ERM-6 Risk Integration, Aggregation, and Correlation Robert F. Wolf, FCAS, MAAA Principal, William M. Mercer Inc./MMC En

1. ERM-6 Risk Integration, Aggregation, and CorrelationRobert F. Wolf, FCAS, MAAAPrincipal, William M. Mercer Inc./MMC Enterprise Risk Consulting Copies of Presentation Available at www.casact.org

2. Correlation • What is Correlation? • Two variables tending to move in the same direction • e.g Commercial Building Fires and Employee Injuries • When Risk is Managed in Silos, a potential domino effect can be missed • 1998 Mercer Management Consulting, Inc. Study • Reasons for Major Stock Price Declines from Fortune 1000 Companies over a 5 year period • Often Multiples Reasons • Seldom a Single Cause • Unanticipated Correlated Impacts

3. MMC Research • Mercer Management Consulting Research • Investigated risk factors behind the 100 largest one month drops in shareholder value amongst Fortune 1000 companies between 1993-98 • Found top 100 stock drops • Identified triggering event • Determined causes of triggering event • Categorized primary cause • Analyzed results and implications

4. Methodology – Stock SelectionSelectedthe largest 100 one-month percentage stock price drops among Fortune 1000 between June 1993 to May 1998. Preliminary Causal Screening (Fortune 1000 group) Stock Selection1 (Fortune 1000 group) # of companies # of companies 1000 55 78 54 813 • Identified each company's worst one-month percent share price drop between June 1993 and May 1998 • Selected 131 companies with the largest share price drops Fortune 1000 Private Mkt Value< Book Value No positive annual earnings Largest one-month share price drops Capital Restructuring Final selection of top 100 • Eliminated the share price drops caused by capital restructuring, such as spin offs, split offs, and discontinued operations • Selected companies with market value/book value>1 and with at least one year of positive earnings over the past five years to reduce the bias caused by fundamentally unsound companies. • June 93 to May 98 was selected because the overall market was performing well, and thus share price drops should reflect company-specific problems All the top 100 drops were over one-quarter of shareholder’s value, in a generally strong U.S. stock market and U.S. economy. 1. Compustat database. The monthly stock prices were adjusted for stock splits.

5. Worst-month stock drops During their worst calendar month between June 1993 and May 1998, 100 of the Fortune 1000 companies lost over 25% of their shareholder. Number of companies with worst-month stock drops greater than... (Between June 1993 and May 1998) Percentage drop in stock price during worst calendar month Number of Fortune 1000 Companies Source. Compustat database. Data is adjusted for stock splits. Note: the monthly stock prices beyond the top 100 were not adjusted for capital restructurings, etc.

6. Industry breakdowns With the exception of energy and process companies, companies in all industry groups have suffered major stock drops. Percentage of Companies Experiencing a Top 100 Share Price Drop by Industry(Number of top 100 Drops / Number of Fortune 1000 Companies) Percentage within an industry of companies with a top 100 drop Industry (Number of top 100 Drops / Number of Fortune 1000 Companies) CIE, Services, and Retail companies particularly need enterprise-wide risk management. Source: Fortune, Mercer Analysis.

7. After the Stock DropThe 100 companies studied never recovered relative to the rest of the market over a 24 month period. Growth in Stock Price relative Growth in S&P 500 (Indexed percent change in stock price) S&P 5001 Index of growth in stock price 100 Cos. Suffering drops2 Months after Initial Drop Source: Compustat, Mercer analysis Note: 1S&P 500 index is the sum of the S&P indexes corresponding to time period for each of the 100 cos. suffering stock drops. 2Data was not available for all companies for all 24 months after the stock drop (e.g., for stock drops in the last two years. Where data was not available, companies were excluded from that month for both the 100 cos. index and the S&P 500 index.

8. Revenue breakdowns Major stock drops happen to companies of all sizes in the Fortune 1000 companies, but twice more often to the Fortune 501-1000. Revenue Classifications Number of Companies in top 100 Stock Drops The second tier Fortune 1000 companies have the most to gain from enterprise-wide risk management. Source: Fortune, Mercer Analysis.

9. Triggering event the apparent triggering event for a major stock drop is usually a company announcement of disappointing current quarter earnings or expected future disappointments in earnings. Triggering Event Major stock drops usually occur in months when quarterly earnings are announced Discovery of Accounting Irregularities Unknown Company announcement about earnings shortfall External Market Forces Other company announce- ment # of Companies Month of Drop By implication, how a company releases negative earnings results to the financial community is important in influencing the volatility of stock market reactions.

10. Methodology – Causal determination To determine the causes of stock drops, we researched analyses written by market observers just after each stock drop. • Relied upon writings from the time of the stock drop to explain the causes • Investment bank analyst reports • Newspaper and magazine articles • Focused on what new or unexpected events caused investors to drop the price of the stock–usually a surprise earnings shortfall relative analyst expectations • Most earnings shortfalls resulted from multiple causes, but for classification purposes a primary cause was always selected. • In five cases, a primary cause could not be determined A Note About Causation • Because the stock market consists of millions of individual decision makers, “causes” of stock drops must be inferred but cannot be observed directly • Analyzing the cause of earnings shortfalls is equally difficult, given the complexity of business economics • Ultimately, selecting a primary cause of a stock drop is an art, not a science Since most earnings drops result from multiple causes, by implication only an integrated approach to risk assessment, quantification, and management can prevent these drops.

11. Methodology – Categorization of causesThe implied causes behind the stock drops were grouped into four different areas: hazard, financial, operational, and strategic risks. Hazard Financial • Lawsuits –Lawsuits that are not related to accounting practices • Natural Disaster – Act of God and other natural phenomena • Foreign Macro-economic – Changes in foreign interest rates and/or currency exchange rates which affects a company’s earnings • High input commodity price – Significant increase in commodity price of a major input causing an earnings decrease • Interest rate fluctuation - Changes in interest rates negatively affect company’s earnings Operational Strategic • Competitive pressure – Loss of revenue due to pricing and/or volume pressures from competitors • Customer demand shortfall – Lower than expected industry-wide demand from customers • Customer pricing pressure – Strong customers negotiate price discounts • Loss of key customer – Loss or major reduction of business from key customers • Misaligned Products/Channels – Product selection/design does not meet customer requirements • M&A integration problems – M&A activities viewed unsound by investors; cost savings and/or synergies from M&A not achieved • Regulatory problems – Regulatory changes affect long-term earnings potential • R&D Delays – Problems with research and development • Supplier Problems – Suppliers oppose company’s strategy • Accounting irregularities – Misrepresentation of financial statements and/or fraud • Cost overruns – Higher than expected overhead or other operating costs, extraordinary charges, and/or heavy investment • Ineffective Management – Poor operating decisions made by executives within the company leading to an earnings shortfall • Supply chain issues – Problems with the inventory and delivery systems leading to revenue shortfalls or cost overruns

12. Causes for stock drops – Fortune 1000 Group1993-1998. Risk Event Precipitating Stock Drop (# of Companies) • MMC Research • Primarily Due to Strategic and Operational Risks % of top 100 Law-suits Natural Disasters Competitive Pressure Mis-aligned Products Loss of Key Customer R&D Delays Manage-ment ineffective- ness Foreign Macro-Economic Issues High Input Comm-odity Price Interest Rate Fluct-uation Cost Overruns Customer Demand Shortfall Customer Pricing Pressure Regulatory Problems Supplier Problems M&A Integration Problems Accounting irregularities Supply Chain Issues Strategic Operational Financial Hazard 58% 31% 6% 0%

13. Risk Management can protect shareholder value Risk Category and Possible Mitigation for 100 Major Stock Drops Success Story: Insurance has successfully transferred Over two-thirds of these risks could have been anticipated and mitigated / transferred using existing tools and techniques. Financial derivativescould transfer Customer research could anticipate 7 0 Up-front integration planning could prevent Scenario Planning & Game Theory could anticipate 30 Proper audit process could prevent # of Companies 12 Effective supply chain strategy could prevent 100 7 7 6 31 Fortune 1000 Companies losing over 25% of value in a month Hazard Risks Financial Risks Customer Risks Competitive Pressure M&A Integration Problems Accounting Irregularities Supply Chain Problems Other Risks • Foreign exchange • Interest Rate • CommodityPrices • MisalignedProducts / Channels • Demand Shortfall Risks causing major Fortune 1000 stock drops

14. Implications from the Study Enterprise-wide risk management can mitigate large drops in a company’s share price. • The typical Fortune 1000 company has a 10% chance of losing at least 1/4 of their value in a month due to company specific problems • Healthcare, CIE and Services companies are particularly prone to drops • Smaller Fortune 1000 companies are more likely to drop • The primary causes of major stock drops cannot be traditionally insured but almost two-thirds can be mitigated • Strategic risks can be anticipated by spotting emerging profit patterns in an industry; once anticipated these risks can be mitigated or prevented • Research, analysis, and scenario planning can be used to think through potential operational and strategic risks; which can be prepared for once considered • Well structured processes and contingency plans can lessen the effect of operations and strategic risks which are not prevented • Companies should explore enterprise-wide risk management to assess, mitigate and if possible transfer, all of their risks

15. XYZ Company • Exposed to many insurable risks • Substantial Annual Costs • Deductible or Retained Losses • Insurance Premiums • Collateral Costs • Goal- Optimal Insurance Structure • Actuary can be a valuable resource in bridging the communications gap between the risk manager and the CEO/CFO/Treasurer

16. Example: ABC Airlines • Rise in Jet Fuel Deemed to correlate and causative with certain events • Increases Expense Raising Fares • Bonuses Cut for Employees • Stock Price Drops • Fewer Passenger Miles • Decreased Maintenance Expense • Decreased Advertising • Employees Layoffs • Workers Compensation Costs Up • Lower Levels of Space Needed • Prices Fall on Rental Space

17. Consider Correlated Events not Causative to Jet Fuel • Rise in Jet Fuel • Correlated with cost of Oil and Natural Gas • Strategy • Purchase a Call Option on Crude Oil • Sell Calls on the Stock • Negotiate for future aircraft when prices are at their highest • variable contract with advertisers • Workers Compensation Retention Inversely Related to Fuel Prices • Tie Lease Negotiations to Fuel Prices

18. Challenges • Difficulty in Measuring Correlation • Attempts to isolate relationships between variables such that historical relationships will continue into the future • Corporate Constraints to Integrating Risk • Budgets Drive Corporate Behavior • Trading Mentality • Not particularly concerned with things that haven’t happened recently • Static Inertia • Risk Manager still seen as insurance buyer

19. Bridge in Organizational Communication-Speak same Language • How much capacity does XYZ Corp have to bear risk? • Within the above capacity, how desirable is it for XYZ Corp to retain/bear additional risk? • XYZ not in the business to just merely survive, but rather to thrive

20. NW A B D The Goal of Optimizing XYZ’s risk retention alternatives is to….. “Go Northwest” C • Option A is Better than Option B because for the same return (I.E. cost savings), option A has less risk (more West). • Option D is a better alternative than Option C, because for the same amount of risk, D has a greater return (I.E. more savings;more North)

21. Each point represents an alternative portfolio of risk financing/transfer strategies. Return = Savings from Guaranteed Cost

22. Markets have hardened - going Southeast Efficient Frontier

23. Current Structure Utility Curve represents XYZ’s levels of indifference to cost savings/risk retention alternatives

24. Two Questions • Does the benefit of reduced costs given additional risk enhance or destroy XYZ’s shareholder value? Does the benefit of reduced costs given the additional risk increase or destroy shareholder value? In theory, shareholder value is enhanced if the Risk Adjusted Return on additional (marginal) capital at risk (by raising retention) exceeds XYZ’s marginal cost of capital.

25. When retaining risk, XYZ is notionally committing capital at risk. When viewed this way, the insurance and or risk-financing decision is essentially equated to an investment decision, and hence, the goal of the retention decision becomes maximizing return while minimizing risk.

26. The Goal is to reach the Tangent of the Market Efficient Frontier and XYZ Indifference Curves. This point represents the best of all available alternatives per the corporation’s risk/reward appetite.

27. A simple numerical example Marginal Cost of Capital = 15%

29. % of top 100 Primary Cause of 25%+ Stock Drops for 100 of Fortune 1000 Companies 24 25 20 15 12 11 10 7 7 7 6 6 4 5 3 2 2 1 1 1 1 0 0 0 Law-suits Natural Disasters Competitive Pressure Mis-aligned Products Loss of Key Customer R&D Delays Manage-ment ineffective- ness Foreign Macro-Economic Issues High Input Comm-odity Price Interest Rate Fluct-uation Cost Overruns Customer Demand Shortfall Customer Pricing Pressure Regulatory Problems Supplier Problems M&A Integration Problems Accounting irregularities Supply Chain Issues Strategic Operational Financial Hazard 58% 31% 6% 0% Source: Compustat, Mercer Management Consulting analysis What Risks Impact Shareholder Value The frontier of integrating risk is including operational and strategic risks

30. …….Significant Opportunities Casualty Actuaries in serving as the bridge between hazard and operational/strategic risks. “….We don’t do things because they are easy. We do them because they are hard.” ….John F. Kennedy