Transcript 6707-D'Arcy.ppt 291KB Dec 08 2009 05:26:23 PM

CIA Annual Meeting
LOOKING BACK…focused on the future
CIA Annual Meeting
Session 6707: Brave New World
Stephen P. D’Arcy
President of the Casualty Actuarial Society
Professor of Finance, University of Illinois
The Brave New World of Enterprise Risk
Management
LOOKING BACK…focused on the future
CIA Annual Meeting
Session 6707: Brave New World
What is ERM?
ERM is the application of the basic risk
management principles to all risks facing an
organization
Other names for ERM
Enterprise-wide risk management
Holistic risk management
Integrated risk management
Strategic risk management
Global risk management
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CIA Annual Meeting
Session 6707: Brave New World
Basic Risk Management Principles
1. Identifying loss exposures
2. Measuring loss exposures
3. Evaluating the different methods for handling risk
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Risk assumption
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Risk transfer
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Risk reduction
4. Selecting a method
5. Monitoring results
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CIA Annual Meeting
Session 6707: Brave New World
Where Did Enterprise Risk
Management Come From?
Traditional risk management
Formally developed as a field in the 1960s
Focused on “pure” risks
Loss/no loss situation
Often could be insured
Developed from insurance purchasing area
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CIA Annual Meeting
Session 6707: Brave New World
New Elements of Risk – 1970s
Foreign exchange risk
End of Bretton Woods agreement in 1972
Commodity price risk
Oil price fluctuations of the 1970s
Equity risk
Development of option markets - 1973
Interest rate risk
U. S. Federal Reserve Board policy shift - 1979
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CIA Annual Meeting
Session 6707: Brave New World
Failure to Manage Financial Risk
Foreign exchange risk
Laker Airlines – 1970s
Borrowing in dollars
Revenue in pounds
Interest rate risk
U. S. Savings and Loans – 1980s
Borrowing short
Lending long
Commodity price risk
Continental Airlines – 1990
Fuel costs not hedged
Oil price doubled with Gulf War
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CIA Annual Meeting
Session 6707: Brave New World
The “New” Risk Management 1980s
Financial risk management
Dealt with financial risk
Foreign exchange risk
Interest rate risk
Equity risk
Commodity price risk
Use derivatives to hedge financial risk
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Session 6707: Brave New World
Financial Risk Management
Toolbox
Forwards
Futures
Options
Swaps
Interest Rate Models
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Session 6707: Brave New World
New Elements of Risk – 1990s
Failure to manage derivatives appropriately
Financial model failures
Improper accounting for derivatives
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Session 6707: Brave New World
Mismanagement of Financial Risk
Mismanagement of derivatives
Gibson Greetings
Proctor and Gamble
Barings Bank
Orange County
Model failure
Long Term Capital
Accounting improprieties
Enron
Arthur Andersen
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CIA Annual Meeting
Session 6707: Brave New World
The “New” Risk Management 1990s and beyond
Enterprise Risk Management
Initial focus on avoiding derivative disasters
Developing into optimizing firm value
Chief Risk Officer
Sarbanes-Oxley Act – 2002
Increased focus on risk models
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CIA Annual Meeting
Session 6707: Brave New World
Evolution of ERM
Control function
How much can we lose?
Risk adjusted returns
Capital allocation
Compensation
Bonuses
Optimization
Maximize stakeholder value
Vision of the future
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Session 6707: Brave New World
ERM Risk Categories
Common risk allocation
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Hazard risk
Financial risk
Operational risk
Strategic risk
Bank view – New Basel Accord
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Credit risk
• Loan and counterparty risk
Market risk (financial risk)
Operational risk
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Session 6707: Brave New World
Hazard Risk
“Pure” loss situations
Property
Liability
Employee related
Independence of separate risks
Risks can generally be handled by
Insurance, including self insurance
Avoidance
Transfer
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Session 6707: Brave New World
Financial Risk
Components
Foreign exchange rate
Equity
Interest rate
Commodity price
Correlations among different risks
Use of hedges, not insurance or risk transfer
Securitization
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Session 6707: Brave New World
Operational Risk
Causes of operational risk
• Internal processes
• People
• Systems
Examples
• Product recall
• Customer satisfaction
• Information technology
• Labor dispute
• Management fraud
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Session 6707: Brave New World
Strategic Risk
Examples
• Competition
• Regulation
• Technological innovation
• Political impediments
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Session 6707: Brave New World
Increased Use of Risk Models
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Technological advances
Theoretical advances
Allocation of economic capital
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Used for divisional profitability
Impacts bonuses
Dueling models
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Session 6707: Brave New World
Traditional Risk Management Silos
Financial risk – Treasury
Insurance risk – Risk Management
Operational risk – Business units
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Session 6707: Brave New World
New Corporate Structure
CFO – capital management
CRO – risk management
Define risk
Gather information
Use information
No consistent risk framework in place yet
Need for risk balance sheet/income statement approach
Control risk
Increase firm value
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CIA Annual Meeting
Session 6707: Brave New World
Essential Skills of a Risk Manager
Understand benefits and limitations of models
Comprehension of data gathering process
Identifying essential data
Gathering information into central location
Interpreting reports
Understanding of how risk measures relate to
strategic and tactical business decisions
Communication skills
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Session 6707: Brave New World
Examples of ERM - 1
Michelin – contingent capital
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Issued by Swiss Re New Markets and Societe
Generale
Option to draw on subordinated long-term bank
credit facility
Option to issue subordinated debt at fixed spread
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This option can only be exercised if GDP growth falls
below a trigger (1.5% 2001-03, 2.0% 2004-05)
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CIA Annual Meeting
Session 6707: Brave New World
Examples of ERM - 2
United Grain Growers – risk integration
• Issued by Swiss Re
• Regional grain volume coverage
• Integrated with other property/liability coverages
• Three year policy
• Annual aggregate retention
• $35 million annual limit
• $80 million policy limit
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Session 6707: Brave New World
Examples of ERM - 3
RLI Corporation – Cat-E-Puts
• Arranged by Aon, issued by Centre Re
• Three year term
• Provided an option to issue $50 million in
convertible preferred shares
• Trigger was major California earthquake
• Subject to minimum capital requirements
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CIA Annual Meeting
Session 6707: Brave New World
Future of ERM
ERM will continue as risk consolidation and
aggregation
Process increases value of risk management skills
Management is concerned with risk control issues
Chief Risk Officer will be a visible figure in an
organization
Many paths to CRO, diverse skills required
ERM’s role in optimization has a long way to go
Potential benefit is worth pursuing for pioneers
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