1. CIA Annual Meeting LOOKING BACK…focused on the future

2. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future Stephen P. D’Arcy President of the Casualty Actuarial Society Professor of Finance, University of Illinois The Brave New World of Enterprise Risk Management Stephen P. D’Arcy President of the Casualty Actuarial Society Professor of Finance, University of Illinois The Brave New World of Enterprise Risk Management

3. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future 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

4. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future 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

5. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future 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

6. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future 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 - 1973 Interest rate risk U. S. Federal Reserve Board policy shift - 1979

7. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future 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

8. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future The “New” Risk Management - 1980s Financial risk management Dealt with financial risk Foreign exchange risk Interest rate risk Equity risk Commodity price risk Use derivatives to hedge financial risk

9. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future Financial Risk Management Toolbox Forwards Futures Options Swaps Interest Rate Models

10. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future New Elements of Risk – 1990s Failure to manage derivatives appropriately Financial model failures Improper accounting for derivatives

11. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future Mismanagement of Financial Risk Mismanagement of derivatives Gibson Greetings Proctor and Gamble Barings Bank Orange County Model failure Long Term Capital Accounting improprieties Enron Arthur Andersen

12. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future The “New” Risk Management - 1990s 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

13. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future Evolution of ERM Control function How much can we lose? Risk adjusted returns Capital allocation Compensation Bonuses Optimization Maximize stakeholder value Vision of the future

14. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future 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

15. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future 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

16. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future Financial Risk Components Foreign exchange rate Equity Interest rate Commodity price Correlations among different risks Use of hedges, not insurance or risk transfer Securitization

17. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future Operational Risk Causes of operational risk Internal processes People Systems Examples Product recall Customer satisfaction Information technology Labor dispute Management fraud

18. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future Strategic Risk Examples Competition Regulation Technological innovation Political impediments

19. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future Increased Use of Risk Models Technological advances Theoretical advances Allocation of economic capital Used for divisional profitability Impacts bonuses Dueling models

20. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future Traditional Risk Management Silos Financial risk – Treasury Insurance risk – Risk Management Operational risk – Business units

21. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future New Corporate Structure CFO – capital management CRO – risk management Define risk Gather information Use information No consistent risk framework in place yet Need for risk balance sheet/income statement approach Control risk Increase firm value

22. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future Essential Skills of a Risk Manager Understand benefits and limitations of models Comprehension of data gathering process Identifying essential data Gathering information into central location Interpreting reports Understanding of how risk measures relate to strategic and tactical business decisions Communication skills

23. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on 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% 2001-03, 2.0% 2004-05)

24. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future 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

25. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future 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

26. CIA Annual Meeting Session 6707: Brave New World LOOKING BACK…focused on the future Future of ERM ERM will continue as risk consolidation and aggregation Process increases value of risk management skills Management is concerned with risk control issues Chief Risk Officer will be a visible figure in an organization Many paths to CRO, diverse skills required ERM’s role in optimization has a long way to go Potential benefit is worth pursuing for pioneers