Enterprise Risk Management For Insurers and Financial Institutions

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EnterpriseRisk ManagementFor Insurers and
Financial Institutions

• David Ingram
• CERA, FRM, PRM

From the International Actuarial Association
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Course Outline

• 1. INTRODUCTION - Why ERM?
• 2. RISK MANAGEMENT FUNDAMENTALS FIRST STAGE OF
  CREATING AN ERM PROGRAM
• 3. RISK ASSESSMENT AND RISK TREATMENT - ACTUARIAL
  ROLES
• 4. ADVANCED ERM TOPICS

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Advanced ERM Topics

• 4.1 Governance And An Enterprise Risk Management
  Framework
• 4.2 Upside Risk Management
• 4.4 Performance Management And Reward Systems
  
• 4.4 Role Of Internal Audit
  
• 4.5 Dealing With New Activities
  
• 4.6 Risk Tolerance, Appetite Limits
• 4.6 Emerging Risks
  
• 4.7 Scenario Planning
• 4.8 Risk and Loss Diagnosis
• 4.9 Reporting and Monitoring
• 4.10 Risk Disclosure

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4.1 Governance And An ERM Framework

• Board Committees ERM
• Risk Tolerance Board
• Communicating ERM with Board

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Board Committees ERM

• Existing Committees
• Executive Committee
• Investment Committee
• Audit Committee

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Risk Tolerance Board
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Turning Tolerances into Limits

• Question 1
• Is Top Management Board able to articulate
  their Risk Tolerance?
• Often the answer is no.

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Determining Risk Tolerance

• Survey Discussion
• Analysis of Past choices Risk Levels
• Review of Current Choices
• External Views of Risk Return

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Survey Discussion

• Brokerage Forms Mutual Fund Companies
  Questionnaires for Individuals
• Income Net Worth
• Knowledge of Investments
• Experience with Investments
• Investment Objectives
• Risk - Return Expectations
• Cash Flow Needs Investment Horizon

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Bank or Insurance Company

• Information needed is the same
• Income Net Worth
• Knowledge of Risks
• Experience with Risks
• Financial Objectives
• Risk - Return Expectations
• Capital Needs Financial Horizon

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Income Net Worth

• Level of Income
• Volatility of Income
• Level of Surplus
• Management attitudes about above
• Preferences for losses to bypass income? Or
  dislike all losses equally?
• Has income grown steadily? If not, is unsteady
  path seen as normal or highly undesirable?

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Knowledge of Risks

• Can Board readily articulate the top risks of the
  company?
• Does Board have a feel for which risks are most
  significant to
• Company Earnings?
• Company Solvency?

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Difference between Knowledge Experience

• Knowledge Intellectual
• Experience Emotional
• Knowledge Read the Book
• Experience Didnt need to read the Book
• Knowledge Heard the News reports of Tsunami
• Experience Was here for the storm

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Difference between Knowledge Experience

• In 1999, it was often said in the US that
  majority of investment management had no
  experience with market downturn
• Now they all do.

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Does the Board have Knowledge or Experience

• Credit Risk
• Interest Rate Risk
• Equity Risk
• Fx Risk
• Insurance Risk
• Operational Risk

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Experience with Risks

• What were the experiences of the company is
  previous periods of industry difficulty?
• What were the personal experiences of top
  managers in those periods?
• Which risks are management more likely to want to
  avoid because of past experiences?

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Example

• In 1987, a US company had equity exposure of 50
  of surplus beginning of 1987
• By end of 3rd Quarter, surplus had grown 15
• In 4th Quarter, Group Health Division reported
  unexpected losses of 12 of Surplus
• Equity market fell 23
• Surplus dropped 25
• Local newspaper reported 96 drop in Company
  earnings

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Experience with Risks

• What kinds of losses has the company experienced?
• Macro Market problems
• Industry-wide problems
• Unique Company Problems

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Financial Objectives

• Earnings, ROE, Increase in Embedded Value
• Ratings Level, surplus ratio
• Sales Level, Assets under management, sales
  growth
• Risk Management

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Risk Return Expectations

• What are return expectations?
• Do they currently vary by product Line?
• What are seen as the drivers of the variances?
• Business Size Age
• Competitors Return or Prices
• Business Risk
• Do return expectations vary with market
  conditions?
• Or do they encourage additional risk taking under
  unfavorable conditions?

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Capital Needs Financial Horizon

• Growth Rates Capital Needs of New Sales
• Profitability of businesses
• Current Capital Level
• Planning Horizon
• 1 year, 3 year, 5 year

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Analysis of Past Choices Risk Levels

• Look at historical risk levels relative to today
• Must be careful to choose right metric for
  comparison
• Should try to choose time of most recent decision
  on risk limit
• Assume that management is comfortable with past
  risk limits

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Example Retention Limit

• Retention limit was set at 1 M 10 years ago
• Reduced probability of one year fluctuation gt 10
  M from 5 to 1
• 10 M was 50 of pre-tax income
• Now a retention limit of 3 M would produce a 1
  probability of fluctuation of 50 of current
  pre-tax income

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Review of Current Choices

• Show the risk characteristics of the current
  proposal
• For several alternate structures
• Variability of Returns
• Results of Stress test

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Review of Current Choices
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Communicating ERM with Board

• Quantity Quality of Risks Plan
• Regular updates
• Changes to Environment
• Changes to Plan
• Losses
• Management Responsibilities Reports
• Unpredictable Events
• Strategic Initiatives Risk Management
• Strategies Risk Management

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Risk Management The Board

• 1. An advance agreement with management
  regarding
• the quantity and quality of risks that the firm
  is expected to take in the coming year and
• how much variability management expects there to
  be in what actually happens.
• This will naturally lead to a discussion of how
  far away from plan things can get before another
  discussion between management and the board is in
  order.

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Risk Management the Board

• 2. Regular updates in the quantity and quality
  of risks that are actually being taken by the
  firm
• as well as the quantity and quality of risks
  retained.
• One of the major issues that banks have faced in
  the current crisis is that some of their risk
  offset programs were not as effective as
  management had expected and very large gross risk
  positions that were thought to be transferred or
  offset did become the responsibility of the bank
  when the losses started to occur.
• Board reporting had focused only on net retained
  risks which put the board outside the discussions
  of how much gross risk was acceptable.

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Risk Management The Board

• 3. Information about the changes in the
  environment that might indicate that certain
  risks might be increasing.
• This information would be in the form of trending
  of key risk indicators

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Risk Management The Board

• 4. Information about the continuous changes that
  management is making to the plans in response to
  the changing environment
• as they relate to the quantity and quality of
  risk.
• Too often management appropriately changes course
  and defers mentioning that to the board. The
  lack of mention of course corrections should be
  seen as a sign of potential trouble by the board.
  
• Management and the board should agree how far
  things can drift from plan before management is
  expected to both do something different and
  mention that to the board.

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Risk Management The Board

• 5. An advance discussion of losses.
• Management and the board must recognize that the
  word risk is short for risk of loss.
• It is uncommon to have these advance discussions.
  
• When firms experiences losses, there is often a
  period of uncertainty during which no one knows
  whether this loss exceeds the tolerance of the
  board and how the board might react.
• While it does not make sense to expect there to
  be an exact list of expected reactions, there is
  much to be gained by having this discussion
  before a real loss occurs.

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Risk Management The Board

• 6. Appointing members of top management to be
  individually assigned personal responsibility
• for each of the major risks and
• risk/loss aversion practices of the firm
• a risk management best practice that is
  internationally recognized.
• A regular update by the top management
  individuals that have been given these
  responsibilities, confirming that they have
  sufficient resources, both in quantity and
  quality, to achieve the objectives for loss
  limitation and reporting on the status of
  projects to improve capabilities.

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Risk Management The Board

• 7. A periodic discussion of the unusual and
  adverse events that might unpredictably impact on
  the firm and the ways in which management expects
  to prepare for such events.

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Risk Management The Board

• 8. When a major corporate strategic initiative
  comes to the board for notice or approval,
  discussion of the ways that this action changes
  the risk of the firm.
• The board should know whether a headline action
  further concentrates the risks of a firm or
  whether is broadens the risk exposures.
• If there are additional concentrations of risks,
  then it would be important to hear more about the
  additional diligence to the existing loss
  aversion actions.
• If it is a diversifying risk, then the board
  should be hearing about the new risk/loss
  aversion actions that are contemplated.
• Too often, management diversifies into a new risk
  and thinks that loss aversion is unnecessary
  because of diversification. The term for that
  type of risk management decision is
  de_WORSE_ification. For new risks, risk/loss
  aversion plans are particularly needed because of
  managements lower experience wit the new risk.

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Risk Management The Board

• 9. When management discusses the major
  strategies of the firm with the board
• discussions should include recognition of the
  implications of the strategic plans on the firm's
  risks and the risk/loss aversion plans.
• The board should be sure that the plans for
  growth of the firm reach for faster growth of
  expected profits than the rate of growth of risks.

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4.2 Upside Risk Management
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Strategic Risk Management

• View of risk across all risks to make decisions
  about optimizing risk adjusted returns.
• capability to assess trade-offs between different
  risk types
• assessment of risk adjusted returns.
• capital budgeting
• strategic investment allocation.

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Strategic Risk ManagementFor Life Inurers

• Strategic trade-offs between products with
• Credit Risk
• Interest Rate Risk
• Equity Risk
• Insurance Risks
• Based on long term view of risk adjusted
  returns of products
• Choosing which to write, how much to retain and
  which to offset
• Strategic trade-offs in Investment Selection
• based on risks embedded in products
• plus long term view of risk adjusted returns of
  investment choices

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Strategic Risk Management For Non-Life (PC)
Insurers

• Strategic Trade-offs between insurance coverages
  AND investments
• based on long term view of risk adjusted return
• Recognizing significance of investment risk to
  total risk profile
• Selecting which risks to write and which to
  retain over the long term
• Some Insurers have 40 or more of their total
  capital tied to Investment risks
• An Insurer with Strategic Risk Management will be
  able to say why they chose to take that much
  Investment risk
• Including discussing relative risk reward of
  Insurance choices and Investments
• Average risk reward vs. marginal risk reward
• With consideration of diversification impact of
  Insurance vs. Investments

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Tactical Risk Selection

• Reacting to short term market conditions to
  choose which risks to take and which to retain in
  the short term
• May use Risk Reward analysis or just combined
  ratio targets
• Cycle Management
• Insurance Cycles
• Credit Cycles
• Interest Rate Cycles
• Equity Market Cycles
• Choices to vary from long term strategic choices
• Usually within a range
• Range of variation authority

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Strategic Risk Mgt

• Companies with Superior Risk Management
  (Controls) will have low volatility of earnings
  and low incidence of losses.
• Companies with Superior ERM will have low
  volatility of earnings, low incidence of losses
  AND Steadily improving Returns.
• Strategic Risk Management is the UPSIDE of Risk
  Management

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4.4 Performance Management And Reward Systems

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4.4 Role Of Internal Audit

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4.5 Dealing With New Activities

• New Products
• Acquisitions
• Other New Activities

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New Product Risk Review

• Multiple Layers of Sign-offs
• Plan for Product
• Go Ahead for Design
• Design of Product
• Go Ahead for implementation
• Implementation of Product
• And implementation of Measures, limits
  controls

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New Product Risk Management Review Questions

• What types of risk is the company assuming with
  this product?
• Market, Credit, Insurance, Operational Risks
• Short Term, Long Term
• Ruin, Volatility
• Specific, Systematic
• Accounting, Market Value, Liquidity
• Aggregation or Diversifying

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New Product Risk Review2. How will these risks
be measured and monitored?

1. By whom and using what techniques and processes?
2. Where/how will the risk exposures be reported?
3. What will the risk reports look like?

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New Product Risk Review

• 3 What are the risk mitigants and plans for
  managing those risks?
• a. Product design, compensation design, control
  processes, reinsurance, hedging
• b. Who will be responsible for the risk
  management?

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New Product Risk Review

• 4 What are the daily, weekly or monthly risk
  limits? a How are those limits determined and
  policed? b What happens when a limit is
  exceeded?

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New Product Risk Review

• Who in Senior Executive Team is personally
  responsible for this product??
• 6 What is the procedure for determining the
  Economic Capital/Risk Surplus required for this
  product? a Has this been demonstrated to be
  consistent with the Economic Capital/Risk Surplus
  for other company products?

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New Product Risk Review

1. What is the Risk Return profile of this product
   and how consistent is it with the Risk return
   profile of the other products?
2. How does the product pricing reflect the risks of
   the product? a What adjustments have been made
   to the pricing to achieve risk adjusted returns
   that are appropriate as compared to the other
   company products?

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1. What training is needed for the staff that will
   be doing the risk measurement and the risk
   management processes?a. What training is needed
   for Senior Management to get a full understanding
   level on these risks?
2. Will the companys internal and external
   financial reporting processes capture the
   appropriate risk adjusted returns for this
   product consistently with existing
   products?a Are there risks for this product
   that have significantly different characteristics
   that special consideration is needed? b Are
   there any pending studies of financial reporting
   for this product that might change the accounting
   significantly when the studies are completed?

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Acquisition Risk

• Risk Profile
• Risk Management Processes
• Implementation Risk

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Other New Ventures
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4.6 Risk Tolerance, Appetite Limits

• Covered Twice already
• Any Questions?

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4.6 Emerging Risks
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Emerging Risks Management

• Primary Components
• Environmental Scanning To provide advance
  signals of potential Crisis developments
• Process for Anticipating Emerging Risks
  Development of Emerging Risk Scenarios
• Process for Envisioning Significance of Emerging
  Risks Stress Testing Liquidity Risk Analysis
• Process for Preparing Response to Emerging Risk
  Solutions Contingency Planning
• Execution of Insurer in Emerging Risk Solutions
  Changes to company business and risk management
  practices
• Insurer learning process from Emerging Risk
  Situation

Objective To anticipate the next big risk
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Emerging Risks Management

• Pocess for Anticipating Emerging Risks
• Development of Emerging Risk Scenarios
• Terrorism, Natural Disasters, Pandemic, Man-made
  Disasters, IT Failures, Power Failures, Stock
  Market Crash, Banking Crisis, Interest Rate
  Spike, Systemic liquidity Crisis, hyperinflation,
  negative interest rates, significant negative
  economic growth, Stagflation, Price deflation,
  currency exchange rate crash
• To the extent these are not considered under
  operational risk management.
• To the extent that the risk are not core
  (catastrophe risk coverage)
• Process for Envisioning Significance of Emerging
  Risks
• Stress Testing
• Liquidity Risk Analysis

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Emerging Risks Management

• Process for Preparing Response to Emerging Risk
  Situations
• Liquidity Crisis planning
• Reputation Risk planning
• Crisis Response Rehearsal
• Contingency Planning
• 5. Execution of Company in Emerging Risk
  Situation
• Company learning process from Emerging Risk
  Situation
• Environmental Scanning
• to provide advance signals of potential Crisis
  developments

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4.7 Scenario Planning
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4.8 Risk and Loss Diagnosis
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4.9 Reporting and Monitoring
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Risk Management Constituencies

• Management
• Board of Directors
• Shareholders
• Securities Analysts
• Investment Firms
• Regulators
• Rating Agencies
• Distributors

External Auditors Creditors Reinsurers Business
Partners Parent Company Customers Employees
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Internal Risk Position Reports

• Asset
• Duration, Convexity, Greeks, Liquidity, VaR,
  Performance Attribution, OAS
• Liability
• A/E analysis, Embedded Value analysis
• ALM
• Scenario Testing, Mismatch Risk, Transfer Pricing
• Operational Risks

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4.10 Risk Disclosure
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Disclosures

• Risk Management Discussion Disclosures in
  Annual Report
• Aegon (ND) 6 pages
• AIG (US) - 12 pages
• Swiss Re (SW) 5 pages
• Manulife (CA) 10 pages
• Nedcor (SA) 30 pages (Bank)

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Aegon Disclosures

• Sensitivity Analysis
• Fx
• Equity Return Assumptions
• Equity RE returns
• Interest Rates
• Exposure Limits
• Credit Name limits
• Derivative Exposure
• Other
• Bonds by Sector

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AIG Disclosures

• VaR
• Market Risk VaR by Major Business Segment for
  Interest, Fx, Equity and Combined High, Low and
  average for year
• Fair Value sources
• Counterparty Credit Summary by quality by
  industry
• Note AIG operations include trading market
  making in Fx, Commodities Metals. Much of
  disclosures relate to that activity.

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Manulife Disclosures

• Discussion of
• RM Structure
• Policies Process
• Risk Measurement
• Risk Limits
• Sensitivity Tests
• Interest Rate
• Equity Market Value
• Fx
• Liquidity Stress
• Exposures
• Seg Fund Guarantees
• Credit

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