Fundamentals of Enterprise Risk Management Introduction and Risk Framework

Transcription

1 Fundamentals of Enterprise Risk Management Introduction and Risk Framework Michael E. Angelina, ACAS, MAAA, CERA Executive Director, Saint Joseph s University Maguire Academy of Insurance and Risk Management I

2 Agenda Framing of Discussion Overview Cultural Aspect Guiding Principles Enterprise Risk Management Defined Ingredients Process Lessons Learned Governance Matters Define your Risk Appetite Manage your Capital Operational Risk is Important do not overcomplicate Concluding Thoughts 2

3 ERM Overview ERM is a competitive advantage, especially in today s volatile environment While excellent ERM practices cannot avoid problems, they can mitigate the impact ERM needs to be part of the company s culture from top to bottom Excellent ERM processes and disciplines can lead to sustainability and ultimately higher enterprise value 3

4 ERM Historical Perspective Significant challenges in the financial services industry over last 15 years Strategic Risk: September 11, Legion Insurance; Financial Risk: Enron, WorldCom, Tyco, Reliance Insurance; Hazard Risk: Hurricanes Katrina, Rita, Wilma; Operational Risk: Financial Crisis; General Motors; Volkswagen; Chipotle. Where was ERM Did it exist? What similarities exist, and what can/have we learned? 4

5 ERM Historical Perspective Failures with ERM typically fall into one of five categories (based on Sim Segal s Corporate Value of ERM) : Golden Boy Unit; Area Deemed Insignificant; Limiting Approach; Differing Cultures; Incomplete Information. Identification of the root causes may prevent further problems. 5

6 Observations on ERM What is it? Enterprise Risk Management Step into a new frontier Competitive advantage ERM Matters ERM due to its name is thought to be defensive Manage risks to protect downside Link ERM to strategic planning process ERM is strategic weapon Process of understanding the drivers of risk and the impact to corporate decisions can be a powerful weapon in the organization. Think portfolio theory and risk levels Avoid too much focus on individual cells at the ERM level 6

7 Observations on ERM What is it? ERM dovetails with technology Analytical insights can take us to the next level ERM is all about culture Transparency, communication, organizational involvement, goals and objectives Consistent messaging from the top followed by actions ERM utilizes both top down and bottom up approaches Need to understand micro and macro level drivers Impact on Enterprise Value (Market Cap) Somewhat circular but in reality a feedback mechanism is created 7

8 Drivers of Risk Appetite Lessons from Other Industries Toyota Pursue perfection relentlessly (Kaizen) A3 thinking more than a report format State of mind PDCA Plan, Do, Check, Act Commit to what matters most Once you buy in to the system, you have to live the life Culture and ethics Maintain a historical perspective; but everything is for the future Favor long-term strategies over short-term fixes Be willing to improve Improve quality by exposing the truth Get to the root cause as opposed to the symptom Ask why 5 times 8

9 Framework - Corporate Objectives ERM Guiding Principles Optimally manage the company s capital Required return on capital Eliminate risks that threaten solvency / viability Target maximum aggregate level of risk given range of opportunities Manage volatility Expected Value Curve Understand, manage, mitigate Shape business by taking risk we can quantify Risk mix, diversification, hedging Strategic plan Create behaviors that reinforce ERM culture Internally and externally Balanced scorecard Transparency and communication 9

10 The commitment to ERM supports superior performance Optimally manage capital and risks Manage towards a required return on risk-adjusted capital Quantify risks taken and limit ones that threaten solvency/viability Strong governance structure Senior management understands and values ERM as a source of competitive advantage Board of Directors highly skilled in insurance and finance Best-in-class ERM Clearly defined risk tolerances and controls Asset management: approach incorporates capital-at-risk limits, Liability management Prudent loss reserves Underwriting / Catastrophe management Concentration management Delegated authorities Corporate culture Ownership mentality Industry leading analytics Transparency and communication of strategy 10

11 Background Insurance Exposure Loss Reserve Risk Misestimating provision for future claims payments Overstating capital and earnings Asset & Investment Risk Poor investments affects both the balance sheet and income statement (Examples include: distressed companies in 2008) Catastrophe Risk US wind and earthquake, International wind and quake Liability: large systemic casualty losses (financial crisis / cyber) Agricultural risks drought and commodity prices Underwriting & Pricing Risk Underwriting cycle, casualty pricing, aggregation of exposures Ceded Reinsurance Risk Failure of counterparty, unwillingness of counterparty Operational Risk Failed controls or processes Reputational risk, regulatory risk, IT, fraud, etc.

12 Essential Ingredients of ERM Many feel that ERM is exclusively about economic capital modeling, it is not. Economic capital modeling is one of the many analytic tools that are available to assist management in their ERM process and initiative. Others include: ROE studies; reserve variability; individual risk assessments; liquidity stress testing; scenario planning; capital management; alignment of interest and compensation; and appreciation of model risk An excellent ERM process is centered around a culture and mindset that: Appreciates the many risks facing an organization Understands the drivers of those risks; and Strategically reacts to those potential risks by making better decisions regarding: capital deployed, opportunities sought; investments made, and business written. At the end of the day ERM is about knowledge based decisions with full contemplation of the various risks facing an organization. Communication, transparency, alignment of interests 12

13 Framework Risk Appetite Process Contemplate, Calibrate, and Communicate how much you are willing to forfeit under a variety of metrics Calendar year / quarter income; capital; cash Consider risk versus reward tradeoff Are we being compensated to take additional risk Model Tail Value at Risk along with Value at Risk Sensitivity test various results to better understand drivers of adverse results Scenario plan for extreme events beyond modeled output Create additional tolerance levels beyond that which are contemplated in models. Consider time horizon and reserving impact; Premium based, occurrence limits for property exposed; total limits for sub class of casualty risks TIVs in location, reinsurance limit in wind exposed area, product/segment number of risks, etc Monitor progress and address outliers/deviations Consistently discuss results with business unit leaders and hold accountable for deviations to target Transparency is key to success 13

14 Annual Aggregate Risk Curve Stated objective is to limit our loss in a 1-in-100 year to 25% of our capital or less; our current level is 20.2% of shareholders' equity at December 31, Endurance Operating Income Profile as of July 1, 2010 Average Result $322 Mil Gain Median Result $374 Mil Gain Probability 1-in-10 Year $10 Mil Gain 1-in-500 Year $976 Mil Loss 1-in-250 Year $783 Mil Loss 1-in-100 Year $543 Mil Loss 1-in-50 Year $365 Mil Loss 1-in-25 Year $195 Mil Loss -1, Operating Result - $ Millions The above chart represents a cumulative analysis of our in-force underwriting portfolio on a full year basis based on thousands of potential scenarios. Loss years are driven largely by the occurrence of natural catastrophes and incorrect pricing of other property and casualty exposures. The operating income depicted includes net premiums earned plus net investment income, less acquisition expenses and G&A expenses. The operating income depicted excludes the effects of income tax (expenses) benefits, amortization of intangibles and interest expense. Forecasted investment income, acquisition and G&A expenses are held constant across all scenarios. Losses included above are net of reinsurance. Our stated objective is to maintain a risk management tolerance that limits our loss in a 1-in-100 year year to be no more than 25% of our shareholders' equity. Changes in Endurance's underwriting portfolio, investment portfolio, risk control mechanisms, market conditions and other factors may cause actual results to vary considerably from those indicated by our value at risk curve. For a listing of risks related to Endurance and its future performance, please see "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2008 as amended on May 8,

15 Process Stress Testing Selection of risk categories to be stressed Single events: assets decrease; reserving issues; catastrophe; systemic event aggregation of medium size events (Reliance) Identification of stressed scenarios Reflect capital model input/output Differentiate internal versus external events Inflation, natural catastrophe, economy, legislation Pricing, credit risk, reserving issues Incorporate concentrated exposures (limits, TIV) Measure financial impact to organization Internal: capital, earnings, liquidity External: outsized loss relative to competitors; management credibility; rating agency reaction

16 Process Stress Testing (continued) Formulation of mitigation strategy / control environment Risk tolerances How will we react to the stress tests? Controls to monitor exposure Are tolerances breached? Timely reporting procedures are crucial Manage business around thresholds Ideally at the point of sale Real time decisions based on risk and return tradeoffs Solicits discussions around strategy and forward planning Ounce of prevention Important to have a culture that fosters a strong control environment

17 Process Stress Testing (continued) Analyze Results Measure against capital position (excess capital) Are there any surprises? Consider in capital management discussions (share buybacks) Determine cost of excess position versus powder dry Similar approach for the cost of liquidity Effectiveness of mitigation strategy Too expensive; Inherent risks assumed (credit risk); Too much mitigation; Gaps in coverage or implicit retention Lack of strategic thinking Contingency planning Capital raise in extreme scenario; seize market opportunity

18 Process Stress Testing (continued) Reflect reverse stress testing Determination / selection of a pain point Capital loss; earnings; liquidity issue May consider a series of pain points (earnings miss) Identify risk scenarios and modify assumptions to have results approach or exceed selected pain point How extreme can you go? May be less extreme than you thought Question assumptions and results Are the results / scenarios appropriate or realistic? Have you missed anything? Fungibility of capital; reputation risk; reinsurance failure; Storm surge; reserve emergence; soft market; Do you have processes in place to avoid this scenario? Similar to rating exercises in soft market How much pain are we willing to take?

19 Strengths Develops insights into business for management to make better decisions Incorporates more discipline into ERM process Business units and functions; Inclusive process facilitates questions, observations, and discussion Strengthens communication with business units, executives, and board Removes black box stigma associated with capital modeling and actuarial exercises Arithmetic is easier to discuss than calculus Provides a more robust understanding of capital needs, earnings volatility, and liquidity Results in a more strategic discussion with regard to mitigation and management action plans Decisions and actions are critical

20 Examples Reserve risk % of IBNR reserves; % of loss ratio (10% / 25% movement); concentration of policy limits (mass tort, construction defects); medical inflation Underwriting / Pricing Soft market conditions (loss ratio off by 25%); LOB/policy limit concentration (financial crisis); legislative change on rates or coverage (CA WC); competition reducing amount of business and resulting profitability; systemic event (cyber, pandemic, terrorism) Reinsurance Unwillingness / inability to pay by major 3 rd party reinsurer(s) Catastrophe Lloyds RDS, historical events, event sets; resulting market share Investments Interest rate movement; inflation; market changes (targeted RMBS)

21 Appendix Lessons Learned 21

22 Primary Causes of P&C Impairments ( ) AM Best 22 All Other Impairment of an 10% Affiliate Reinsurance 4% Failure 4% All Significant Change 5% Deficient Loss Reserves 36% Catastrophic Losses 7% Overstated Assets 8% Alleged Fraud 9% Rapid Growth 17%

23 Historical Reserving Errors Excess of Loss Reinsurance Percentage Difference Between 12/60 Month Estimates and Ultimate (Sch P Reinsurance B) 80% 70% 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% Month Error 60 Month Error In the hard market (AY ), ultimate loss selections as of 12 month and 60 months are redundant. In the soft market (AY ), they are deficient. As accident years mature, the errors decrease; the 60 month reserve error is almost always less than the 12 month estimate.

24 24 Process Silos and Integrated Approach ERM Initial Phase Silo approach focus on broad categories Identification Assessment / Measurement Mitigation / Management Communication by individual risk owners ERM Second Phase Bringing it all together Integrated Approach Holistic approach / Connecting the silos Dashboards can be helpful Understanding the overall risks in the portfolio Stress test different scenarios

25 25 Process Advanced Steps ERM Process Third phase Correlation Analyses Need to reflect interactions with other risks Measure effect to all stakeholders Enron effect Examples casualty policies, professional exposures, assets Catastrophe events on property coverages, investments in cat bonds, mortgage backed securities Sub-prime lenders, E&O policies, financial institutions Homebuilders policies, surety coverages, interest rates Pricing errors and impacts on loss reserves Adding value by understanding other parts of business Modeling, understanding and communicating Develop mitigation strategy

26 Risk Identification Initial Phase Separate Risks into General Categories Primary Asset and Investment Underwriting and Pricing Catastrophe (property and casualty) Reserving (case outstanding and IBNR) Operational broadly defined IT, data, outwards reinsurance, legal, disaster, strategic Consequential (downward spiral) Based on primary risk or event Liquidity Reputation (client/investor) Rating agency / Regulatory Others 26

27 27 Identification of Key Risk Categories Assessment and Quantification Select risk owners / gatekeepers of the broad risk categories Functional level or business unit level Identify various types of events/risks associated with each of the primary categories Change in asset value, movement in interest rates, large property/casualty event (hurricane, earthquake, Enron), adverse claims trends, etc Measure financial and operational impact to organization Balance sheet, liquidity, capital requirements Contingency planning (think operational risk) Define tolerances for such events/risks Percent of capital, cash-flow, change in rating agency capital Establish controls to monitor risk exposure within established tolerance levels Timely reporting procedures dashboards can be helpful Enhances risk profile Manage business around such thresholds Optimally at the point of sale Enables real time decisions based on risk & return trade-offs Solicits discussions around strategy and forward-planning

28 Mitigation Risk Tolerances and Controls Overall Risk Tolerances derived at organizational level Percent of equity limits Rating agency trigger capital adequacy levels Liquidity Additional tolerances should be established for all primary risk categories Levels of investments, peak exposure zones, casualty premium, etc Controls Framework and Governance Assets/Investments investment process & guidelines/ monitoring Underwriting rating models & data, authority limits / referral process, actuarial involvement, external underwriting & claims reviews Catastrophe Occurrence & Aggregate Limits, vendor models Reserves large loss reporting/ round table, external reviews Operational risk assessment process, internal audits, Sarbanes-Oxley process, disaster recovery planning & testing, succession planning 28

29 Concluding Thoughts What are the Challenges in the Risk Identification / Assessment Process 29 Tendency to be looking in the rear view mirror Identify that with which you are familiar Unleashing of the Sorcerer s Apprentice too many risks identified to be practical Difficulty identifying risks that are not able to be modeled Over-confidence and Hubris use past experiences Katrina, Sandy, Galveston Storm, Soft Market, Floods in Thailand, New Zealand earthquakes, Reserving errors associated with soft market ($60 Billion), credit crisis Risk Mitigation Challenges Confusion between risk mitigation and risk decision process Mitigation is a decision; retention is a decision; setting risk tolerances is a strategy based on a decision Tolerances need to be part of the business process (3 principles) Incorporate into the planning process at an early stage Develop a plan if tolerances are exceeded (or close to exhaustion) Hard Limits NEVER breached Soft Limits Set of a trigger or plan to remediate Measured and readily available fro monitoring

30 ERM Guiding Principles As part of a strong Enterprise Risk Management culture, many organizations establish a set of guiding principles around ERM. These principles act as both a mission statement and a set of behaviors which affect decision making processes, and ultimately should result in increased shareholder value. Many feel that ERM is about economic capital modeling, it is more. Economic capital modeling is one of the many analytic tools that are available to assist management in their ERM process and initiative. An excellent ERM process is centered around a culture and mindset that: Appreciates the many risks facing an organization Understands the drivers of those risks; and Strategically reacts to those potential risks by making better decisions regarding capital deployed, opportunities sought; investments made, and business written. Guiding Principles Optimally manage the company s capital Eliminate risks that threaten solvency / viability Manage volatility Expected Value Curve Shape business by taking risk that you can quantify Create behaviors that reinforce ERM culture 30

31 ERM Guiding Principles Optimally Manage the Company s Capital Capital management has traditionally been and still remains one of the key elements of an organization s strategy. Requires a thorough understanding of the risks and exposures in the portfolio. Forces a delicate balance between held capital, rating agency capital, economic capital, and regulatory capital. Fosters strategic thinking and forward planning at corporate & business unit level Results in a more balanced and robust portfolio of risks Enhances returns on risk adjusted capital by adding or withdrawing capacity depending on market conditions To measure our success in this area, organizations may utilize a variety of analytical tools and reports such as: Profitability studies including metrics such as RORAC, RAROC Rating agency / regulatory capital requirements Economic capital, scenario planning, and opportunity costs Risk levels for major categories and aggregate level 31

32 ERM Guiding Principles Eliminate risks that threaten solvency/viability Survival is critical in any industry, and the ability to create an efficient portfolio of risks given a range of possibilities to ensure long term sustainability creates shareholder value. The major risks threatening the company s solvency would be investment, reserving, catastrophe, pricing, and operational. The tone from the top, supported by actions is what sets great organizations apart from others. Prudent loss reserving; strategic re-deployment of catastrophe capacity to businesses that optimize returns and future business opportunities; and strong cycle management are examples of excellent behavior. A corporate vision, compensation plan, or set of behaviors that over-reward short term thinking and sacrifice long term success could generate the wrong result. Tools to ensure success Strategic allocation of underwriting authority and catastrophe capacity Industry leading processes, strong loss reserve discipline, outside actuarial involvement, and engaged audit committee. Proactive underwriting and claims auditing prior to binding accounts Internal peer review processes and multi-functional approach to underwriting Dynamic capital allocation and catastrophe models identifying peak-zone accumulations coupled with aggregate tracking tool to prevent over-concentration of exposures. Culture of open communication and transparency to avoid aggressive pricing and reserving decisions. 32

33 ERM Guiding Principles Manage Volatility Volatility of results in our industry cannot be avoided; however, by understanding the drivers of volatility and the sources of uncertainty, we can more proactively manage our exposures, and potentially mitigate outsized risks to better improve our expected results. Volatility comes from our major sources of risk: adverse reserve development; outsized catastrophe losses, significant changes in investment returns; deviation from plan results. To achieve this result, many organizations have invested resources and funds towards state of the art data and analytical capabilities : Industry leading catastrophe modeling and aggregate tracking to better identify outsized concentrations; Excellent management information systems and leading indicators around reserve estimates to mitigate future adverse development from long tailed lines of business; Investment metrics that measure the strategy to preserve capital first; meet liquidity needs; and to provide a stable stream of income & growth in book value. Risk focused and transparent culture balancing both the modeled results with industry experiences to make better decisions regarding operating results Value of risk curve published semi-annually in investor supplement 33

34 ERM Guiding Principles Shape business by taking risks we can quantify Throughout the industry, the analytical capabilities and data quality have increased significantly. However, there are instances in specific line of business or geographies where this has not been the case. For better corporate performance, great organizations are committed to being a specialist or becoming a specialist player in our business units. Being a specialist can be accomplished through a variety of attributes: Industry leading data and analytics; distribution; underwriting and risk selection; market knowledge Incorporating this philosophy into the strategic planning to have the right balance of risk in the portfolio; seek opportunities to diversify where possible; and if needed utilise a hedging strategy in over concentrated areas or new and developing books of business. Processes in place to accomplish this end Engaged board of directors, holdings company, and segment/business unit underwriting leaders during strategic planning process; Prospective allocation of underwriting capacity to business leaders prior to key new business dates; Commitment to high data quality standards and model integrity; Constant monitoring of results relative to plan and expected risk profile. 34

35 ERM Guiding Principles Create behaviors that reinforce ERM culture While it is important to have robust modeling and analytical capabilities for industry leading ERM capabilities, it is imperative that the analytics are equally supplemented with a culture and set of behaviors within the organization to drive operational excellence. These behaviors include: Commitment to excellence to both colleagues (internal) and our clients / other external constituents (regulators, rating agencies, shareholders); Transparency and communication of our results and assumptions; Alignment of interests through goals and objectives and ultimately compensation. Examples of excellent behaviors Internal and external transparency - reserve disclosures, risk profile, investor disclosures; Top down and cascading of corporate goals and objectives; Compensation plan based on balance of corporate and individual results Varies by level; Consistent messaging from the top regarding bottom line results versus top line growth; Seasoned management team and engaged board of directors 35