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Finance 590 Enterprise Risk Management. Steve D’Arcy Department of Finance Lecture 2 Risk Analytics March 28, 2006. Reference Material. Chapters 8 and 9 – Enterprise Risk Management by Lam Overview of Enterprise Risk Management by the Casualty Actuarial Society

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Finance 590 enterprise risk management

Finance 590Enterprise Risk Management

Steve D’ArcyDepartment of Finance

Lecture 2

Risk Analytics

March 28, 2006


Reference material
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


Overview
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


Risk control analytics
Risk Control Analytics

  • Scenario Analysis

    • Stress testing

    • Simulation

  • Economic Capital

    • Solvency standards

  • Risk Indicators

    • External

    • Internal


Risk optimization analytics
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)


Risk types
Risk Types

  • Hazard or Insurance Risk

  • Financial or Market Risk

  • Credit Risk

  • Operational Risk

  • Strategic Risk


Hazard risk management analytics
Hazard Risk Management Analytics

  • Probable Maximum Loss (PML)

  • Maximum Possible Loss (MPL)

  • Loss Frequency

  • Loss Severity

  • Actuarial Models

    • Loss Distributions


Financial risk management analytics
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)


Credit risk analytics
Credit Risk Analytics

  • Credit Scoring Models

  • Credit Migration Models

  • Credit Exposure Models

  • Credit Portfolio Models

    • Financial models

    • Econometric models

    • Actuarial models


Operational and strategic risk analytics
Operational and Strategic Risk Analytics

  • Top-Down Approaches

    • Analogs

    • Historical loss data

  • Bottom-Up Approaches

    • Self assessment

    • Cash flow model


Performance measures general
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)


Performance measures insurance industry
Performance MeasuresInsurance Industry

  • Economic Capital

  • RAROC

    • Expected net income divided by economic capital

  • Embedded value

  • Risk Based Capital (RBC)


Risk measures solvency related
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


Risk measures performance related
Risk MeasuresPerformance Related

  • Variance

  • Standard Deviation

  • Semi-variance and Downside Standard Deviation

  • Below-target-risk (BTW)


Risk modeling
Risk Modeling

  • Analytic Methods

  • Simulation Methods

  • Statistical Methods

  • Structural Methods

  • Dynamic Financial Analysis (DFA)


Risk integration
Risk Integration

  • Covariance

  • Covariance Matrix

  • Structural Simulation Model


Characteristics of hazard risk
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


Insurance terminology
Insurance Terminology

  • Exposures

  • Deductibles or retentions

  • Policy limits

  • Coinsurance

  • Claims or losses

    • Incurred

    • Paid

    • Loss adjustment expenses

  • Loss frequency and severity

  • Triggers


Alternative risk transfer art terminology
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


Loss frequency
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


Loss severity
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


Hazard risk example
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%



Analysis of potential losses
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


Current state of hazard risk management
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


Conclusion
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


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