Finance 590 Enterprise Risk Management

1. Finance 590Enterprise Risk Management Steve D’ArcyDepartment of Finance Lecture 2 Risk Analytics March 28, 2006

2. Reference Material • Chapters 8 and 9 – Enterprise Risk Management by Lam • Overview of Enterprise Risk Management by the Casualty Actuarial Society http://www.casact.org/research/erm/overview.pdf • Risk and Insurance by Anderson and Brown http://www.soa.org/ccm/cms-service/stream/asset/?asset_id=8027034

3. Overview • Risk Control Analytics • Risk Optimization Analytics • Classification of Risk Types • Risk Analytics by Risk Type • Performance Measures • Risk Measures • Risk Modeling • Risk Integration • Characteristics of Hazard Risk • Insurance Terminology

4. Risk Control Analytics • Scenario Analysis • Stress testing • Simulation • Economic Capital • Solvency standards • Risk Indicators • External • Internal

5. Risk Optimization Analytics • Return on Capital (Financial Services Industry) • Risk-adjusted return on capital (RAROC) • Return on risk-adjusted capital (RORAC) • Risk-adjusted return on risk-adjusted capital (RARORAC) • Economic Income Created • Risk-adjusted return – (Hurdle rate x economic capital) • Shareholder Value • Shareholder value (SHV) • Shareholder value added (SVA)

6. Risk Types • Hazard or Insurance Risk • Financial or Market Risk • Credit Risk • Operational Risk • Strategic Risk

7. Hazard Risk Management Analytics • Probable Maximum Loss (PML) • Maximum Possible Loss (MPL) • Loss Frequency • Loss Severity • Actuarial Models • Loss Distributions

8. Financial Risk Management Analytics • Interest Rate Models • Equilibrium models • Arbitrage free models • Value-at-Risk (VaR) • Parametric • Monte Carlo simulation • Historical simulation • Asset/Liability Management (ALM)

9. Credit Risk Analytics • Credit Scoring Models • Credit Migration Models • Credit Exposure Models • Credit Portfolio Models • Financial models • Econometric models • Actuarial models

10. Operational and Strategic Risk Analytics • Top-Down Approaches • Analogs • Historical loss data • Bottom-Up Approaches • Self assessment • Cash flow model

11. Performance MeasuresGeneral • Return on Equity (ROE) • Operating Earnings • Earnings before interest, dividends, taxes, depreciation and amortization (EBITDA) • Cash Flow Return on Investments (CFROI) • Weighted Average Cost of Capital (WACC) • Economic Value Added (EVA)

12. Performance MeasuresInsurance Industry • Economic Capital • RAROC • Expected net income divided by economic capital • Embedded value • Risk Based Capital (RBC)

13. Risk MeasuresSolvency Related • Probability of Ruin • Shortfall Risk • Value-at-Risk (VaR) • Expected Policyholder Deficit (EPD) or Economic Cost of Ruin (ECOR) • Tail Value at Risk (Tail VaR) or Tail Conditional Expectation (TCE) • Tail Events

14. Risk MeasuresPerformance Related • Variance • Standard Deviation • Semi-variance and Downside Standard Deviation • Below-target-risk (BTW)

15. Risk Modeling • Analytic Methods • Simulation Methods • Statistical Methods • Structural Methods • Dynamic Financial Analysis (DFA)

16. Risk Integration • Covariance • Covariance Matrix • Structural Simulation Model

17. Characteristics of Hazard Risk • Loss/no loss situations (pure risk) • Independence of individual exposures • Important for risk to be insurable • Types of hazard risk • Persons • Property • Liability

18. Insurance Terminology • Exposures • Deductibles or retentions • Policy limits • Coinsurance • Claims or losses • Incurred • Paid • Loss adjustment expenses • Loss frequency and severity • Triggers

19. Alternative Risk Transfer (ART) Terminology • Captives • Finite insurance or reinsurance • Insurance-linked bonds • Insurance securitization • Cat-E-Puts (Catastrophe equity put options) • Contingent surplus notes

20. Loss Frequency • Number of losses during policy period • Often modeled as a Poisson distribution Pr(k) = e-λλk/k! where Pr = probability k = number of claims per year (0,1,2,...) λ = expected number of claims per year

21. Loss Severity • Size of loss given a loss has occurred • Variety of potential severity distributions • Empirical • Exponential (Gamma) • Lognormal • Pareto • Distribution characteristics • Non-negative • Positively skewed • Variance positively correlated with mean

22. Hazard Risk Example • Assume independent losses • Loss frequency • 0 80% • 1 15% • 2 5% • Loss severity • $1,000 40% • $10,000 30% • $25,000 20% • $100,000 10%

23. Hazard Risk Example (2)

24. Analysis of Potential Losses • Expected losses = 4,600 • Maximum possible loss = 200,000 • Maximum probable loss (0.25%) = 125,000 • Expected losses excess of a $100,000 retention = 1,084

25. Current State of Hazard Risk Management • Insurance industry has developed a high level of mathematical sophistication for valuing hazard risks • Alternative market has also developed for dealing with hazard risks • Key questions for organizations involve amount of risk to retain (deductible) and how much coverage to purchase (policy limits) • These questions begin to tie hazard risk into enterprise risk management

26. Conclusion • There is a standard approach for dealing with each type of risk • Each area has its own terminology and techniques • The ERM challenge is to combine these different approaches into a common method that can deal with risk in an integrated manner • The first step is to understand the different approaches