ERM 57 ReviewCAD 010

Speakers:

Michael W. Elliott, CPCU, AIAF, Senior Director of Knowledge Resources, The Institutes

Ann Myhr, CPCU, ARM, AU, Senior Director of Knowledge Resources,

The Institutes

Learning Objectives

At the end of this session, you will:

• Dissect the most challenging ERM 57 course topics.

• Practice ERM 57 exam questions.

• Familiarize yourself with the ERM 57 exam format.

What to Expect on the Exam

• Educational Objectives

• Balanced Exam

• Pretest Items

Test Taking Tips

• Get the easy ones

• Don’t get bogged down early

• Use the “mark for later review” feature

• Eliminate the obviously wrong answers

• Use your scratch paper to keep track

Assignment 1

Introduction to Enterprise

Risk Management

ERM Definition

RIMS

A strategic business discipline that supports the achievementof an organization’s objectives by addressing the full spectrum of its risks and managing the combined impact of those risks as an interrelated risk portfolio.

Traditional Risk Management Department

ERM Governance Model

Classifications ofRisk

Risk Quadrants

Risk quadrants differ from risk classifications. While risk classifications focus on specific characteristics of the risk itself, risk quadrants focus onA: pure and subjective risks.B: subjective and objective risks.C: risk diversification.D: sources of risk.

Assignment 2

Enterprise Risk Management

In an Organization

Purpose and Types of Maturity Models

The purpose of a maturity model is to evaluate or improve a business process.

Two types of particular interest are:

• Capability Maturity Model

• RIMS Risk Maturity Model

Capability Maturity Model (CMM) and Capability Maturity

Model IntegrationHas five levels:

• Ad hoc

• Initial

• Defined

• Managed

• Optimizing

Based on the Capability Maturity Model (CMM) developed by Carnegie Mellon, an organization that has basic risk management processes with no attempt at enterprise-wide risk management is at which one of the maturity levels?

A: Managed

B: Initial

C: Ad hoc

D: Defined

RIMS Risk Maturity ModelUses 5 maturity levels based on CMM applied to 7 attributes:

• Adoption of ERM-based approach

• ERM process management

• Risk appetite management

• Root cause discipline

• Uncovering risks

• Performance management

• Business resiliency and sustainability

A risk maturity model that uses five maturity levels based on the Capability Maturity Model, determining the maturity level for each of seven attributes by evaluating the degree to which key drivers are present, is known as the

A: Capability Maturity Model

B: Standard and Poor’s (S&P) Risk Maturity Model

C: RIMS Risk Maturity Model

D: Aon Risk Maturity Index

Organizational Functions Related to ERM

Assignment 3

Enterprise Risk Management

Framework and Process

ERM Framework and Process

ISO 31000 Framework and Process

Source: ISO31000:2009

According to the ISO 31000 risk management standards, which one of the following is a component of risk assessment?

A: Establishing the context

B: Risk evaluation

C: Risk treatment

D: Monitoring and review

COSO ERM

Source: COSO – Enterprise Risk Management – Integrated Framework

Assignment 4

Risk Oversight

Role of Corporate Governance

• Separation of ownership and control

• Agency costs

• Aligning manager and shareholder interests

Corporate Governance Codes

• Balance of nonexecutive and executive directors

• Nonexecutive directors have access to others

• Nomination process

• Compensation committee

• Audit committee

• Evaluation of board members’ performance

• Shareholder approval of director and executive officer compensation

Board Membership and Committees

Membership

• Chair

• Inside directors

• Outside directors

Committees

• Compensation

• Audit

• Nominations/corporate governance

Risk Governance

• Architecture within which risk management operates in a company.

• Clarity about which risks are managed

• Provides guidance for sound and informed decision making

Source: Risk Governance Guidance for Listed Boards, (Singapore: Corporate Governance Council, May 10, 2012)

Chief Risk Officer (CRO)

• Senior manager

• Has access to the board an top management and partners with business unit managers

• Compliance champion vs. modeling expert

• CRO as strategic controller vs. CRO as strategic adviser

Risk Committees

Board-level

• Risk oversight

• Assist board in setting risk appetite

• Advise board on risk strategy

• Oversee critical risk exposures

Executive-level

• Risk management execution

• Provide board with information on key risks and how they are managed

• Approve risk management strategy design

Which one of the following is a responsibility of an executive-level risk committee?

A: Set the organization’s risk appetite

B: Oversee risk at the board level

C: Approve the design of an organization’s risk management strategy

D: Serve as a modeling expert rather than a compliance champion

Assignment 5

Strategic Planning and EnterpriseRisk Management

SWOT Analysis Table

Strategy Implementation

Some organizations apply a balanced scorecard approach to

implement strategy and to provide a foundation for strategy

evaluation. The balanced scorecard approach translates an

organization’s strategy into specific goals and actions

assigned to each department within the organization.

Organizational Levels

Which one of the following types of strategy determines how individual departments within an organization direct their activities?

A: Functional strategy

B: Business strategy

C: Corporate strategy

D: Operational strategy

Assignment 6

Risk-Based Performance and

Process Management

Risk Based Performance

Key Performance Indicators (KPIs)

o Critical Success Factors

o Risk Tolerance

Successful organizations have goals and objectives. A financial or nonfinancial measurement that defines how successfully an organization is progressing toward its long-term goals is referred to as

A: an operating standard (OS).

B: a critical success factor (CSF).

C: a key performance indicator (KPI).

D: an objective gauge (OG).

Purpose of Key Risk Indicators (KRIs)

Effective KRIs provide objective, quantifiable information about emerging risks and trends in existing risks that can affect an organization’s success.

Which one of the following is an example of an external key risk indicator (KRI) that a manufacturer might monitor?

A: Number of employee injuries

B: Age of accounts payable

C: Amount of budget variances

D: Cost of raw materials

Assignment 7

Internal Audit and Control

Internal Control and Risk Management

Internal control – a system or process that an organization

uses to achieve its operational goals, internal and external

financial reporting goals, or legal and regulatory compliance

goals.

Three Lines of Defense Model

Source: FERMA/ECIIA

According to the Three Lines of Defense Model, internal audit’s role in risk assessment techniques is to A: design them. B: implement them. C: provide assurance on their effectiveness. D: perform a control risk self-assessment (CRSA).

Risk-Based Auditing

Aligns audit resources with the areas that pose the greatest

organizational risk.

Evolution of Internal Audit

Transaction Approvals

Assurance of Internal Controls

Risk-based Approach

The modern approach to internal auditing differs from the traditional approach by focusing onA: the effectiveness of internal controls.B: the relative riskiness of various activities.C: transaction approvals.D: systems-based compliance.

Assignment 8

Regulation and Compliance

Roles of Compliance and Internal Audit

Compliance

• Determines compliance issues

• Develops work plans to meet compliance requirements

• Conducts compliance risk assessments

Internal Audit

• Audits internal controls that test for compliance

• Identifies gaps in internal control systems and processes

• Serves as internal consultant on compliance threats and opportunities

Regulation

Rules-Based

• More certainty and predictability

• Less responsive to change

• Inflexible

• Often circumvented

Principles-Based

• More flexible and focuses on outcomes

• Responds more quickly in a changing environment

• Requires more communication between the regulator and the regulated

NAIC ORSA

Risk Management Framework

Assessment of Risk Exposure

Prospective Solvency

Assessment

• Principles-based (guidelines)

• Applies ERM to insurance companies

The NAIC Own Risk and Solvency Assessment (ORSA) model law represents a change from past NAIC directives because it isA: specific in terms of reporting.B: retrospective.C: voluntary.D: principles-based.

Assignment 10

Risk Modeling

Influence Diagrams and Probabilities

• GEV Industries hires inexperienced and experienced workers

to operate simple and complex machines. Accident rates vary

by worker experience and complexity of machine.

• GEV would like to estimate accident rates if it (a) assigns

workers randomly to machines or (b) assigns workers to

machines based on experience.

Influence Diagram

Worker Experience

AccidentRate

? Machine Complexity

Cost ofRisk

Worker assignment to machines

Machine and Worker Data

Simplemachines

Complexmachines

Inexperiencedworkers

Experienced workers

40 160 60 140

Inexp. worker (30%) Exp. Worker (70%)

Simple machine (20%) 6% 14%

Complex machine (80%) 24% 56%

Random Worker Assignments Probabilities

Accident Conditional Probability

Inexperienced Experienced

Simple Machine 5% 0%

Complex Machine 40% 10%

Random Worker Assignments Probabilities

Inexp. worker Exp. worker

Simple machine .3% 0.0%

Complex machine 9.6% 5.6%

Accident Conditional Probability

Accident Probability

Inexperienced Experienced

Simple Machine 5% 0%

Complex Machine 40% 10%

Inexp. worker (30%) Exp. Worker (70%)

Simple machine (20%) 6% 14%

Complex machine (80%) 24% 56%

Total accident probability = 15.5%

Worker Assignments by Experience

Inexp. worker Exp. worker

Simple machine 1% 0%

Complex machine 4% 7%

Accident Conditional Probability

Accident Probability

Inexperienced Experienced

Simple Machine 5% 0%

Complex Machine 40% 10%

Inexp. worker (30%) Exp. Worker (70%)

Simple machine (20%) 20% 0%

Complex machine (80%) 10% 70%

Total accident probability = 12%

Twenty percent of PDQ Transport’s trucks have advanced safety equipment and 80% do not. Thirty of PDQ’s drivers are inexperienced and 90 are experienced. Assuming drivers are assigned randomly to trucks, what is the probability that an inexperienced driver is assigned to a truck without advanced safety equipment?A: 18%B: 20%C: 24%D: 60%

Correlation

• Relationship between two variables

• Number between +1 and -1

• 0 means no correlation

Two variables are perfectly positively correlated. If one of the variables increases, the other willA: increase in direct proportion.B: decrease in direct proportion.C: increase at half the rate.D: decrease at half the rate.

Value at Risk (VaR)

A $500,000, 2 percent VaR means losses from an investment are expected to be A: $10,000. B: less than $500,000 2 percent of the time. C: $490,000. D: greater than $500,000 2 percent of the time.

Assignment 11

Risk-Based Capital Allocation

Cost of Equity

KE = rf + ß (rm – rf )

Where:ß = Beta of securityrm = Expected return on the marketrf = Risk-free rate

Cost of Debt Equation

Cost of debt KD = (risk free rate of return rf +

risk premium) × (1 – tax rate)

Polytech Company

Tax rate 40%

Risk-free rate 4%

Current Debt $10 million

Polytech credit spread 2.10%

Current Equity $100 million

Expected market return 10%

Market risk premium 6%

Polytech Beta 1.20

Polytech Company

• Estimate the cost of debt

• Estimate the cost of equity

• Optimal capital structure = weighted average of the cost of debt and the cost of equity

Polytech Company – Cost of Debt

(Risk-free rate of return + credit spread) X (1 – tax rate)

(4% + 2.10%) X (1-.40)

3.66%

Polytech Company – Cost of Equity

Risk-free rate of return + Beta X (Market rate of return – risk-free rate of return)

4% + 1.20 (10% - 4%)

11.20%

Polytech Company – Weighted Average Cost of Capital

$10 mil. debt divided by $110 mil. (debt + equity) = .091

.091 weight of debt; .909 weight of equity

(3.66% X .091) + (11.20% X .909)

.333% + 10.181%

10.514%

Market Value Surplus (MVS)

Economic Capital

Market Value Surplus Example

Autumn Assurance Group has assets at fair value of $100 million. The present value of Autumn’s liabilities is $85 million. The market value margin is $5 million. Using probability models, Autumn determines that its VaR is $8 million because it expects to incur an $8 million or greater loss of capital at a .5 percent probability over a one-year period.

1. What is Autumn’s MVS?

2. What is Autumn’s economic capital?

3. Does Autumn have excess capital or a deficiency in capital?

Questions?

Assignment 9

Risk Assessment and Treatment

Risk Identification Tools

• Facilitated workshops

• Delphi technique

• Scenario analysis

• HAZOP

• SWOT

Which one of the following team approaches to risk identification involves a select group of experts in question-and-response cycles until a consensus is achieved?A: HAZOPB: Scenario analysisC: Delphi techniqueD: SWOT

Risk Treatment Techniques

Assignment 12

Risk Management Environment and Culture

Risk Centers and Owners

• Risk center – unit within an organization at which level a risk (or

risks) is most effectively managed

• Risk owner – individual accountable for identification, assessment,

treatment, and monitoring of risks in a specific environment

Advantages of Risk Centers

• Reduces the scope of risk analysis

• Allows for the involvement of operational managers

• Helps focus on the organization’s strategic goals and operational objectives

• Ensures that risks are managed at the most appropriate level in the organization

Risk Attitude

Risk Avoiding Risk SeekingRisk Optimizing

Additional Slides

Evolution of Risk Management

Insurance Management

RiskManagement

Enterprise Risk Management

ERM Value Proposition

• Identify key risks

• Employ risk-based decision making

• Improve internal control

• Improve risk governance

• Comply with legal and regulatory requirements

Solvency I and II (Insurance Cos)

• Solvency I

• Early 1970s

• Focused on capital adequacy

• Solvency II

• 3 pillars

• 1 – Risk-based capital

• 2 – Risk management and governance

• 3 – Transparent reporting

• Includes an own risk and solvency assessment (ORSA)

Basel II and III (Banks)

• Basel II

• Issued in 2004

• Minimum capital requirements using weights for different types of credit risk

• Basel III

• Response to the Great Recession

• Operational risk added

• Risk management framework

• Board of directors role (approve framework, risk appetite, governance)

ERM Process Model

Risk Identification Tools – Risk Register

EventID

Risk Scenario Likelihood Impact Risk Level Risk Treatment(present)

Proposed improvement action

Next Review Date

Loss of personal computer

3 1 None None Remove from list

Damage to reputation

2 4 Review policy Implement … 2 months

Loss of statefunding

3 5 None •Increase lobbying•Step up givingcampaign

1 month

….

1

2

3

Public University

Risk Identification Tools - Risk Map

3

2

1

1

2

3

Loss of a personal

computer

Damage to reputation

Loss of state funding

Inherent and Residual Risk

Inherent

Treat

Residual

Treat

Optimum

A risk map showing a large difference between inherent and residual risk indicates that the A: current risk treatment is ineffective. B: risk does not need to be treated. C: current risk treatment is effective. D: risk exceeds the organization’s risk tolerance.

Decision Tree

ERM Tools - Modern Portfolio TheoryEx

pec

ted

Val

ue

of

the

Ret

urn

Risk – standard deviation (variability)

X

Ris

k A

pp

etit

e

X

X

X

The efficient frontier consists of portfolios that A: are riskless. B: provide the average market return. C: provide the highest return at different risk levels. D: return the risk-free rate of return.

Earnings at Risk

Earnings at risk of $200,000 with 90 percent confidence are projected to be

A: $180,000.

B: less than $200,000 10 percent of the time.

C: $200,000 90 percent of the time.

D: greater than $200,000 10 percent of the time.