cia annual meeting looking back…focused on the future

CIA Annual MeetingCIA Annual Meeting

LOOKING BACK…focused on the futureLOOKING BACK…focused on the future

CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World


Stephen P. D’Arcy President of the Casualty Actuarial

SocietyProfessor of Finance, University of Illinois

The Brave New World of Enterprise Risk Management

Stephen P. D’Arcy President of the Casualty Actuarial

SocietyProfessor of Finance, University of Illinois

The Brave New World of Enterprise Risk Management



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



Basic Risk Management Principles1. Identifying loss exposures

2. Measuring loss exposures

3. Evaluating the different methods for handling risk• Risk assumption• Risk transfer• Risk reduction

4. Selecting a method

5. Monitoring results



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



New Elements of Risk – 1970sForeign 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



Failure to Manage Financial Risk Foreign exchange risk

Laker Airlines – 1970sBorrowing in dollarsRevenue in pounds

Interest rate riskU. S. Savings and Loans – 1980s

Borrowing shortLending long

Commodity price riskContinental Airlines – 1990

Fuel costs not hedgedOil price doubled with Gulf War



The “New” Risk Management -1980s

Financial risk management Dealt with financial risk

Foreign exchange riskInterest rate riskEquity riskCommodity price risk

Use derivatives to hedge financial risk



Financial Risk Management Toolbox

Forwards

Futures

Options

Swaps

Interest Rate Models



New Elements of Risk – 1990s

Failure to manage derivatives appropriately

Financial model failures

Improper accounting for derivatives



Mismanagement of Financial RiskMismanagement of derivatives

Gibson GreetingsProctor and GambleBarings BankOrange County

Model failureLong Term Capital

Accounting improprietiesEnronArthur Andersen



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



Evolution of ERMControl function

How much can we lose?

Risk adjusted returns

Capital allocation Compensation

Bonuses

OptimizationMaximize stakeholder value

Vision of the future



ERM Risk CategoriesCommon risk allocation• Hazard risk• Financial risk• Operational risk• Strategic risk

Bank view – New Basel Accord• Credit risk

• Loan and counterparty risk• Market risk (financial risk)• Operational risk



Hazard Risk“Pure” loss situations

Property

Liability

Employee related

Independence of separate risks

Risks can generally be handled byInsurance, including self insurance

Avoidance

Transfer



Financial RiskComponents

Foreign exchange rate

Equity

Interest rate

Commodity price

Correlations among different risks

Use of hedges, not insurance or risk transfer

Securitization



Operational RiskCauses of operational risk• Internal processes• People• SystemsExamples• Product recall• Customer satisfaction• Information technology• Labor dispute• Management fraud



Strategic RiskExamples• Competition• Regulation• Technological innovation• Political impediments



Increased Use of Risk Models• Technological advances• Theoretical advances• Allocation of economic capital

• Used for divisional profitability• Impacts bonuses• Dueling models



Traditional Risk Management Silos

Financial risk – Treasury

Insurance risk – Risk Management

Operational risk – Business units



New Corporate StructureCFO – capital management

CRO – risk managementDefine 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



Essential Skills of a Risk Manager

Understand benefits and limitations of models

Comprehension of data gathering processIdentifying essential data

Gathering information into central location

Interpreting reports

Understanding of how risk measures relate to strategic and tactical business decisions

Communication skills



Examples of ERM - 1Michelin – contingent capital• 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

• This option can only be exercised if GDP growth falls below a trigger (1.5% 2001-03, 2.0% 2004-05)



Examples of ERM - 2United 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



Examples of ERM - 3RLI 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



Future of ERMERM will continue as risk consolidation and

aggregationProcess increases value of risk management skillsManagement is concerned with risk control issuesChief Risk Officer will be a visible figure in an

organization Many paths to CRO, diverse skills requiredERM’s role in optimization has a long way to goPotential benefit is worth pursuing for pioneers

cia annual meeting looking back…focused on the future

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