enterprise risk m training awaereness.ppt

enterprise risk m training awaeren

1. Enterprise Risk Management:
Hollow Tree or Giant Redwood?
Midwestern Actuarial Forum
Chicago
March 7, 2008
Rick Gorvett, FCAS, MAAA, ARM, FRM, PhD
Director, Actuarial Science Program
State Farm Companies Foundation Scholar in Act. Sci.
University of Illinois at Urbana-Champaign
MAF

2. Regarding the title of this talk
I certainly have nothing against
hollow trees…

4. E
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D

5. E
C
D
xcessive
ookie
isorder

8. Agenda
ERM in general
Observations from the CAS ERM Online Course
Issues in advancing ERM
◦ERM as complex systems analysis
◦ERM as an evolutionary process
◦ERM as subject to behavioral patterns
Conclusion

9. “Who am I? Why am I here?”
- Admiral Stockdale, 1992
Currently
◦Director, Actuarial Science Program
◦State Farm Companies Foundation Scholar in Actuarial
Science
◦Professor, Depts. of Mathematics, Statistics & Finance
◦University of Illinois at Urbana-Champaign
Prior
◦Senior Vice President
◦Director of Internal Audit & Risk Management
◦Internal Audit
◦Corporate Investigations
◦Risk Management
◦Enterprise Risk Management
◦Business Continuity

10. ERM – General Thoughts

11. Steps in the
Risk Management Process
Determine the corporation’s objectives
Identify the risk exposures
Quantify the exposures
Assess the impact
Examine alternative risk management tools
Select appropriate risk management approach
Implement and monitor program

12. Impact of Financial Risk Management
on Cash Flow Volatility
Cash Flow
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Pre-FRM
Post-FRM

13. An Initial ERM Comment
You don’t become a famous writer by…
◦Reading a book
◦Reading about other authors
◦Watching someone else write
Similarly, you don’t become an “Enterprise Risk Manager” by…
◦Reading a book
◦Taking a course
◦Listening to a presentation

14. Rather, ERM is…
A complex process…
… involving broad-based and in-depth knowledge and understanding…
… requiring an appropriate corporate culture,…
… and creativity…
… born of a variety of experiences…
… and insatiable curiosity.

15. Enterprise Risk Management
Or “Enterprise Risk and Assurance Management” or…
What is ERM?
◦Concerned with a broad financial and operating perspective
◦Recognizes interdependencies among corporate, financial, and environmental
factors
◦Strives to determine and implement an optimal strategy to achieve the primary
objective: maximize the value of the firm

16. Other Possible Goals of ERM
Create and increase company value
Ensure business continuity
Stabilize earnings
Enhance opportunities for the company to achieve its objectives
Make risk management more cost-efficient

17. Evolution of ERM
Historically: “risk silo” mentality
Mid-1990s:
◦First “Chief Risk Officer”
◦First use of ERM terminology
Late-1990s:
◦Risk-related regulatory requirements (e.g., Turnbull)
◦Earnings protection insurance debuts
2001:
◦September 11
◦Corporate scandals
◦Beginning of efforts to improve corporate governance

18. Current State
Findings from various surveys
◦An acknowledged need to improve risk management
◦A recognition that a holistic approach is appropriate and preferable
◦ERM can improve overall capital management and thus enhance corporate value
and competitiveness
◦A variety of approaches to improving risk management
◦There are still problems to overcome

19. A Paradigm Shift
Traditional
Risks managed in silos
Concentrates on physical
hazards and financial
risks
Insurance orientation
Ad hoc / one-off projects
Emerging
Centralized mgt., with
exec-level coordination
Integrated consideration of
all risks, firm-wide
Opportunities for hedging,
diversification
Continuous and embedded

20. Types of Risks
Operational
◦Hazard
◦Physical
Strategic
◦Capital / resource allocation
◦Industry / competitors
Technological
◦Databases
◦Security
◦Confidential information
Stakeholder
Legal
◦Compliance
◦Regulatory
Financial
◦Capital markets
◦Credit risks
◦Taxes
Human capital
◦Retention
◦Training
Reputational

21. Issues in ERM Implementation
Different corporate cultures require different ERM approaches
Who is going to be the ERM champion within the company
◦Among senior executives
◦Among departments / functions
How to embed a risk management culture and responsibilities throughout
the firm

22. Components of the ERM Process
Determine corporate objectives
Risk identification
◦Goal: comprehensiveness
◦E.g., self-assessment
Risk measurement
◦Volatility measures
◦Value at Risk (VaR)
Impact
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Size of loss
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23. Components of ERM (cont.)
Assessing the impact
◦Stress or scenario testing
◦Stochastic simulation
Examine and select alternative risk management tools and techniques
◦Traditional risk transfer
◦Natural hedging / diversification
◦Integration of risks
E.g.,
“dynamic
financial
analysis”

24. Keys to Success in ERM
Senior management commitment and sponsorship
Embed a “risk management culture” in the corporation at the operational
level
Provide for accountability, both specific and widespread
Clearly defined responsibilities for coordination and maintenance
Adequate communication

25. ERM Tries to Avoid…
“A failure of imagination.”
- Frank Borman, in testimony to Congress,
responding to a question regarding the real
cause of the Apollo 1 fire and the resulting
three astronaut deaths, as dramatized in
HBO’s series From the Earth to the Moon

26. Observations from the CAS
ERM Online Course

27. CAS Online Courses
Originally, four modules in a Financial Risk Management series
Newest course: “Intro to ERM”
◦First offering: October 2006
◦Fourth offering: January 2008
Course components:
◦12 lectures (PPT with voiceovers)
◦Readings, and case studies
◦Discussion forum
◦“Final exam”

28. Titles of Lectures
1)Introduction to ERM
2)ERM in Context
3)ERM in Practice
4)ERM Framework
5)Hazard Risk
6)Financial Risk
7)Operational Risk
8)Strategic Risk
9)Risk Metrics
10)Application of ERM
11)COSO Pros and Cons
12)Conclusion

29. Some Preliminary Observations
Significant But Most Difficult Risk to Quantify

Reputational risk
◦Quantification suggestions – e.g., “event study”
Human capital
Operational risk
Strategic risk

30. Some Preliminary Observations (cont.)
Status of ERM at Company

Many companies have moved in the direction of ERM
Some are well along
◦CROs, risk committees
Some have a long way to go
◦Still some silo mentality
◦Focus on more immediate issues (e.g., SOX)
◦Question ERM’s staying power

31. Some Preliminary Observations (cont.)
Risk Measures – Alternatives to VaR

Economic capital
Measures relating risk and return (e.g., RAROC)
Probability of ruin
A few thought VaR and TVaR are reasonable and serviceable

32. Some Preliminary Observations (cont.)
Greatest Risks Faced

Hazard risks (particularly catastrophe and terrorism risks)
Reputational risks
Operational risks
Pricing – reserving risks
Financial risks
Strategic risks

33. Issues in Advancing ERM

34. (1) Complex Adaptive System
A system of individual “agents” which interact and adapt / evolve to changing
conditions
Characteristics
◦Not reducible
◦Self-organized emergence, exhibiting nonlinearities
◦Bottom-up rather than top-down
Some examples
◦Economies
◦Ecologies
◦Consciousness
◦Organizations

35. Complex Social Systems
“One must study the laws of human action and social cooperation as the
physicist studies the laws of nature.”
- Human Action, Ludwig von Mises, 1949

36. Historical Recognition
“He intends only his own gain, and he is in this, as in many other cases,
led by an invisible hand to promote an end which was no part of his
intention.”
- An Inquiry into the Nature and Causes of
the Wealth of Nations, Adam Smith, 1776

37. (2) Evolutionary Process
There are several important parallels between economic systems and
biological evolutionary theory
◦Complex systems
◦Self-organized agents / individuals
◦Adaptation / natural selection
◦Emergence of “order”
◦Understanding the historical process helps to explain behavior

38. Biology and Economics
“The precise mathematical relationship which describes the link between the
frequency and size of the extinction of companies, for example, is virtually
identical to that which describes the extinction of biological species in the
fossil record. Only the timescales differ.”
- Why Most Things Fail: Evolution, Extinction &
Economics, Paul Ormerod, 2005

39. (3) Behavioral Concerns
Various well-documented “fallacies” can cause inaccurate or biased estimates
of values, probabilities, etc. E.g.,
◦Anchoring fallacy: bias toward an initial value
◦Inattentional blindness: concentrating in one area can induce blindness to other
events
◦Availability fallacy: immediately-available examples have a perhaps undue
influence on our estimates

40. Evaluating Probabilities
“The information provided by advocacy groups is blunt.

“Y-Me states that breast cancer is ‘the overall leading cause of death in women
between the ages of 40 and 55.’ It adds: ‘In the United States, 1 in 8 women will
develop breast cancer in her lifetime. This year, breast cancer will be newly
diagnosed every three minutes and a woman will die of breast cancer every 13
minutes.’

“CapCure, the organization founded by Michael Milken to fight prostate cancer,
states similar statistics: ‘In 2002, an estimated 189,000 men will be diagnosed
with prostate cancer. This represents one new case every three minutes.’

“While the figures are accurate, some medical researchers are concerned by the
messages they convey. Such statements, they say, may lead people to
exaggerate their chances of getting and dying from a fearsome disease.”
- “Experts Strive to Put Diseases in Proper Perspective,” by Gina Kolata, New York Times, 7/2/02

41. Evaluating Probabilities (cont.)
“Even concerns about real dangers, when blown out of proportion, do
demonstrable harm. Take the fear of cancer. Many Americans
overestimate the prevalence of the disease, underestimate the odds of
surviving it, and put themselves at greater risk as a result. Women in their
forties believe they have a 1 in 10 chance of dying from breast cancer, a
Dartmouth study found. Their real lifetime odds are more like 1 in 250.
Women’s heightened perception of risk, rather than motivating them to
get checkups or seek treatment, can have the opposite effect. A study of
daughters of women with breast cancer found an inverse correlation
between fear and prevention: the greater a daughter’s fear of the disease
the less frequent her breast self-examination. Studies of the general
population-both men and women-find that large numbers of people who
believe they have symptoms of cancer delay going to a doctor, often for
several months. When asked why, they report they are terrified about the
pain and financial ruin cancer can cause as well as poor prospects for a
cure….”
- The Culture of Fear: Why Americans are Afraid of the Wrong Things, Barry Glassner, 2000,
Basic Books

42. Research
New undergraduate research initiative at the University of Illinois
Current research projects
◦Agent-based modeling
◦Predator – prey models
◦Power laws and their applications
◦Neuroeconomics and behavioral economics

43. Conclusion

44. ERM Predictions – Lam*
1.ERM will become an industry standard
2.CRO position will be prevalent
3.Audit committees will become risk committees
4.Economic capital will replace VaR
5.Enterprise-level transfer of risk
6.Impact of advanced technology
7.Measurement standard for operational risk
8.Mark-to-market accounting
9.Risk education will grow
10.Salary gap between risk professionals will widen
*Enterprise Risk Management: From Incentives to Controls, James Lam, 2003

45. Personal Conclusions
ERM is a giant redwood
However, let’s not underestimate how big a challenge it is
◦Even in a “frictionless” world, quantifying and codifying a holistic
approach to risk management is an enormous task
◦Real-world realities make it even more difficult
But it’s worth the effort

46. Concluding Quotation
“The revolutionary idea that defines the boundary between modern times
and the past is the mastery of risk”
- Peter Bernstein, Against the Gods