Number The Strategic & Governance Challenges of Enterprise Risk Management Thomas C. Wilson Managing...

Number

The Strategic & Governance Challenges of Enterprise Risk Management

Thomas C. WilsonManaging Director, Head of Finance & Risk Practice Mercer Oliver Wyman

Chicago, April 27th, 2004

Copyright © 2004 Mercer Oliver Wyman 2

Number

Enterprise Risk Management – Objectives & Complexity

Institution

U/WInvestment Etc.

SecuritiesDerivatives

CreditFinancialOperational

P&C, Specialty Life & Health

Mortality & LongevityProperty & CasualtyClaims DevelopmentFrequency & Severity, ParameterOperational

Across All RisksAt All Levels

• Economic capital, Risk Adjusted Return on Capital, EVA• Comprehensive, Comparable & in financial terms• Supporting cross-risk decisions, e.g.

- Risk appetite & strategy, - Solvency & capital management- Economic performance measurement- Asset/Liability Management- Reinsurance optimization

• Consistent with corporate governance


Number

Risk & Risk Capital Measurement Becoming the Norm

No Overall Programme

Planned

Programme in Development

ProgrammePiloted

Mature Internal Programme

Comprehensive Internal Programme (+ external reporting)

Level of Sophistication

ECAP Survey 2000: Classification of participating institutions

2003 “norm”

2 1 5 3 3

2000 ‘norm’

0 2 5 8 4

ECAP Survey 2003

14 participants

19participants

Source: Economic Capital Survey 2003, Mercer Oliver Wyman


Number

Risk Capital Potentially at Centre of Business Impact

Risk and Economic

Capital Measurement

2. Performance Measurement &

Management

1. Business Portfolio

Management

3. ALM and

Investment

Strategy

4. Pricing

5. Reinsurance Optimisation

6. Limit Setting

• Common measurement standard leading to common language

• Common risk ‘currency’, interpretation as capital


Number

Facilitating Business Unit Performance Evaluation on a ‘Apples-to-apples’ Basis

RAROC Versus Economic CapitalRAROC

Economic Capital

AB

C

D

E

F

G

H

Hurdle Rate

Grow/invest more aggressively in these businesses

Restructure/sell/downsizethese businesses


Number

Rating downgrade

P/E re-rating Increased

cost of capital

Possible Consequences

Disconnect

0

2

4

6

8

10

12

14

mid2002

end2005

end2005

mid2002

BU 2

BU 1

20% Asset Growth

Current

Solvency IIRequirements

RatingAgencies

StrategicBuffer

Current

ShareBuyback

DividendsPaid Out

RetainedEarnings

Cap

ital

US

$ B

N

CyclicalityPremium

Required Capital Available Capital

Capital Planning Implications


Number

Five Components of a Group Risk Framework

5. IT Infrastructure

Data architecture: risk, performance, etc. Application architecture Technical architecture

1. Strategic Objectives

Communication& Confidence

Risk Underwriting

Risk Controlling

Risk Strategy

Line, staff and committee structures Policies & procedures Roles & responsibilities Limits & authorities

2. Structure & Organization

Committees

4. Methods, Information & Reports

Methods for risk, capital and economic performance Standardized reports for control & decision making Underlying reporting processes

3. Management Processes

Corporate Calendar Jan Apr Jul Oct Ad Hoc

Risk target setting X

EVA & Ecap plans X

Limit setting and capital allocations X

Balance sheet capital, funding & liquidity plans X X X X X X X X X X X X

Accounting parameters X

Reserving standards, parameter selection X

New products and lines of business X X X X X

Underwriting guidelines X X X X

Large transactions X X X X X X X X X X X X X

TAA X X X X

Internal/external audit recommendations X X


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Formulating Risk Strategy and Objectives: Key Questions

Communication &Confidence

Risk Underwriting

Risk Controlling

Risk Strategy

• Disclosure, risk and risk management?• Guidance and potential scenario impact

• Insurance company’s risk appetite and solvency? • What products/markets create economic value? • Allocation of finite capital and risk limits?

• Risk profile and exposures understood ? • Risk profile within delegated limits? • Authorities delegated?

• Risks structured, underwritten and priced? • All other risks identified, analysed and mitigated?• Pervasive ‘risk culture’? • Incentives aligned?• Policies, guidelines, control mechanisms?


Number

Representative CRO Organization

Source: Mercer Oliver Wyman, “Evolving Role of the Chief Financial Officer & Chief Risk Officer”


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Reporting Lines

Source: Mercer Oliver Wyman, “Evolving Role of the Chief Financial Officer & Chief Risk Officer”

BY SECTOR

REPORTING LINES OVERALL BANKING INSURANCE

CEO/CHAIRMAN 40% 55% 22%

VICE CHAIRMAN 15% 27% 0%

CFO 35% 18% 56%

OTHER 15% 0% 33%

~66% have CRO ~25% to create CRO within next 18 months ~60%+ of CROs have enterprise mandate


Number

Roles & Responsibilities

WHAT RISK MANAGEMENT FUNCTIONS ARE YOU RESPONSIBLE FOR?

0% 20% 40% 60% 80% 100%

Activity

Percentage

Limit Monitoring

Limit Setting

Risk Reporting

Portfolio Measurement

Transaction Measurement and

Underwriting

Economic Capital

Policies and Procedures

MITIGATION

STRATEGIC

EXPOSURE & LIMITCONTROLLING

TRANSACTIONLEVEL


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Illustrative Organisational Structure: Issues

BU CIO

BU CRO

BU CFO Local Committees Finance/ALCO Committee Risk & Capital Committee Etc

CEO

Board

Group Committees Finance/ALCO Committee Risk & Capital Committee Underwriting Committee Reserving Committee Etc.

Group Risk Group Finance

Group Investments

BU CEO BU CEO

Insurance

A/LM

Credit

Operational

Reporting

BU CIO

BU CRO

BU CFO

Reporting LinesNetworks

Risk Finance Actuarial


Number

Group Risk Committee

Chief Risk Officer, Chair CFO, CIO, CUO Business representation Group Risk Management,

Process Owner

Composition & Staffing

Roles & Responsibility

Ensure risk management capabilities, controls and culture throughout the organisation

Monitor Group and BU exposure, risk and solvency against delegated authorities

Ensure alignment of corporate business and risk strategy

Define & execute external communication guidelines

Authorities

Approval of

– Risk Management Minimum Standards

– Underwriting authorities, policies and guidelines

– Limit structures Risk measurement methodologies Risk mitigation, e.g. reinsurance, asset

sales, etc.

- DISGUISED CLIENT EXAMPLE -

Performance Metrics Loss realization, e.g. combined ratio,

asset writedowns, credit defaults Loss ‘surprises’ Loss performance relative to peers 360 degree feedback Expense management


Number

Management Processes: Designing Corporate Calendar

: Standing Agenda

Decisions Jan Apr Jul Oct Ad hoc

Capital & Risk Committee – Risk Strategy & Control

Review/approve EVA & Ecap plans X

Review/approve Ecap/risk resource allocations (e.g. NatCat) X

Review/approve internal/external retrocession strategies X

Review current risk profile against strategy and limits X X X X

Finance Committee – Risk & Financial Solvency

Review/approve balance sheet capital, funding & liquidity plans X X

Review/approve internal/external retrocession implementation X X

Review/approve accounting 'judgement' parameters X

Review/approve reserving standards, parameter selection X

A/L Committees – Focus on SAA/TAA

Review/approve strategic asset allocation X X X

Review/approve tactical asset allocation X X X X

Product Management Committee

Review/approve new products and lines of business X X X X X

Review/approve underwriting guidelines X X X X

Underwriting Committee

Approve large transactions above LE authorities X X X X X

Audit Committee

Review internal & external audit & op risk recommendations X X

– Illustration –


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Integration into Strategic Planning Process

Long-term Group strategiesEVA/ROE targets (TDIs) for next year

at Group and BUs

BU three-year plan based on TDIs

S-chart for Group and BUs(incl. medium-term BU EVA

targets)

P-chart for Group and BUs (approved budget for next

year)

Jan. Feb. March April May June July Aug. Sept. Oct. Nov. Dec.

BU Planning

Board

GFC

BUs

BUTarget Setting

Top-down Targets

Strategic Survey

GroupStrategic

Plan

KeyPlanningFigures

Aggre-gation

Communi-cation of

TDIs

Source: GFC; Mercer Oliver Wyman Analysis

Disagg-regation of targets

BU dialogue

Aggregation Gap analysis

target vs. plan

Revenue EVA RoE Grow/

stable/shrink capital

Revenues per LoB/ product line P&L Balance sheet Funding Capital needs

Strategic self -assess-ment of business models

Market share

Revenues Costs

EVA ROI IAS net

income

1. Strategic Analysis 2. Strategic Dialogue

Group Strategy

Prepare offsite

Deter-mine top-down indicators (TDIs)

– Current Management Dialogue –

3. Planning Dialogue

- DISGUISED CLIENT EXAMPLE -


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Measurement Challenges for Integrating Into Strategic Decision Making Processes

Source: CFO/CRO Survey 2002

Which three measures are most used by your institution for

strategic planning and decision making*

1. Earnings and earnings growth

2. Revenue and revenue growth

3. Cost or cost/income ratios

4. Return on book capital

5. Return on risk capital

6. Market share

7. Other

8. Market valueEmbedded valueShareholder value

How satisfied are you with the following aspects of your current

performance measurement framework?

Accurately reflects shareholder

perspectives

90%

83%

67%

58%

27%

58%

Accepted with organization

Level of detail

Transparency with respect to value drivers

Accurate reflection of business economics

Link between internal metrics (e.g. RAROC, ECAP) and

shareholder value

What are the most important pieces of financial information

that you communicate externally?

Revenue and growth

83%

58%

58%

58%

42%

42%

33%

33%

17%

Earnings guidance

Return on equity

Cost/income ratio

Exposure/risk information

Earnings and growth

Return on risk capital

Capital ratio

Line of business information


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Measurement Challenges (continued)

Source: CFO/CRO Survey 2002

What prevents economic capital from being as important as it could?

Complexity 82%

82%

45%

45%

36%

36%

36%

27%

27%

ECAP is not a constraint

Management acceptance

Not understood internally/ externally

Reconciliation with financials

Accuracy

Instability

Not as important as earnings or growth

Reconciliation with shareholder valuation

Which areas of performance measurement could be most

improved?

Revenue recognition

75%

42%

42%

25%

17%

Cost recognition

Credit loss estimates

Capital measurement

Cost of capital


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Example Reporting Framework – Group ALCO Report

A4 vertical

12-15 pages enhanced, excluding appendix

Annual, enhanced form, for Board Finance Committee

Monthly for positioningTABLE OF CONTENTS

1. Executive Summary

2. ALCO Positioning Recommendation – SAA Performance to date – MD&A Recommendation (Quarterly) – Current Positions – Scenarios

Financial Scenarios Business Plan Scenarios Re-positioning scenarios

– Financial & Economic Impact (NII, NAV, Ecap, etc.) – Final SAA Recommendation, including Group limits

3. Local Implementation

– Current positions – Recommended positions, including LE tactical limits

4. Review of limit structure, investment guidelines (Annually, ad hoc)

5 Next steps

6. Appendix

- ILLUSTRATIVE -


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Example Risk Reporting Templates – Group Risk Dashboard

I. Group Overview- Risk & exposures- Scenario analysis

II. Exposure, risk & limits– Credit Risk– Market/ALM Risk– Insurance Risk– Operational Risk– Liquidity Risk

III. Watchlist

IV. Recommendations

IV. Appendix

Contents Screen Shots

Liquidity Exposure under "Panic" & "Nightmare" ScenariosEntity: GroupAs of: Q4, 2002Currency: €MM

Group Liquidity – Panic Scenario

Group Liquidity – Nightmare Scenario & Impaired Capital Markets

10,989

25,024

52,246

80,077

130,289

161,294

177,570

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

180,000

200,000

Current 1mo 3mo 6mo 1yr 2yr 3yr

Euro MM

0.0

1.0

2.0

3.0

4.0

5.0

6.0Excess 2003 Q1

Excess 2003 Q2Ratio 2003 Q2

5,76013,925

33,260

60,300

110,505

149,835

166,000

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

180,000

200,000

Current 1mo 3mo 6mo 1yr 2yr 3yr

Euro MM

0.0

1.0

2.0

3.0

4.0

5.0

6.0Excess 2003 Q1Excess 2003 Q2Ratio 2003 Q2

Recent Performance: Event Losses & Cases OutstandingEntity: OEsAs of: Q4, 2002Currency: €MM

Recent Operational Failures OE Size of Loss Date Comment

E.g. US IT System failure A 30-50 Oct-02 Cause investigated & solvedE.g. D Internal fraud B 8 2002 Fictitious benefit paymentsE.g. Delays to F policy processing

C 5-10 2002 Problems will be resolved by Q2 2003

E.g. UK product withdrawn C 3 May-02Poor sales documentation – has now been corrected

… … … … …

Major Legal/Compliance Cases Outstanding OE

Magniture of Remaining Exposure

(€MM) Likelihood Comment

E.g. US Discrimination Class Action

A 1,000 L Case pending

E.g. UK Asset Mismanagement Case

B 400 L Risk of further pay-outs

E.g. I Misleading Marketing Case etc.

C 50 M/H Awaiting regulator's decision

… … … … …

Market Risk – Current ExposuresEntity: GroupAs of: Q4, 2002Currency: €BN

A B C D E F G H I J K L M N O P Other

Equity Total

Traded Shares

Equity FundsPrivate Equity

Real Estate TotalPrivate

Commercial

Funds

Fixed Income Total

SovereignCommercial BondsCDO/CBOs/ABSHigh Yield

LoansMortgagesOtherTotal

Assets at Market Value in €MM

Credit Risk Contribution by OEEntity: All Red lightAs of: Q4, 2002 Yellow lightCurrency: €BN

OE EL EL LimitUL

(C-VaR) UL Limit

ABCDEF

Group

HIJKLMNOtherPOtherGroupComments:

Risk Contribution

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