Enterprise Risk Management: Enterprise Risk Management Shaun Wang, Ph.D., FCAS, ASA Director of Actuarial Science Program Georgia State University shaunwang@gsu.edu 2004 C.A.S.E. Forum


Outline: Outline Concept of Risk Inherent Risks for P&C insurers ERM Approaches ERM Education at GSU


ERM as a New Discipline: ERM as a New Discipline High expectations & excitements!! ERM takes integrated approaches to major risks of an enterprise ERM represents new ways of understanding & managing risks ERM is a new and evolving discipline


Concept of Risk: Concept of Risk Risk = Random “Volatility” Risk = Not knowing reality (lack of info, driving in dark) Risk = Wrong Existing Structure Poor coordination & communication Organizational cancer; needs structural reform! Risk = Opportunity for the Prepared & Discerning


(I) Risk & Diversification : (I) Risk & Diversification “Offset” produces the highest benefits: long and short positions of the same asset “Random drivers” offer good benefits natural catastrophe events in various regions “Expertise Intensive”: pooling across sectors may yield little or even negative risk diversification Different market dynamics; different sets of expertise “Drag effort”: legal or reputation spillover


Right and Wrong Diversifications: Right and Wrong Diversifications Years of under-pricing were partially caused by the “low correlation” argument by some multi-line players Diversification needs to match with areas of expertise Renaissance Re, a mono-line CAT-writer, achieves diversification by geographic region and by peril “ART” benefited buyers, but not sellers


(II) Risk & Information: (II) Risk & Information Quality and timeliness of information are critical for decision-making Relative to their banking counterparts, many insurers have poor grades on this ERM modeling needs forward-looking data Need aggregate risk info, as well as every way we want to look at the business


(III) Risk & Incentive Misalignment: (III) Risk & Incentive Misalignment Many “risks” are created by misalignment of incentives Underwriters short-term goal v.s. long-tailed liabilities Managers’ expansion of his/her own kingdom CEO’s compensation linked to growth and acquisition Trial Attorneys and the U.S. legal dynamics Lawyer Contingent Fees & Punitive Damages


(IV) Risk & Valuation/Market Dynamics: (IV) Risk & Valuation/Market Dynamics Risk often manifested in changes in value Market participants can drive value changes Real estate bubble Momentum investing Portfolio insurance strategies UK FSA experience Current versus Long-term Valuation Pension funding deficit


Outline: Outline Concept of Risk Inherent Risks for P&C insurers ERM Approaches ERM Education at GSU


US Insured CAT Losses (in $billion) and Rate On Line Index (1989=100): US Insured CAT Losses (in $billion) and Rate On Line Index (1989=100) Source: Guy Carpenter & *III Estimate ROL showed big jump after major CAT losses, and then came down gradually …


Inherent Risks for P&C Insurers : Inherent Risks for P&C Insurers The infamous underwriting/reserving cycle Independent from equity market risks Not knowing final result for years Lack of feedback on estimated reserves Hedging using reinsurance (within sector): high information asymmetry & transaction costs


S&P Report 19-Nov-2003Insurance Actuaries – A Crisis of Credibility: S&P Report 19-Nov-2003 Insurance Actuaries – A Crisis of Credibility S&P report: “Actuaries are signing off on reserves that turn out to be wildly inaccurate” … It sent a shockwave around the globe in the actuarial and insurance community!! American Academy of Actuaries countered 2 days after S&P release: “It is an obvious attempt to explain away the errors that some analysts have made in estimating property/casualty insurers’ earnings.” Both agree It is high-time for “Reserving Reformation”


P/C Insurance Industry Prior Year Reserve Development*: P/C Insurance Industry Prior Year Reserve Development* *Year 2003 number is an estimate by S&P. Source: A.M. Best, Morgan Stanley, Dowling & Partners Securities $23 billion reserve increase = Hurricane Andrew Reserve Cycle & Pricing Cycle are correlated


Reason for P/C Insolvencies (218 Insolvencies, 1993-2002): Reason for P/C Insolvencies (218 Insolvencies, 1993-2002) Source: A.M. Best, Insurance Information Institute Reserve deficiencies account for more than half of all p/c insurers insolvencies


Cyclical Nature of Reserve Estimates: Cyclical Nature of Reserve Estimates The adequacy of reserve estimates showed a clear cycle over the years Reserve cycle coupled with the pricing UW cycle Pressure on short-term performance Following the competitors Smoothing taxes for some players A slow-death sentence for many companies


Outline: Outline Concept of Risk Inherent Risks for P&C insurers ERM Approaches ERM Education at GSU


ERM Focuses on “Business Processes”: ERM Focuses on “Business Processes” Loss Modeling Is Only Part of the Story A company had the state-of-the-art actuarial pricing model, but in the end still lost so much money Need to quantify the Business Process Risk Top-line growth in a soft market poses a major risk Over-crowded competitive market poses a major risk Need to enter the deep water by understanding the risk drivers and market dynamics


ERM Model of Market Competition: ERM Model of Market Competition Result = Min{Quote1, …, Quotek}  Loss, where Quotek  Normal(k, k) For long-tailed lines, delayed info  higher k  higher chance of premium deficiency more bidders k  higher chance of premium deficiency The Winner’s Curse: In insurance competitive pricing, the lowest price gets the business, but may be cursed with financial losses


ERM Solution on Reserving: Contingent Payoffs: ERM Solution on Reserving: Contingent Payoffs Payoff contingent on magnitude of reserve development for a fixed block of business As deferred compensation (or tradable index) Force decision-makers (managers, actuaries) to put their money where their mouth is Provide feedback channel for a block of business


Slide21: Tame U/W Cycle by financial engineering: Contingent payoff on reserve estimates


Outline: Outline Concept of Risk Inherent Risks for P&C insurers ERM Approaches ERM Education at GSU


ERM Education at GSU: ERM Education at GSU Actuarial Education Scale back traditional components Go deeper and go wider Mathematical Risk Management Financial risk modeling and … Enterprise Risk Management


An actuarial/engineer approach: An actuarial/engineer approach Look risk as a “dynamics” Model each agent? External dynamics Financial risk modeling and … Internal dynamics


Q & A: Q & A


DFA versus ERM: DFA versus ERM DFA has not yet fulfilled its promises Did not focus on dominant risks Fancy stochastic model without benchmark parameters Weak organizational backing & poor communication How does ERM differ from DFA? ERM offers these missing elements for success


Did “U.S. Risk Based Capital” Help?: Did “U.S. Risk Based Capital” Help? U.S. Benchmark RBC has only limited success: Factor based reserve charges ignored the bigger issue of reserve adequacy Incentives for putting up inadequate reserves Same capital charge factor for premium written in a hard market versus in a soft market A point-in-time measure, without reference to future direction and sensitivity over time


Opportunities for Creating Industry Benchmarks: Opportunities for Creating Industry Benchmarks Industry benchmarks on risk parameters and capital charges are badly needed Benchmarks should reflect the inherent risks of the business, regardless of risk portfolio Parameters are more important than the model It will take much fundamental analysis, expert opinion, and timely updates


Extras: Extras


Quality of Information: Quality of Information Information asymmetry -- major hurdle for securitization (and reinsurers) Value of Information? Think about the US search for Al Qaeda Do we have a measure for “quality of information”?


Ideology v.s. Reality Check: Ideology v.s. Reality Check Major Culture Differences in merger and acquisition, and in international operations A Noble Cause or Being Good Hearted does not guarantee good outcomes


What Creates Value?: What Creates Value? Stability and liquidity Value creation Preparing a delicious meal Well-run organization creates franchise value 70% of US GDP are from services? Hassle-free  Quality of life My moving experience with Mayflower


What Destroys Value?: What Destroys Value? Sept 11 terror attach changed everything Connectivity: a small part of a huge machine Negligence in medical malpractice Can we make a patient whole through large sum of compensation? What effects on the society as a whole


Reaction Time: Reaction Time “Reaction Time” is an important aspect of risk XOL reinsurance has a higher severity volatility than proportional reinsurance. However, the reaction time for rate increase is quicker for XOL Rate increase delays in some jurisdictions For long-tailed liabilities or long-term guarantees: the ability to react is much limited. You have a stack of policies written in the past Too late to re-act