EnterpriseRisk ManagementFor Insurers and Financial Institutions
David IngramCERA, 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 Fraud1983: Baldwin United Shell Game1986: 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 Failures1991: Mutual Benefit Life Failure 1994: Orange County Default1994: Kidder Peabody Fiasco. 1994: Confederation Life Failure1994: Monarch Life Seizure1995: 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 Conduct1998: Russian Bond Debacle. 1998: The Long-Term Capital Management
Model Failure. 1999: General American Liquidity Failure1999: Unicover Fiasco2000: Equitable UK Pension guarantees2001: American Express CBO Losses2002: Enron & Worldcom2003: Parmalat2003: Allmerica VA reserving2003: Annuity & Life Re Overgrowth2004: Marsh Contingent Commissions2005: AIG Finite Re2006: Scottish Re Tax Asset2006: Hurricane Katrina2007: Countrywide Sub Primes 2008: Bear Sterns/ Lehman/ AIG Sub Prime
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
Barings (UK)
Venerable UK Bank
Trading losses in Singapore
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
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 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
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 don’t 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 expected losses
Stress testing that is credible to Top Management
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.
B. Increasing & rewarding activities with superior risk adjusted return and fixing or limiting activities with inferior risk adjusted return.
C. Identifying & preparing for special events that could significantly impair the earnings &\or the solvency of the firm.
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
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ERM Framework
Strategic
Tactical
Risk control Balance sheet protection
Risk/return optimization
Value creation
Compliance
Loss minimization
Risk management
Risk measurement
Strategic integration
Value optimization
Risk Controlling
Risk Trading
Risk Steering
Change Risk Management
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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
Potential Benefits of Effective Risk Management
Reduction in management
time spent “fire-fighting”
Increased likelihood of change initiatives
being achieved.
Potential Benefits
(ICA)
More focus internally on
doing the right things properly.
Lower cost of capital.Better basis for
strategy setting.
Competitive advantage.
Fewer sudden shocks and unwelcome surprises.
Better able to take advantage
of new business opportunities.
Higher share price
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
4/21/2005 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
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
Planning Projection
Average Scenario
Confidence Interval
Management – Level 4 Risk Management
Planning Projection
Average Scenario
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. Risk Management has evolved over many years.
2. Learning from Failures.
3. Interest in Risk Mgt is increasing.
4. Risk Management is preventing losses and improving risk adjusted return.
5. Risk Management replaces Crisis Management.