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ERM 57 Review. Mike Elliott, CPCU, AIAF, MBA Rich Berthelsen, JD, CPCU, AIC, ARM, AU, ARe , MBA RIMS – April 2014. Exam Basics – What to Expect Test-Taking Tips Review of Sections Students Find the Most Challenging. Overview. What to Expect on the Exam. Educational Objectives

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erm 57 review

ERM 57 Review

Mike Elliott, CPCU, AIAF, MBA

Rich Berthelsen, JD, CPCU, AIC, ARM, AU, ARe, MBA

RIMS – April 2014

overview
Exam Basics – What to Expect

Test-Taking Tips

Review of Sections Students Find the Most Challenging

Overview
what to expect on the exam
What to Expect on the Exam
  • Educational Objectives
  • Balanced Exam
  • Pretest Items
test taking tips
Test-Taking Tips
  • Get the easy ones
  • Don’t get bogged down early
  • Use the “mark for later review” feature
  • Eliminate the obviously wrong answers
  • Use your scratch paper to keep track
assignment 1
Assignment 1
  • Introduction to Enterprise Risk Management
erm definition
ERM Definition
  • RIMSA strategic business discipline that supports the achievement of an organization’s objectives by addressing the full spectrum of its risks and managing the combined impact of those risks as an interrelated risk portfolio.
slide11

Risk quadrants differ from risk classifications. While risk classifications focus on specific characteristics of the risk itself, risk quadrants focus on

  • A: pure and subjective risks.
  • B: subjective and objective risks.
  • C: risk diversification.
  • D: sources of risk.
assignment 2
Assignment 2
  • Enterprise Risk Management
  • in an Organization
purpose and types of maturity models
Purpose and Types of Maturity Models
  • The purpose of a maturity model is to evaluate or improve a business process.
  • Two types of particular interest are:
  • Capability Maturity Model
  • RIMS Risk Maturity Model
capability maturity model cmm and capability maturity model integration
Capability Maturity Model (CMM) and Capability Maturity Model Integration
  • Has five levels:
  • Ad hoc
  • Initial
  • Defined
  • Managed
  • Optimizing
slide15

Based on the Capability Maturity Model (CMM) developed by Carnegie Mellon, an organization that has basic risk management processes with no attempt at enterprise-wide risk management is at which one of the maturity levels?

  • A: Managed
  • B: Initial
  • C: Ad hoc
  • D: Defined
rims risk maturity model
RIMS Risk Maturity Model
  • Uses 5 maturity levels based on CMM applied to 7 attributes:
  • Adoption of ERM-based approach
  • ERM process management
  • Risk appetite management
  • Root cause discipline
  • Uncovering risks
  • Performance management
  • Business resiliency and sustainability
slide17

A risk maturity model that uses five maturity levels based on the Capability Maturity Model, determining the maturity level for each of seven attributes by evaluating the degree to which key drivers are present, is known as the

  • A: Capability Maturity Model
  • B: Standard and Poor’s (S&P) Risk Maturity Model
  • C: RIMS Risk Maturity Model
  • D: Aon Risk Maturity Index
assignment 3
Assignment 3
  • Enterprise Risk Management Framework and Process
iso 31000 framework and process
ISO 31000 Framework and Process

Source: ISO 31000:2009

coso erm
COSO ERM

Source: COSO – Enterprise Risk Management – Integrated Framework

applying risk management framework
Applying Risk Management Framework
  • The main purpose of the framework is to integrate risk management throughout the organization. The framework has 4 components
  • Lead and establish creditability
  • Align and integrate
  • Allocate resources
  • Communicate and report
assignment 4
Assignment 4
  • Risk Oversight
slide26

The European Corporate Law Directive on Auditing has produced a recommended framework that defines the corporate governance roles. Under this framework, which one of the following is responsible for converting strategy into operational objectives?

  • A: Board of directors
  • B: Chief executive officer
  • C: Operational management
  • D: Senior management
slide28

Which statement describes one of the responsibilities of an executive-level risk committee?

  • A: Assist the board in establishing risk appetite and risk tolerance levels
  • B: Monitor the organization’s compliance with established risk limits
  • C: Approve the organization’s risk management strategies, including their design and implementation
  • D: Oversee exposures of the organization’s critical risks and advise the board on risk strategy
assignment 5
Assignment 5
  • Strategic Planning and Enterprise
  • Risk Management
strategy implementation
Strategy Implementation
  • Some organizations apply a balanced scorecard approach to implement strategy and to provide a foundation for strategy evaluation. The balanced scorecard approach translates an organization’s strategy into specific goals and actions assigned to each department within the organization.
slide33

Which one of the following types of strategy determines how individual departments within an organization direct their activities?

  • A: Functional strategy
  • B: Business strategy
  • C: Corporate strategy
  • D: Operational strategy
assignment 6
Assignment 6
  • Risk-Based Performance and Process Management
key performance indicators
Key Performance Indicators
  • A key performance indicator (KPI) measures progress toward an organization’s goals, provides an attainable standard for a specific activity, and gives the focus or direction the activity is to take.
slide36

Successful organizations have goals and objectives. A financial or nonfinancial measurement that defines how successfully an organization is progressing toward its long-term goals is referred to as

  • A: an operating standard (OS).
  • B: a critical success factor (CSF).
  • C: a key performance indicator (KPI).
  • D: an objective gauge (OG).
purpose of key risk indicators kris
Purpose of Key Risk Indicators (KRIs)
  • Effective KRIs provide objective, quantifiable information about emerging risks and trends in existing risks that can affect an organization’s success. A KRI can reveal an upward trend in the level of a risk that, if it continues, will exceed the designated risk threshold for that risk.
slide38

Which one of the following is an example of an external key risk indicator (KRI) that a manufacturer might monitor?

  • A: Number of employee injuries
  • B: Age of accounts payable
  • C: Amount of budget variances
  • D: Cost of raw materials
assignment 7
Assignment 7
  • Internal Audit and Control
internal control and risk management
Internal Control and Risk Management
  • Internal control – a system or process that an organization uses to achieve its operational goals, internal and external financial reporting goals, or legal and regulatory compliance goals.
coso internal control framework
COSO Internal Control Framework

Source: COSO Internal Control – Integrated Framework

three lines of defense model
Three Lines of Defense Model

Source: FERMA/ECIIA

slide43

According to the Three Lines of Defense Model, internal audit’s role in risk assessment techniques is to

  • A: design them.
  • B: implement them.
  • C: provide assurance on their effectiveness.
  • D: perform a control risk self-assessment (CRSA).
evolution of internal audit
Evolution of Internal Audit

Transaction Approvals

Assurance of Internal Controls

Risk-based Approach

risk based auditing
Risk-Based Auditing
  • Aligns audit resources with the areas that pose the greatest organizational risk.
slide46

The modern approach to internal auditing differs from the traditional approach by focusing on

  • A: the effectiveness of internal controls.
  • B: the relative riskiness of various activities.
  • C: transaction approvals.
  • D: systems-based compliance.
assignment 8
Assignment 8
  • Regulation and Compliance
regulation
Regulation

Rules-Based

Principles-Based

More flexible and focuses on outcomes

Responds more quickly in a changing environment

Requires more communication between the regulator and the regulated

  • More certainty and predictability
  • Less responsive to change
  • Inflexible
  • Often circumvented
naic orsa
NAIC ORSA
  • Principles-based (guidelines)
  • Applies ERM to insurance companies
slide50

The NAIC Own Risk and Solvency Assessment (ORSA) model law represents a change from past NAIC directives because it is

  • A: specific in terms of reporting.
  • B: retrospective.
  • C: voluntary.
  • D: principles-based.
assignment 9
Assignment 9
  • Risk Assessment and Treatment
risk identification tools
Risk Identification Tools
  • Facilitated workshops
  • Delphi technique
  • Scenario analysis
  • HAZOP
  • SWOT
slide53

Which one of the following team approaches to risk identification involves a select group of experts in question-and-response cycles until a consensus is achieved?

  • A: HAZOP
  • B: Scenario analysis
  • C: Delphi technique
  • D: SWOT
assignment 10
Assignment 10
  • Risk Modeling
influence diagrams and probabilities
Influence Diagrams and Probabilities
  • GEV Industries hires inexperienced and experienced workers to operate simple and complex machines. Accident rates vary by worker experience and complexity of machine.
  • GEV would like to estimate accident rates if it (a) assigns workers randomly to machines or (b) assigns workers to machines based on experience.
influence diagram
Influence Diagram

Worker assignment to machines

?

Machine Complexity

Worker Experience

AccidentRate

Cost of

Risk

slide58

Machine and Worker Data

Random Worker Assignments Probabilities

Accident Conditional Probability

slide59

Random Worker Assignments Probabilities

Accident Conditional Probability

Accident Probability

Total accident probability = 15.5%

slide60

Worker Assignments by Experience

Accident Conditional Probability

Accident Probability

Total accident probability = 12%

slide61

Twenty percent of PDQ Transport’s trucks have advanced safety equipment and 80% do not. Thirty of PDQ’s drivers are inexperienced and 90 are experienced. Assuming drivers are assigned randomly to trucks, what is the probability that an inexperienced driver is assigned to a truck without advanced safety equipment?

  • A: 18%
  • B: 20%
  • C: 24%
  • D: 60%
correlation
Correlation
  • Relationship between two variables
  • Number between +1 and -1
  • 0 means no correlation
slide63

Two variables are perfectly positively correlated. If one of the variables increases, the other will

  • A: increase in direct proportion.
  • B: decrease in direct proportion.
  • C: increase at half the rate.
  • D: decrease at half the rate.
slide65

A $500,000, 2 percent VaR means losses are expected to be

  • A: $10,000.
  • B: less than $500,000 2 percent of the time.
  • C: $490,000.
  • D: greater than $500,000 2 percent of the time.
assignment 11
Assignment 11
  • Risk-Based Capital Allocation
cost of equity
Cost of Equity
  • KE = rf + ß (rm – rf )
  • Where:
  • ß = Beta of security
  • rm = Expected return on the market
  • rf = Risk-free rate
cost of debt equation
Cost of Debt Equation
  • Cost of debt KD = (risk free rate of return rf + risk premium) × (1 – tax rate)
polytech company1
Polytech Company
  • Estimate the cost of debt
  • Estimate the cost of equity
  • Optimal capital structure = weighted average of the cost of debt and the cost of equity
polytech company cost of debt
Polytech Company – Cost of Debt

(Risk-free rate of return + credit spread) X (1 – tax rate)

(4% + 2.10%) X (1-.40)

3.66%

71

polytech company cost of equity
Polytech Company – Cost of Equity

Risk-free rate of return + Beta X (Market rate of return – risk-free rate of return)

4% + 1.20 (10% - 4%)

11.20%

72

polytech company weighted average cost of capital
Polytech Company – Weighted Average Cost of Capital

$10 mil. debt divided by $110 mil. (debt + equity) = .091

.091 weight of debt; .909 weight of equity

(3.66% X .091) + (11.20% X .909)

.333% + 10.181%

10.514%

market value surplus example
Market Value Surplus Example
  • Autumn Assurance Group has assets at fair value of $100 million. The present value of Autumn’s liabilities is $85 million. The market value margin is $5 million. Using probability models, Autumn determines that its VaR is $8 million because it expects to incur an $8 million or greater loss of capital at a .5 percent probability over a one-year period.
  • What is Autumn’s MVS?
  • What is Autumn’s economic capital?
  • Does Autumn have excess capital or a deficiency in capital?
evolution of risk management
Evolution of Risk Management

Insurance Management

Risk Management

Enterprise Risk Management

erm value proposition
ERM Value Proposition
  • Identify key risks
  • Employ risk-based decision making
  • Improve internal control
  • Improve risk governance
  • Comply with legal and regulatory requirements
solvency i and ii insurance cos
Solvency I and II (Insurance Cos)

Solvency I

Solvency II

3 pillars

1 – Risk-based capital

2 – Risk management and governance

3 – Transparent reporting

Includes an own risk and solvency assessment (ORSA)

  • Early 1970s
  • Focused on capital adequacy
basel ii and iii banks
Basel II and III (Banks)

Basel II

Basel III

Response to the Great Recession

Operational risk added

Risk management framework

Board of directors role (approve framework, risk appetite, governance)

  • Issued in 2004
  • Minimum capital requirements using weights for different types of credit risk
risk idenficationtools risk map
Risk IdenficationTools - Risk Map

Public University

3

1

Loss of a personal computer

2

Damage to reputation

2

3

Loss of state funding

1

slide86

A risk map showing a large difference between inherent and residual risk indicates that the

  • A: current risk treatment is ineffective.
  • B: risk does not need to be treated.
  • C: current risk treatment is effective.
  • D: risk exceeds the organization’s risk tolerance.
erm tools modern portfolio theory
ERM Tools - Modern Portfolio Theory

X

X

X

Expected Value of the Return

Risk Appetite

X

Risk – standard deviation (variability)

slide89

The efficient frontier consists of portfolios that

  • A: are riskless.
  • B: provide the average market return.
  • C: provide the highest return at different risk levels.
  • D: return the risk-free rate of return.
slide91

Earnings at risk of $200,000 with 90 percent confidence are projected to be

  • A: $180,000.
  • B: less than $200,000 10 percent of the time.
  • C: $200,000 90 percent of the time.
  • D: greater than $200,000 10 percent of the time.
assignment 12
Assignment 12
  • Risk Management Environment and Culture
risk centers and owners
Risk Centers and Owners
  • Risk center – unit within an organization at which level a risk (or risks) is most effectively managed
  • Risk owner – individual accountable for identification, assessment, treatment, and monitoring of risks in a specific environment
advantages of risk centers
Advantages of Risk Centers
  • Reduces the scope of risk analysis
  • Allows for the involvement of operational managers
  • Helps focus on the organization’s strategic goals and operational objectives
  • Ensures that risks are managed at the most appropriate level in the organization
risk attitude
Risk Attitude

Risk Optimizing