The Enterprise in Enterprise Risk Management

A Case Study

CAS Special Interest Seminar

Understanding the Enterprise Risk Management Process

Case Study - ABC Corporation

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

• Quantify risks individually and aggregate

• Measure “untreated” earnings impact

• Quantify the impact of the “portfolio effect” on aggregate risk

ABC Corporation -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)

ABC Corporation 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

ABC Corporation 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

ABC Corporation Risks - III

• Strategic Risks– Model Selection

– Geographic Expansion

– Brand Image

– Product Pricing

– R&D Investments

– Acquisitions & Divestitures

Examples of Correlated Risks

– Property

– Business Interruption

– Warranty

– Residual Value

– Political

– Geographic Expansion

– Product Recall

– Product Liability

– Strike/Labor Relations

– Employment Practices

– Acquisitions & Divestitures

– Directors & Officers

Approaches to Correlation

• Measurement– “CORREL” function

– Rank Correlation

– Regression Analysis

– Judgement

• Implementation– Causative/Formulaic

– Correlation Matrix

– Resort/Resampling

– Combinations

ABC Corporation Hazard Risk

0

1,000

2,000

3,000

4,000

5,000

6,000

10

0%

99

%

90

%

80

%

70

%

60

%

50

%

40

%

30

%

20

%

10

%

1%

0%

Probability of Exceedence

$M

illi

on

s

Avg. NI

NI (Agg)

$Loss (Sum)

NI (Sum)

$Loss (Agg)

Avg. Loss

Case Study - Hazard Risk

Case Study - Hazard RiskRisk Area Min. Mean 100 Yr. 250 Yr. Max. St. Dev CV

Property 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)

ABC Corporation Financial Risk

-2,000

0

2,000

4,000

6,000

8,0001

00

%

99

%

90

%

80

%

70

%

60

%

50

%

40

%

30

%

20

%

10

%

1%

0%

Probability of Exceedence

$M

illi

on

s

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

ABC Corporation Operational Risk

-5,000

0

5,000

10,000

15,000

20,0001

00

%

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

ABC Corporation Strategic Risk

-2,000

0

2,000

4,000

6,000

8,0001

00

%

99

%

90

%

80

%

70

%

60

%

50

%

40

%

30

%

20

%

10

%

1%

0%

Probability of Exceedence

$M

illi

on

s

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)

ABC Corporation Composite Risk

-10,000

-5,000

0

5,000

10,000

15,000

20,000

25,000

30,0001

00

%

99

%

90

%

80

%

70

%

60

%

50

%

40

%

30

%

20

%

10

%

1%

0%

Probability of Exceedence

$M

illi

on

s

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

ABC Corporation - 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.

ABC Corporation - 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.).