The Enterprise in Enterprise Risk Management A Case Study CAS Special Interest Seminar Understanding the Enterprise Risk Management Process

Case Study - ABC Corporation Based on composite and rescaled individual data, industry information, recent press releases and some pure “guestimates” Quantify risks individually and aggregate Measure “untreated” earnings impact Quantify the impact of the “portfolio effect” on aggregate risk

ABC Corporation -Assumptions Market Cap = $42.8 Billion Net Income = $5.45 Billion (ttm) EPS = $4.72 (ttm); Share Price = $38.12 Effective Tax Rate = 35% Protect against the “1 in 100 year event” Exposures can be transferred at pretax nominal cost (expenses offset PV factor)

ABC Corporation Risks - I Hazard/Legal Risks –Property –Business Interruption –Cargo/Marine –Workers’ Compensation –Automobile Liability –General Liability –Product Liability –Employment Practices –Crime –Boiler & Machinery –Directors & Officers –Intellectual Property –Product Recall –Foreign Liability –E&O/Professional Liability

ABC Corporation Risks - II Financial Risks –Credit –Residual Value –ERISA/Fiduciary –Foreign Exchange –Commodity Prices –Energy Prices –Interest Rates Operational Risks –Warranty –Product Recall –Contingent Business Interruption –Political –Intellectual Property –E-Commerce –Strike/Labor Relations

ABC Corporation Risks - III Strategic Risks –Model Selection –Geographic Expansion –Brand Image –Product Pricing –R&D Investments –Acquisitions & Divestitures

Examples of Correlated Risks –Property –Business Interruption –Warranty –Residual Value –Political –Geographic Expansion –Product Recall –Product Liability –Strike/Labor Relations –Employment Practices –Acquisitions & Divestitures –Directors & Officers

Approaches to Correlation Measurement – “CORREL” function –Rank Correlation –Regression Analysis –Judgement Implementation –Causative/Formulaic –Correlation Matrix –Resort/Resampling –Combinations

70%60%50%40%30%20%10% 1%0% Probability of Exceedence $Millions Avg. NI NI (Agg) $Loss (Sum) NI (Sum) $Loss (Agg) Avg. Loss Case Study - Hazard Risk

40%30%20%10% 1%0% Probability of Exceedence $Millions Avg. NI NI (Agg) $Loss (Sum) NI (Sum) $Loss (Agg) Avg. Loss Case Study - Financial Risk

40%30%20%10% 1%0% Probability of Exceedence $ Millions NI (Agg) Avg. NI $Loss (Sum) NI (Sum) $Loss (Agg) Avg. Loss Case Study - Operational Risk

40%30%20%10% 1%0% Probability of Exceedence $Millions Loss ($Millions) Avg. NI NI (Agg) $Loss (Sum) NI (Sum) $Loss (Agg) Avg. Loss Case Study - Strategic Risk

25,000 30, % 99%90%80%70%60%50%40%30%20%10% 1%0% Probability of Exceedence $Millions Avg. NI NI (Agg) $Loss (Sum) NI (Sum) $Loss (Agg) Avg. Loss Case Study - Composite Risk

ABC Corporation - Implications To protect against earnings volatility at the “1 in 100 year” level on a pretax basis: –finance $11.2 B if risks treated individually; –finance $3.6 B if risks treated as a portfolio. Risk finance cost difference of $76 Million. –$0.04 in after-tax EPS. –Almost $400 M in market capitalization at current P/E multiple.

ABC Corporation - Caveats Not all risks to Net Income are included. –WC, cargo, etc. due to lack of data; –general economic risks - interest rates, etc. “Portfolio Effect” potentially overstated –not all correlations reflected (warranty, recall and product liability, for example); –companies may look at some risks in portfolios (integrated insurance programs, combined aggregate excess programs, etc.).