7 ERM and the financial crisis a failure of theory or practice

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7 ERM and the financial crisis a failure of theory or practice

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ERM and the Financial Crisis: A Failure of Theory or Practice? Sim Segal, FSA, CERA, MAAA President SimErgy Consulting LLC Federated Press 3rd Board Risk Management Conference E t bli hi and Establishing d Maintaining M i t i i Effective Eff ti ERM Practices P ti April 12, 2010 Defining ERM ways  ERM 10 key criteria  ERM process cycle  Value-based V l b d ERM fframework k Copyright © SimErgy All rights reserved ERM 10 key criteria 1) Enterprise-wide – all areas in scope 2) All risk categories – financial, operational & strategic 3) Key risks only – not hundreds of risks 4)) Integrated – captures interactivity off 2+ risks 5) Aggregated – enterprise-level risk exposure/appetite 6) Decision-making Decision making – not just risk reporting 7) Risk-return mgmt – mitigation plus risk exploitation 8) Risk disclosures – integrates ERM information 9) Value impacts – includes enterprise value metrics 10) Primary stakeholder – not rating agency-driven Copyright © SimErgy All rights reserved ERM 10 key criteria – banking scorecard X 1) X 2) Enterprise-wide – “golden boys” out of scope All risk categories – overly-focused on financial 3) Key risks only “ management / measurement X 4)) Integrated – “silo” X 5) Aggregated – no aggregate enterprise-level metrics 6) Decision-making Decision making X 7) Risk-return mgmt – metrics only support mitigation post-event event X 8) Risk disclosures – inappropriate even post X 9) Value impacts – only capital metrics X 10) Primary stakeholder – focus on ratings / regulators   Copyright © SimErgy All rights reserved ERM process cycle Risk Identification Risk Quantification Risk Messaging Risk Ri k DecisionMaking Copyright © SimErgy All rights reserved ERM process cycle – banking scorecard Risk Identification X Lack of focus on non-financial risks Incentive compensation does not adjust for risk exposure X Risk Quantification Risk Messaging X Poor performance X Risk Ri k DecisionMaking Poor risk exposure metrics and poor d l assumptions ti model Copyright © SimErgy All rights reserved Value-Based ERM Framework Risk Appetite Strategy Qualitative Assessment Risk Mgmt Tactics ERM Committee Scenario Development Value Impact Enterprise Risk Exposure 24 32 22 21 17 18 15 26 12 25 34 16 35 27 31 19 28 23 30 13 11 20 All Risks 14 10 Likelihood Key Risk Scenarios Correlation Likelihood Severitty 33 29 Mostly Objective X Enterprise Value FINANCIAL Market Credit … STRATEGIC Key Risks Strategy 1+ events / sim event / sim Mostly Subjective Execution … ERM Model Baseline Value ▪ ΔValue OPERATIONAL HR “Pain Point” Likelihood ΔValue ≤ -10% 15% ΔValue ≤ -20% 3% Individual Risk Exposures Enterprise Value Impact IT Risk Legislatiion Risk Process Loss of Critical EEs … M&A Risk Execution Risk International Risk Loss of Keyy Supplier pp Loss of Key Distributor IT Risk International Risk Union Negotiations Competitor Risk Consumer Relations Risk 0.0% -5.0% -10.0% -15.0% -20.0% -25.0% Identification Quantification Decision-Making Copyright © SimErgy All rights reserved Value-Based ERM Framework – banking scorecard 10 Strategy Qualitative Assessment 1) Risks not defined by source Risk Mgmt Tactics 22 15 26 12 25 34 19 28 13 11 Key Risk Scenarios 20 14 10 Likelihood Credit … STRATEGIC Correlation Mostly Objective FINANCIAL Market 3)Key Not analyzing multiple risks occurring together Risks Strategy 1+ events / sim … HR X Enterprise Value Likelihood ΔValue ≤ -20% 3% Enterprise Value Impact IT Risk Legislatiion Risk Process Identification “Pain Point” 8) VaR metric hides ΔValue ≤ -10% 15% exposure beyond tail Baseline Individual Risk 6) Poor Value model assumptions Exposures ▪ ΔValue OPERATIONAL ERM Model event / sim Mostly Subjective Execution … Enterprise Risk Exposure 23 30 All Risks 16 35 27 31 Value Impact Likelihood Severitty 17 18 33 ERM Committee 9) N No calculation l l ti off enterprise risk exposure 5) Overly complex correlations 24 32 21 10) No definition of risk appetite Scenario Development 29 Risk Appetite 2) Not using discrete scenarios for nonfinancial risks Quantification Decision-Making 7) Lack of enterprise value metrics Loss of Critical EEs M&A Risk Execution Risk International Risk Loss of Keyy Supplier pp Loss of Key Distributor IT Risk International Risk Union Negotiations 4) Not measuring/reporting risk on pre-mitigation basis Competitor Risk Consumer Relations Risk 0.0% -5.0% -10.0% -15.0% -20.0% -25.0% Copyright © SimErgy All rights reserved Some actions to prevent another crisis    Require companies to implement ERM, in a robust manner Require incentive compensation plans to reflect risk exposure (SEC rule) Require enhanced risk disclosures, including free cash flow projection – Baseline scenario (strategic plan) / key risk scenarios (defined by management )/ standard t d d risk i k scenarios i (d (defined fi d b by regulators) l t ) – Investors apply their own discount rates, and compare scenarios cross-sector  Replace capital requirements with pooled risk charges – Capital not there when needed anyway (must replace or be downgraded) – Government guarantee protects rating during rehab period to rebuild capital  Employ ERM principles at the country level (e.g., concentration risks) – Firms “too too large to fail” fail (e.g., banks, auto companies) / supplier concentration (e.g., energy) / oligopolies (e.g., rating agencies, monoline insurers)  Employ ERM principles at the retail level (e.g., financial planning) – Holistic view of risks and solutions for individuals/families Copyright © SimErgy All rights reserved Contact Co tact information o at o Sim Segal, FSA, CERA, MAAA President SimErgy Consulting LLC Chrysler Building 405 Lexington Ave., 26th Flr New York, NY 10174 (917) 699-3373 Mobile (646) 862-6134 Office ((347)) 342-0346 Fax sim@simergy.com www.simergy.com 10 Copyright © SimErgy All rights reserved ... by management )/ standard t d d risk i k scenarios i (d (defined fi d b by regulators) l t ) – Investors apply their own discount rates, and compare scenarios cross-sector  Replace capital requirements... principles at the retail level (e.g., financial planning) – Holistic view of risks and solutions for individuals/families Copyright © SimErgy All rights reserved Contact Co tact information o at o... risk charges – Capital not there when needed anyway (must replace or be downgraded) – Government guarantee protects rating during rehab period to rebuild capital  Employ ERM principles at the country

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