Is [Enterprise] Risk Management for Actuaries?

David OakdenOCCA MeetingNov. 4, 2004

Based on a Presentation by Barry Franklin

2

The Actuary and ERM

• ERM Definition

• CAS Activities

• SOA Activities

• Examples

3

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

4

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

5

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

6

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

7

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

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Risk TypeRisk Type

• Strategic• Operational• Financial• Hazard

• Strategic• Operational• Financial• Hazard

Risk ManagementProcess Step

Risk ManagementProcess 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

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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

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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

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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

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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

13

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

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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.

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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

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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)

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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

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Assessing Critical Risks Relative to Risk Tolerance

ABC Critical Risk AnalysisPotential EPS Impact of Average Loss Event

$-

$0.20

$0.40

$0.60

$0.80

$1.00

$1.20

O1 O2 O5 L1 L2 L3 L4 S1 S2

Critical Risk Area

Aft

er-

Ta

x E

PS

Im

pa

ct

Avg Loss Event

$0.03 per Share

Supply Chain Disruption

Manufacturing Disruption

LocationConcentration

Changes in Regulation

Third PartyLiability

IntellectualProperty

EnvironmentalContamination

Product LaunchDelay

OutsourcedManufacturing

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Operational Risk O1Potential Impact on After-Tax Cash Flow

(2,000)

(1,000)

-

1,000

2,000

3,000

4,000

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Plan Year

Cas

h F

low

($M

illio

ns)

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)100

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Plan Year

Dev

iatio

n fr

om L

RP

($M

)

LRP

Avg Event

1 SD

2 SD

Operational Risk O1Potential Impact on After-Tax EPS

(8.00)

(6.00)

(4.00)

(2.00)

-

2.00

4.00

6.00

8.00

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Aft

er-T

ax E

PS

LRP

Avg Event

1 SD

2 SD

Operational Risk O1Potential Impact on NPV 2008 Market Cap

12,626

25,251

37,877

19,54816,290

13,0329,774

6,516

33,126

27,605

22,084

16,563

11,042

31,564

18,938

-

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

10 15 20 25 30

NP

V L

oss

($M

illi

on

s)

Avg Event

1SD

2 SD

Quantifying Critical Risks

Assumed P/E Ratio

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Enterprise risk models translate risk into financial measures

Company Strategy

Investments Products Capital/Structure Reinsurance/

Hedging Operating

Economic Scenario Generator

Projected Financials

Risk Profile = Distribution of FutureFinancial Results

Prob

abilit

y

Asset Behavior Models

Product Behavior Models

Operational Risk Models

Catastrophes & Random Claims

Optimization

Inflation Interest Rates Credit Costs Currency

Exchange GDP

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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

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ABC Corporation 2002-2003 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

Deb

t Cov

erag

e R

atio

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 2002-2003 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.

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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