Scott SandersonMarsh Advanced Risk Solutions

Enterprise Risk Management Post 9/11-Enterprise Risk Management Post 9/11-A Benefit or a Fad?A Benefit or a Fad?

Risk Quiz

On some questions, there are multiple right answers

On all questions, there’s multiple wrong answers

Write in answers are fine and may garner extra credit (or a debit)

Choose the Best Phrase for your View on Risk Management

A. Risk can be assessed and managed through mathematical techniques. I think math is fun; my friends find me geeky and I have a difficult time interacting with “normal” peopleB. I find trading to be the essence of risk management. I trade to make a profit and enhance my bonus. I can always make a profit if my employer would just remove all trading constraintsC. Risk goes away over time. I just need to be able to get around the accounting rules. Using financial engineering tools is fundamentally stupid, as they cost money to trade over time.D. Producing and selling product is all that matters. Price volatility is the shareholders problem.E. ____________________________________________________

Risk Quiz

Risk is:

A - B - C - Mostly but with an element of D - Mostly but modified by E - What the _____ is and and why should I care?

The Most Important Aspect of Risk Management is:

A. Protecting the outcomes of my operationB. Protecting market shareC. Creating the opportunity for trading profitsD. Making sure my bonus formula is achievedE. Enhancing shareholder value through maximized income at a lower volatility

What is a Garch Model

A. Used in thermodynamics and measures the movement of heat through a semi-permeable metalic membraneB. Uses a physical theory of random movement of a molecule in a vacuum to simulate random motions of financial variablesC. Measures and simulates outcomes for interest rate movementsD. Captures financial volatility that demonstrates heteroskedastic propertiesE. None of the aboveF. C&D

A Naked Straddle is:

A. An interesting way to ride a horseB. Concurrently selling a put and a callC. The part the director eliminates from a movie so people 18 and under can gain admissionD. Not something polite people would put in a quizE. A & CF. A, B & CG. All of the aboveH. None of the aboveI. I don’t know, I don’t care but I’m willing to give it a try

Match the Formula and the Description

(X - X)(Y -Y)i i

n-1

2. Sample Covariance

P(A|B) = P(A&B)

P(B)

1. Bayes Rule for Conditional Probability

f(x)= 2

1 e-(x-)/222

3. Density of Normal Distribution C = 2R

4. Circumference of a circle

A.

B.

C.

D.

Your View on Risk ManagementAnswer

Requires analysis and understanding of the analysis - being modeling conversant is an asset, but social oddness is not

Trading is fine if it’s the organizational strategy but don’t confuse trading with risk management

True - volatility over time matters relatively little, but does impact business operations

Good to keep sight of the objectives of the organization - but the shareholder issues are your issues

Risk Quiz

Risk is:

A - B - C - Mostly but with an element of D - Mostly but modified by E - What the _____ is & and why should I care?

The Most Important Aspect of Risk Management Answer:

A. Protecting the outcomes of my operationB. Protecting market shareC. Creating the opportunity for trading profitsD. Making sure my bonus formula is achievedE. Enhancing shareholder value through maximized income at a lower volatility

A Naked Straddle is:

A. An interesting way to ride a horseB. Concurrently selling a put and a callC. The part the director eliminates from a movie so people 18 and under can gain admissionD. Not something polite people would put in a quizE. A & CF. A, B & CG. All of the aboveH. None of the aboveI. I don’t know, I don’t care but I’m willing to give it a try

What is a Garch Model

A. Used in thermodynamics and measures the movement of heat through a semi-permeable metalic membraneB. Uses a physical theory of random movement of a molecule in a vacuum to simulate random motions of financial variablesC. Measures and simulates outcomes for interest rate movementsD. Captures financial volatility that demonstrates heteroskedastic propertiesE. None of the aboveF. C&D

Extra Credit - GARCH stands for Generalized Auto - Regressive Conditional Heteroskedactic model

Match the Formula and the Description

(X - X)(Y -Y)i i

n-1

2. Sample Covariance

P(A|B) = P(A&B)

P(B)

1. Bayes Rule for Conditional Probability

f(x)= 2

1 e-(x-)/222

3. Density of Normal Distribution C = 2R

4. Circumference of a circle

A.

B.

C.

D.

A.

B.

C.

D.

Write Down as Many Risks as Possible based on The Following Exposure

Jack and Jill went up a hill to fetch a pail of water,

Jack fell down and broke his crown

and Jill came tumbling after.

Jack and Jill Scenario

J & J sue landowner for slick surface and failure to warn of dangerous conditions

Jill sues Jack for encouraging her to climb an unsafe hill Purchaser of water sue J & J for non-delivery J & J sue purchaser of water for encouraging them to perform

an inherently unsafe act J & J sue maker of pails for creating unbalanced pail system J&J sue shoemakers for unsafe sole pattern J&J sue school system for not teaching hill-climbing dangers Price spikes on water, compounding J&J’s spillage loss J&J sue ambulance company for failure to render adequate care

and to safeguard the water supply Jill sues Jack for sexual harassment for the implication that she

couldn’t climb the hill because “she was just a girl”

Risk and Why We Care

Impacts stock price Impacts ability to make future

investments Impacts business decisions and

willingness to enter a business Impacts cash flows and earnings from

non-core activitiesDefines the potential deviations from

expectations of the company

Clients changing their view of risk to encompass many areas Risk is no longer defined by the products the insurance industry sells Measurement is defined by what the client thinks it is

– EVA– CFaR– Internally created metrics– Stock price movements

Enterprise Risk Management

Generally: Risk can be defined as a deviation from anexpected outcome

Clients have traditionally viewed their risks as a series of single elements Each risk stood alone - assumed one wasn’t related to another Optimized silos meant optimized risk management Insurance risk management wasn’t a problem Cheap insurance was an effective tool with these assumptions Derivatives allowed other risks (FX, commodity, interest rates) to be managed with their unique set

of tools Assumes that management can deal with other non-tradable, non-insurable risks in their role of

managing the business effort

Traditional View of Risk

Ignores portfolio effect Human beings are extremely bad at dealing with things that have not happened to them recently People assume mean reversion in short time periods Ignores possibility of related events (embedded, unrecognized correlation) Budgets are silo based and drive individual behaviors, even though the true outcomes are

inherently intertwined Management of enterprise wide risk is perceived as complex The tools to manage enterprise risk are in their infancy

Issues

Portfolio Effect

0%

5%

10%

15%

20%

25%

30%

24 30 36 42 48 54 60 66 72 79 85 91 97

PR

OB

AB

ILIT

Y

0%

5%

10%

15%

20%

25%

30%

Impact of Portfolio EffectApparent Silo Volatility vs. Real Portfolio Volatility

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

Silo Management Actual Portfolio

Vol

atili

ty

Auto Liability

General Liability

Workers Comp

Property

Foreign Exchange

Portfolio

Client Issues

Budgets and Silos

Organizations seldom take an overall view– Budgets drive behaviors– Assumed that the sum of optimized

elements optimizes the whole

How do you split an integrated outcome?How to retain an entrepreneurial spiritHow to reward and punish

Client Issues

Trading Mentality

Current purchasing/treasury functions attempt to optimize timing

Beating the market goes into the budget of the department, working against the desire to integrate

People like to trade - its fun

Client Issues

Understanding the Cost of Volatility

Unlike banks and insurers, non-financial companies have no explicit cost to take risk

Hard to know the impact to the stock price if an unforeseen event does occur

Not particularly concerned with things that haven’t happened recently

Little concept of scope of volatility or correlation in the organization

Client Issues

Organizational Dynamics

Decision process is inherently across a diverse group of managers

Each member views in the context of their role Inertia Communication Difficult explanation to most senior

management - too complex to show in three slides

How many others have done this; “We don’t want to be first”

Client Issues

Economic Foundations

Never really considered or modeled the volatility of the exposures, thus never concerned with risks not actually experienced

Difficult to determine price elasticity questions on commodities and other economic indicators

Underlying belief that economic elements can be forecasted with adequate certainty

Mean reversion assumption and ability to view whether something is expensive or cheap

It’s a lot of work and most organizations don’t have people with the skills

Client Issues

Market Pricing Inefficiency

Complex structures lack transparency Differing view of modeling processes, resulting

in differing view on value Markets have their own silos that have to be

circumvented to capture portfolio pricing Lack of depth of people with multiple

experience Lack of integrated reinsurance marketplace

Is there a Future in Managing Risk together?

There are rational economic foundationsMarketplace for insurers and banking is

overlapping, encouraging organizations to use the talents of each

Will be slow to take off, but will flyThe logical extension to Enterprise Risk

Management approaches - why study something if there is no intent to manage?

Evolving Tools

Application of simulation modeling for single and multi-variant exposures is being slowly accepted as a tool to measure risk

The models are being taken from a combination of actuarial and econometric modeling processes

May haven’t done it yet, but are interested in pursuing the subject

There is a broadening of the insurance market to include derivative-like exposures for– Commodities that don’t trade– Exposures that trade, but may be illiquid– Correlation proxy opportunities

A realization that risk is risk and should be treated consistently

Risk Example

Client makes nylon based products

In their processes, they use – Ammonia– Cyclohexane– Benzene– Propylene– Natural gas (fuel and input)

Product pricing presumed to be inelastic to input costs

How do you manage this?

Understand the risk

All commodities are oil or natural gas based Can we model the inputs? Compare to proxy basket of oil and natural gas? Measure the volatility of the correlation? Structure an arrangement with and insurer where

– they provide the client a cover for what they purchase– trade out the proxy basket– Charge for the volatility of the exposure

Outcome - a synthetic derivative with excellent margins for the insurer that solves the client problem

Optimized correlation

$-

$10,000,000

$20,000,000

$30,000,000

$40,000,000

$50,000,000

$60,000,000

$70,000,000

$80,000,000

$90,000,000

Optimized oil/gas w absorber

Client Basket

Annual Volatility of Correlation

Volatility of Correlation

Mean = -3.601814E-04

X <=-0.195%

X <=0.2595%

0

0.5

1

1.5

2

2.5

3

-30.00% -2.50% 25.00% 52.50% 80.00%

Enterprise Risk Management

Its coming - slowly Actuary’s opportunity - to understand and

support modeling and understanding of the opportunity

Provides an opportunity to increase insurer’s results while concurrently providing valuable tool for clients

Not yet everyday - but will be The way risks will be managed tomorrow