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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
ad