Finance 432: Managing Financial Risk for Insurers Actuaries of the 4 th Kind - Enterprise Risk Management

Bühlmann’s Kinds of Actuaries Actuaries of the First Kind –Life – deterministic calculations Actuaries of the Second Kind –Casualty – probabilistic calculations Actuaries of the Third Kind –Financial – stochastic calculations Actuaries of the Fourth Kind –Enterprise risk management – mathematics of integration and interrelations

What is ERM? ERM is the application of the basic risk management principles to all risks facing an organization Other names for ERM Enterprise-wide risk management Holistic risk management Integrated risk management Strategic risk management Global risk management

Basic Risk Management Principles 1.Identifying loss exposures 2.Measuring loss exposures 3.Evaluating the different methods for handling risk Risk assumption Risk transfer Risk reduction 4.Selecting a method 5.Monitoring results

Why Manage Risk? Diversifiable risk argument Shareholders are diversified investors They will not pay a premium to reduce unsystematic risk How risk management can add value Decreasing taxes Decreasing the cost of financial distress –Customers –Employees –Suppliers Facilitating optimal investment Increasing firm value

Where Did Enterprise Risk Management Come From? Traditional risk management Formally developed as a field in the 1960s Focused on “pure” risks Loss/no loss situation Often could be insured Developed from insurance purchasing area

New Elements of Risk – 1970s Foreign exchange risk End of Bretton Woods agreement in 1972 Commodity price risk Oil price fluctuations of the 1970s Equity risk Development of option markets Interest rate risk Federal Reserve Board policy shift

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

The “New” Risk Management -1980s Financial risk management Dealt with financial risk Foreign exchange risk Interest rate risk Equity risk Commodity price risk Used derivatives to hedge financial risk

Financial Risk Management Toolbox Forwards Futures Options Swaps

New Elements of Risk – 1990s Failure to manage derivatives appropriately Financial model failures Improper accounting for derivatives

Mismanagement of Financial Risk Mismanagement of derivatives –Gibson Greetings –Proctor and Gamble –Barings Bank –Orange County Model failure –Long Term Capital Accounting improprieties –Enron –WorldCom –Arthur Andersen

The “New” Risk Management s and beyond Enterprise Risk Management –Initial focus on avoiding derivative disasters –Developing into optimizing firm value Chief Risk Officer Sarbanes-Oxley Act – 2002 Increased focus on risk models

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

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

Financial Risk Components –Foreign exchange rate –Equity –Interest rate –Commodity price Correlations among different risks Use of hedges, not insurance or risk transfer Securitization

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

Strategic Risk Examples Competition Regulation Technological innovation Political impediments

Evolution of ERM Control function –How much can we lose? Risk adjusted returns Capital allocation (Stefan Lippe – Swiss Re) –Compensation –Bonuses Optimization –Maximize stakeholder value –Vision of the future

Examples of ERM - 1 Michelin – contingent capital Issued by Swiss Re New Markets and Societe Generale Option to draw on subordinated long-term bank credit facility Option to issue subordinated debt at fixed spread –This option can only be exercised if GDP growth falls below a trigger (1.5% , 2.0% )

Examples of ERM - 2 United Grain Growers – risk integration Issued by Swiss Re Regional grain volume coverage Integrated with other property/liability coverages Three year policy Annual aggregate retention $35 million annual limit $80 million policy limit

Examples of ERM - 3 RLI Corporation – Cat-E-Puts Arranged by Aon, issued by Centre Re Three year term Provided an option to issue $50 million in convertible preferred shares Trigger was major California earthquake Subject to minimum capital requirements

Examples of ERM - 4 Hurricane Katrina

Katrina Induced Gas Lines

Conclusion ERM is continuing to evolve Started as hazard risk management Financial risk management developed Failures brought increased attention Technology and risk management experience led to new approaches Regulation is pushing organizations to improve Modeling risks is key component No standard approach has yet emerged Challenging and attractive area