The Role of Auditing in the ERM Process SOA Annual Meeting Chicago – October 2006 Rick Gorvett, FCAS, MAAA, ARM, FRM, PhD Director, Actuarial Science Program State Farm Companies Foundation Scholar in Actuarial Science University of Illinois at Urbana-Champaign

Agenda Background Enterprise risk management Internal audit and ERM NAIC risk-focused surveillance framework Conclusion

“Who am I? Why am I here?” - Admiral Stockdale, 1992 Currently Director, Actuarial Science Program State Farm Companies Foundation Scholar in Actuarial Science Professor, Depts. of Mathematics, Statistics & Finance University of Illinois at Urbana-Champaign Prior Senior Vice President Director of Internal Audit & Risk Management Internal Audit Corporate Investigations Risk Management Enterprise Risk Management Business Continuity

An Initial ERM Comment You don’t become a famous writer by… Reading a book Reading about other authors Watching someone else write Similarly, you don’t become an “Enterprise Risk Manager” by… Taking a course Listening to a presentation

Rather, ERM is… A complex process… … involving broad-based and in-depth knowledge and understanding,… … requiring an appropriate corporate culture,… … and creativity… … born of a variety of experiences… … and insatiable curiosity.

ERM Definition from IIA From Position Statement, The Institute of Internal Auditors: ERM “is a structured, consistent and continuous process across the whole organization for identifying, assessing, deciding on responses to and reporting on opportunities and threats that affect the achievements of its objectives.”

Steps in the Risk Management Process Determine the corporation’s objectives Identify the risk exposures Quantify the exposures Assess the impact Examine alternative risk management tools Select appropriate risk management approach Implement and monitor program

Enterprise Risk Management Or “Enterprise Risk and Assurance Management” What is ERM? Concerned with a broad financial and operating perspective Recognizes interdependencies among corporate, financial, and environmental factors Strives to determine and implement an optimal strategy to achieve the primary objectives: e.g., maximize the value of the firm

Evolution of ERM Historically: “risk silo” mentality Mid-1990s: First “Chief Risk Officer” First use of ERM terminology Late-1990s: Risk-related regulatory requirements (e.g., Turnbull) Earnings protection insurance debuts 2001: September 11 Corporate scandals Beginning of efforts to improve corporate governance (e.g., Sarbanes-Oxley)

A Paradigm Shift Traditional Risks managed in silos Concentrates on physical hazards and financial risks Insurance orientation Ad hoc / one-off projects Emerging Centralized mgt., with exec-level coordination Integrated consideration of all risks, firm-wide Opportunities for hedging, diversification Continuous and embedded

Current State Findings from various surveys An acknowledged need to improve risk management A recognition that a holistic approach is appropriate and preferable ERM can improve overall capital management and thus enhance corporate value and competitiveness A variety of approaches to improving risk management There are still problems to overcome

Types of Risks Operational Strategic Technological Stakeholder Legal Hazard Physical Strategic Capital / resource allocation Industry / competitors Technological Databases Security Confidential information Stakeholder Legal Compliance Regulatory Financial Capital markets Credit risks Taxes Human capital Retention Training Reputational

Issues in ERM Implementation Different corporate cultures require different ERM approaches Who is going to be the ERM champion within the company Among senior executives Among departments / functions How to embed a risk management culture and responsibilities throughout the firm

Components of the ERM Process Determine corporate objectives Risk identification Goal: comprehensiveness E.g., self-assessment Risk measurement Volatility measures Value at Risk (VaR) Likelihood Impact Likelihood Size of loss

Components of ERM (cont.) Assessing the impact Stress or scenario testing Stochastic simulation Examine and select alternative risk management tools and techniques Traditional risk transfer Natural hedging / diversification Integration of risks E.g., “dynamic financial analysis”

Keys to Success in ERM Senior management commitment and sponsorship Embed a “risk management culture” in the corporation at the operational level Provide for accountability, both specific and widespread Clearly defined responsibilities for coordination and maintenance Adequate communication

Internal Audit and ERM Overview Provide independent and objective assurance for Board on effectiveness of ERM Identify/assess/manage key risks Internal controls IA has assurance and consulting roles Function of other resources Relative time/effort between roles may vary among firms and over time

Internal Audit and ERM “The Role of Internal Auditing in Enterprise-wide Risk Management” - The Institute of Internal Auditors Core Roles Assurance regarding, and evaluation of, the risk management process Risk reporting, evaluation, management Assurance regarding handling of key risks

Internal Audit and ERM (cont.) “The Role of Internal Auditing in Enterprise-wide Risk Management” - The Institute of Internal Auditors NOT Roles Establishment of “risk appetite” Imposing / implementing risk responses / management

Internal Audit and ERM (cont.) “The Role of Internal Auditing in Enterprise-wide Risk Management” - The Institute of Internal Auditors Possible Roles Facilitating risk management Identification, evaluation, championing Coordinating ERM “Developing risk management strategy for board approval”

“Risk-Focused Surveillance Framework” NAIC “Risk-Focused Surveillance Framework” Main Objectives Focus on areas posing greatest risk to solvency Focus on “the assessment of governance structure, corporate culture, and management processes in insurance companies to identify, assess and manage (where manage is defined as measurement, mitigation and monitoring) risk”

NAIC (cont.) Risk Classifications Credit Market Pricing and underwriting Reserving Liquidity Operational Legal Strategic Reputation

NAIC (cont.)

Conclusion “The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk” - Peter Bernstein, Against the Gods