David Ingram CERA, FRM, PRM. Enterprise Risk Management For Insurers and Financial Institutions. From the International Actuarial Association. 1. INTRODUCTION - Why ERM? 2. RISK MANAGEMENT FUNDAMENTALS – FIRST STAGE OF CREATING AN ERM PROGRAM

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Enterprise Risk Management For Insurers and Financial Institutions

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3.1 Types of Risks • Systematic v. Specific • Traded v. Non-Traded • Paid to Take v. Not Paid to Take • Market, Credit, Insurance, Operational

Systematic Risk vs. Specific Risk • Flood – Systematic Risk -everyone gets wet • Bucket of water thrown by your brother – Specific risk – only you get wet • Insuring one House – Systematic or Specific? • Insuring thousands of houses – Systematic or Specific?

3.2 Risk Models • Cause / Effect - Outcome • Outcome – Frequency/Severity • Closed Form v. Single Scenario v. Monte Carlo • Stress v. Scenario • Sensitivity

Cause Effect - Outcome • Typical Life Insurance Actuarial Model • Model follows the steps taken over the life of an insurance contract following a tree branching logic • Policy Issue, continue to next year (1 – q - w) • Death & Claim in first year (q) • Lapse or surrender the contract (w) • Repeat – year after year • Outcome = PV of three paths for each year

Outcome – Frequency/Severity • Model commonly used for non-life insurance and for financial market instruments • Past observations of frequency and severity of outcomes used to parameterize statistical models of future outcomes

Closed Form v. Single Scenario v. Monte Carlo • Close Form models • one step calculations • usually depend upon assumption of distribution of outcomes (normal or log normal) that have formulaic outcomes • Black Sholes • Single Scenario • Also one step (the one scenario) • Using either CEO or OFS • Monte Carlo (stochastic) model • Multi scenario • Often do not presume to know distribution of outcomes

Stress v. Scenario • Stress Test • Redo calculation changing one parameter • Scenario Test • Adjust all parameters to reflect a fictional total world • Includes interactions of factors and dependencies in the assumed situation

3.3.0 Risk Treatment Process • May vary significantly with each major risk category • Depending on Nature of Risk • Assessment Capabilities • Relationship with Risk Takers • Knowledge & Experience of Staff

Components of Risk Treatment Process • Risk Identification • Measuring & Monitoring System • Risk Assessment & Communication • Establishment of Risk Limits & Standards • Risk Treatments • Enforcement of Limits & Standards • Risk Learning

Risk Identification • Within a broad category • Need to know which sub categories of the risk can be treated together • And which need to be treated separately

Measuring & Monitoring System • Measures of risk v. Key Risk Indicators • Existing v. Future • Manual v. Automated • Quantitative v. Qualitative

Risk Assessment & Communication • Need to establish regular schedule of assessment • Assessments must be communicated at several levels in the organization • Operational Levels • Management levels • Management MUST have discussions with subordinates about the risk positions

Establishment of Risk Limits & Standards • Limits = How large, How much, How many, Authorities • Limits must be quantitative • Also may use Checkpoints • Standards • For how things are to be done • Treatments permitted/ required

To set Standards • Ask the best person in a function what needs to be done to “get it right” • Ask supervisors what information that they need to be able to tell that things are being done “right” • Standards also apply to documentation and recordkeeping

Enforcement of Limits & Standards • Assessment & Communication systems need to include comparison of risk positions to limits • And adherence to standards • Must clearly establish what will happen if limit or standard is violated • Might depend on seriousness of breach • Hard limits v. Soft Limits

Credit Risk Treatment • Traditional Credit Risk Treatment • Standards for • Underwriting • Authorities • Collateral, Coverage • Limits & Enforcement • Limits by credit quality, Size of Position • Authority Limits • Active Workout with Risk Learning

“Modern” Credit Risk Treatment • Credit VaR risk model & Aggregate limits • Gives aggregate portfolio view of Credit Risk • Allows trade-offs within aggregate limits • Use of credit derivatives to offset excessive specific or aggregate risk levels

Insurance Underwriting • Traditional Risk Control Mechanism for Insurance • Standards for • Underwriting • Authorities • Insurable Interest Limits & Enforcement • Limits by quality, Amount of Coverage • Authority Limits Active Claims management with Risk Learning

Crediting Rate Matching • Portfolio Rate • New Money Rate • Investment Year Rates Mismatched crediting rates can lead to large harmful cashflows

Cashflow Matching • Project out expected cashflows from liabilities • Project out expected cashflows from assets • Identify major gaps where there is a large difference between the projected cash outflow and inflow in a future year • Make plans to fill those gaps (usually on asset side for insurers) • Targeting future asset purchases • Targeting asset sales & repurchases

Duration Matching • Duration is sensitivity of value to a change in interest rate • Also equal to PV of time weighted cashflows Sum of PV(t x Cft) • Focus on DA v. DL • Set Limit for abs(DA – DL) • Usually ½ to 1 year

Duration Matching • Most Insurers adjust assets to match duration of liabilities • First step is to assess expected DL for a new product • Set DA target for new cashflow • Second step is to set schedule for assessment of portfolio DA & DL

Duration Matching • If assessment reveals excessive abs(DA – DL) gap then will plan to: • Adjust DA target for future cashflows • Sell some assets and purchase others to change DA • Purchase derivatives • Macro or Micro Hedge

ALM – Advanced • Duration matching only works well if interest rate moves are • Small • Similar for all durations • Advanced methods take care of: • Larger movements (Convexity) • Non-parallel shifts (Key Rate Durations)

Convexity • Change in Duration with change in interest rates • Second derivative of value with respect to a change in interest • Duration measures slope of the value plot • If Value Plot is a curve, then slope is only accurate measure for very small moves

Key Rate Durations • Change in value with change in rate at a specific duration • For example, 5 year rate only • Matching Key Rate Durations allows protection against yield curve twists

3.4 Risk Treatment Options – Hedging • Financial Market Risk Treatment • Derivative Instruments used for Hedging • Futures • Put & Call Options • Swaps • Derivatives are often low cash outlay • Usually means that derivatives involve significant leverage

Example of Financial Market Risk • Product – Index Annuity • Feature – Product promises the greater of • 80% of stock market growth • Floor interest Rate on 90% of funds On a specified maturity date To match without derivatives would require insurer to invest twice • 80% In Stock Fund • 90% in Bonds • For a total of 170% of deposit

Hedging Methods • Cashflow Hedging • Works like Cashflow matching in ALM • Purchase derivatives that have strike dates where there are potential cash mismatches • Most firms use this method to manage Index Annuities • Invest 90% of deposit in fixed income • Use other 10% to buy Option contracts tied to Equity market • Adjust participation percentage (80%) based upon cost of Options • Strike Date3 for Options is maturity date • Of Index Annuity Contract

Hedging Methods • Delta Hedging • Is fundamentally the same idea as Duration Matching • Delta is change in price (value) per change in an underlying (usually a market index) • Delta hedging often uses derivatives with extremely different term to hedge obligations • Delta hedges are only good for a very short time period (usually a day) • Delta Hedges must be rebalanced every day

Delta Hedging Index Annuity • Buy bonds to cover interest guarnatees • Delta hedging ignores interest rate risk • Then determine Delta of liabilities • Plus Delta of existing hedges • Purchase new derivatives that will bring Delta of assets + hedges to be within tolerance for difference from liabilities

Hedging Methods • Greeks • Greeks are partial derivatives of Prices with change in various factors • Gamma • Vega • Tau Get Definitions

Hedging Index Annuity with Greeks • Investments can be any mixture of bonds and stocks • Greeks will determine adjustments needed with derivatives to match all of the risk characteristics

Custom Hedging • Can purchase custom hedge contracts from a bank that have terms tailored to your specific need • If using custom hedges, would expect very low amount of rebalancing needed • Hedges are tied to market indices – not to actual liabilities

3.5 Risk Treatment Options – Reinsurance • Insurance & Financial Market Risk Treatment • Reinsurance is broadly similar to Custom hedges just described • Usually much more customized than Custom hedges • Reinsurers will usually promise to offset some portion of an insurers exact claims experience

Types of Reinsurance • Facultative v. Treaty • Proportional v. Non-Proportional • Per Risk v. Per Occurrence v. Aggregate

Facultative v. Treaty • “Facultative” reinsurance applies to a single insurance contract • “Treaty” reinsurance applies to all contracts in a defined block

Proportional v. Non-Proportional • Proportional reinsurance: the reinsurer takes a defined percentage of all losses • Non-proportional reinsurance: the reinsurer only takes losses that exceed some threshold • Almost always subject to a maximum limit • Threshold may be on per risk, per occurrence, or aggregate basis

Per Risk v. Per Occurrence v. Aggregate • Types of loss threshold for non-proportional reinsurance • Per Risk: threshold applies to losses from each insurance policy • Per Occurrence: threshold applies to total loss from each specific event (for example, each hurricane or earthquake) • Aggregate: threshold applies to total loss from a specific time period

Reinsurance • Advantages: • Customized to take exact aspect of risk that insurer wants to lay off • Available through a market of 50-100 firms globally • Disadvantages • Cost and availability of specific covers varies widely • Need to be concerned about credit quality of reinsurer • Sometimes for many, many years