enterprise risk management shaun wang, ph.d., fcas, asa director of actuarial science program...
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Enterprise Risk Management
Shaun Wang, Ph.D., FCAS, ASADirector of Actuarial Science Program
Georgia State University
2004 C.A.S.E. Forum
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Copyright by S. Wang, 2004 2
Outline
1. Concept of Risk
2. Inherent Risks for P&C insurers
3. ERM Approaches
4. ERM Education at GSU
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ERM as a New Discipline
• High expectations & excitements!!
• ERM takes integrated approaches to major risks of an enterprise
• ERM represents new ways of understanding & managing risks
• ERM is a new and evolving discipline
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Concept of Risk
1. Risk = Random “Volatility”
2. Risk = Not knowing reality (lack of info, driving in dark)
3. Risk = Wrong Existing Structure
Poor coordination & communication
Organizational cancer; needs structural reform!
4. Risk = Opportunity for the Prepared & Discerning
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(I) Risk & Diversification
1. “Offset” produces the highest benefits:
long and short positions of the same asset
2. “Random drivers” offer good benefits
natural catastrophe events in various regions
3. “Expertise Intensive”: pooling across sectors may yield little or even negative risk diversification
Different market dynamics; different sets of expertise
4. “Drag effort”: legal or reputation spillover
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Right and Wrong Diversifications
• Years of under-pricing were partially caused by the “low correlation” argument by some multi-line players
• Diversification needs to match with areas of expertise
Renaissance Re, a mono-line CAT-writer, achieves diversification by geographic region and by peril
• “ART” benefited buyers, but not sellers
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(II) Risk & Information
• Quality and timeliness of information are critical for decision-making– Relative to their banking counterparts, many
insurers have poor grades on this
• ERM modeling needs forward-looking data
• Need aggregate risk info, as well as every way we want to look at the business
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(III) Risk & Incentive Misalignment
• Many “risks” are created by misalignment of incentives
Underwriters short-term goal v.s. long-tailed liabilities
Managers’ expansion of his/her own kingdom
CEO’s compensation linked to growth and acquisition
• Trial Attorneys and the U.S. legal dynamics
Lawyer Contingent Fees & Punitive Damages
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(IV) Risk & Valuation/Market Dynamics
• Risk often manifested in changes in value• Market participants can drive value changes
– Real estate bubble– Momentum investing– Portfolio insurance strategies– UK FSA experience
• Current versus Long-term Valuation– Pension funding deficit
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Outline
1. Concept of Risk
2. Inherent Risks for P&C insurers
3. ERM Approaches
4. ERM Education at GSU
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100
150
200
250
89 90 91 92 93 94 95 96 97 98 99 00 01 02*
US Insured CAT Losses (in $billion) and Rate On Line Index (1989=100)
Source: Guy Carpenter & *III EstimateROL showed big jump after
major CAT losses, and then came down gradually …
$7.5
$2.7$4.7
$22.9
$5.5
$16.9
$8.3 $7.3
$2.6
$10.1$8.3
$4.3
$28.1
$5.8
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Inherent Risks for P&C Insurers
• The infamous underwriting/reserving cycle– Independent from equity market risks– Not knowing final result for years– Lack of feedback on estimated reserves
• Hedging using reinsurance (within sector): high information asymmetry & transaction costs
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S&P Report 19-Nov-2003Insurance Actuaries – A Crisis of Credibility
• S&P report: “Actuaries are signing off on reserves that turn out to be wildly inaccurate” …
• It sent a shockwave around the globe in the actuarial and insurance community!!
• American Academy of Actuaries countered 2 days after S&P release: “It is an obvious attempt to explain away the errors that some analysts have made in estimating property/casualty insurers’ earnings.”
• Both agree It is high-time for “Reserving Reformation”
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$ Billions, Calendar Year Basis
$2.3 $2.2 $1.2
($8.5)
($1.5)
($7.5)($6.7)($10.0)
$22.7 $23
$0.3
($3.7)($0.3)
$9.9
($15)
($10)
($5)
$0
$5
$10
$15
$20
$25
90 91 92 93 94 95 96 97 98 99 00 01 02 03
P/C Insurance Industry Prior Year Reserve Development*
*Year 2003 number is an estimate by S&P.Source: A.M. Best, Morgan Stanley, Dowling & Partners Securities
$23 billion reserve increase = Hurricane Andrew
Reserve Cycle & Pricing Cycle are correlated
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Reason for P/C Insolvencies (218 Insolvencies, 1993-2002)
Unidentified17%
Impaired Affiliate3%
Overstated Assets2%
Change in Business
3%
CAT Losses3%
Reinsurer Failure0%
Rapid Growth10%
Discontinued Ops8%
Alleged Fraud3%
Deficient Loss Reserves
51%
Source: A.M. Best, Insurance Information Institute
Reserve deficiencies account for
more than half of all p/c insurers
insolvencies
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Cyclical Nature of Reserve Estimates
• The adequacy of reserve estimates showed a clear cycle over the years
• Reserve cycle coupled with the pricing UW cycle
Pressure on short-term performance
Following the competitors
Smoothing taxes for some players
A slow-death sentence for many companies
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Outline
1. Concept of Risk
2. Inherent Risks for P&C insurers
3. ERM Approaches
4. ERM Education at GSU
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ERM Focuses on “Business Processes”
• Loss Modeling Is Only Part of the Story A company had the state-of-the-art actuarial pricing
model, but in the end still lost so much money
• Need to quantify the Business Process Risk
Top-line growth in a soft market poses a major risk
Over-crowded competitive market poses a major risk
• Need to enter the deep water by understanding the risk drivers and market dynamics
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ERM Model of Market Competition
• Result = Min{Quote1, …, Quotek} Loss,
where Quotek Normal(k, k)
1. For long-tailed lines, delayed info higher k
higher chance of premium deficiency
2. more bidders k higher chance of premium deficiency
• The Winner’s Curse: In insurance competitive pricing, the lowest price gets the business, but may be cursed with financial losses
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ERM Solution on Reserving: Contingent Payoffs
• Payoff contingent on magnitude of reserve development for a fixed block of business
• As deferred compensation (or tradable index)• Force decision-makers (managers, actuaries) to
put their money where their mouth is• Provide feedback channel for a block of business
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Contingent Payoff Contract on Reserve Development
$(0.25)
$(0.20)
$(0.15)
$(0.10)
$(0.05)
$-
$0.05
$0.10
$0.15
-40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60%
Future Reserve Development
Pay
off V
alue
PayOff
Tame U/W Cycle by financial engineering: Contingent payoff on reserve estimates
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Outline
1. Concept of Risk
2. Inherent Risks for P&C insurers
3. ERM Approaches
4. ERM Education at GSU
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ERM Education at GSU
• Actuarial Education
– Scale back traditional components
– Go deeper and go wider
• Mathematical Risk Management
– Financial risk modeling and …
• Enterprise Risk Management
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An actuarial/engineer approach
• Look risk as a “dynamics”
– Model each agent?
• External dynamics
– Financial risk modeling and …
• Internal dynamics
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Q & A
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DFA versus ERM
• DFA has not yet fulfilled its promises
– Did not focus on dominant risks
– Fancy stochastic model without benchmark parameters
– Weak organizational backing & poor communication
• How does ERM differ from DFA?
– ERM offers these missing elements for success
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Did “U.S. Risk Based Capital” Help?
• U.S. Benchmark RBC has only limited success:
Factor based reserve charges ignored the bigger issue of reserve adequacy
Incentives for putting up inadequate reserves
Same capital charge factor for premium written in a hard market versus in a soft market
• A point-in-time measure, without reference to future direction and sensitivity over time
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Opportunities for Creating Industry Benchmarks
• Industry benchmarks on risk parameters and capital charges are badly needed
• Benchmarks should reflect the inherent risks of the business, regardless of risk portfolio
• Parameters are more important than the model
• It will take much fundamental analysis, expert opinion, and timely updates
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Extras