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Explore the fundamentals of Enterprise Risk Management (ERM) in the context of life insurance companies, covering risk identification, measurement, appetite, culture, and the benefits of ERM implementation.
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Enterprise Risk Management in Life Insurance CompanyYi ZhengPortfolio Modeling Analyst, Manulife Investment Division University of Connecticut 12/3/2014
Agenda • What is Risk Management? • The Definition of Enterprise Risk Management (ERM) • Risk Identification (Risk Types) • Risk Measurement (Risk Quantification) • Risk Appetite (Risk Decision Making) • Risk Culture/Philosophy • Benefit of Enterprise Risk Management (ERM)
What is Risk Management? • Definition of Risk • Risk is uncertainty • Risk includes upside volatility • Risk is deviation from expected • Risk Management • Balancing risk and reward • Balancing art and science • Balancing process and people • Risk Management is ultimately about people
Definition of Enterprise Risk Management • James Lam, Enterprise Risk Management-From Incentives to Controls (2nd edition): • “ERM is a comprehensive and integrated framework for managing key risks in order to achieve business objectives, minimize unexpected earning volatility, and maximize firm value.” • Sim Segal, Corporate Value of Enterprise Risk Management-The Next Step in Business Management: • “The process by which companies identify, measure, manage, and disclose all key risks to increase value to stakeholders.”
Risk Measurement • Three popular risk measures • Value at Risk (VaR): The amount of losses that an entity is not expected to exceed, at a specified confidence level and period of time (i.e. 95% 1-day VaR is a level of loss that is expected to be exceeded only 5% of days) • Volatility: A measure that provides information about uncertainty of returns over a defined time period (i.e. may be expressed as a standard deviation of returns over the specified time period or the standard deviation of “tracking error” vs. a specified index) • Expected Shortfall: The expected size of loss that for all losses exceeding a defined threshold
Risk Measurement in Life Insurance Company • Three key risk measurements applied in Life Insurance Company. • Earnings at Risk (EaR), which focuses on earnings volatility: the amount by which quarterly earnings can be expected to vary from plan earnings no more than a pre-defined level • Economic Capital (EC), which focuses on capital adequacy: Amount of capital needed, together with policyholder liabilities held, to ensure the company can fulfill all policyholder obligations under extreme stress • Risk Based Capital (RBC) or Minimum Continuing Capital and Surplus Requirements (MCCSR)
The Problem of Operationalizing Risk Taking • Investors and managers are faced with decisions about how much and what types of risk to take • It is a simple concept with major execution challenges • What is the relevant universe of risk? • How can risk be measured? • Which risks do we want and how much of each? • How can the desired risk profile be achieved? • The goal of the Risk Appetite framework is to make that operationalization possible
Risk Appetite Framework • Establishes and defines the risk types that are relevant (e.g., “Public Equity Risk”=risk from the changes in the level the equity markets) • Define how risk will be measured (e.g., “how much money do we lose if the S&P 500 drops by 5% tomorrow”) • Defines a risk appetite through quantitative limits and qualitative statements • “We want to lose no more than $100 million if the S&P 500 drops by 5% tomorrow.”
Risk Culture/Philosophy • Traditionally, companies managed risk in organizational silos. Market, credit, and operational risks were treated separately and often dealt with by different individuals or functions within an institution. • The problem is that individual risk functions measure and report their specific risks using different methodologies and formats. • Risk management should act like a fund manager and set portfolio targets and risk limits to ensure appropriate diversification and optimal portfolio returns.
Risk Culture/Philosophy • A key barrier for many life insurance companies in implementing ERM is that each of the financial risks within the overall business portfolio is managed independently. • The actuarial function is responsible for estimating liability risks arising for the company’s insurance policies. • The investment group invests company’s cash flows in fixed-income and equity investments. • The interest rate risk function hedges mismatches between assets and liabilities.
Benefit of Enterprise Risk Management • Enterprise Risk Management (ERM) provides integrated analyses, integrated strategies, and integrated reporting with respect to an organization's key risks, which address their interdependencies and aggregate exposures. In addition, an integrated ERM framework supports the alignment of oversight functions such as risk, audit, and compliance. Such an alignment would rationalize risk assessment, risk mitigation and reporting activities. • Enterprise Risk Management has three major benefits: • Increase organizational effectiveness • Better risk reporting • Improved business performance
Benefit of Enterprise Risk Management • A life insurance company which has implemented ERM would manage all of its liability, investment, interest rate, and other risks as an integrated whole in order to optimize overall risk/return. The integration of financial risks is one step in the ERM process, while strategic, business, and operational risks must also be considered in the overall ERM framework.
