Finance 590 Enterprise Risk Management

ERM Quick review of last class Today’s discussion –ERM Basics –ERM Concepts and processes –ERM Risk Analytics

ERM Enterprise Risk Management –Some Basics

ERM In virtually all business there are trade-offs –Growing earnings v managing risks –Business decisions on many fronts build up over time in reflecting a “unique” risk profile Impact earnings over the short term and long term

ERM Risk v Return –Business expects higher return for more risk –Theoretical v real life Optimal balance –Risk adjusted return –A “sweet spot” in balancing risk and return

ERM Key message from our brief discussion –Businesses(companies) should develop an integrated approach to measuring and managing all its risk Key management requirement is risk return optimization Integrate risk management in the business processes of the company

ERM So why enterprise risk management –Why not just accept risk What is the value proposition How do you convince senior management and your board the importance

ERM Benefits of Risk Management –Practical “Whys” from Lam Managing risk is management’s job Managing risk can reduce earnings volatility Managing risk can maximize shareholder value Risk management promotes job and financial security

ERM Benefits of Risk Management –Some practical “whys” from Vonnahme Successful companies are just as prone to risk management issues as poorly run companies Business conditions can change quickly and radically –Economic issues –Terrorism –Consolidation –Legal and regulatory –Business partners can change overnight

ERM Tales and Lessons –Recent history includes numerous examples of business failures –Wheel of Misfortune Examples include –Enron –Barings –Many, many others

ERM Lessons learned from a number of cases. Common themes include: –Know your business –Establish checks and balances –Set limits and boundaries –Keep your eye on the cash –Use the right yardstick –Pay for the performance you want –Balance the yin and the yang

ERM Know your business –It is everyone’s responsibility CEO Management Supervisors The board of directors –No place today for passive board members

ERM Establish checks and balances –Application of portfolio diversification concepts to risk management –Segregation of duties –No concentration of power by group or individuals Authority levels in HO and Field Adequate monitor and controls Management response to violations

ERM Set limits and boundaries –“Where to stop” –Risk limits are part of sound risk management Limits on financial risk Limits on credit risk Limits on operational risks Limits on a variety of business risks

ERM Keep your eye on the cash –Appropriate safeguards for cash positions and cash flow Basic internal controls Development of internal processes for monitor of cash transactions Checks on reasonableness looking at actual positions Challenges of new technology

ERM Use the right yardstick –The right measures of success Drive the behavior you want business wise and risk wise Balanced scorecard –Financial measures and performance measures Risk measures incorporated in processes that generate management reports and measure performance –An early warning system

ERM Pay for the performance you want –Performance measurement and incentive comp Can be a positive or negative depending on structure Want to drive the right behavior

ERM Balance the yin and the yang –The hard side, the yin Focus on processes, systems, and reporting The enablers, which support risk management activity –The soft side, the yang Focus on people, skills, culture, values and incentives The key drivers of risk taking activity

ERM Questions Next will begin to consider Concepts and Processes

Finance 590 Enterprise Risk Management Concepts and Processes

ERM Risk –Businesses are exposed to different types of risk –The definition and meaning of risk varies by industry Market risk may be different for insurance than energy Operational risk may vary by industry

ERM Risk –Financial risk v operational risk

ERM Financial risk –Credit risk –Market risk

ERM Operational risk –Business risk –Organizational risk –Everything else as well

ERM No one individual can manage all risk –Risk management is every employee’s responsibility –Needs to come from all parts of an org –Employees know where risk exists –Means risk is managed throughout the company

ERM Employees need to know and understand Risk Concepts –Exposure –Volatility –Probability –Severity –Time horizon –Correlation –Capital

ERM Exposure –What will we lose –May vary by industry or business –Generally the maximum amount of damage if some event occurs Risk increases as exposure increases

ERM Volatility –How uncertain is the future –Variability of potential outcomes –Greater the volatility, higher the risk

ERM Probability –How likely will the risky event occur –The more likely, the greater the risk Likely v unlikely events require different strategies and planning

ERM Severity –Amount of damage that is likely to be suffered –Greater the severity, the greater the risk

ERM Correlation –How are risks in a business related to each other Higher the correlation, higher the risk Concentration of risk by industry –Aggregation of exposure in insurance and surety –Reinsurers look at this today more than ever Key to concepts of diversification

ERM Time Horizon –How long will we be exposed –Longer the duration, greater the risk Many examples in credit extension and the surety business

ERM Capital –How much capital allocated to business Adequate return for the capital allocation –How much capital to cover unexpected losses –What financial ratings are necessary for a business –Capital allocated to internal business units Adequate return Compare businesses to each other

ERM Risk concepts –First step in understanding risk Risk processes –Risk awareness –Risk measurement –Risk control

ERM Risk processes –Risk awareness-first step Objective –Proactive identification of key risks –Thinking seriously about consequences of risks –Communication up and down the org the risks that warrant others’ attention

ERM Risk processes –Organization’s promote Risk Aware-ness in a number of ways Set the tone from the top Ask the right questions Establish a risk taxonomy Provide training and education Link compensation to risk

ERM Risk awareness –Set the tone from the top CEO Senior Management team –“Walk the Talk” –Participate in meetings –How do they handle violations –Demonstrate buy- in by actions

ERM Risk awareness –Ask the right questions Examples –Return »Acceptable return for the risks we take? –Immunization »What limits and controls are in place to limit downside? –Systems »Right systems to track and measure risks? –Knowledge »Do we have the right people with skills to manage risk?

ERM Risk awareness –Link compensation to risk Risk management part of their job Compensation linked to business and risk performance at business and individual levels –“Same rules for everyone” »Particularly to senior management

ERM Risk awareness –Provide training and education Starts at Orientation Is ongoing process or “Continuing Education” Tailored to the employees responsibilities –Understand the spirit and letter of the law –The whys behind the process

ERM Risk awareness –Establish a Risk taxonomy Establish a common language for risk –“Everyone is on the same page” –Meaningful to the business Common structure for describing categories of risk Allows break down into manageable components –Allows aggregation for reporting and measurement

ERM Risk Measurement –Need appropriate risk information to support to support business and policy decisions –Executive risk report Key elements –Losses –Incidents –Management assessments –Risk indicators

ERM Risk Control –Optimize risk/return of the business Effect real change in the risk profile of the company –Accomplished through »Selective growth of business »Support of profitability »Control downside risks

ERM Summary Questions

Finance 590 Enterprise Risk Management Steve D’Arcy Department of Finance Lecture 2 Risk Analytics March 29, 2005

Reference Material Chapter 9 – Enterprise Risk Management by Lam Overview of Enterprise Risk Management by the Casualty Actuarial Society

Overview Risk Control Analytics Risk Optimization Analytics Classification of Risk Types Risk Analytics by Risk Type Performance Measures Risk Measures Risk Modeling Risk Integration

Risk Control Analytics Scenario Analysis –Stress testing –Simulation Economic Capital –Solvency standards Risk Indicators –External –Internal

Risk Optimization Analytics Return on Capital (Financial Services Industry) –Risk-adjusted return on capital (RAROC) –Return on risk-adjusted capital (RORAC) –Risk-adjusted return on risk-adjusted capital (RARORAC) Economic Income Created –Risk-adjusted return – (Hurdle rate x economic capital) Shareholder Value –Shareholder value (SHV) –Shareholder value added (SVA)

Risk Types Hazard or Insurance Risk Financial or Market Risk Credit Risk Operational Risk Strategic Risk

Hazard Risk Management Analytics Probable Maximum Loss (PML) Maximum Possible Loss (MPL) Loss Frequency Loss Severity Actuarial Models –Loss Distributions

Financial Risk Management Analytics Interest Rate Models –Equilibrium models –Arbitrage free models Value-at-Risk (VaR) –Parametric –Monte Carlo simulation –Historical simulation Asset/Liability Management (ALM)

Credit Risk Analytics Credit Scoring Models Credit Migration Models Credit Exposure Models Credit Portfolio Models –Financial models –Econometric models –Actuarial models

Operational and Strategic Risk Analytics Top-Down Approaches –Analogs –Historical loss data Bottom-Up Approaches –Self assessment –Cash flow model

Performance Measures General Return on Equity (ROE) Operating Earnings Earnings before interest, dividends, taxes, depreciation and amortization (EBITDA) Cash Flow Return on Investments (CFROI) Weighted Average Cost of Capital (WACC) Economic Value Added (EVA)

Performance Measures Insurance Industry Economic Capital RAROC –Expected net income divided by economic capital Embedded value Risk Based Capital (RBC)

Risk Measures Solvency Related Probability of Ruin Shortfall Risk Value-at-Risk (VaR) Expected Policyholder Deficit (EPD) or Economic Cost of Ruin (ECOR) Tail Value at Risk (Tail VaR) or Tail Conditional Expectation (TCE) Tail Events

Risk Measures Performance Related Variance Standard Deviation Semi-variance and Downside Standard Deviation Below-target-risk (BTW)

Risk Modeling Analytic Methods Simulation Methods Statistical Methods Structural Methods Dynamic Financial Analysis (DFA)

Risk Integration Covariance Covariance Matrix Structural Simulation Model

Conclusion There is a standard approach for dealing with each type of risk Each area has its own terminology and techniques The ERM challenge is to combine these different approaches into a common method that can deal with risk in an integrated manner The first step is to understand the different approaches