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EnterpriseRisk Management

For Insurers and FinancialInstitutions

David IngramCERA, FRM, PRM

From the International Actuarial Association


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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


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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


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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


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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)


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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Does the Global

Financial Crisis provethat ERM is Ineffective?


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Frequently Asked Question. ..


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Study of 11 majorbanks in 2007

Found differencesin ERM Practices


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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.


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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


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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


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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.jpg


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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.


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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


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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


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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


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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


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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


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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


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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


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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)


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Management Level 1 Planning

Planning Projection


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Management Level 2

Scenario Testing


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Management Level 3

Scenario Analysis

Planning Projection

Average Scenario

Confidence Interval


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Management Level 4

Risk Management

Planning Projection

Average Scenario

Confidence Interval


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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


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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


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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


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GFC & ERM

Progress has been made instrengthening . . . Risk Management

Leaders' Statement from G20 Summit,2009


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Questions


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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.


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