Finance 432: Managing Financial Risk for Insurers

1. Finance 432: Managing Financial Risk for Insurers Actuaries of the 4th Kind -Enterprise Risk Management

2. Bühlmann’s Kinds of Actuaries • Actuaries of the First Kind • Life – deterministic calculations • Actuaries of the Second Kind • Casualty – probabilistic calculations • Actuaries of the Third Kind • Financial – stochastic calculations • Actuaries of the Fourth Kind • Enterprise risk management – mathematics of integration and interrelations

3. What is ERM? ERM is the application of the basic risk management principles to all risks facing an organization Other names for ERM Enterprise-wide risk management Holistic risk management Integrated risk management Strategic risk management Global risk management

4. Basic Risk Management Principles • Identifying loss exposures • Measuring loss exposures • Evaluating the different methods for handling risk • Risk assumption • Risk transfer • Risk reduction • Selecting a method • Monitoring results

5. Why Manage Risk? Diversifiable risk argument • Shareholders are diversified investors • They will not pay a premium to reduce unsystematic risk How risk management can add value • Decreasing taxes • Decreasing the cost of financial distress • Customers • Employees • Suppliers • Facilitating optimal investment • Increasing firm value

6. Where Did Enterprise Risk Management Come From? Traditional risk management Formally developed as a field in the 1960s Focused on “pure” risks Loss/no loss situation Often could be insured Developed from insurance purchasing area

7. New Elements of Risk – 1970s Foreign exchange risk End of Bretton Woods agreement in 1972 Commodity price risk Oil price fluctuations of the 1970s Equity risk Development of option markets - 1973 Interest rate risk Federal Reserve Board policy shift - 1979

8. Failure to Manage Financial Risk • Foreign exchange risk • Laker Airlines – 1970s • Borrowing in dollars • Revenue in pounds • Interest rate risk • U. S. Savings and Loans – 1980s • Borrowing short • Lending long • Commodity price risk • Continental Airlines – 1990 • Fuel costs not hedged • Oil price doubled with Gulf War

9. The “New” Risk Management -1980s Financial risk management Dealt with financial risk Foreign exchange risk Interest rate risk Equity risk Commodity price risk Used derivatives to hedge financial risk

10. Financial Risk Management Toolbox • Forwards • Futures • Options • Swaps

11. New Elements of Risk – 1990s • Failure to manage derivatives appropriately • Financial model failures • Improper accounting for derivatives

12. Mismanagement of Financial Risk • Mismanagement of derivatives • Gibson Greetings • Proctor and Gamble • Barings Bank • Orange County • Model failure • Long Term Capital • Accounting improprieties • Enron • WorldCom • Arthur Andersen

13. The “New” Risk Management - 1990s and beyond • Enterprise Risk Management • Initial focus on avoiding derivative disasters • Developing into optimizing firm value • Chief Risk Officer • Sarbanes-Oxley Act – 2002 • Increased focus on risk models

14. ERM Risk Categories Common risk allocation • Hazard risk • Financial risk • Operational risk • Strategic risk Bank view – New Basel Accord • Credit risk • Loan and counterparty risk • Market risk (financial risk) • Operational risk

15. Hazard Risk • “Pure” loss situations • Property • Liability • Employee related • Independence of separate risks • Risks can generally be handled by • Insurance, including self insurance • Avoidance • Transfer

16. Financial Risk • Components • Foreign exchange rate • Equity • Interest rate • Commodity price • Correlations among different risks • Use of hedges, not insurance or risk transfer • Securitization

17. Operational Risk Causes of operational risk • Internal processes • People • Systems Examples • Product recall • Customer satisfaction • Information technology • Labor dispute • Management fraud

18. Strategic Risk Examples • Competition • Regulation • Technological innovation • Political impediments

19. Evolution of ERM • Control function • How much can we lose? • Risk adjusted returns • Capital allocation (Stefan Lippe – Swiss Re) • Compensation • Bonuses • Optimization • Maximize stakeholder value • Vision of the future

20. Examples of ERM - 1 Michelin – contingent capital • Issued by Swiss Re New Markets and Societe Generale • Option to draw on subordinated long-term bank credit facility • Option to issue subordinated debt at fixed spread • This option can only be exercised if GDP growth falls below a trigger (1.5% 2001-03, 2.0% 2004-05)

21. Examples of ERM - 2 United Grain Growers – risk integration • Issued by Swiss Re • Regional grain volume coverage • Integrated with other property/liability coverages • Three year policy • Annual aggregate retention • $35 million annual limit • $80 million policy limit

22. Examples of ERM - 3 RLI Corporation – Cat-E-Puts • Arranged by Aon, issued by Centre Re • Three year term • Provided an option to issue $50 million in convertible preferred shares • Trigger was major California earthquake • Subject to minimum capital requirements

23. Examples of ERM - 4Hurricane Katrina

24. Katrina Induced Gas Lines

25. Conclusion • ERM is continuing to evolve • Started as hazard risk management • Financial risk management developed • Failures brought increased attention • Technology and risk management experience led to new approaches • Regulation is pushing organizations to improve • Modeling risks is key component • No standard approach has yet emerged • Challenging and attractive area