Enterprise Risk Management For Insurers and Financial Institutions

1. David Ingram CERA, FRM, PRM EnterpriseRisk ManagementFor Insurers and Financial Institutions From the International Actuarial Association

2. 1. INTRODUCTION - Why ERM? 2. RISK MANAGEMENT FUNDAMENTALS – FIRST STAGE OF CREATING AN ERM PROGRAM 3. RISK ASSESSMENT AND RISK TREATMENT - ACTUARIAL ROLES 4. ADVANCED ERM TOPICS Course Outline

3. INTRODUCTION • 1. INTRODUCTION - Why ERM? • 1.1 Enterprise risk management history • 1.2 What is enterprise risk management? • 1.3 ERM & the Financial Crisis • 1.4 ERM Adoption in the Insurance Industry

4. A Brief History of Risk Management • 1952 – Markowitcz – Portfolio Theory – Risk = variance • 1973 – Black Scholes – Derivative Pricing – variance is key driver • 1987 – Black Monday – Portfolio Insurance implicated in record 1 day fall in stock market • 1992 – Cadbury (UK) Report urges centralized, comprehensive corporate RM • 1993 – First CRO named at GE

5. Current Trends in Risk Management • Dedicated risk management function • Risk Management decision making remains largely decentralized 2. Risk Aggregation / Economic Capital • in early stages of development 3. Regulatory practices encourage ERM 4. Regulatory Capital  Economic Capital Basel Survey (August 2003)

6. 1997: UBS Derivatives Model Problems. 1997: Prudential Insurance US Market Conduct 1998: Russian Bond Debacle. 1998: The Long-Term Capital Management Model Failure. 1999: General American Liquidity Failure 1999: Unicover Fiasco 2000: Equitable UK Pension guarantees 2001: American Express CBO Losses 2002: Enron & Worldcom 2003: Parmalat 2003: Allmerica VA reserving 2003: Annuity & Life Re Overgrowth 2004: Marsh Contingent Commissions 2005: AIG Finite Re 2006: Scottish Re Tax Asset 2006: Hurricane Katrina 2007: Countrywide Sub Primes 2008: Bear Sterns/ Lehman/ AIG Sub Prime Risk Management Failures • 1973: Equity Funding Fraud • 1983: Baldwin United Shell Game • 1986: The ZZZ Best Carpet Scandal. • 1988: Equitable (NY) GIC losses. • 1989: The US S&L Crisis. • 1991: Salomon Brothers Bond Scandal. • 1991: BCCI Scandal. • 1991: Executive Life / First Capital Life Failures • 1991: Mutual Benefit Life Failure • 1994: Orange County Default • 1994: Kidder Peabody Fiasco. • 1994: Confederation Life Failure • 1994: Monarch Life Seizure • 1995: The Barings Derivatives Scandal. • 1996: Sumitomo Copper Scandal. • 1997: The Natwest Hole. • 1997: The Bre-X Mining Scandal. • 1997: Smith Barney Investor Fraud. • 1997: Bank of Tokyo-Mitsubishi Derivatives Loss.

7. Risk Management Failures • Bank / Financial • Barings – Controls Missing, mgt didn’t understand risks • LTCM – Models inadequate, overleveraging • Northern Rock – Excessive Growth Insurance • Nissan Mutual – ALM mismatch, underpricing interest credits • Equitable UK – underpriced annuities, poor relationship with regulators • HIH – insurance mispricing, underreserving • Confed Life – Over-concentration in illiquid investments, shell game • General American – ALM mismatch, rating downgrade, downgrade trigger options • American International Group – Small Financial Group brings down Insurance giant

8. Barings (UK) • Venerable UK Bank • Trading losses in Singapore • Exceeded value of bank • Problems • Management didn’t understand what the trader was doing • Trades were not the hedged transactions they were supposed to be • Trader did all reporting of trades • No separation of duties

9. Long Term Capital Management (US) • Private Investment Fund • Very highly Leveraged portfolio of investments • Highly sophisticated risk management • Capital was insufficient to withstand market movement Problems: • Risk Model was inadequate to predict 1998 international financial problems • Counterparties did not know the extant of their full exposure

10. Northern Rock (UK) • Mortgage lender grew rapidly to become one of the top 5 mortgage lenders in the UK • Had used securitization to fund mortgage lending growth • Encountered liquidity problems when mortgage securitization markets froze in Aug 2007 • Problem: • Request for help with liquidity from Bank of England triggered first run on UK bank in over 100 years

11. Nissan Mutual (Japan) • Savings product guaranteed high interest rates • High sales growth of this product • Investment losses & inadequate yield • ¥200 billion net losses covered by Life Association of Japan Problem: • Asset Liability Mismatch • Underpricing (over crediting) of interest

12. Equitable (UK) • Guaranteed payout annuity product sold to pension plans • Improvement in mortality & decline in interest rates • Management tried to “force” solution on regulators Problem: • Underpricing & poor Asset Liability matching • Poor relationship with regulators lead to company demise rather than workout

13. HIH (AUS) • Second largest General Insurer “suddenly” found to be insolvent Problem: • Total control failure at all levels • Company, Auditor, Regulator • Ultimate problem was fundamental underpricing and overspending • Hidden by systematic underreserving

14. Confederation Life (Can) • Company invested over 70% of assets in Real Estate • Company failed following valuation and liquidity crunch • Concentration hidden by accounting Problem: • Lack of Diversification, Liquidity • Limited oversight from regulators, rating agencies due to accounting “gimmicks”

15. General American Life (US) • Funding agreement product sold to banks and mutual funds with 7-day put option • Investments were made in 1 to 2 year maturity securities • Partner handled large share of funds • Downgrade of partner =>triggered downgrade of company => triggered calls • Company unable to raise cash for multi billion $$ calls Problem: • Asset Liability Mismatch • High dependency of business on ratings • Huge Counterparty exposure

16. American International Group • In late 2006, AIG claimed to have $16B of excess capital • In early 4th Quarter 2008, AIG needed over $100B of funds from US government to meet obligations Problem: • Small Financial Products unit has written Trillions of CDS, some on sub prime CDOs • MTM losses lead to downgrade which leads to collateral call

17. Reasons for Current Interest in Risk Management • World Markets Interdependent • Chaos Theory – Butterfly Effect • Wide Use of Derivatives • “Financial WMD” Warren Buffett • Accelerated Pace of Business • Recent Experiences of Losses • 1998 International Currency Crisis • 2001/2002 Terrorism & Investment Losses • Tsumani and Hurricanes • Financial Crisis

18. Reasons • Tools for Risk Mgt are getting better and better • Success of RM in banking over the past down cycle (view in 2004) • No Major Bank Failures • Insurance Companies in Europe fared much worse with less Risk Mgt • Extreme over exposure to equities • Insurance regulators are getting interested • In many jurisdictions same regulators for banking & insurance

19. Does the Global Financial Crisis prove that ERM is Ineffective?

20. Frequently Asked Question. ..

21. Study of 11 major banks in 2007 • Found differences in ERM Practices

22. Better Risk Management Practices • Four main differences in practices. • Better-performing banks: • Shared risk and exposure information both quickly and broadly among business unit staff, risk management staff and top management. • Used rigorous internal practices and models, consistent across all business units, to evaluate their risk positions. • Coordinated cash planning centrally, avoiding or limiting activities that created large contingent liquidity needs and setting incentives to make such activities unattractive to business unit management. • Used multiple risk assessment tools and metrics and generally had very adaptive risk models.

23. Insurers should be concerned if: • Business Units are empowered to add significantly to risk concentrations without frequent disclosures to Top Management • Business Units apply different risk models • Risk sign-off sometimes relies totally on the presumption that someone else is doing good analysis • Contingent risks are not usually identified • Risk models are inflexible, requiring changes to be planned out a year in advance • “Nobody believes those stress tests anyway, so we don’t put much time into them”

24. Insurers should be encouraged if: • Open communications among Business Units, Risk Management staff and Top Management • Enterprise level decision-making about major risk accumulations • Systematic internal evaluation of risks • Low reliance on third party risk evaluations • Identification of and plans for contingent risks • Incentives for business units to minimize contingent risks • Multiple risk management tools and metrics • Flexible and adaptive risk models • Aggregation of net and gross exposures in addition to expected losses • Stress testing that is credible to Top Management

25. ERM & Seatbelts • They only work if you use them!

26. Risk Management is • Setting & enforcing limits for all firm risks that are appropriate for the capital of the firm. • Increasing & rewarding activities with superior risk adjusted return and fixing or limiting activities with inferior risk adjusted return. • Identifying & preparing for special events that could significantly impair the earnings &\or the solvency of the firm.

27. Benefits of Risk Management(James Lam) • Market Value Improvement • Due to decreased volatility 2. Early Warning of Risks • Risk management replaces Crisis Management 3. Reduction of Losses 4. Rating Agency Capital Relief 5. Risk Transfer Rationalization • Reinsurance cost/benefit 6. Corporate Insurance Savings

28. ERM Framework Change Risk Management Value optimization Strategic Strategic integration Risk measurement Risk Controlling Risk management Risk Steering Loss minimization Risk Trading Compliance Tactical Value creation Balance sheet protection Risk/return optimization Risk control

29. Scope of ERM • Risk Controlling • Limit exposures and therefore losses • ERM adds Aggregate approach to risk tolerance Risk Trading • Getting paid for risks taken • ERM adds consistent approach to risk margins Risk Steering • Strategic choices to improve value • ERM adds risk vs. reward point of view Change Risk Management • Managing the risks from new projects, products, territories, • ERM adds fitting into the risk profile & ERM program

30. Potential Benefits of Effective Risk Management Better able to take advantage of new business opportunities. Reduction in management time spent “fire-fighting” Higher share price • Increased likelihood of change initiatives being achieved. Potential Benefits (ICA) Fewer sudden shocks and unwelcome surprises. More focus internally on doing the right things properly. Lower cost of capital. Competitive advantage. Better basis for strategy setting.

31. Moody’s View of Risk Management • Environment More Risky • More complex products • Higher regulatory scrutiny • Reinsurers leaving markets Insurers Response • Stress Testing • Risk Management Committee/CRO

32. What is the difference between Risk Management and ERM? • An ERM Program comprehensively applies Risk Management… • across ALL of the significant risks of the Enterprise • Consistently across the risks • Consistently with the fundamental objectives of the enterprise Standard & Poor's

33. Full Benefits of an ERM Program • Once a firm’s enterprise wide risks are identified and objectives are set, an ERM Program should… • Develop and maintain systems to periodically measure the capital needed to support the retained risks of the company • Reflect the risk capital in: • strategic decision making, • product design and pricing, • strategic and tactical investment selection • financial performance evaluation The product of a fully-realized ERM Program is theoptimization of enterprise risk adjusted return Standard & Poor's

34. Benefits of Integrated Risk Management Strategy • Avoid “land mines” and other surprises • Improve Stability & Quality of Earnings • Enhance growth and shareholder return • By more knowledgeably exploiting risk opportunities • Identify specific opportunities such as natural synergies & risk arbitrage • Reassure stakeholders that the business is well managed Life Office Management Association (USA)

35. Planning Projection Management – Level 1 Planning

36. Management – Level 2 Scenario Testing

37. Planning Projection Management – Level 3 Scenario Analysis Average Scenario Confidence Interval

38. Planning Projection Management – Level 4 Risk Management Average Scenario Confidence Interval

39. ERM Benefits & Uses • Insurance = Risk Taking • Risk Management = Management for Insurance Companies • Risk Management => systematic risk selection • as more insurance companies adopt risk management they will select the better risks • companies without RM will not know

40. ERM Benefits & Uses • Communicating with Rating Agencies • Risk Management can provide language for dialogue with RA • Communicating with Board • Markets become more volatile • as more financial institutions use Risk Management

42. Solvency 2 & ERM • Pillar 2 • Article 43 requires firms to have an effective risk management system. • Requires firms to consider all risks • Risk management system to be fully integrated into the organisation

43. GFC & ERM • “Progress has been made in strengthening . . . Risk Management” • Leaders' Statement from G20 Summit, 2009

44. Questions Questions??

45. Key Points from Intro • Risk Management has evolved over many years. • Learning from Failures. • Interest in Risk Mgt is increasing. • Risk Management is preventing losses and improving risk adjusted return. • Risk Management replaces Crisis Management.