use other parts of your organization.

9 As Plato said, “The first and best victory is to conquer self”– If you understand your company better, you have a better state of

readiness

10 ERM should exercise senior managements’ minds and make them more agile in responding to risk surprises!