Enterprise Risk Management Papers Presentation at CAS 2001 Seminar on Understanding the Enterprise Risk Management Process Jerry Miccolis, FCAS, MAAA, Tillinghast - Towers PerrinSamir Shah, FSA, MAAA, Tillinghast - Towers Perrin April 2-3, 2001
We will be addressing two ERM papers today • “Enterprise Risk Management: An Analytic Approach” by Jerry Miccolis and Samir Shah, Tillinghast - Towers Perrin Monograph, January 2000 • “Creating Value through Enterprise Risk Management — A Practical Approach for the Insurance Industry” by Jerry Miccolis and Samir Shah, Tillinghast - Towers Perrin Monograph, April 2001 • We will focus primarily on the second paper • It represents our most current thinking • It illustrates how to practically apply the concepts of the first paper (within a specific industry) • Applications to other industries should be clear
Value Growth Return Consistency Capital Creating Value through Enterprise Risk Management A Practical Approach for the Insurance Industry Jerry Miccolis, FCAS, MAAASamir Shah, FSA, MAAA This document is incomplete without the accompanying discussion; it is confidential and intended solely for the information and benefit of the immediate recipient thereof.
Here are some key findings from our recent ERM survey of insurance executives • Executives believe ERM is critical to helping them deal with their key business issues • They are not satisfied with current tools, techniques and processes to implement ERM — especially for dealing with operational risks • They want a more robust conceptual and methodological framework that: • Encompasses all relevant risks — both financial and operational • Integrates both financial and operational strategies to manage those risks
In our client work, insurers are increasingly asking important risk-related questions • How much capital do we need? And how do we convince the rating agencies? • How should our capital be deployed to business segments? • How can we maximize our return on capital, given our risk appetite? • How do we best invest our assets, given our liability mix? • Can we get a handle on our operational risks? • How can we optimize our distribution channel strategy? • How much, and on what terms, should we reinsure/hedge? • How do we encourage the right risk management behavior? • Are we prepared against our most critical down-side risks? • How can we minimize economic and accounting volatility? We believe these questions need to be answered within the context of a comprehensive and coherent risk management framework...
The RiskValueInsights Framework NYO 5 Property of Tillinghast - Towers Perrin
Investments Organization Product andDistribution CapitalStructure • Asset/liabilitymanagement • Liquidity • Market risk tolerance • Tax profile • Hiring/training • HR policies • Pay and benefits • Communication • Product mix • Distribution strategy • Pricing • Customerservice • Equity vs. debt • Managingexcess capital • Reinsurance • Securitization Companiesare managing a number of separate, but related, activities...
More on… using Embedded Value as the value measure More on…the link between consistency and enterprise value …with the overall objective of increasing enterprise value Increase value by Enhancing growth Increasing return Improving consistency Providing appropriate level, structure and allocation of capital
External Environment Internal Environment Risk Financial Economic conditions Expansion/diversification Asset Social/legal trends Culture Liability Political/regulatory climate Distribution Natural catastrophes Risk appetite Reputation/rating agency Business People Customer behavior Event Processes Competition Operational Investor expectations Technology The best way to effectively drive value is to understand the full risk environment in which you operate...
Financial Strategies Operational Strategies Risk Financial Capital structure M&A Asset Technology Investment strategy Internal controls Liability Pricing Incentive programs Hiring/training Product mix Business Customer service Event Dynamic hedging Market strategy Operational Reinsurance Distribution …and the complete set of strategies available to you…
Understand both internal and external environments Investigate both financial and operational strategies …and to use this knowledge in a holistic risk management framework Increase value Enhance growth Increase return Improve consistency Establish capital Holistically manage financial and operational risks Exploit natural hedges and portfolio effects
The RiskValueInsights Process NYO 11 Property of Tillinghast - Towers Perrin
Establish business performance requirements Assess organization capabilities Build the change strategy Set the agenda Align & deliver Evaluate Strategies: Policyholders’ Perspective Evaluate Strategies: Owners’ Perspective Assess Risks Articulate Strategies Leadership Communication Change Enablers Refine Strategies Involvement Measurement Develop Best Strategies Implement Strategies MonitorPerformance and Environment A continual management process is needed to “operationalize” the framework
Evaluate Strategies: Policyholders’ Perspective Evaluate Strategies: Owners’ Perspective Assess Risks Articulate Strategies Refine Strategies Identify financial & operational risk factors Identify & overlay financial & operational strategies Establish economic capital requirement Establish risk & value metrics for growth, return & consistency Link to key performance indicator(s) via financial model Classify & prioritize risk factors Attribute capital to business segment Set objectives & constraints Optimize strategies & sensitivity-test KPI distribution Risk factor distributions Isolate impact of each strategy Decompose risk into root causes Developing best strategies involves a five-step exercise Develop Click on appropriate chevron above to see details of that step
Implement Set the Agenda Establish Business Performance Requirements Assess Organization Capabilities Build the Change Strategy Align & Deliver Deliver Design Articulate the Ambition Focus and Sequence Effort Mobilize First Wave and Secure Early Wins Energize and Engage for Broader Impact Develop Change Capability Leadership Communication Change Enablers Involvement Measurement Successfully implementing certain strategies requires a change management process
Monitor Marketing Financial Human Resources • New business sold • Retention of old business • Mix of business: new and renewal • Market share • Revenue • Underwriting profit • Investment profit • Pre-tax operating income • Net income • Return on equity and total capital • Agency composition (number, age, service) • Total employment by department • Number and percentage leaving the company • Vacancy rates • Average salary increase vs. plan Underwriting Investments • Price achieved vs. target price • Exposure mix • Quotes accepted/declined • Variance analysis • Cash flow • Yield on new investments • Yield on portfolio by class and duration • Convexity of assets • Duration of assets • Investment mix: new and portfolio • Credit default • Total return Other • Audit compliance • Inflation rates • Interest rates • GNP • Exposure data (number of cars, payroll, etc.) • Competitor pricing Claims • Frequency and severity of claims • Claims productivity Strategy performance and risk environment must be monitored to adjust strategies as necessary Click here…to see these measures combined as a dashboard for performance management
Insurance and banking approaches to ERM are -- and should be -- different • Asset risk and liability risk • Liability characteristics: • Certainty • Liquidity • Duration • Demand payments • Risk metrics/models: • VaR and ECOR/EPD • Coherence • Operational risks • Business risks and event risks • Regulatory pressure • Modeling approaches
Summary NYO 17 Property of Tillinghast - Towers Perrin
Increase value Enhance growth Increase return Improve consistency Establish capital Holistically manage all risks Investigate both financial and operational strategies Understand both internal and external environments Expansion/ diversification Capital structure Economic conditions M&A Financial Risk Technology Social/legal trends Culture Investment strategy Political/regulatory climate Internal controls Distribution Incentive programs Pricing Natural catastrophes Risk appetite Reputation/ rating agency Hiring/training Product mix People Customer behavior Customer service Dynamic hedging Processes Competition Market strategy Operational Risk Investorexpectations Reinsurance Technology Distribution The framework is holistic... Exploit natural hedges and portfolio effects
Establish business performance requirements Assess organization capabilities Build the change strategy Set the agenda Align & deliver Evaluate Strategies: Policyholders’ Perspective Evaluate Strategies: Owners’ Perspective Assess Risks Articulate Strategies Leadership Communication Change Enablers Refine Strategies Involvement Measurement Develop Best Strategies Implement Strategies MonitorPerformance and Environment ...The process is complete...
…And the approach can provide great value • Enables you to determine your appropriate capital level, redeploy unneeded capital and improve return on capital • Permits the proper attribution of capital to business segments and supports performance tracking of each segment • Helps you evaluate alternative capital structures that leverage returns • Provides a method for ensuring that enterprise owners receive proper compensation for risks assumed • Allows you to stabilize earnings and thereby increase enterprise value • Supports the development of an optimal risk financing strategy and program • Provides better information about your company, which increases negotiating leverage with: • Reinsurers • Rating agencies • Capital markets • Industry analysts • M&A targets