Is [Enterprise] Risk Management for Actuaries? David Oakden OCCA Meeting Nov. 4, 2004 Based on a Presentation by Barry Franklin

1 The Actuary and ERM ERM Definition CAS Activities SOA Activities Examples

2 CAS ERM Definition “The discipline by which an organization in any industry assesses, controls, exploits, finances and monitors risk from all sources for the purpose of increasing the organization’s short- and long-term value to its stakeholders” Key elements: –Dual nature of risk –Value creation –CAS relevance beyond insurance industry

3 Risk factors in an organization Enterprise Risk Property Catastrophe Reinsurance Recoverables Investment Risk Corporate Credit Risk Casualty Clash Sovereign Risk Premium Growth Risks to Capital Operations Risks Legislative / Regulatory Action Rating / Reputation Decline Risks to Earnings

4 The CAS sees ERM in its Future CAS members will be recognized as leading experts in the evaluation of hazard risk and the integration of hazard risk with strategic, financial, and operational risk. Excerpt from CAS 2014 Centennial Goal

5 CAS Efforts to Date CAS ERM Advisory Committee (2000/1) –ERM Definition and Framework –CAS Research & Education Priorities CAS ERM Research Committee (2002-) –Research Priorities

6 CAS Advisory Committee on ERM: Goals Define ERM; develop conceptual framework Determine current/desired knowledge level Identify research needs to close gaps Identify education needs to close gaps Recommend methods, priorities, timetable Compile initial ERM bibliography Recommend additional efforts of existing/new CAS committees

7 Risk Type Strategic Operational Financial Hazard Strategic Operational Financial Hazard Risk Management Process Step Establish context Identify risks Analyze/quantify risks Integrate risks Assess/prioritize risks Treat/exploit risks Monitor and review Establish context Identify risks Analyze/quantify risks Integrate risks Assess/prioritize risks Treat/exploit risks Monitor and review CAS ERM Conceptual Framework: Two Dimensions

8 CAS Recommendations -- Research Highest priority topics –ERM overview –Value creation through ERM –Risk quantification (financial, operational, strategic) –Risk correlation & integration Other priority topics –Risk tolerances, risk/reward metrics, portfolio optimization, monitoring, treatment, integrated products

9 CAS Recommendations -- Research (cont’d) Form standing ERM Research Committee –Direct & monitor research per above –Expand, update, organize, maintain ERM bibliography –Work with other CAS committees to coordinate ERM research and provide content for education –Partner with other organizations –Develop internal and external communications, designate spokespersons

10 CAS Recommendations -- Education Codified 2005 CAS ERM education needs –For each element of ERM framework –By degree of desired knowledge level –By type of education vehicle Syllabus Continuing Education Developed detailed Learning Objectives for each element of ERM framework Publish ERM bibliography Accomplish through existing committees

11 ERM Research Committee -- Research Priorities “ERM Overview” document Financial risk quantification Risk correlation/concentration/integration Value creation through ERM ERM bibliography Coordination with other CAS committees Coordination with other professions

12 SOA Efforts to Date Established a Risk Management Task Force within the SOA Finance Practice Area in 2002 –to address the growing need for information on risk management –to make risk management a regular part of actuarial practice –to advance professional recognition and career opportunities for actuaries in the arena of risk management

13 Risk Management Task Force Implementing Task Force Goals –promotion of actuarial expertise in areas of risk management, –promotion of opportunities for actuaries in the arena of risk management, –sponsorship of seminars on risk management, and –development of new risk management educational materials.

14 Task Force Subgroups –Credit risk management –Economic capital calculation and allocation –Enterprise risk management –Equity modeling –Extreme value models –Health risk management –Policyholder behavior in the tail –Pricing for risk –Risk-based capital covariance –Risk management metrics

15 Risk Management Section The purposes of this Section are to further the education and research in the area of risk management and to establish leading risk management techniques. These efforts should be rigorous and based on sound principles such that resulting techniques are broadly transportable across disciplines and industries. These efforts should help to increase the profile of the actuarial profession as being leaders in the field of risk management. (emphasis added)

16 Other SOA Activities Co-sponsorship of ERM Symposium Course 8 offers an ERM extension Joint effort with CAS on public relations effort to raise awareness of the actuary as chief risk officer RFP for Internal Hedging Programs for Life Insurance Companies

17 Assessing Critical Risks Relative to Risk Tolerance ABC Critical Risk Analysis Potential EPS Impact of Average Loss Event $- $0.20 $0.40 $0.60 $0.80 $1.00 $1.20 O1O2O5L1L2L3L4S1S2 Critical Risk Area After-Tax EPS Impact Avg Loss Event $0.03 per Share Supply Chain Disruption Manufacturing Disruption Location Concentration Changes in Regulation Third Party Liability Intellectual Property Environmental Contamination Product Launch Delay Outsourced Manufacturing

18 Operational Risk O1 Potential Impact on After-Tax Cash Flow (2,000) ( 1,000) - 1,000 2,000 3,000 4, Plan Year Cash Flow ($Millions) LRP Avg Event 1 SD 2 SD Operational Risk O1 Potential Impact on After-Tax Cash Flow (4,900) (4,400) (3,900) (3,400) (2,900) (2,400) (1,900) (1,400) (900) (400) Plan Year Deviation from LRP ($M) LRP Avg Event 1 SD 2 SD Operational Risk O1 Potential Impact on After-Tax EPS (8.00) (6.00) (4.00) (2.00) After-Tax EPS LRP Avg Event 1 SD 2 SD Operational Risk O1 Potential Impact on NPV 2008 Market Cap 12,626 25,251 37,877 19,548 16,290 13,032 9,774 6,516 33,126 27,605 22,084 16,563 11,042 31,564 18, ,000 10,000 15,000 20,000 25,000 30,000 35,000 40, NPV Loss ($Millions) Avg Event 1SD 2 SD Quantifying Critical Risks Assumed P/E Ratio

19 Enterprise risk models translate risk into financial measures Company Strategy Investments Products Capital/Structure Reinsurance/Hedgin g Operating Economic Scenario Generator Projected Financials Risk Profile = Distribution of Future Financial Results Asset Behavior Models Product Behavior Models Operational Risk Models Catastrophes & Random Claims Optimization Inflation Interest Rates Credit Costs Currency Exchange GDP

20 Determining EC involves an analysis of the risk profile for a selected risk tolerance level Selected risk tolerance level Economic Capital Ranked distribution of present values of future profits from each simulation Cumulative probability + – 0 $m = “sufficient surplus capital to cover potential losses, at a given risk tolerance level, over a specified time horizon” EXAMPLE

21 ABC Corporation Debt Coverage 75.0% 85.0% 95.0% 105.0% 115.0% 125.0% 135.0% 145.0% 155.0% 165.0% 0%20%40%60%80%100% Probability Debt Coverage Ratio Model Target Evaluating Impact of Critical Risks on Debt Ratings ABC’s debt ratings are based on a number of factors, the most prominent of which in the ratings analyses we have reviewed is Debt Service Coverage. Based on our understanding of the rating agency analyses we reviewed, ABC’s rating would likely be lowered if the Debt Service Coverage Ratio drops below 125%. Our simulation analysis suggests that the likelihood of the Debt Service Coverage Ratio dropping below 125%, as a result of the risk areas analyzed herein, is approximately 6.3%; that is to say ABC can be 93.7% confident that its rating will not be lowered due to contingencies associated with the risks analyzed. Reading the graph: The vertical axis represents the ABC’s Debt Service Coverage Ratio. The horizontal axis represents the probability of the ratio being at or below the indicated level. For example, the point indicated by the arrow suggests that in 80% of simulated years, the ratio is projected to be 155% or less.

22 Concluding Thoughts ERM is a value creation tool ERM is a unifying framework ERM is an actuarial recruitment tool ERM is an important part of the actuarial profession’s future