Enterprise Risk Management For Insurers and Financial Institutions

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EnterpriseRisk ManagementFor Insurers and
Financial Institutions

• David Ingram
• CERA, FRM, PRM

From the International Actuarial Association
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Course Outline

• 1. INTRODUCTION - Why ERM?
• 2. RISK MANAGEMENT FUNDAMENTALS FIRST STAGE OF
  CREATING AN ERM PROGRAM
• 3. RISK ASSESSMENT AND RISK TREATMENT - ACTUARIAL
  ROLES
• 4. ADVANCED ERM TOPICS

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INTRODUCTION

• 1. INTRODUCTION - Why ERM?
• 1.1 Enterprise risk management history
• 1.2 What is enterprise risk management?
• 1.3 ERM the Financial Crisis
• 1.4 ERM Adoption in the Insurance Industry

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A Brief History of Risk Management

• 1952 Markowitcz Portfolio Theory Risk
  variance
• 1973 Black Scholes Derivative Pricing
  variance is key driver
• 1987 Black Monday Portfolio Insurance
  implicated in record 1 day fall in stock market
• 1992 Cadbury (UK) Report urges centralized,
  comprehensive corporate RM
• 1993 First CRO named at GE

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Current Trends in Risk Management

• Dedicated risk management function
• Risk Management decision making remains largely
  decentralized
• 2. Risk Aggregation / Economic Capital
• in early stages of development
• 3. Regulatory practices encourage ERM
• 4. Regulatory Capital ? Economic Capital

Basel Survey (August 2003)
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Risk Management Failures

• 1973 Equity Funding Fraud
• 1983 Baldwin United Shell Game
• 1986 The ZZZ Best Carpet Scandal.
• 1988 Equitable (NY) GIC losses.
• 1989 The US SL Crisis.
• 1991 Salomon Brothers Bond Scandal.
• 1991 BCCI Scandal.
• 1991 Executive Life / First Capital Life
  Failures
• 1991 Mutual Benefit Life Failure
• 1994 Orange County Default
• 1994 Kidder Peabody Fiasco.
• 1994 Confederation Life Failure
• 1994 Monarch Life Seizure
• 1995 The Barings Derivatives Scandal.
• 1996 Sumitomo Copper Scandal.
• 1997 The Natwest Hole.
• 1997 The Bre-X Mining Scandal.
• 1997 Smith Barney Investor Fraud.
• 1997 Bank of Tokyo-Mitsubishi Derivatives Loss.

• 1997 UBS Derivatives Model Problems.
• 1997 Prudential Insurance US Market Conduct
• 1998 Russian Bond Debacle.
• 1998 The Long-Term Capital Management Model
  Failure.
• 1999 General American Liquidity Failure
• 1999 Unicover Fiasco
• 2000 Equitable UK Pension guarantees
• 2001 American Express CBO Losses
• 2002 Enron Worldcom
• 2003 Parmalat
• 2003 Allmerica VA reserving
• 2003 Annuity Life Re Overgrowth
• 2004 Marsh Contingent Commissions
• 2005 AIG Finite Re
• 2006 Scottish Re Tax Asset
• 2006 Hurricane Katrina
• 2007 Countrywide Sub Primes
• 2008 Bear Sterns/ Lehman/ AIG Sub Prime

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Risk Management Failures

• Bank / Financial
• Barings Controls Missing, mgt didnt understand
  risks
• LTCM Models inadequate, overleveraging
• Northern Rock Excessive Growth
• Insurance
• Nissan Mutual ALM mismatch, underpricing
  interest credits
• Equitable UK underpriced annuities, poor
  relationship with regulators
• HIH insurance mispricing, underreserving
• Confed Life Over-concentration in illiquid
  investments, shell game
• General American ALM mismatch, rating
  downgrade, downgrade trigger options
• American International Group Small Financial
  Group brings down Insurance giant

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Barings (UK)

• Venerable UK Bank
• Trading losses in Singapore
• Exceeded value of bank
• Problems
• Management didnt understand what the trader was
  doing
• Trades were not the hedged transactions they were
  supposed to be
• Trader did all reporting of trades
• No separation of duties

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Long Term Capital Management (US)

• Private Investment Fund
• Very highly Leveraged portfolio of investments
• Highly sophisticated risk management
• Capital was insufficient to withstand market
  movement
• Problems
• Risk Model was inadequate to predict 1998
  international financial problems
• Counterparties did not know the extant of their
  full exposure

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Northern Rock (UK)

• Mortgage lender grew rapidly to become one of the
  top 5 mortgage lenders in the UK
• Had used securitization to fund mortgage lending
  growth
• Encountered liquidity problems when mortgage
  securitization markets froze in Aug 2007
• Problem
• Request for help with liquidity from Bank of
  England triggered first run on UK bank in over
  100 years

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Nissan Mutual (Japan)

• Savings product guaranteed high interest rates
• High sales growth of this product
• Investment losses inadequate yield
• 200 billion net losses covered by Life
  Association of Japan
• Problem
• Asset Liability Mismatch
• Underpricing (over crediting) of interest

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Equitable (UK)

• Guaranteed payout annuity product sold to pension
  plans
• Improvement in mortality decline in interest
  rates
• Management tried to force solution on
  regulators
• Problem
• Underpricing poor Asset Liability matching
• Poor relationship with regulators lead to company
  demise rather than workout

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HIH (AUS)

• Second largest General Insurer suddenly found
  to be insolvent
• Problem
• Total control failure at all levels
• Company, Auditor, Regulator
• Ultimate problem was fundamental underpricing and
  overspending
• Hidden by systematic underreserving

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Confederation Life (Can)

• Company invested over 70 of assets in Real
  Estate
• Company failed following valuation and liquidity
  crunch
• Concentration hidden by accounting
• Problem
• Lack of Diversification, Liquidity
• Limited oversight from regulators, rating
  agencies due to accounting gimmicks

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General American Life (US)

• Funding agreement product sold to banks and
  mutual funds with 7-day put option
• Investments were made in 1 to 2 year maturity
  securities
• Partner handled large share of funds
• Downgrade of partner gttriggered downgrade of
  company gt triggered calls
• Company unable to raise cash for multi billion
  calls
• Problem
• Asset Liability Mismatch
• High dependency of business on ratings
• Huge Counterparty exposure

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American International Group

• In late 2006, AIG claimed to have 16B of excess
  capital
• In early 4th Quarter 2008, AIG needed over 100B
  of funds from US government to meet obligations
• Problem
• Small Financial Products unit has written
  Trillions of CDS, some on sub prime CDOs
• MTM losses lead to downgrade which leads to
  collateral call

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Reasons for Current Interest in Risk Management

• World Markets Interdependent
• Chaos Theory Butterfly Effect
• Wide Use of Derivatives
• Financial WMD Warren Buffett
• Accelerated Pace of Business
• Recent Experiences of Losses
• 1998 International Currency Crisis
• 2001/2002 Terrorism Investment Losses
• Tsumani and Hurricanes
• Financial Crisis

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Reasons

• Tools for Risk Mgt are getting better and better
• Success of RM in banking over the past down cycle
  (view in 2004)
• No Major Bank Failures
• Insurance Companies in Europe fared much worse
  with less Risk Mgt
• Extreme over exposure to equities
• Insurance regulators are getting interested
• In many jurisdictions same regulators for banking
  insurance

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Does the Global Financial Crisis prove that ERM
is Ineffective?
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Frequently Asked Question. ..
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• Study of 11 major banks in 2007
• Found differences in ERM Practices

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Better Risk Management Practices

• Four main differences in practices.
• Better-performing banks
• Shared risk and exposure information both quickly
  and broadly among business unit staff, risk
  management staff and top management.
• Used rigorous internal practices and models,
  consistent across all business units, to evaluate
  their risk positions.
• Coordinated cash planning centrally, avoiding or
  limiting activities that created large contingent
  liquidity needs and setting incentives to make
  such activities unattractive to business unit
  management.
• Used multiple risk assessment tools and metrics
  and generally had very adaptive risk models.

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Insurers should be concerned if

• Business Units are empowered to add significantly
  to risk concentrations without frequent
  disclosures to Top Management
• Business Units apply different risk models
• Risk sign-off sometimes relies totally on the
  presumption that someone else is doing good
  analysis
• Contingent risks are not usually identified
• Risk models are inflexible, requiring changes to
  be planned out a year in advance
• Nobody believes those stress tests anyway, so we
  dont put much time into them

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Insurers should be encouraged if

• Open communications among Business Units, Risk
  Management staff and Top Management
• Enterprise level decision-making about major risk
  accumulations
• Systematic internal evaluation of risks
• Low reliance on third party risk evaluations
• Identification of and plans for contingent risks
• Incentives for business units to minimize
  contingent risks
• Multiple risk management tools and metrics
• Flexible and adaptive risk models
• Aggregation of net and gross exposures in
  addition to expected losses
• Stress testing that is credible to Top Management

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ERM Seatbelts

• They only work if you use them!

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Risk Management is

1. Setting enforcing limits for all firm risks
   that are appropriate for the capital of the firm.
2. Increasing rewarding activities with superior
   risk adjusted return and fixing or limiting
   activities with inferior risk adjusted return.
3. Identifying preparing for special events that
   could significantly impair the earnings \or the
   solvency of the firm.

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Benefits of Risk Management(James Lam)

• Market Value Improvement
• Due to decreased volatility
• 2. Early Warning of Risks
• Risk management replaces
• Crisis Management
• 3. Reduction of Losses
• 4. Rating Agency Capital Relief
• 5. Risk Transfer Rationalization
• Reinsurance cost/benefit
• 6. Corporate Insurance Savings

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ERM Framework
Change Risk Management
Value optimization
Strategic
Strategic integration
Risk measurement
Risk Controlling
Risk management
Risk Steering
Loss minimization
Risk Trading
Compliance
Tactical
Value creation
Balance sheet protection
Risk/return optimization
Risk control
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Scope of ERM

• Risk Controlling
• Limit exposures and therefore losses
• ERM adds Aggregate approach to risk tolerance
• Risk Trading
• Getting paid for risks taken
• ERM adds consistent approach to risk margins
• Risk Steering
• Strategic choices to improve value
• ERM adds risk vs. reward point of view
• Change Risk Management
• Managing the risks from new projects, products,
  territories,
• ERM adds fitting into the risk profile ERM
  program

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Potential Benefits of Effective Risk Management
Better able to take advantage of new business
opportunities.
Reduction in management time spent fire-fighting
Higher share price

• Increased likelihood of change initiatives being
  achieved.

Potential Benefits (ICA)
Fewer sudden shocks and unwelcome surprises.
More focus internally on doing the right things
properly.
Lower cost of capital.
Competitive advantage.
Better basis for strategy setting.
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Moodys View of Risk Management

• Environment More Risky
• More complex products
• Higher regulatory scrutiny
• Reinsurers leaving markets
• Insurers Response
• Stress Testing
• Risk Management Committee/CRO

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What is the difference between Risk Management
and ERM?

• An ERM Program comprehensively applies Risk
  Management
• across ALL of the significant risks of the
  Enterprise
• Consistently across the risks
• Consistently with the fundamental objectives of
  the enterprise
• Standard Poor's

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Full Benefits of an ERM Program

• Once a firms enterprise wide risks are
  identified and objectives are set, an ERM Program
  should
• Develop and maintain systems to periodically
  measure the capital needed to support the
  retained risks of the company
• Reflect the risk capital in
• strategic decision making,
• product design and pricing,
• strategic and tactical investment selection
• financial performance evaluation
• The product of a fully-realized ERM Program is
  the optimization of enterprise risk adjusted
  return
• Standard Poor's

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Benefits of Integrated Risk Management Strategy

• Avoid land mines and other surprises
• Improve Stability Quality of Earnings
• Enhance growth and shareholder return
• By more knowledgeably exploiting risk
  opportunities
• Identify specific opportunities such as natural
  synergies risk arbitrage
• Reassure stakeholders that the business is well
  managed

Life Office Management Association (USA)
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Management Level 1 Planning
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Management Level 2 Scenario Testing
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Management Level 3 Scenario Analysis
Average Scenario
Confidence Interval
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Management Level 4 Risk Management
Average Scenario
Confidence Interval
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ERM Benefits Uses

• Insurance Risk Taking
• Risk Management Management
• for Insurance Companies
• Risk Management gt systematic risk selection
• as more insurance companies adopt risk management
  they will select the better risks
• companies without RM will not know

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ERM Benefits Uses

• Communicating with Rating Agencies
• Risk Management can provide language for dialogue
  with RA
• Communicating with Board
• Markets become more volatile
• as more financial institutions use Risk Management

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Solvency 2 ERM

• Pillar 2
• Article 43 requires firms to have an effective
  risk management system.
• Requires firms to consider all risks
• Risk management system to be fully integrated
  into the organisation

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GFC ERM

• Progress has been made in strengthening . . .
  Risk Management
• Leaders' Statement from G20 Summit, 2009

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Questions
Questions??
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Key Points from Intro

• Risk Management has evolved over many years.
• Learning from Failures.
• Interest in Risk Mgt is increasing.
• Risk Management is preventing losses and
  improving risk adjusted return.
• Risk Management replaces Crisis
  Management.

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