Enterprise Risk Management ??????

1
Enterprise Risk Management??????

• Steve DArcy
• ??????
• Chairman of the Board of the Casualty Actuarial
  Society
• ???????????
• Professor of Finance at the University of
  Illinois
• ???????????
• Presented at Shanghai University of Finance
  Economics
• ??????
• July 3, 2006

2
What is ERM?

• ERM is the application of basic risk management
  principles to all risks facing an organization
• ERM ??????????????????
• Other names for ERM ??
• Integrated risk management ??????
• Global risk management ??????

3
Basic Risk Management Principles????????

• Identifying loss exposures ??????
• Measuring loss exposures ????
• Evaluating the different methods for handling
  risk ?????????????
• Risk assumption ????
• Risk transfer ????
• Risk reduction ????
• Selecting a method ??????
• Monitoring results ????

4
Where Did ERM Come From?ERM ??

• Traditional risk management ??????
• Formally developed as a field in the 1960s
• ?60 ???????????
• Focused on pure risks ??????
• Loss/no loss situation ??/?????
• Often could be insured ???????
• Developed from insurance purchasing area
• ?????????

5
New Elements of Risk 1970s70?????????

• Foreign exchange risk ????
• End of Bretton Woods agreement in 1972
• 1972?????????????
• Commodity price risk ??????
• Oil price fluctuations of the 1970s 70?????????
• Equity risk ????
• Development of option markets - 1973 ???????
• Interest rate risk ????
• U. S. Federal Reserve Board policy shift 1979
• ??????????

6
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 ??????????

7
The New Risk Management -1980s??????

• Financial risk management ??????
• Dealt with financial risk ??????
• Foreign exchange risk ????
• Interest rate risk ????
• Equity risk ????
• Commodity price risk ??????
• Use derivatives to hedge financial risk
• ?????????????

8
Financial Risk Management Toolbox ????????

• Forwards ??
• Futures ??
• Swaps ????
• Options ??

9
Forward Contracts ????

• A forward contract obligates one party to sell
  and another party to buy an asset
• ???????????,????????,???????????
• The exchange takes place in the future
• ???????
• The price is fixed today ????????
• No payment is made until maturity ????????
• The buyer has a gain if the asset value increases
• ??????,????

10
Futures Contracts ????

• A future obligates one party to buy and another
  to sell a specified asset in the future at a
  price agreed on today ????????????????????????????
  ???,????,??????????
• Futures are standardized contracts traded on
  organized exchanges
• ???????,???????????????
• Price changes are settled each day
• ??????????
• Margin accounts must maintained
• ??????????????

11
Swap Contracts ??????

• An agreement between two parties to exchange (or
  swap) periodic cash flows
• ????????????????????
• At each payment date, only the net value of cash
  flows is exchanged ?????????????
• The cash flows are based on a notional principal
  or notional amount ????????????????
• The notional amount is only used to determine the
  cash flows ?????????????

12
Option Contracts ????

• Options provide the right, but not the
  obligation, to buy or sell an asset at a fixed
  price
• ??????????????????????
• Call option is right to buy ??????????
• Put option is right to sell ??????????
• Options are one sided agreements ???????
• Exercising the option forces the seller to
  perform
• ??????????????????
• Expiration date is the date at which the option
  ceases to exist ??????????

13
New Elements of Risk 1990s90?????????

• Failure to manage derivatives appropriately
• ???????????
• Financial model failures ??????
• Improper accounting for derivatives
• ????????????????

14
Mismanagement of Financial Risk??????????

• Mismanagement of derivatives ????????
• Gibson Greetings
• Barings Bank ????
• Orange County, California ??,??
• Model failure ??????
• Long Term Capital Management ??????
• Accounting improprieties ?????
• Enron ????
• Arthur Andersen ?????

15
The New Risk Management - 1990s and
beyond90???????????

• Enterprise Risk Management ??????
• Initial focus on avoiding derivative disasters
• ????????????????
• Developing into optimizing firm value
• ??????????
• Chief Risk Officer ?????????
• Sarbanes-Oxley Act in the U. S. 2002 SOX??
• Increased focus on risk models
• ????????????

16
ERM Risk Categories ????

• Common 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 ????

17
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 ??

18
Financial Risk ????

• Components ??
• Foreign exchange rate ??
• Equity ??
• Interest rate ??
• Commodity price ????
• Correlations among different risks
• ?????????
• Use of hedges, reinsurance or risk transfer
• ????, ????????
• Securitization ???

19
Operational Risk ????

• Causes of operational risk ??
• Internal processes ????
• People ?
• Systems ??
• Examples ??
• Product recall ????
• Customer satisfaction ?????
• Information technology ????
• Labor dispute ????
• Management fraud ?????

20
Strategic Risk ????

• Examples
• Competition ??
• Regulation ??
• Technological innovation ????
• Political impediments ????

21
ERM Approach ?????
22
Evolution of ERM ??

• Control function ????
• How much can we lose? ????????
• Risk adjusted returns ????????
• Capital allocation ????
• Compensation ????
• Bonuses ????
• Optimization ???
• Maximize shareholder value ???????
• Vision of the future ????

23
Impediments to Effective ERM????ERM???

• Risk models and technology ???????
• Organization ??
• Motivation ??
• Operating infrastructure ????
• Data problems ????
• Regional fiefdoms ??????
• High failure rate of IT projects IT???????

24
Increased Use of Risk Models??????????

• Technological advances ????
• Theoretical advances ????
• Allocation of economic capital ???????
• Used for divisional profitability ????
• Impacts bonuses ????
• Dueling models ?????????

25
Chief Risk Officer ???????

• Reports to CFO, CEO or Board
• ??????????????????
• Responsible for managing all aspects of risk
• ?????????????
• Understand technology ????
• Communication skills ????

26
How ERM Can Increase Firm Value ERM????????

• Process can focus on protecting
• Value ??
• Cash flows ???
• Earnings ??
• Cannot protect all three at once ????????
• Examples
• Reducing taxes is earnings based strategy
• ????????????????
• Insuring to prevent assets from declining is
  value based
• ??????????????????
• Hedging to maintain internal funding sources is
  cash flow based ??????????????????????

27
Future of ERM ??

• ERM will continue as risk consolidation and
  aggregation
• ERM????????????
• Process increases value of risk management skills
• ?????????????????
• Management is concerned with risk control issues
• ???????????
• Chief Risk Officer will be a visible figure in an
  organization
• ??????????????????
• Many paths to CRO, diverse skills required
• ??????CRO, ???????
• ERMs role in optimization has a long way to go
• ERM????????????????
• Potential benefit is worth pursuing for pioneers
• ????????