1. Enterprise Risk Management and Business Continuity Rick Gorvett, FCAS, MAAA, ARM, FRM, Ph.D. Actuarial Science Professor Departments of Mathematics and Finance University of Illinois at Urbana-Champaign Crisis Management & Business Continuity Seminar Bloomington, IL October 10, 2003

2. Agenda About me A risky world Broadening our perspective Enterprise risk management (ERM) –Evolution –Current state –Relationship to Business Continuity Conclusion

3. “Who am I? Why am I here?” - Admiral James Stockdale, 1992 Currently –Professor, Depts. of Mathematics and Finance –University of Illinois at Urbana-Champaign Prior –Senior Vice President –Director of Internal Audit & Risk Management Internal Audit Corporate Investigations Risk Management Enterprise Risk Management Business Continuity

4. A Risky World And it just seems to be getting riskier! What’s getting riskier about our world? What isn’t ? –Perhaps aspects of technology, medical care,…? Evidence of riskiness –Catastrophic events in a more crowded world with greater vulnerabilities –Current events –Books – e.g., Safe Food: Eating Wisely in a Risky World –Financial markets

5. Why Worry About Interest Rate Risk? (cont.) Data per FRED II, St. Louis FRB, for 3-Month T-Bills, Secondary Market

6. Why Worry About Interest Rate Risk? (cont.) Data per FRED II, St. Louis FRB

7. Why Worry About FX Risk?

8. Steps in the Risk Management Process Determine the corporation’s objectives Identify the risk exposures Quantify the exposures Assess the impact Examine alternative risk management tools Select appropriate risk management approach Implement and monitor program

9. The Bottom Line: It All Boils Down to Capital “Capital” –Assets less liabilities; owners’ equity; net worth –Support for (riskiness of) operations –Thus, supports profitability and solvency of firm “Capital Management” –Determine need for and adequacy of capital –Plans for increasing or releasing capital –Strategy for efficient use of capital

10. Why Do We Care About Managing Capital? Leads to solvency and profitability Benefits of solidity and profitability –Higher company value –Happy claimholders –Better ratings –Less unfavorable regulatory treatment –Ability to price products competitively –Customer loyalty –Potentially lower costs

11. The “Problem” With Capital A certain amount of capital is needed in order to promote solvency –Thus, we need to be able to raise capital But.... If there is too much capital, profitability (as measured by return on equity) will suffer –Thus, we need to be able to efficiently deploy capital

12. What Does Capital Management Entail? Capital Management Product Pricing Financial Risk Mgt. Setting Objectives Raising Capital Strategic Planning Liability Valuation Asset Allocation Risk Management

13. Financial Theory and Capital Management Why bother to worry about financing or FRM (or any risk management activity), in light of the “capital structure irrelevance proposition”? Modigliani-Miller (1958): if financing does matter, it must be because of one or more of: –Tax effects – convex tax function –Financial distress / bankruptcy costs –Effects on future investment decisions

14. Capital Structure - Reality Modigliani-Miller Proposition: capital structure decision is irrelevant to firm value, under certain “friction-free” assumptions (e.g., no taxes) But: in reality, there are taxes There are also costs associated with financial distress Different corporate situations may indeed lead to different capital investment decisions

15. Pre-FRM Post-FRM

16. Enterprise Risk Management Or “Enterprise Risk and Assurance Management” What is ERM? –Concerned with a broad financial and operating perspective –Recognizes interdependencies corporate, financial, and environmental factors –Strives to determine and implement an optimal strategy to achieve the primary objective: maximize the value of the firm

17. Goals of ERM Ensure business continuity Enhance opportunities for the company to achieve its objectives Create and increase company value Make risk management more cost-efficient Stabilize earnings

18. Evolution of ERM Historically: “risk silo” mentality Mid-1990s: –First “Chief Risk Officer” –First use of ERM terminology Late-1990s: –Risk-related regulatory requirements (e.g., Turnbull) –Earnings protection insurance debuts 2001: –September 11 –Corporate scandals –Beginning of efforts to improve corporate governance

19. Current State Findings from various surveys –An acknowledged need to improve risk management –A recognition that a holistic approach is appropriate and preferable –ERM can improve overall capital management and thus enhance corporate value and competitiveness –A variety of approaches to improving risk management –There are still problems to overcome

20. A Paradigm Shift Traditional Risks managed in silos Concentrates on physical hazards and financial risks Insurance orientation Ad hoc / one-off projects Emerging Centralized mgt., with exec-level coordination Integrated consideration of all risks, firm-wide Opportunities for hedging, diversification Continuous and embedded

21. Types of Risks Operational –Hazard –Physical Strategic –Capital / resource allocation –Industry / competitors Technological –Databases –Security –Confidential information Stakeholder Legal –Compliance –Regulatory Financial –Capital markets –Credit risks –Taxes Human capital –Retention –Training Reputational

22. Issues in ERM Implementation Different corporate cultures require different ERM approaches Who is going to be the ERM champion within the company –Among senior executives –Among departments / functions How to embed a risk management culture and responsibilities throughout the firm

23. Components of the ERM Process Determine corporate objectives Risk identification –Goal: comprehensiveness –E.g., self-assessment Risk measurement –Volatility measures –Value at Risk (VaR) Impact Likelihood Size of loss Likelihood

24. Components of ERM (cont.) Assessing the impact –Stress or scenario testing –Stochastic simulation Examine and select alternative risk management tools and techniques –Traditional risk transfer –Natural hedging / diversification –Integration of risks E.g., “dynamic financial analysis”

25. An Analytic Technique: Dynamic Financial Analysis Dynamic –Stochastic / variable – not fixed / static –Reflects uncertainty Financial –Integration of financial, operational, etc., factors –Assets and liabilities Analysis –“An examination of a complex, its elements and their relations” –Complex: “a whole made up of complicated or interrelated parts”

26. Definition of “DFA” “Dynamic Financial Analysis is the process by which an actuary analyzes the financial condition of an insurance enterprise. Financial condition refers to the ability of the company’s capital and surplus to adequately support the company’s future operations through an unknown future environment. : The process of DFA involves testing a number of adverse and favorable scenarios regarding an insurance company’s operations. DFA assesses the reaction of the company’s surplus to the various selected scenarios.” -- CAS DFA Handbook

27. Key Ideas in this DFA Definition “Financial condition” –Specifically, capital and surplus “Future operations” –Going concern “Unknown future environment” –Uncertainty / stochastic “Testing a number of.... scenarios” –Analysis across different environments “Assesses the reaction of.... surplus” –Analyze acceptability of results

28. Types of DFA Scenario testing –Projects results under specific conditions –Catastrophe, interest rate shift –Used for cash flow or stress testing –New York Life Insurance Regulation 126 Stochastic simulation –Models uncertainty components by distributions –Uses randomly selected values to calculate a large number of outcomes –Evaluate risk by proportion of unacceptable outcomes

29. Sample DFA Model Output

30. Keys to Success in ERM Senior management commitment and sponsorship Embed a “risk management culture” in the corporation at the operational level Provide for accountability, both specific and widespread Clearly defined responsibilities for coordination and maintenance Adequate communication

31. Keys to Success in Business Continuity Planning Senior management commitment and sponsorship Provide for accountability, both specific and widespread Clearly defined responsibilities for coordination and maintenance Adequate communication Differentiate BCP from “technology disaster recovery”

32. Conclusion “The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk” - Peter Bernstein, Against the Gods