CIA Annual Meeting LOOKING BACK…focused on the future.
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Transcript of CIA Annual Meeting LOOKING BACK…focused on the future.
CIA Annual MeetingCIA Annual Meeting
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Stephen P. D’Arcy President of the Casualty Actuarial
SocietyProfessor of Finance, University of Illinois
The Brave New World of Enterprise Risk Management
Stephen P. D’Arcy President of the Casualty Actuarial
SocietyProfessor of Finance, University of Illinois
The Brave New World of Enterprise Risk Management
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
What is ERM?ERM is the application of the basic risk management principles to all risks facing an organization
Other names for ERM
Enterprise-wide risk management
Holistic risk management
Integrated risk management
Strategic risk management
Global risk management
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Basic Risk Management Principles1. Identifying loss exposures
2. Measuring loss exposures
3. Evaluating the different methods for handling risk• Risk assumption• Risk transfer• Risk reduction
4. Selecting a method
5. Monitoring results
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Where Did Enterprise Risk Management Come From?
Traditional risk management
Formally developed as a field in the 1960s
Focused on “pure” risks
Loss/no loss situation
Often could be insured
Developed from insurance purchasing area
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
New Elements of Risk – 1970sForeign exchange risk
End of Bretton Woods agreement in 1972
Commodity price risk
Oil price fluctuations of the 1970s
Equity risk
Development of option markets - 1973
Interest rate risk
U. S. Federal Reserve Board policy shift - 1979
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Failure to Manage Financial Risk Foreign exchange risk
Laker Airlines – 1970sBorrowing in dollarsRevenue in pounds
Interest rate riskU. S. Savings and Loans – 1980s
Borrowing shortLending long
Commodity price riskContinental Airlines – 1990
Fuel costs not hedgedOil price doubled with Gulf War
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
The “New” Risk Management -1980s
Financial risk management Dealt with financial risk
Foreign exchange riskInterest rate riskEquity riskCommodity price risk
Use derivatives to hedge financial risk
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Financial Risk Management Toolbox
Forwards
Futures
Options
Swaps
Interest Rate Models
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
New Elements of Risk – 1990s
Failure to manage derivatives appropriately
Financial model failures
Improper accounting for derivatives
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Mismanagement of Financial RiskMismanagement of derivatives
Gibson GreetingsProctor and GambleBarings BankOrange County
Model failureLong Term Capital
Accounting improprietiesEnronArthur Andersen
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
The “New” Risk Management - 1990s and beyond
Enterprise Risk Management
Initial focus on avoiding derivative disasters
Developing into optimizing firm value
Chief Risk Officer
Sarbanes-Oxley Act – 2002
Increased focus on risk models
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Evolution of ERMControl function
How much can we lose?
Risk adjusted returns
Capital allocation Compensation
Bonuses
OptimizationMaximize stakeholder value
Vision of the future
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
ERM Risk CategoriesCommon risk allocation• Hazard risk• Financial risk• Operational risk• Strategic risk
Bank view – New Basel Accord• Credit risk
• Loan and counterparty risk• Market risk (financial risk)• Operational risk
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Hazard Risk“Pure” loss situations
Property
Liability
Employee related
Independence of separate risks
Risks can generally be handled byInsurance, including self insurance
Avoidance
Transfer
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Financial RiskComponents
Foreign exchange rate
Equity
Interest rate
Commodity price
Correlations among different risks
Use of hedges, not insurance or risk transfer
Securitization
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Operational RiskCauses of operational risk• Internal processes• People• SystemsExamples• Product recall• Customer satisfaction• Information technology• Labor dispute• Management fraud
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Strategic RiskExamples• Competition• Regulation• Technological innovation• Political impediments
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Increased Use of Risk Models• Technological advances• Theoretical advances• Allocation of economic capital
• Used for divisional profitability• Impacts bonuses• Dueling models
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Traditional Risk Management Silos
Financial risk – Treasury
Insurance risk – Risk Management
Operational risk – Business units
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
New Corporate StructureCFO – capital management
CRO – risk managementDefine risk
Gather information
Use information No consistent risk framework in place yet
Need for risk balance sheet/income statement approach
Control risk
Increase firm value
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Essential Skills of a Risk Manager
Understand benefits and limitations of models
Comprehension of data gathering processIdentifying essential data
Gathering information into central location
Interpreting reports
Understanding of how risk measures relate to strategic and tactical business decisions
Communication skills
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Examples of ERM - 1Michelin – contingent capital• Issued by Swiss Re New Markets and Societe
Generale• Option to draw on subordinated long-term bank
credit facility• Option to issue subordinated debt at fixed spread
• This option can only be exercised if GDP growth falls below a trigger (1.5% 2001-03, 2.0% 2004-05)
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Examples of ERM - 2United Grain Growers – risk integration• Issued by Swiss Re• Regional grain volume coverage• Integrated with other property/liability coverages• Three year policy• Annual aggregate retention• $35 million annual limit• $80 million policy limit
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Examples of ERM - 3RLI Corporation – Cat-E-Puts• Arranged by Aon, issued by Centre Re• Three year term• Provided an option to issue $50 million in
convertible preferred shares• Trigger was major California earthquake• Subject to minimum capital requirements
CIA Annual MeetingCIA Annual MeetingSession 6707: Brave New WorldSession 6707: Brave New World
LOOKING BACK…focused on the futureLOOKING BACK…focused on the future
Future of ERMERM will continue as risk consolidation and
aggregationProcess increases value of risk management skillsManagement is concerned with risk control issuesChief Risk Officer will be a visible figure in an
organization Many paths to CRO, diverse skills requiredERM’s role in optimization has a long way to goPotential benefit is worth pursuing for pioneers