1. Enterprise Risk Management For Insurers and Financial Institutions
David Ingram
CERA, FRM, PRM
From the International Actuarial Association

2. 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

3. 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

4. A Brief History of Risk Management
1952 – Markowitcz – Portfolio Theory – Risk = variance
1973 – Black Scholes – Derivative Pricing – variance is key driver
1987 – Black Monday – Portfolio Insurance implicated in record 1 day fall in stock market
1992 – Cadbury (UK) Report urges centralized, comprehensive corporate RM
1993 – First CRO named at GE

5. Current Trends in Risk Management
Dedicated risk management function
Risk Management decision making remains largely decentralized
2. Risk Aggregation / Economic Capital
in early stages of development
3. Regulatory practices encourage ERM
4. Regulatory Capital  Economic Capital
Basel Survey (August 2003)

6. 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 Seizure
1995: 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 Derivatives Loss.
1997: UBS Derivatives Model Problems.
1997: Prudential Insurance US Market Conduct
1998: Russian Bond Debacle.
1998: The Long-Term Capital Management Model Failure.
1999: General American Liquidity Failure
1999: 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 Primes
2008: Bear Sterns/ Lehman/ AIG Sub Prime

7. Risk Management Failures
Bank / Financial
Barings – Controls Missing, mgt didn’t 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 trigger options
American International Group – Small Financial Group brings down Insurance giant

8. Barings (UK) Venerable UK Bank Trading losses in Singapore Problems
Exceeded value of bank
Problems
Management didn’t 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

9. Long Term Capital Management (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 international financial problems
Counterparties did not know the extant of their full exposure

10. Northern Rock (UK) Problem:
Mortgage lender grew rapidly to become one of the top 5 mortgage lenders in the UK
Had used securitization to fund mortgage lending growth
Encountered liquidity problems when mortgage securitization markets froze in Aug 2007
Problem:
Request for help with liquidity from Bank of England triggered first run on UK bank in over 100 years

11. 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 of Japan
Problem:
Asset Liability Mismatch
Underpricing (over crediting) of interest

12. Equitable (UK) Guaranteed payout annuity product sold to pension 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 company demise rather than workout

13. HIH (AUS)
Second largest General Insurer “suddenly” found to be insolvent
Problem:
Total control failure at all levels
Company, Auditor, Regulator
Ultimate problem was fundamental underpricing and overspending
Hidden by systematic underreserving

14. 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 agencies due to accounting “gimmicks”

15. 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

16. American International Group
In late 2006, AIG claimed to have $16B of excess capital
In early 4th Quarter 2008, AIG needed over $100B of funds from 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
<<<Chihong – I cannot find the story of KLI anywhere – do we need to include this or are we better of leaving it out?>>>

17. Reasons for Current Interest in 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

18. Reasons Tools for Risk Mgt are getting better and better
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 for banking & insurance

19. Does the Global Financial Crisis prove that ERM is Ineffective?

20. Frequently Asked Question. ..
Question – How many here have had this question pass through your head or escape your lips?
How many have heard someone ask this question?
Well, let’s think about that for a minute..
What is ERM? I think of ERM as having three components:
1. The set of organized and deliberate management practices that work to keep risk exposures (and therefore losses) within predetermined limits. Management has always wanted to limit losses. The new part with ERM is the organized and deliberate part. So the alternative is to make sure that you are impulsive and chaotic in your approach to your risks?
Exploiting risk knowledge to make profits through superior risk selection (micro)
Exploiting risk knowledge to enhance long term value through superior selection of major business opportunities. (macro)
The problems were caused by failing to really do 1 and meanwhile getting 2 & 3 wrong. And not everyone had the same problems.
So I compare ERM to seatbelts.

21. Study of 11 major banks in 2007
Found differences in ERM Practices

22. Better Risk Management Practices
Four main differences in practices.
Better-performing banks:
Shared risk and exposure information both quickly and broadly among business unit staff, risk management staff and top management.
Used rigorous internal practices and models, consistent across all business units, to evaluate their risk positions.
Coordinated cash planning centrally, avoiding or limiting activities that created large contingent liquidity needs and setting incentives to make such activities unattractive to business unit management.
Used multiple risk assessment tools and metrics and generally had very adaptive risk models.

23. Insurers should be concerned if:
Business Units are empowered to add significantly to risk concentrations without frequent disclosures to Top Management
Business Units apply different risk models
Risk sign-off sometimes relies totally on the presumption that someone 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 don’t put much time into them”

24. Insurers should be encouraged if:
Open communications among Business Units, Risk Management staff and Top Management
Enterprise level decision-making about major risk accumulations
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
Aggregation of net and gross exposures in addition to expected losses
Stress testing that is credible to Top Management

25. ERM & Seatbelts They only work if you use them!
More items if there is time
Models are not good at recognizing inflections
Growth & Risk – growth does not always mean big risk, but large losses almost always follow high growth
Diversification vs. Correlation - diversification only occurs when risks are truly totally unconnected. Correlations are not predictive.
Recognition of Uncertainty – risk models tend to add together numbers with totally different degrees of certainty. The models would never get the required answer otherwise,
Risk limit for new risks – Sub Prime is not 1/1000, it is 1/1. Should set a limit on risk from new activities.

26. Risk Management is
Setting & enforcing limits for all firm risks that are appropriate for the capital of the firm.
Increasing & rewarding activities with superior risk adjusted return and fixing or limiting activities with inferior risk adjusted return.
Identifying & preparing for special events that could significantly impair the earnings &\or the solvency of the firm.

27. Benefits of Risk Management (James Lam)
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

28. ERM Framework Change Risk Management Risk Controlling Risk Steering
Value optimization
Strategic
Strategic integration
ERM has been developing for about 20 years.
This graphic shows one path that ERM has followed. Or call it an ERM Conceptual Framework.
The ERM processes start out in the bottom left with a program that is compliance based. The objective is to control risks. At this stage, there is usually very little connection between ERM and firm strategy.
The next stage in development is ADD loss minimization focus. This means that There is identification of the largest risks and a more priortized approach based on the size of potential losses.
Often in this stage, the main focus is to make sure that the risks taken by the firm are only the risks that the firm wants. A fully developed system will set aggregate loss limits and control risks to stay within those aggregate limits. The objective of a loss minimization system moves into Balance sheet protection with the focus on the larger risks that could impair the balance sheet. As managers focus on the largest risks, there is a natural growth of awareness of the relation between the size of the larger risks and the strategic importance of the activity that leads to that risk.
The next two steps bring in the idea that risks can be actively managed. By managing, it means that the firm might take on risks that it ultimately might not want but has developed methods to actively manage their exposures to keep what they want to retain. Risk measurement is when the firm moves from separate measurements for each risk to broadly consistent measurements across all risks. Usually, these risk management and measurement systems have some significant costs for development and ongoing operations. These costs will at first be focused on the most strategically important risks. Ultimately the full risk measurement development is motivated by a a drive to consistency in approach to risk. A major focus in these stages is the pricing of risk. Active risk management is only possible if risks are priced within the firm at a level that is consistent with the markets where they will want to resell (or offset) their risks. Pricing ultimately means developing a position on the appropriate risk reward trade-offs. This is applied in this stage to the micro transaction level decision making.
The Strategic Integration stage is when the information gathered in the prior stages now becomes usable and used in the strategic decision making process. Top mangement and the board now start to look at the risk reward information on a line of business and/or regional and/or legal entity basis. Firms at this stage of ERM development will often use RAROC style internal financial statements. They will look to optimize the joint risk reward position of the entire firm. This process becomes a major concern of the strategic decisionmaking process.
Finally, in the ultimate stage of development, management moves to looking at the total franchise value. This look adjusts from a ratio approach of RAROC to an absolute value approach. This also can take into account multi year decisions and resultant revenues. Where the RAROC approach takes in only a single point in the risk curve, the value approach recognizes multiple points on the loss distribution that may affect value. A shift to value requires a clearer look at volume related issues also.
Now, these six stages can be grouped into three major groups, Risk Controlling, Risk Trading and Risk Steering. And the developmental idea can be dropped to just think of these activities as three different parts of ERM, with different objectives.
Risk Controlling
Risk measurement
Risk management
Risk Steering
Loss minimization
Risk Trading
Compliance
Tactical
Balance sheet protection
Risk/return optimization
Value creation
Risk control

29. 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
Risk Controlling is basic to all firms in all industries. ERM also adds an attempt at consistency in approach to risks based on business financial considerations rather than history and prejudices. In Insurance companies this includes insurance underwriting and claims controls plus investment limits and controls. In Non-financial firms this includes treasury activities around cashflow management, loss control activities, corporate insurance, business continuity, IT security. In all firms operations risks would be includes here.
Risk Trading includes all hedging Activities. In insurance, it includes the pricing of risk.
Not all firms in all industries will have any activities in Risk Trading. Many firms hedge FX. Energy and Ag firms often hedge raw materials risk.
Risk Steering also applies to all industries. What ERM adds to the strategic discussion is to provide some rigor to the discussion around risk at the strategic level, rather than the mystically invoked idea that “you have to take a risk to get a reward” to a discussion of how much risk for how much reward.

30. Potential Benefits Potential Benefits of Effective Risk Management
Better able to take advantage of new business opportunities.
Reduction in management time spent “fire-fighting”
Higher share price
Potential Benefits
(ICA)
Increased likelihood of change initiatives being achieved.
Fewer sudden shocks and unwelcome surprises.
More focus internally on doing the right things properly.
Lower cost of capital.
Competitive advantage.
Better basis for strategy setting.

31. Moody’s View of Risk Management
Environment More Risky
More complex products
Higher regulatory scrutiny
Reinsurers leaving markets
Insurers Response
Stress Testing
Risk Management Committee/CRO

32. What is the difference between Risk Management and ERM?
An ERM Program comprehensively applies Risk Management…
across ALL of the significant risks of the Enterprise
Consistently across the risks
Consistently with the fundamental objectives of the enterprise
Standard & Poor's
4/21/2005

33. Full Benefits of an ERM Program
Once a firm’s enterprise wide risks are identified and objectives are set, an ERM Program should…
Develop and maintain systems to periodically measure the capital needed to support 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 the optimization of enterprise risk adjusted return
Standard & Poor's
4/21/2005

34. Benefits of Integrated Risk Management 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)

35. Management – Level 1 Planning
Planning Projection

36. Management – Level 2 Scenario Testing

37. Management – Level 3 Scenario Analysis
Planning Projection
Average Scenario
Confidence Interval

38. Management – Level 4 Risk Management
Planning Projection
Average Scenario
Confidence Interval

39. 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

40. 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 Risk Management

42. 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

43. GFC & ERM
“Progress has been made in strengthening Risk Management”
Leaders' Statement from G20 Summit, 2009

44. Questions
Questions??

45. Key Points from Intro Risk Management has evolved over many years.
Learning from Failures.
Interest in Risk Mgt is increasing.
Risk Management is preventing losses and improving risk adjusted return.
Risk Management replaces Crisis Management.