1 / 28

ERM -- A New Discipline

ERM -- A New Discipline. Shaun Wang , Ph.D., FCAS, ASA SCOR Reinsurance Georgia State University 2004 Bowles Symposium Leader. Intro. A study shows that watching too much TV is killing the brain Switching from one scene to the next too fast, cannot focus on one thing to develop a sense

creola
Download Presentation

ERM -- A New Discipline

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. ERM -- A New Discipline Shaun Wang, Ph.D., FCAS, ASA SCOR Reinsurance Georgia State University 2004 Bowles Symposium Leader Copyright by Shaun Wang 2004-04

  2. Intro • A study shows that watching too much TV is killing the brain • Switching from one scene to the next too fast, cannot focus on one thing to develop a sense • Some conferences are like shows: flip charts too quickly, not having time to think about things deeply Copyright by Shaun Wang 2004-04

  3. Theoretical foundation for ERM • Financial economics (esp. Black-Scholes-Merton) underpin the development of derivative markets • Utility Theory and Portfolio Theory are foundations for traditional risk management • What is underlying ERM -- a newly emerging discipline? Copyright by Shaun Wang 2004-04

  4. ERM Calls For Theoretical Innovation • Conventional theories start out with axioms and assumptions, use logic to derive results • In reality, this continuous 1-dimensional thinking is broken • multiple perspectives of the same “reality” • Ever-changing situation/sentiment • We need to take fresh look at “risk” and “portfolio theory” Copyright by Shaun Wang 2004-04

  5. Outline • Revisit “Risk” and “Portfolio Theory” • Inherent Risks & Reserve Cycles • Risk & Economic Capital • Theoretical Foundation of ERM • Implications in Education & Research Copyright by Shaun Wang 2004-04

  6. 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 thePrepared & Discerning Copyright by Shaun Wang 2004-04

  7. Risk & Information • People make decisions based on incomplete information • Quality and timeliness of information that are critical for decision-making • ERM modeling needs forward-looking data • Need not only aggregate risk info, but every way we want to look at the business Copyright by Shaun Wang 2004-04

  8. New Portfolio Theory: Di-versify or Di-worsify? • “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 Copyright by Shaun Wang 2004-04

  9. Modeling Risk Correlation • Correlation modeling should focus more on causal links and extreme circumstances • e.g. WTO losses; Enron  Kmart chain • e.g., Hyper-inflation brings what? • Lack of information (ambiguity) impacts correlation modeling Copyright by Shaun Wang 2004-04

  10. Outline • Revisit “Risk” and “Portfolio Theory” • Inherent Risks & Reserve Cycles • Risk & Economic Capital • Theoretical Foundation of ERM • Implications in Education & Research Copyright by Shaun Wang 2004-04

  11. Inherent Risks for Life Insurers • Asset Risk (credit risk, interest rate risk) • Liabilities (mispricing of embedded options and guarantees) • Asset Liability Mismatch (improper hedging strategy) • Interest rate risks, credit risks, and equity risks can be (partially) hedged through capital markets Copyright by Shaun Wang 2004-04

  12. P&C Insurers have different systematic (inherent) risks • 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 Copyright by Shaun Wang 2004-04

  13. S&P Report 19-Nov-2003Insurance 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” Copyright by Shaun Wang 2004-04

  14. P/C Insurance Industry Prior Year Reserve Development* $23 billion reserve increase = Hurricane Andrew Reserve Cycle & Pricing Cycle are correlated *Year 2003 number is an estimate by S&P. Source: A.M. Best, Morgan Stanley, Dowling & Partners Securities Copyright by Shaun Wang 2004-04

  15. Financial Engineering Solution: 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 Copyright by Shaun Wang 2004-04

  16. Tame U/W Cycle by financial engineering: Contingent payoff on reserve estimates Copyright by Shaun Wang 2004-04

  17. Outline • Revisit “Risk” and “Portfolio Theory” • Inherent Risks & Reserve Cycles • Risk & Economic Capital • Theoretical Foundation of ERM • Implications in Education & Research Copyright by Shaun Wang 2004-04

  18. Economic Capital & Risk-based Capital • From a regulatory perspective: there are debates on whether capital charges should be additive (goes back to portfolio theory) • There is opportunity cost for capital commitment • Need to calculate economic capital for measuring performance of individual business activities Copyright by Shaun Wang 2004-04

  19. Cross-Sector Comparison • Different capital charges in banking & insurance • fueling cross-sector risk transfers • Some banks took advantage of ignorant insurers • Transfer credit derivative business • Insurance for mortgage loan guarantees • Would “operational risk transfer” be the next? • Need more harmonization in Risk-Based-Capital Copyright by Shaun Wang 2004-04

  20. Outline • Revisit “Risk” and “Portfolio Theory” • Inherent Risks & Reserve Cycles • Risk & Economic Capital • Theoretical Foundation of ERM • Implications in Education & Research Copyright by Shaun Wang 2004-04

  21. “Manifold” ERM Representation • Top-down big-picture views are essential for managing the enterprise • Business units may have different local views • It is imperative not to use top-down perspective to suppress local perspectives • Otherwise decisions may lose common sense. Copyright by Shaun Wang 2004-04

  22. Manifolds -- Time Dimension • Sentiments and environments can change rapidly • Do not rule out other possibilities • Most decisions are driven by the current sentiment • Company strategy altered during times of stress Copyright by Shaun Wang 2004-04

  23. ERM -- A New Kind of Management Science • Actuarial studies of incentives • Managing general agents business • Analyze business processes in quantifying operational risks and business risks • Number of competitors and the winners’ curse • A central claims data management system Copyright by Shaun Wang 2004-04

  24. Military Battle Analogy • We need to choose our own battle and battle field • Intelligence: knowing the competition • Timing is critical: decide when to apply brake or acceleration • Ability to mobilize soldiers: RM should involve everyone, at every front • Extensive planning while being flexible for new circumstances Copyright by Shaun Wang 2004-04

  25. It is a business decision after all • Taking Mortgage: Variable versus Fixed Interest Rate • Duration mismatch for Property-Casualty companies • Offering competitive product and hedging at the same time • Timing and hedging cost Copyright by Shaun Wang 2004-04

  26. Outline • Revisit “Risk” and “Portfolio Theory” • Inherent Risks & Reserve Cycles • Risk & Economic Capital • Theoretical Foundation of ERM • Implications in Education & Research Copyright by Shaun Wang 2004-04

  27. Call for Innovations in Education/Research • Publication is name of game in academia • Universities teach theories (axioms, assumptions, theorems) • Information explosion makes it harder to keep abreast of new publications • Essential to convey business sense and experience in a simulated market environment Copyright by Shaun Wang 2004-04

  28. Need More Research on ERM • Multidisciplinary collaboration: • Finance, accounting, auditing, legal • Studies of institutional behavior & corporate culture • The optimal ERM framework: • How to use business senses to guide risk analytics • How to build analytical tools to frame senses Copyright by Shaun Wang 2004-04

More Related