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Risk and Capital Management Seminar Washington, DC July 29, 2003.

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Presentation on theme: "Risk and Capital Management Seminar Washington, DC July 29, 2003."— Presentation transcript:

1 Risk and Capital Management Seminar Washington, DC July 29, 2003

2 Enterprise Risk Management: Benefit or Fad? July 29, 2003 Scott M. Sanderson Marsh Advanced Risk Solutions - Minneapolis

3 3 Marsh Viewpoint of the Non-Financial Company What is the “cost” of risk Financial companies have an explicit cost to capital of assuming risk, others do not Risk is often viewed in the context of the expectations of the securities market For a private company, there may be no value of risk at all Measure of success is to maximize income with little regard for balance sheet and cash flow Leads to a view that risk is a subjective issue to be considered, but seldom studied, quantified or managed systematically

4 4 Marsh What is Risk? Essentially, the negative deviation from an expected value

5 5 Marsh What is ERM? Essentially the management of all risks that are embedded within an organization’s final results Does the ERM process include: – Study? – Modeling? – Control functions? – Sarbanes-Oxley compliance? – A deal structure to manage multiple exposures? – Change of operational methods? – Consideration of risk when entering a new business? – Consideration of risk for all activities? – Rigorous process for discovery, measurement and management?

6 6 Marsh What is ERM? Essentially the management of all risks that are embedded within an organization’s final results Does the ERM process include: – Study? – Modeling? – Control functions? – Sarbanes-Oxley compliance? – A deal structure? – Change of operational methods? – Consideration of risk when entering a new business? – Consideration of risk for all activities? – Rigorous process for discovery and management?

7 7 Marsh Does Anyone Really do it? Why Not? – Budgets (silos) – Can’t get blamed for another operation’s failure – Expense – People time – Not important – Its not what drives organizational value – No explicit cost to capital – Hard to prove return on the expenditure – Requires more rigor than most organizations exhibit – Too big and amorphous to effectively do anything – Some elements are impossible to measure

8 8 Marsh Perhaps Partial Measures are OK – Manageable, bite-sized pieces – Sarbanes-Oxley will be a driver, but slowly – Easier to execute on the elements that:  Are not part of core business  Are more subject to stochastic approaches  Where there are developed markets already to manage – The whole is simply too big to tackle and doesn’t lead to actions

9 9 Marsh Roadblocks to Managing Enterprise Risk – Risk are less important when they happened in the distant past – Operating budgets – assuming that maximizing the outcomes of the parts maximizes the whole – Managing the silo, ignoring the farm – Assuming risk structured can be timed for optimization (in hedging) – Ignoring the implications of capital charges on volatility assumed – Ignoring correlation and cause-and-effect relationships - compounding the outcomes – Accounting rules – Modeling sloth – using “feel” rather than objective analysis – Analysis paralysis – Assuming buying insurance coverage protects risk – Belief that future events can be forecasted – Assumption of mean reversion – Inability to manage to price elasticity

10 10 Marsh Show Me the Money Value of Covariance Sum of Individual Risks Joint Distribution

11 11 Marsh A Single Risk has a Value, but Multiple Risks are Different – Aggregating all risks together produce a less volatile outcome than the sum of the individual risks - portfolio effect – Correlation decreases the portfolio effect – What happens when an organization transfers risk?  The cost of transfer is higher than the value to the insured, even in an efficient market  Market for transfer (insurance/hedging, etc.) is not as efficient as desired, especially where the risk carries a differing view of possible outcomes  Cost of transfer is therefore not appealing to a rational client – However, client can’t afford to not cover traditional areas - management can’t afford to take a hit in a short time frame, even if transfer is inefficient – Concurrently, many clients will not purchase needed coverage, if not a traditional exposure

12 12 Marsh Client Inefficiencies – Management driven by:  Inertia  Silo-centric decision processes  Last year’s and this year’s budget (and bonus formula)  Committee decisions with conflicting interests  Quarterly earnings reporting  Retirement horizon – Resulting in:  They are willing to insure or hedge what they have in the past  Won’t consider managing a real exposure if not in last year’s budget  Resistance to change  Won’t cover what impacts other parts of the organization  Must protect short time horizons

13 13 Marsh What is Possible and Potentially Efficient for an Insurer to Provide? – Non-traded indexes and event observations (parametric coverages?) - Example United Grain Growers – Risk integration, like Honeywell (FX and hazard perils) – Multi-peril aggregation exposures without per occurrence protection – Double triggers – Traditional integrated risk – Outcome guarantees on cash flow streams – Of questionable value:  Finite risk  Contingent capital  Catastrophe bonds

14 14 Marsh Impediments for Insurers – Have their own silos - can’t provide efficient integrated product if they disintegrate in the reinsurance placement – Scared of the unknown, even if measurable – Inferiority complex to investment bankers – Actuaries have a limited background in other risk types - no confidence in the modeling outcomes – Limited understanding of the tradable markets – Limited personnel with broad risk experience beyond traditional insurance products – Inertia – Budgets – Short time horizon – Not perceived as their business

15 15 Marsh Example - Chemical Company – Make many products – Largest single product is nylon fiber – Inputs =  Ammonia  Cyclohexane  Benzene  Propylene  Natural Gas – No pricing power on selling price - driven by demand based and competition, not input cost

16 16 Marsh Example - Chemical Company – Correlation's  Ammonia = natural gas  Cyclohexane = crude oil  Benzene = crude oil  Propylene = crude oil (maybe heating oil)  Natural Gas – In proportion, correlation to tradables = 92% – Annual cost to protect the basket = 4.7% of notional – If hedged just as gas and oil, cost to protect > 6% of notional – Client on the edge of losing investment grade credit rating – Public company

17 17 Marsh Example - Chemical Company Outcome – Studied and worked with commodity buyers, risk manager, treasurer and senior management for two years to model, quantify and prove effectiveness – Quoted in November, 2002 an annual rate of 4.7% on notional – All parties agreed that this was the most efficient arrangement possible and would have mitigated prior issues they experienced in a fundamental way – CFO and CEO promised the street a certain return for the coming year – The 4.7% wasn’t in those estimates, therefore, they weren’t going to buy – Gas and oil both spiked in 1st and 2nd quarter, 2003 – Earnings went massively negative – Stock price went from $5.00 in October to $1.29 today – Debt burden increased dramatically,and is now junk quality – Long run probability of survival low

18 18 Marsh Example - Chemical Company Analysis and Implications – Client studied but wouldn’t act, even though the event had happened before. When it happened before, share price was over $15 – Evidence of the client process – Organizational process change slowly, and the decision-making matches that speed – Forecasting to the street was important to management – Easier to take a risk than to not tell a positive story to analysts – Some people in the organizations see the value - there are visionaries – Process didn’t fail from lack of a viable product, but has in many other cases – The value was there and was proven.

19 19 Marsh Economic Basis for ERM Modigliani and Miller ’s Hedging currency has no value - investor will diversify Froot/Scharfstein/Stein ’s Managing risk has value by avoiding the inability to make efficient investments

20 20 Marsh Benefit or Fad? – Risk has a cost and therefore managing it has a corresponding benefit – Looking at an organization as a financial system, rather than its elemental parts, provides a clearer view of the risk within it – Its harder to do and harder to measure, resulting in a tendency to avoid – Today’s integrated insurance and derivative products remain inefficient, making the reality difficult to capture – It will be slow to evolve

21 21 Marsh Benefit or Fad? – Risk has a cost and therefore managing it has a corresponding benefit – Looking at an organization as a financial system, rather than its elemental parts, provides a clearer view of the risk within it – Its harder to do and harder to measure, resulting in a tendency to avoid – Today’s integrated insurance and derivative products remain inefficient, making the reality difficult to capture – It will be slow to evolve But it will be the way risk will be managed in the future


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