1. Lecture 1 – Part B: ERM Concept
Finance 562: Enterprise Risk Management Professor Stephen P. D’Arcy and Professor Weili Lu
Lecture 1 – Part B:
ERM Concept

2. 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)

3. 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

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

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

6. Strategic Risk Examples Competition Regulation
Technological innovation
Political impediments

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

8. 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% )

9. 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

10. 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

11. Examples of ERM - 4 Hurricane Katrina

12. Katrina Induced Gas Lines

13. 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