finance 432: managing financial risk for insurers
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Finance 432: Managing Financial Risk for Insurers. Actuaries of the 4 th Kind -Enterprise Risk Management. B ühlmann’s Kinds of Actuaries. Actuaries of the First Kind Life – deterministic calculations Actuaries of the Second Kind Casualty – probabilistic calculations - PowerPoint PPT PresentationTRANSCRIPT
Finance 432: Managing Financial Risk for Insurers
Actuaries of the 4th Kind -Enterprise Risk Management
Bühlmann’s Kinds of Actuaries• Actuaries of the First Kind
– Life – deterministic calculations
• Actuaries of the Second Kind– Casualty – probabilistic calculations
• Actuaries of the Third Kind– Financial – stochastic calculations
• Actuaries of the Fourth Kind– Enterprise risk management – mathematics of
integration and interrelations
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 Principles
1. 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
Why Manage Risk?
Diversifiable risk argument• Shareholders are diversified investors• They will not pay a premium to reduce unsystematic risk
How risk management can add value• Decreasing taxes• Decreasing the cost of financial distress
– Customers– Employees– Suppliers
• Facilitating optimal investment• Increasing firm value
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 – 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
Federal Reserve Board policy shift - 1979
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
The “New” Risk Management -1980s
Financial risk management
Dealt with financial risk
Foreign exchange risk
Interest rate risk
Equity risk
Commodity price risk
Used derivatives to hedge financial risk
Financial Risk Management Toolbox
• Forwards
• Futures
• Options
• Swaps
New Elements of Risk – 1990s
• Failure to manage derivatives appropriately
• Financial model failures
• Improper accounting for derivatives
Mismanagement of Financial Risk• Mismanagement of derivatives
– Gibson Greetings– Proctor and Gamble– Barings Bank– Orange County
• Model failure– Long Term Capital
• Accounting improprieties– Enron– WorldCom– Arthur 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
ERM Risk CategoriesCommon risk allocation• Hazard risk• Financial risk• Operational risk• Strategic riskBank 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 by– Insurance, including self insurance– Avoidance– Transfer
Financial Risk
• Components– 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 Risk
Examples
• Competition
• Regulation
• Technological innovation
• Political impediments
Evolution of ERM
• Control function– How much can we lose?
• Risk adjusted returns
• Capital allocation (Stefan Lippe – Swiss Re)– Compensation– Bonuses
• Optimization– Maximize stakeholder value– Vision of the future
Examples of ERM - 1
Michelin – 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 - 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
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
Katrina Induced Gas Lines
Conclusion• ERM is continuing to evolve• Started as hazard risk management• Financial risk management developed• Failures brought increased attention• Technology and risk management experience led to
new approaches• Regulation is pushing organizations to improve• Modeling risks is key component• No standard approach has yet emerged• Challenging and attractive area