the gps framework : a comprehensive approach to strategic risk management

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The GPS Framework: A Comprehensive Approach to

Strategic Risk Management

Damon Levine, CFA, CRCMPVice President, Enterprise Risk ManagementAssurant Inc.


Legal Disclaimer

The views expressed herein are my own and not necessarily those of my employer, Assurant Inc.


About the Speaker• Damon Levine is Vice President, Enterprise Risk

Management at Assurant Inc. • 20 years experience in actuarial consulting,

portfolio strategy, and risk management with past presentations to the ERM Symposium, ISO's ERM Forum, and the Actuarial Society of NY.

• Published in The Actuary, SOA's Risk Management journal, and the Society of Actuaries exam syllabus.


Today’s Key Takeaways• A clear understanding of the approach, tools, methods, and scalability of GPS• The ability to measure all types of threats to strategic execution with the same set of metrics• The capability to manage strategic risks with a powerful and practical method which:

•Creates buy-in and improves both strategic planning and execution•Enables informed management reaction to strategic risks


AgendaERM, Strategic Risk Management, and GPS

Risk Quantification in GPS

Important GPS Concepts and Tools

An Execution Management Cycle

Quantitative Applications


A Convenient Fallacy

• Strategy versus strategic objectives

• Risks to strategic objectives

• Does strong Enterprise Risk Management (ERM) imply effective Strategic Risk Management (SRM)?


GPS: Goals-Progress-Strategy• Goals: Ensure a well defined business goal,

i.e. strategic objective; it identifies key risks to achievement of the objective and its foundational “critical-to-success” goals and lower level checkpoints

• Progress: GPS includes key progress metrics and an Execution Management Cycle (EMC)

• Strategy: the EMC assesses risk evolution and informs risk-intelligent “course correction”


Risk Quantification in GPS

• Scenario analysis Goals Process: the risk interview Benefits

• Probability• Macro events and conditional probability


Example: Scenario Approach

Scenario Description Probability Impacts to Business Drivers Year 1 Earnings Impact Company Value Impact

1. Exchange rate stays within 10% of March 1 levels for next 12 months 35%

Assume baseline forecast interval estimate applies



2. Dollar appreciates vs. Euro by 10-20% 25%$US Sales Down 20% (vs. baseline, post currency translation) -$20M -$54M

3. Dollar appreciates vs. Euro by >20% 20% $US Sales Down 35% -$35M -$95M

4. Dollar depreciates vs. Euro by 10-20% 15% $US Sales Up 15% $15M $41M5. Dollar depreciates vs. Euro >20% 5% $US Sales Down 30% $30M $81M

Statistical Expectation -8M -22M

Downside Conditional Expectation -27M -72M

Challenges [list perceived difficulties in risk prevention or impact reduction]

Mitigations [identify existing risk controls that reduce likelihood and/or expected business effects]

Potential for Action [assess the expected benefit to the company’s risk-reward profile from additional focus or effort on risk mitigation]

Scenario Summary for Foreign Exchange Rate Risk (Dollar vs. Euro)


Financial Quantification of Risk• Frame each scenario’s impacts in terms of key

performance drivers including sales/other cash flows, expenses, etc.

• Translate scenario impacts into effects on income statement and balance sheets

• Spreadsheet logic and accounting rules make the key metrics simply “fall out” of model (e.g. earnings, ROE, IRR etc.)


Additional Tools: Old and New

• Well known techniques from ERM play key roles in GPS

Scenario approach to risk ID and quantification Mitigation/control assessment

• Potential for Action (PFA)• Required Recovery Ratio (RRR)• The Logical Framework Approach (LFA)


Potential for Action (PFA) and Risk Velocity

• PFA is a qualitative assessment of the expected improvement in a company’s risk-reward profile due to increasing or expanding risk controls/mitigation

• Expected “bang for the buck” of additional effort/resources for a specific risk exposure

• Risk Velocity: measure of expected time from risk manifestation to financial impact


Required Recovery Ratio (RRR)• Assume a strategic objective based on a sales metric and 3-

year forecast horizon: year 1: 100M, year 2: 200M, year 3: 250M (a 3-year total of 550M)

• Assume actual year 1 sales are 50M and define RRR by the “get back on plan” relation:

50 + RRR(200+250) = 550• RRR=111% we must outperform forecast by 11% in years

2-3• Higher RRRs smaller likelihood (estimated at beginning of

year or before project launch!)


RRR & Probability of Success• RRR is a function of actual performance to date and

plan projections for the remaining time horizon

• Various ranges of RRR are considered before a strategic project launch and corresponding probabilities are estimated

• RRR, in conjunction with other indicators, provides a dynamic estimate of the probability of goal achievement


The Logical Framework Approach (LFA)• A powerful management tool driving successful

strategic planning and execution • Developed in 1969 for the United States Agency for

International Development (USAID) • Originally used for international development

projects and used in over 35 countries • Very effective in corporate settings to ensure

attainment of strategic objectives• Temporal Logic Model and If-Then Thinking


Effective Strategic Planning and LFA

• A “time-reversed” causal chain Strategic objective Critical-to-Success Goals Sub-goals

and Tasks Plan left to right and (ideally) execute right to left

• If-Then thinking and progress metrics in an SRM setting


An Execution Management Cycle• ID Critical-to-Success (CtS) Goals• Goals Progress Strategy

Goal definition and project planning Risk ID and progress assessment with metrics and early

warning indicators (EWI) Adaptive Management: strategic course correction and

tactical actions

• Informed and dynamic execution of an objective from start to finish


Define SMART Strategic Objective, Critical to Success (CtS) Goals & pre-requisite

tasks

Select metrics/indicators, upfront RRR analysis, and risk ID & quantification through scenario

approach

Calculate and track metric/EWI values, risk velocity & exposures, mitigation effectiveness

(PFA), and RRRs

Report and interpret data and findings, PFAs, and overall risk-reward

outlook/assessment

Apply adaptive management: revise risk mitigation

Business tactics/strategy and inform ‘go/no-go’ calls

Research performance drivers, metrics and EWI. Employ Logical Framework techniques to

analyze CtS goals, sub-goals, and if-then assumptions

Does overall strategy need to be

altered?

No

Yes

Do we needto re-define metrics/EWI

or revise risk

scenarios?

No

Yes

GPS in Action: Managing Strategic Execution


GPS and Strategic Planning• Strategic objective Critical-to-Success (CtS)Goals

Sub-goals and Tasks• Identify challenges and risks to attaining CtS goals

and the smaller sub-goals or tasks (include LFA’s if-then thinking)

• Quantify potential impacts in light of existing mitigations or controls

• Provide a ranking of key risks and their PFAs to prioritize management action


Progress Assessment for Strategic Objectives

• At regular time steps GPS will: Identity and quantify risks to key tasks, projects, and CtS

goals and assess corresponding risk controls/mitigations Determine progress metrics, RRR & outlook for success Provide an estimate of the expected benefit of increased

mitigation effort (PFA)

• Crucial performance indicators are tracked and reported for those areas driving success (e.g. training, marketing , sales, profit, etc.)


Enabling Adaptive Management• The EMC allows for:

Timely assessment of progress toward goals expressed in objective measures and metrics

A dynamic view of risks to achievement of the key foundational tasks and the overarching strategy

A risk-intelligent basis for course correction: high level and tactical revisions to business plans

• Management has a realistic view of the priority for shoring up risk mitigation and increased focus on strategic elements


Stochastic Approaches

• Scenario impacts need not be point estimates• Uniform, triangle, normal or other

distributions may be assumed for impact estimates of key business drivers or income statement items

• Refining scenario analysis with conditional probabilities

• Macro factors and correlation


Stochastic Simulation in Excel• Assume a risk source modeled with three scenarios:

S1 = no/mild impact, S2 = moderate impact, and S3 = severe impact & probabilities 60%, 30%, 10% resp.

• Generate random digit in (0,1): r• Use r to determine which scenario has occurred:

0<r<.6 S1, .6<r<.9 S2, and r>.9 S3• Next slide illustrates this concept in Excel; note that

subintervals corresponding to scenarios have widths equal to the scenario probabilities


Stochastic Simulation in Excel (cont’d)

r in (.6,.9) then S2 Occurs r>.9-->S30 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

if r falls in (0,.6) then S1 Occurs

•Assume P(S1)=.6, P(S2)=.3 and P(S3)=.1•Use “=rand()” in Excel to generate random digit, r, from (0,1)•The rule below associates r with a particular scenario (i.e. the random value of r indicates the scenario which occurs)


Simulation of a Strategic Objective with Two Risk Sources

•A random digit from (0,1), r1 determines the simulated scenario for risk source 1 •Another independent random digit r2 determines the simulated scenario for risk source 2

r1=.6531

Use r1 and r2 to indicate simulated state of each risk source

risk source 1: scenario 2 is simulated

determine performance for strategic objective X:aggregate impacts from above simulated scenarios

r2=.3215

risk source 2: scenario 1 is simulated

0 0.2 0.7 1

scen 1 scen 2 scen 3prob=.20 prob=.50 prob=.30

0 0.4 0.9 1

scen 3prob=.10prob=.50

scen 1prob=.40

scen 2


The Macro Factory Overlay • Model macro factors that significantly affect

likelihood of outcomes for risk sources of strategic objective X

• Simulate macro factor states: M1,M2,… (e.g. recession, inflation, pandemic)

• For each macro state i, estimate strategic objective probabilities: pr(scen 1 | Mi), pr(scen 2 | Mi), …


Simulate performance of Strategic Objective X: Based on the simulated impacts for the scenarios, aggregate the effects on key metrics such as

earnings, IRR, ROE, etc

Simulating Strategic Objective Performance

Generate several random digits from (0,1) to simulate the state of each of the macro factors; i.e. model the “state of the world”

For each risk source (R1, R2,…) affecting the performance of strategic objective X, we note the “activated set” of scenario probabilities

For each of R1, R2, …generate a random digit from (0,1) to simulate which scenario occurs for each of these risk sources


Macro Factor Based Simulation of a Strategic Objective

Economic scenario 2 is simulated

Regulatory scenario 3 is simulated

r1=.3531

r2=.8108

Simulate each state of each Risk Source X, Y, Z,…thus simulating the strategic objective

0 0.2 1

scen 2prob=.80

scen 1prob=.20

0 0.2 0.7 1

scen 1 scen 2 scen 3prob=.20 prob=.50 prob=.30

Strategic Objective Risk Source XMacro “state of the world” activates conditional probabilities for simulation of risk x:

(15%,60%,25%), (20%,50%,30%), (10%,55%,35%)

The above macro scenarios activate conditional probabilities for each risk source of the objective…


Simulated Infusions

Risk-adjusted Capital of a Strategic Objective

• Best estimate/baseline forecast for 3 years of objective X: B1, B2, & B3 (e.g. $earnings in years 1-3)

• Denote years 1, 2, and 3 earnings levels in simulation k by E1k, E2k, and E3k

• Notional supplemental flows to meet baseline: B1- E1k , B2- E2k , and B3- E3k for years 1-3 respectively

• Kth infusion = PV(supplement) = (B1- E1k)/(1+i) + (B2- E2k)/(1+i)2 + (B3- E3k)/(1+i)3


Strategic Objective Risk Capital

Risk-adjusted Capital of a Strategic Objective

• In large number of simulations observe 95th%ile of simulated infusions for strategic objective X

• RACX = risk-adjusted capital = 95th %ile of infusions

• In one run risk capital may be determined for all objectives simultaneously: RAC1, RAC2, …


Return on Risk-Adjusted Capital

of a Strategic Objective• Calculate in large run: RAC1, RAC2, …

• Observe average “reward” for each objective (e.g. average PV(distributable earnings) or IRR): y1, y2,…

• Define return on RAC for the “strategic objective i” as RORACi = yi/RACi


The Portfolio View

• Simulation allows for portfolio infusion notion and RACPORT and yPORT, the average reward for the portfolio of strategic objectives

• We may define RORACPORT = yPORT/ RACPORT

• Estimating a strategic objective’s contribution to portfolio RAC and RORAC

• “Risk classes” and exposure to macro factors


Risk Appetite

• A previously vague or “pie in the sky” risk construct

• Now we may define: Desired risk class allocation of the portfolio of

strategic objectives Support only those objectives increasing RORACPORT Portfolio exposure limits to specific macro factors


Risk-Intelligent Capital Deployment• Based on upfront risk analysis how does one

decide on the “green light” for an objective or choose among competing objectives?

• Illustrative policy: Priority based on objective or portfolio RORAC Priority as a function of resulting portfolio exposure to macro

factor(s) or maximum risk class allocation Consider performance distribution of the objective


In the Research Paper• More detail, slower buildup to ideas• A risk-adjusted compensation framework and

100 Day Implementation Plan• Definitions & examples of risk velocity, RRR, &

PFA• Illustrative application to a new product launch• Available online at:

http://www.ermsymposium.org/2013/pdf/erm-2013-paper-levine.pdf


Closing Thoughts

• These techniques generally apply to ERM and to a large extent, GPS is an application of robust ERM to strategic risks

• GPS will still “work” if only partially implemented and does not commit a company to a single SRM/ERM path

• Contact: [email protected]• Questions?

the gps framework : a comprehensive approach to strategic risk management

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