Transcript CAS Seminar on Ratemaking Las Vegas, Ne March 11

FIN-13:The Evolving Role of
Enterprise Risk Management
Considerations in Ratemaking
2002 CAS Ratemaking Seminar
March 7-8, 2002
Moderator
Robert F. Wolf, FCAS, MAAA
Principal, William M. Mercer, Incorporated/MMC
Enterprise Risk Consulting
Panelists:
Scott M. Sanderson, Senior Vice President
Marsh, Inc./Marsh Advanced Risk Solutions
Benedetto Conti, Chief Actuary
Winterthur Insurance Group
Agenda



Introduction
What is ERM?
ERM Platforms
– Insurance Customers
– Insurance Companies


Wrap-up
Q&A
Copies of Presentations Downloadable at www.casact.org
What is ERM?


To me, Enterprise Risk Management is a process for identifying
and prioritizing critical risks facing an organization, quantifying
their impact on financial and strategic objectives, and
implementing financial and organizational solutions to address
them.
To others, it varies but the essence is the same
– “ERM assesses and manages all risks while looking for upsides in
identifying risks.”
– “Enterprise Risk Management is about information and capital
management.”
– “The ultimate goal of Enterprise Risk Management is preservation
of shareholder value.”
– “The job of Enterprise Risk Management is figuring out where the
edge of the cliff is, and making sure the risk takers know where it
is.”
No Consensus on Best Risk
Measure
1,500,000
1,400,000
Nominal
PV
Reserve
1,300,000
Reserve Amount
Reserve+Capital
C
1,200,000
EPD Principal
B
1,100,000
B= VaR (Pr Ruin)
Principle
A
1,000,000
D
A =Variance Principal=
900,000
TVaR Principal=
Squared Dev from Mean
C+D
800,000
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
Percentile
60.0%
70.0%
80.0%
90.0%
100.0%
Why the Evolution of ERM




New/Larger Risk
– E-Commerce, Market/Book Values
New Risk Products
– Merger of Insurance and Financial
Institutions
Realization that Silo-Based Approaches are
Flawed
– Ignores inherent hedges and correlation
Increased Management Accountability
– New Regulations requiring corporate
governance
Why the Evolution of ERM
In short, because Society Demands it
 Computer and Information Age

– We couldn’t do what we are doing today if
we needed to use slide-rules or abacus.

Focus
Optimize Shareholder Value
First-Step: Two Inquiries?


How much capacity does a corporation have to bear risk?
– = F(size and financial Structure, Attitude Towards Where the
Edge of the Cliff Lies)
Within the above capacity, how desirable is it to retain/bear
additional risk?
– Businesses are not in business to merely survive, but to
thrive.
Two Questions

Does the benefit of reduced costs given additional risk
enhance or destroy a corporation’s shareholder value?

“How will the additional risk influence the total risk of
retained portfolio of risks with regard to the marginal
rewards in retaining the additional risk?”
Risk Retention: A Pseudo-Investment
Decision
Goal of this Project is to Go Northwest
The Efficient Frontier of
Optimal Retentions
Figure - The Efficient Frontier and Preference Indifference (Utility)
25%
NW
20%
15%
Cu
rv
e
As retentions are increased, both
risk and return should increase.
Programs that offer only higher
costs with higher risks are
identified as sub-optimal.
til
it
y
10%
U
Return = Mean Value of Return Distribution
A guaranteed cost policy transfers
all losses to the insurer and
carries no retention: depicted
here in the space of risk and
return, this insurance option
resides at the origin where risk
and return are both zero.
5%
0%
0%
1%
2%
3%
4%
5%
6%
7%
Risk = Standard Deviation of Return Distribution
Return = Cost Savings
8%
9%
10%
…Subject to Market Constraints
…however, the market is going southeast
- The Efficient Frontier and Preference Indifference (Utility)
25%
20%
Cu
rv
e
15%
til
it
y
10%
U
Return = Mean Value of Return Distribution
Getting the
Best Deal
in this area.
5%
0%
0%
1%
2%
3%
4%
5%
6%
7%
Risk = Standard Deviation of Return Distribution
8%
9%
10%
Goal Accomplished
This point signifies the best of all alternatives.
The Efficient Frontier and Preference Indifference (Utility)
25%
Cu
rv
e
y
til
it
U
Return = Mean Value of Return Distribution
20%
15%
Optimum
Portfolio
10%
5%
0%
0%
1%
2%
3%
4%
5%
6%
7%
Risk = Standard Deviation of Return Distribution
8%
9%
10%
How Does Risk Manifest
Itself?
Fortune 1000 Group Analysis
10% of the Fortune 1000 companies suffered a loss of over 25% of shareholder value within one month
% of top 100
25
24
Primary Cause of Stock Drop (# of Companies)
20
15
12
11
10
7
7
6
7
6
4
5
2
3
1
1
2
1
1
0
0
0
Competitive
Pressure
Customer
Demand
Shortfall
MisLoss of
R&D
ManageForeign
Cost
aligned
Key
Delays
ment
MacroOverruns
Products
Customer
ineffectiveEconomic
Customer
Regulatory
Supplier
M&A
Accounting nessSupply Chain
Issues
Pricing
Problems
Problems
Integration
irregularities
Issues
Pressure
Problems
Strategic
Operational
High Interest
Input
Rate
Comm- Fluctodity uation
Price
Financial
Source: Compustat, Mercer Management Consulting analysis - Period Examined was June 1993 to May 1998
Note: There were also 5 stock drops for which the primary cause could not reliably be determined. These 5 stock drops are not depicted.
Law- Natural
suits Disasters
Hazard
Two Ways to Interpret Graph
Hazard and Financial Risk is Not
Important
 Hazard and Financial Risk has been and
continues to be managed well

– Testimonial for risk managers, actuaries,
brokers, and financial analysts.
– We need to continue the process

…The opportunity now is to work on the
left side of the graph.
…….Significant Challenges and Opportunities for Actuaries.
“….We don’t do things because they are easy.
We do them because they are hard.”
….John F. Kennedy
Thank You
Q&A