1 Math 479 / 568 Casualty Actuarial Mathematics Fall 2014 University of Illinois at Urbana-Champaign Professor Rick Gorvett Session 18: Enterprise Risk Management November 20, 2014

2 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… –Reading a book –Taking a course –Listening to a presentation

3 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.

Enterprise Risk Management Or “ Enterprise Risk and Assurance Management ” or… 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 objective: maximize the value of the firm

Other Possible Goals of ERM Create and increase company value Ensure business continuity Stabilize earnings Enhance opportunities for the company to achieve its objectives Make risk management more cost-efficient

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

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

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

Types of Risks Operational –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) Impact Likelihood Size of loss Likelihood

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 ”

Components of ERM Copyright © 2004 by the Committee of Sponsoring Organizations of the Treadway Commission.

Basel III, Solvency II, etc. Regulations concerned with corporate management of risks Three pillars of Solvency II: –Capital requirements for insurers –Framework for corporate governance and risk management –Reporting and disclosure requirements, transparency

15 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

16 ERM Tries to Avoid… “ A failure of imagination. ” - Frank Borman, in testimony to Congress, responding to a question regarding the real cause of the Apollo 1 fire and the resulting three astronaut deaths, as dramatized in HBO ’ s series From the Earth to the Moon

ERM Perspective: Steps in the ERM 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

ERM Perspective: Risk Profile Firm Risk Operational Risks Strategic Risks Hazard Risks Legal Risks Regulatory Risks Credit Risk Financial Risks Market Risk

Case Study: Honeywell One of the first uses of integrated risk management Mid-1990s: traditional risk management approach –Widely separated activities –Silo mentality: different areas / departments responsible for different risk exposures

Honeywell (cont.) Nature of the firm –Diversified technology and manufacturing company –Worldwide activities –Key businesses: Aerospace Automation and control Materials Transportation

Honeywell (cont.) In 1997, company considered a new risk management structure and approach Old approach: –Separate annual insurance policies for each hazard risk (each with its own deductible) –Options to hedge FX risk New approach: –Multiyear combined hazard-and-FX risk policy

Honeywell (cont.) Additional information: –Based on simulations of aggregate risk portfolio, a $30 million aggregate retention was proposed for the new policy

Honeywell (cont.) Question 1: –What do you think were some of the barriers that Honeywell might have faced in switching to the proposed multi-year, multi-line policy? How might each of these barriers been addressed or overcome?

Honeywell (cont.) Question 2: –Does this new, proposed policy “ add value ” to Honeywell? If so, how? Question 3: –Why might the proposed, bundled policy be less costly to Honeywell than the aggregate costs associated with the unbundled risks?

The Challenge of ERM – Beyond Honeywell “ The Honeywell integrated insurance policy is a first step, but a true integrated risk management strategy must go beyond the scope of the Honeywell contract: It must incorporate more of the firm ’ s risks, shift the analysis from tactical to strategic, and evaluate how the other ways to manage risk… should be used. ” –Lisa Meulbroek, 2002, “ The Promise and Challenge of Integrated Risk Management, ” Risk Management and Insurance Review, Vol. 5, No. 1,

UGG Case Study In 1999, a $200+ million (Canadian) revenue firm, headquartered in Winnipeg, Manitoba Originally a farmer cooperative Business segments: –Grain handling –Crop production –Livestock –Business communications

UGG (cont.) Risk management committee + Willis identified 47 areas of exposure Six key risks analyzed further: –Environmental liability –Weather –Counterparty –Credit –Commodity –Inventory

UGG (cont.) Analysis of each key risk –Probability distributions of losses –Impact on financial / corporate measures of interest Main concern: weather risk Regressions of crop yields against temperature and precipitation

UGG (cont.) Questions in case study –1 and 2: impact of ownership structure –3: constructing a weather derivative –4: constructing an insurance contract –5: integration with other risks and coverages –6: insurance versus derivative –7: loss control measures