Enterprise Risk Management An Introduction Frank Reynolds, Reynolds, Thorvardson, Ltd

Traditional Approach Calculate a refined mean value Limited model offices to see effects of variation in experience

Reasons Lack of computational power Multiplicity of products and riders Multiplicity of cells due to duration and age Slow response of competition Moderate term economic stability

New Environment Variable insurance and annuities Increase in number and complexity of options Vast increases in computational power Increased awareness of risks Advances in the modelling of risk Change in focus from life insurance to annuities Increased complexity of regulation

Deterministic to Stochastic Models Stochastic cash flow projections Dynamic financial condition analysis Fair value accounting Economic capital calculations Risk measure calculations

Changing Nature of Risk Originally –C-1 Credit risk –C-2 Pricing errors –C-3 Yield curve risk –C-4 Operational risk –C-5 Liquidity

Changing Nature of Risk II Increased emphasis on equity risk Longevity not death risk Recognition of interdependence of risks Change from diversifiable to non- diversifiable –Variable annuities –Equity indexed annuities –Hybrid pension plans

Result Enterprise Risk Management

Definition of ERM “ERM is the discipline by which an organisation in any industry assess, controls, exploits, finances, and monitors risks from all sources for the purpose of increasing the organisation’s short and long term value to its stakeholders” –( Casualty Actuarial Society)

ERM for Financial Institutions A frame work for identifying, measuring and managing risk exposure for the enterprise as a whole Includes –Process controls eg Barings –Mechanisms to transfer risk – securitisation –Reporting and managing functions –Mechanisms to assess risk/return tradeoffs –Measurement of capital needs

Key Elements An on going process involving –Identification of hazards –Measurement of risk exposure –Management to achieve objectives –Value creation

Who Is Interested Management and boards Shareholders Bondholders Policyholders Regulators Auditors Rating agencies

Development of the CRO Recognition of ERM by rating agencies and regulators has caused managements to focus on risk exposure Recognition of risk has become an increasing part of governance of financial institutions The senior management person is the CRO

Economic Capital ERM adds value by exploiting risk Requires more efficient decision making about capital usage EC is a common metric used to attach the cost of risk to strategic initiatives It is the amount of capital required to sustain losses at a given risk tolerance over some horizon

Communicating Risk Key tool for communicating with management Highly company specific Integrates disjoint data Increases transparency Leverages existing infrastructures Allows real time assessment

Actuarial Growth Study of risk types Study of risk analysis methods Study of financial markets –Asset side. Particularly equities and derivatives Study of financial economic theory –valuation in incomplete markets

Traditional Silos Strategic Risk Board CEO Strategic planning Balanced scorecard Business Risk Business managers Project managers Business Risk New products Business reviews Project management Financial Risk · CFO · Treasurer · Country and credit limits ·Trading and ALM limits · Financial derivatives Operational Risk · Internal Audit · Compliance · IT ·Controls ·Audits ·Contingency planning ·Insurance Underwriting Risk · Actuaries · Underwriters · Agents · Reserving and modelling · Underwriting guidelines · Profitability based commissions

Benefits of ERM Periodically measure the capital needed to support the retained risks Reflect the risk capital in –Strategic decisions –Product pricing and design –Strategic and tactical investing –Performance evaluation Optimise enterprise risk adjusted return

Economic Scenario Generators Probability based models of the economy Capture dependencies among the economic variables External to the company Input to the company’s internal model

Risk Measures An attempt to quantify the riskiness of a portfolio Popular risk measures include –Value at risk (VaR) –Conditional Tail Expectation (CTE)

Acknowledgements I wish to thank Harry Panjer for allowing me to use the slides from his talk at the IAA meeting in Boston as the basis for this presentation