Enterprise Risk Management
Shaun Wang, Ph.D., FCAS, ASADirector of Actuarial Science Program
Georgia State University
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
Copyright by S. Wang, 2004 3
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
Copyright by S. Wang, 2004 4
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
Copyright by S. Wang, 2004 5
(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
Copyright by S. Wang, 2004 6
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
Copyright by S. Wang, 2004 7
(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
Copyright by S. Wang, 2004 8
(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
Copyright by S. Wang, 2004 9
(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
Copyright by S. Wang, 2004 10
Outline
1. Concept of Risk
2. Inherent Risks for P&C insurers
3. ERM Approaches
4. ERM Education at GSU
Copyright by S. Wang, 2004 11
100
150
200
250
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 …
$7.5
$2.7$4.7
$22.9
$5.5
$16.9
$8.3 $7.3
$2.6
$10.1$8.3
$4.3
$28.1
$5.8
Copyright by S. Wang, 2004 12
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
Copyright by S. Wang, 2004 13
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”
Copyright by S. Wang, 2004 14
$ Billions, Calendar Year Basis
$2.3 $2.2 $1.2
($8.5)
($1.5)
($7.5)($6.7)($10.0)
$22.7 $23
$0.3
($3.7)($0.3)
$9.9
($15)
($10)
($5)
$0
$5
$10
$15
$20
$25
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
Copyright by S. Wang, 2004 15
Reason for P/C Insolvencies (218 Insolvencies, 1993-2002)
Unidentified17%
Impaired Affiliate3%
Overstated Assets2%
Change in Business
3%
CAT Losses3%
Reinsurer Failure0%
Rapid Growth10%
Discontinued Ops8%
Alleged Fraud3%
Deficient Loss Reserves
51%
Source: A.M. Best, Insurance Information Institute
Reserve deficiencies account for
more than half of all p/c insurers
insolvencies
Copyright by S. Wang, 2004 16
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
Copyright by S. Wang, 2004 17
Outline
1. Concept of Risk
2. Inherent Risks for P&C insurers
3. ERM Approaches
4. ERM Education at GSU
Copyright by S. Wang, 2004 18
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
Copyright by S. Wang, 2004 19
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
Copyright by S. Wang, 2004 20
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
Copyright by S. Wang, 2004 21
Contingent Payoff Contract on Reserve Development
$(0.25)
$(0.20)
$(0.15)
$(0.10)
$(0.05)
$-
$0.05
$0.10
$0.15
-40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60%
Future Reserve Development
Pay
off V
alue
PayOff
Tame U/W Cycle by financial engineering: Contingent payoff on reserve estimates
Copyright by S. Wang, 2004 22
Outline
1. Concept of Risk
2. Inherent Risks for P&C insurers
3. ERM Approaches
4. ERM Education at GSU
Copyright by S. Wang, 2004 23
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
Copyright by S. Wang, 2004 24
An actuarial/engineer approach
• Look risk as a “dynamics”
– Model each agent?
• External dynamics
– Financial risk modeling and …
• Internal dynamics
Q & A
Copyright by S. Wang, 2004 26
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
Copyright by S. Wang, 2004 27
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
Copyright by S. Wang, 2004 28
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