Enterprise Risk Management Shaun Wang, Ph.D., FCAS, ASA Director of Actuarial Science Program...

transcript

Enterprise Risk Management

Shaun Wang, Ph.D., FCAS, ASADirector of Actuarial Science Program

Georgia State University

shaunwang@gsu.edu

2004 C.A.S.E. Forum

Copyright by S. Wang, 2004 2

Outline

1. Concept of Risk

2. Inherent Risks for P&C insurers

3. ERM Approaches

4. ERM Education at GSU

ERM as a New Discipline

• High expectations & excitements!!

• ERM takes integrated approaches to major risks of an enterprise

• ERM represents new ways of understanding & managing risks

• ERM is a new and evolving discipline

Concept of Risk

1. Risk = Random “Volatility”

2. Risk = Not knowing reality (lack of info, driving in dark)

3. Risk = Wrong Existing Structure

Poor coordination & communication

Organizational cancer; needs structural reform!

4. Risk = Opportunity for the Prepared & Discerning

(I) Risk & Diversification

1. “Offset” produces the highest benefits:

long and short positions of the same asset

2. “Random drivers” offer good benefits

natural catastrophe events in various regions

3. “Expertise Intensive”: pooling across sectors may yield little or even negative risk diversification

Different market dynamics; different sets of expertise

4. “Drag effort”: legal or reputation spillover

Right and Wrong Diversifications

• Years of under-pricing were partially caused by the “low correlation” argument by some multi-line players

• Diversification needs to match with areas of expertise

Renaissance Re, a mono-line CAT-writer, achieves diversification by geographic region and by peril

• “ART” benefited buyers, but not sellers

(II) Risk & Information

• Quality and timeliness of information are critical for decision-making– Relative to their banking counterparts, many

insurers have poor grades on this

• ERM modeling needs forward-looking data

• Need aggregate risk info, as well as every way we want to look at the business

(III) Risk & Incentive Misalignment

• Many “risks” are created by misalignment of incentives

Underwriters short-term goal v.s. long-tailed liabilities

Managers’ expansion of his/her own kingdom

CEO’s compensation linked to growth and acquisition

• Trial Attorneys and the U.S. legal dynamics

Lawyer Contingent Fees & Punitive Damages

(IV) Risk & Valuation/Market Dynamics

• Risk often manifested in changes in value• Market participants can drive value changes

– Real estate bubble– Momentum investing– Portfolio insurance strategies– UK FSA experience

• Current versus Long-term Valuation– Pension funding deficit

Outline

1. Concept of Risk

3. ERM Approaches

89 90 91 92 93 94 95 96 97 98 99 00 01 02*

US Insured CAT Losses (in $billion) and Rate On Line Index (1989=100)

Source: Guy Carpenter & *III EstimateROL showed big jump after

major CAT losses, and then came down gradually …

$2.7$4.7

$8.3 $7.3

$10.1$8.3

Inherent Risks for P&C Insurers

• The infamous underwriting/reserving cycle– Independent from equity market risks– Not knowing final result for years– Lack of feedback on estimated reserves

• Hedging using reinsurance (within sector): high information asymmetry & transaction costs

S&P Report 19-Nov-2003Insurance Actuaries – A Crisis of Credibility

• S&P report: “Actuaries are signing off on reserves that turn out to be wildly inaccurate” …

• It sent a shockwave around the globe in the actuarial and insurance community!!

• American Academy of Actuaries countered 2 days after S&P release: “It is an obvious attempt to explain away the errors that some analysts have made in estimating property/casualty insurers’ earnings.”

• Both agree It is high-time for “Reserving Reformation”

$ Billions, Calendar Year Basis

$2.3 $2.2 $1.2

($8.5)

($1.5)

($7.5)($6.7)($10.0)

$22.7 $23

($3.7)($0.3)

90 91 92 93 94 95 96 97 98 99 00 01 02 03

P/C Insurance Industry Prior Year Reserve Development*

*Year 2003 number is an estimate by S&P.Source: A.M. Best, Morgan Stanley, Dowling & Partners Securities

$23 billion reserve increase = Hurricane Andrew

Reserve Cycle & Pricing Cycle are correlated

Reason for P/C Insolvencies (218 Insolvencies, 1993-2002)

Unidentified17%

Impaired Affiliate3%

Overstated Assets2%

Change in Business

CAT Losses3%

Reinsurer Failure0%

Rapid Growth10%

Discontinued Ops8%

Alleged Fraud3%

Deficient Loss Reserves

Source: A.M. Best, Insurance Information Institute

Reserve deficiencies account for

more than half of all p/c insurers

insolvencies

Cyclical Nature of Reserve Estimates

• The adequacy of reserve estimates showed a clear cycle over the years

• Reserve cycle coupled with the pricing UW cycle

Pressure on short-term performance

Following the competitors

Smoothing taxes for some players

A slow-death sentence for many companies

Outline

1. Concept of Risk

3. ERM Approaches

ERM Focuses on “Business Processes”

• Loss Modeling Is Only Part of the Story A company had the state-of-the-art actuarial pricing

model, but in the end still lost so much money

• Need to quantify the Business Process Risk

Top-line growth in a soft market poses a major risk

Over-crowded competitive market poses a major risk

• Need to enter the deep water by understanding the risk drivers and market dynamics

ERM Model of Market Competition

• Result = Min{Quote1, …, Quotek} Loss,

where Quotek Normal(k, k)

1. For long-tailed lines, delayed info higher k

higher chance of premium deficiency

2. more bidders k higher chance of premium deficiency

• The Winner’s Curse: In insurance competitive pricing, the lowest price gets the business, but may be cursed with financial losses

ERM Solution on Reserving: Contingent Payoffs

• Payoff contingent on magnitude of reserve development for a fixed block of business

• As deferred compensation (or tradable index)• Force decision-makers (managers, actuaries) to

put their money where their mouth is• Provide feedback channel for a block of business

Contingent Payoff Contract on Reserve Development

$(0.25)

$(0.20)

$(0.15)

$(0.10)

$(0.05)

-40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60%

Future Reserve Development

PayOff

Tame U/W Cycle by financial engineering: Contingent payoff on reserve estimates

Outline

1. Concept of Risk

3. ERM Approaches

ERM Education at GSU

• Actuarial Education

– Scale back traditional components

– Go deeper and go wider

• Mathematical Risk Management

– Financial risk modeling and …

• Enterprise Risk Management

An actuarial/engineer approach

• Look risk as a “dynamics”

– Model each agent?

• External dynamics

– Financial risk modeling and …

• Internal dynamics

DFA versus ERM

• DFA has not yet fulfilled its promises

– Did not focus on dominant risks

– Fancy stochastic model without benchmark parameters

– Weak organizational backing & poor communication

• How does ERM differ from DFA?

– ERM offers these missing elements for success

Did “U.S. Risk Based Capital” Help?

• U.S. Benchmark RBC has only limited success:

Factor based reserve charges ignored the bigger issue of reserve adequacy

Incentives for putting up inadequate reserves

Same capital charge factor for premium written in a hard market versus in a soft market

• A point-in-time measure, without reference to future direction and sensitivity over time

Opportunities for Creating Industry Benchmarks

• Industry benchmarks on risk parameters and capital charges are badly needed

• Benchmarks should reflect the inherent risks of the business, regardless of risk portfolio

• Parameters are more important than the model

• It will take much fundamental analysis, expert opinion, and timely updates

Extras

Enterprise Risk Management Shaun Wang, Ph.D., FCAS, ASA Director of Actuarial Science Program...

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