Enterprise Risk Management For Insurers and Financial Institutions

David Ingram
CERA, FRM, PRM

From the International Actuarial Association

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

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

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

Current Trends in Risk Management

1.
-

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)

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

Risk Management Failures

Bank / Financial

Barings Controls Missing, mgt didnt 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

Barings (UK)

Venerable UK Bank Trading losses in Singapore

Exceeded value of bank

Problems

Management didnt 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

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

Northern Rock (UK)

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

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

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

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

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

General American Life (US)

Funding agreement product sold to banks and mutual funds with 7day 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

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

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

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

Does the Global Financial Crisis prove that ERM is Ineffective?

Frequently Asked Question. ..

Study of 11 major banks in 2007

Found differences in ERM Practices

Better Risk Management Practices

Four main differences in practices. Better-performing banks: 1) Shared risk and exposure information both quickly and broadly among business unit staff, risk management staff and top management.

2) Used rigorous internal practices and models, consistent across all business units, to evaluate their risk positions.
3) 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. 4) Used multiple risk assessment tools and metrics and generally had very adaptive risk models.

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 dont put much time into them

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

ERM & Seatbelts

They only work if you use them!

Risk Management is
A.

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.

B.

C.

Benefits of Risk Management

(James Lam)
1.

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

ERM Framework
Change Risk Management
Strategic Value optimization Strategic integration

Risk Controlling
Risk management Loss minimization Compliance Tactical Risk control Balance sheet protection

Risk measurement

Risk Steering

Risk Trading

Risk/return optimization

Value creation

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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
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Potential Benefits of Effective Risk Management

Better able to take advantage of new business opportunities. Higher share price Reduction in management time spent fire-fighting Increased likelihood of change initiatives being achieved. More focus internally on doing the right things properly.

Fewer sudden shocks and unwelcome surprises.

Potential Benefits
(ICA)
Lower cost of capital.

Competitive Better basis for advantage. strategy setting.

Moodys View of Risk Management

Environment More Risky

More complex products

Higher regulatory scrutiny Reinsurers leaving markets

Insurers Response

Stress Testing Risk Management Committee/CRO

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

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Full Benefits of an ERM Program

Once a firms 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
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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)

Management Level 1 Planning

Planning Projection

Management Level 2 Scenario Testing

Management Level 3 Scenario Analysis

Average Scenario

Planning Projection

Confidence Interval

Management Level 4 Risk Management

Average Scenario

Planning Projection

Confidence Interval

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

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

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

GFC & ERM

Progress has been made in strengthening . . . Risk Management
Leaders' Statement from G20 Summit, 2009

Questions

Key Points from Intro

1. 2. 3. 4. 5.

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.