Enterprise Risk Management For Insurers and Financial Institutions

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Enterprise Risk Management For Insurers and Financial Institutions David Ingram CERA, FRM, PRM From

Enterprise Risk Management For Insurers and Financial Institutions David Ingram CERA, FRM, PRM From the International Actuarial Association

Course Outline 1. INTRODUCTION - Why ERM? 2. RISK MANAGEMENT FUNDAMENTALS – FIRST STAGE

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

INTRODUCTION 1. INTRODUCTION - Why ERM? 1. 1 Enterprise risk management history 1. 2

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

A Brief History of Risk Management 1952 – Markowitcz – Portfolio Theory – Risk

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

Current Trends in Risk Management Dedicated risk management function 1. - Risk Management decision

Current Trends in Risk Management Dedicated risk management function 1. - 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)

Risk Management Failures 1973: Equity Funding Fraud 1983: Baldwin United Shell Game 1986: The

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 S&L 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

Risk Management Failures Bank / Financial Barings – Controls Missing, mgt didn’t understand risks

Risk Management Failures Bank / Financial Barings – Controls Missing, mgt didn’t 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

Barings (UK) Venerable UK Bank Trading losses in Singapore Exceeded value of bank Problems

Barings (UK) Venerable UK Bank Trading losses in Singapore Exceeded value of bank Problems Management didn’t 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

Long Term Capital Management (US) Private Investment Fund Very highly Leveraged portfolio of investments

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

Northern Rock (UK) Mortgage lender grew rapidly to become one of the top 5

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

Nissan Mutual (Japan) Savings product guaranteed high interest rates High sales growth of this

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

Equitable (UK) Guaranteed payout annuity product sold to pension plans Improvement in mortality &

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

HIH (AUS) Second largest General Insurer “suddenly” found to be insolvent Problem: Total control

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

Confederation Life (Can) Company invested over 70% of assets in Real Estate Company failed

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”

General American Life (US) Funding agreement product sold to banks and mutual funds with

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 =>triggered downgrade of company => triggered calls Company unable to raise cash for multi billion $$ calls Problem: Asset Liability Mismatch High dependency of business on ratings Huge Counterparty exposure

American International Group In late 2006, AIG claimed to have $16 B of excess

American International Group In late 2006, AIG claimed to have $16 B of excess capital In early 4 th Quarter 2008, AIG needed over $100 B 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

Reasons for Current Interest in Risk Management World Markets Interdependent Chaos Theory – Butterfly

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

Reasons Tools for Risk Mgt are getting better and better Success of RM in

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

Does the Global Financial Crisis prove that ERM is Ineffective?

Does the Global Financial Crisis prove that ERM is Ineffective?

Frequently Asked Question. . .

Frequently Asked Question. . .

Study of 11 major banks in 2007 Found differences in ERM Practices

Study of 11 major banks in 2007 Found differences in ERM Practices

Better Risk Management Practices Four main differences in practices. Better-performing banks: 1) Shared risk

Better Risk Management Practices Four main differences in practices. Better-performing banks: 1) Shared risk and exposure information both quickly and broadly among business unit staff, risk management staff and top management. 2) Used rigorous internal practices and models, consistent across all business units, to evaluate their risk positions. 3) 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. 4) Used multiple risk assessment tools and metrics and generally had very adaptive risk models.

Insurers should be concerned if: Business Units are empowered to add significantly to risk

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 don’t put much time into them”

Insurers should be encouraged if: Open communications among Business Units, Risk Management staff and

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

ERM & Seatbelts They only work if you use them!

ERM & Seatbelts They only work if you use them!

Risk Management is A. Setting & enforcing limits for all firm risks that are

Risk Management is A. Setting & enforcing limits for all firm risks that are appropriate for the capital of the firm. B. Increasing & rewarding activities with superior risk adjusted return and fixing or limiting activities with inferior risk adjusted return. C. Identifying & preparing for special events that could significantly impair the earnings &or the solvency of the firm.

Benefits of Risk Management (James Lam) 1. Market Value Improvement – Due to decreased

Benefits of Risk Management (James Lam) 1. 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

ERM Framework Change Risk Management Strategic Value optimization Strategic integration Risk Controlling Risk measurement

ERM Framework Change Risk Management Strategic Value optimization Strategic integration Risk Controlling Risk measurement Risk management Loss minimization Risk Steering Risk Trading Compliance Tactical Risk control Balance sheet protection Risk/return optimization Value creation 28

Scope of ERM Risk Controlling Limit exposures and therefore losses ERM adds Aggregate approach

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 29

Potential Benefits of Effective Risk Management Better able to take advantage of new business

Potential Benefits of Effective Risk Management Better able to take advantage of new business opportunities. Fewer sudden shocks and unwelcome surprises. Higher share price Potential Benefits Competitive Better basis for advantage. strategy setting. (ICA) Lower cost of capital. Reduction in management time spent “fire -fighting” Increased likelihood of change initiatives being achieved. More focus internally on doing the right things properly.

Moody’s View of Risk Management Environment More Risky More complex products Higher regulatory scrutiny

Moody’s View of Risk Management Environment More Risky More complex products Higher regulatory scrutiny Reinsurers leaving markets Insurers Response Stress Testing Risk Management Committee/CRO

What is the difference between Risk Management and ERM? An ERM Program comprehensively applies

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 4/21/2005 32

Full Benefits of an ERM Program Once a firm’s enterprise wide risks are identified

Full Benefits of an ERM Program Once a firm’s 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 4/21/2005 33

Benefits of Integrated Risk Management Strategy Avoid “land mines” and other surprises Improve Stability

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)

Management – Level 1 Planning Projection

Management – Level 1 Planning Projection

Management – Level 2 Scenario Testing

Management – Level 2 Scenario Testing

Management – Level 3 Scenario Analysis Average Scenario Planning Projection Confidence Interval

Management – Level 3 Scenario Analysis Average Scenario Planning Projection Confidence Interval

Management – Level 4 Risk Management Average Scenario Planning Projection Confidence Interval

Management – Level 4 Risk Management Average Scenario Planning Projection Confidence Interval

ERM Benefits & Uses Insurance = Risk Taking Risk Management = Management for Insurance

ERM Benefits & Uses Insurance = Risk Taking Risk Management = Management for Insurance Companies Risk Management => systematic risk selection as more insurance companies adopt risk management they will select the better risks companies without RM will not know

ERM Benefits & Uses Communicating with Rating Agencies Risk Management can provide language for

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

Solvency 2 & ERM Pillar 2 • Article 43 requires firms to have an

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

GFC & ERM • “Progress has been made in strengthening. . . Risk Management”

GFC & ERM • “Progress has been made in strengthening. . . Risk Management” – Leaders' Statement from G 20 Summit, 2009

Questions

Questions

Key Points from Intro 1. Risk Management has evolved over many years. 2. Learning

Key Points from Intro 1. Risk Management has evolved over many years. 2. Learning from Failures. 3. Interest in Risk Mgt is increasing. 4. Risk Management is preventing losses and improving risk adjusted return. 5. Risk Management replaces Crisis Management.