Finance 590 Enterprise Risk Management

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Finance 590Enterprise Risk Management

• Steve DArcyDepartment of Finance
• Lecture 2
• Risk Analytics
• March 28, 2006

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Reference Material

• Chapters 8 and 9 Enterprise Risk Management by
  Lam
• Overview of Enterprise Risk Management by the
  Casualty Actuarial Society
• http//www.casact.org/research/erm/overview.pdf
• Risk and Insurance by Anderson and Brown
• http//www.soa.org/ccm/cms-service/stream/asset/?a
  sset_id8027034

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Overview

• Risk Control Analytics
• Risk Optimization Analytics
• Classification of Risk Types
• Risk Analytics by Risk Type
• Performance Measures
• Risk Measures
• Risk Modeling
• Risk Integration
• Characteristics of Hazard Risk
• Insurance Terminology

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Risk Control Analytics

• Scenario Analysis
• Stress testing
• Simulation
• Economic Capital
• Solvency standards
• Risk Indicators
• External
• Internal

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Risk Optimization Analytics

• Return on Capital (Financial Services Industry)
• Risk-adjusted return on capital (RAROC)
• Return on risk-adjusted capital (RORAC)
• Risk-adjusted return on risk-adjusted capital
  (RARORAC)
• Economic Income Created
• Risk-adjusted return (Hurdle rate x economic
  capital)
• Shareholder Value
• Shareholder value (SHV)
• Shareholder value added (SVA)

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Risk Types

• Hazard or Insurance Risk
• Financial or Market Risk
• Credit Risk
• Operational Risk
• Strategic Risk

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Hazard Risk Management Analytics

• Probable Maximum Loss (PML)
• Maximum Possible Loss (MPL)
• Loss Frequency
• Loss Severity
• Actuarial Models
• Loss Distributions

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Financial Risk Management Analytics

• Interest Rate Models
• Equilibrium models
• Arbitrage free models
• Value-at-Risk (VaR)
• Parametric
• Monte Carlo simulation
• Historical simulation
• Asset/Liability Management (ALM)

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Credit Risk Analytics

• Credit Scoring Models
• Credit Migration Models
• Credit Exposure Models
• Credit Portfolio Models
• Financial models
• Econometric models
• Actuarial models

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Operational and Strategic Risk Analytics

• Top-Down Approaches
• Analogs
• Historical loss data
• Bottom-Up Approaches
• Self assessment
• Cash flow model

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Performance MeasuresGeneral

• Return on Equity (ROE)
• Operating Earnings
• Earnings before interest, dividends, taxes,
  depreciation and amortization (EBITDA)
• Cash Flow Return on Investments (CFROI)
• Weighted Average Cost of Capital (WACC)
• Economic Value Added (EVA)

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Performance MeasuresInsurance Industry

• Economic Capital
• RAROC
• Expected net income divided by economic capital
• Embedded value
• Risk Based Capital (RBC)

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Risk MeasuresSolvency Related

• Probability of Ruin
• Shortfall Risk
• Value-at-Risk (VaR)
• Expected Policyholder Deficit (EPD) or Economic
  Cost of Ruin (ECOR)
• Tail Value at Risk (Tail VaR) or Tail Conditional
  Expectation (TCE)
• Tail Events

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Risk MeasuresPerformance Related

• Variance
• Standard Deviation
• Semi-variance and Downside Standard Deviation
• Below-target-risk (BTW)

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Risk Modeling

• Analytic Methods
• Simulation Methods
• Statistical Methods
• Structural Methods
• Dynamic Financial Analysis (DFA)

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Risk Integration

• Covariance
• Covariance Matrix
• Structural Simulation Model

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Characteristics of Hazard Risk

• Loss/no loss situations (pure risk)
• Independence of individual exposures
• Important for risk to be insurable
• Types of hazard risk
• Persons
• Property
• Liability

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Insurance Terminology

• Exposures
• Deductibles or retentions
• Policy limits
• Coinsurance
• Claims or losses
• Incurred
• Paid
• Loss adjustment expenses
• Loss frequency and severity
• Triggers

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Alternative Risk Transfer (ART) Terminology

• Captives
• Finite insurance or reinsurance
• Insurance-linked bonds
• Insurance securitization
• Cat-E-Puts (Catastrophe equity put options)
• Contingent surplus notes

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Loss Frequency

• Number of losses during policy period
• Often modeled as a Poisson distribution
• Pr(k) e-??k/k!
• where Pr probability
• k number of claims per year (0,1,2,...)
• ? expected number of claims per year

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Loss Severity

• Size of loss given a loss has occurred
• Variety of potential severity distributions
• Empirical
• Exponential (Gamma)
• Lognormal
• Pareto
• Distribution characteristics
• Non-negative
• Positively skewed
• Variance positively correlated with mean

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Hazard Risk Example

• Assume independent losses
• Loss frequency
• 0 80
• 1 15
• 2 5
• Loss severity
• 1,000 40
• 10,000 30
• 25,000 20
• 100,000 10

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Hazard Risk Example (2)
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Analysis of Potential Losses

• Expected losses 4,600
• Maximum possible loss 200,000
• Maximum probable loss (0.25) 125,000
• Expected losses excess of a 100,000 retention
  1,084

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Current State of Hazard Risk Management

• Insurance industry has developed a high level of
  mathematical sophistication for valuing hazard
  risks
• Alternative market has also developed for dealing
  with hazard risks
• Key questions for organizations involve amount of
  risk to retain (deductible) and how much coverage
  to purchase (policy limits)
• These questions begin to tie hazard risk into
  enterprise risk management

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Conclusion

• There is a standard approach for dealing with
  each type of risk
• Each area has its own terminology and techniques
• The ERM challenge is to combine these different
  approaches into a common method that can deal
  with risk in an integrated manner
• The first step is to understand the different
  approaches