The GPS Framework : A Comprehensive Approach to Strategic Risk Management

1. The GPS Framework: A Comprehensive Approach toStrategic Risk Management Damon Levine, CFA, CRCMP Vice President, Enterprise Risk Management Assurant Inc.

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

3. 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.

4. 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

5. Agenda • ERM, Strategic Risk Management, and GPS • Risk Quantification in GPS • Important GPS Concepts and Tools • An Execution Management Cycle • Quantitative Applications

6. A Convenient Fallacy • Strategy versus strategic objectives • Risks to strategic objectives • Does strong Enterprise Risk Management (ERM) imply effective Strategic Risk Management (SRM)?

7. 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”

8. Risk Quantification in GPS • Scenario analysis • Goals • Process: the risk interview • Benefits • Probability • Macro events and conditional probability

9. Example: Scenario Approach

10. 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.)

11. 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)

12. 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

13. 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!)

14. RRR & Probability of Success RRR is a function of actual performance to dateandplan 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

15. 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

16. 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

17. 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

18. GPS in Action: Managing Strategic Execution Define SMART Strategic Objective, Critical to Success (CtS) Goals & pre-requisite tasks Yes Research performance drivers, metrics and EWI. Employ Logical Framework techniques to analyze CtS goals, sub-goals, and if-then assumptions Yes Select metrics/indicators, upfront RRR analysis, and risk ID & quantification through scenario approach Do we need to re-define metrics/EWI or revise risk scenarios? Calculate and track metric/EWI values, risk velocity & exposures, mitigation effectiveness (PFA), and RRRs No Report and interpret data and findings, PFAs, and overall risk-reward outlook/assessment No Does overall strategy need to be altered? Apply adaptive management: revise risk mitigation Business tactics/strategy and inform ‘go/no-go’ calls

19. 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

20. 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.)

21. 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

22. 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

23. 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

24. Stochastic Simulation in Excel (cont’d) • 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)

25. 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 • Use r1 and r2 to indicate simulated state of each risk source • r1=.6531 • risk source 1: scenario 2 is simulated • r2=.3215 • risk source 2: scenario 1 is simulated • determine performance for strategic objective X: • aggregate impacts from above simulated scenarios

26. 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), …

27. 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 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

28. Macro Factor Based Simulation of a Strategic Objective • r1=.3531 • Economicscenario 2 is simulated • r2=.8108 • Regulatoryscenario 3 is simulated • The above macro scenarios activate conditional probabilities for each risk source of the objective… • Strategic Objective Risk Source X • Macro “state of the world” activates conditional probabilities for simulation of risk x: • (15%,60%,25%), (20%,50%,30%), (10%,55%,35%) • Simulate each state of each Risk Source X, Y, Z,…thus simulating the strategic objective

29. Simulated InfusionsRisk-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

30. Strategic Objective Risk CapitalRisk-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, …

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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: Damon.Levine@Assurant.com • Questions?