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Finance 590 Enterprise Risk ManagementPowerPoint Presentation

Finance 590 Enterprise Risk Management

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### Finance 590Enterprise Risk Management

Steve D’ArcyDepartment 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
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

- 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

- Scenario Analysis
- Stress testing
- Simulation

- Economic Capital
- Solvency standards

- Risk Indicators
- External
- Internal

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

- Hazard or Insurance Risk
- Financial or Market Risk
- Credit Risk
- Operational Risk
- Strategic Risk

Hazard Risk Management Analytics

- Probable Maximum Loss (PML)
- Maximum Possible Loss (MPL)
- Loss Frequency
- Loss Severity
- Actuarial Models
- Loss Distributions

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 Scoring Models
- Credit Migration Models
- Credit Exposure Models
- Credit Portfolio Models
- Financial models
- Econometric models
- Actuarial models

Operational and Strategic Risk Analytics

- Top-Down Approaches
- Analogs
- Historical loss data

- Bottom-Up Approaches
- Self assessment
- Cash flow model

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 MeasuresInsurance Industry

- Economic Capital
- RAROC
- Expected net income divided by economic capital

- Embedded value
- Risk Based Capital (RBC)

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 MeasuresPerformance Related

- Variance
- Standard Deviation
- Semi-variance and Downside Standard Deviation
- Below-target-risk (BTW)

Risk Modeling

- Analytic Methods
- Simulation Methods
- Statistical Methods
- Structural Methods
- Dynamic Financial Analysis (DFA)

Risk Integration

- Covariance
- Covariance Matrix
- Structural Simulation Model

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

- 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

- Captives
- Finite insurance or reinsurance
- Insurance-linked bonds
- Insurance securitization
- Cat-E-Puts (Catastrophe equity put options)
- Contingent surplus notes

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

- 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

- 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

- 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

- 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

- 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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