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

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 3 ways
 ERM 10 key criteria
 ERM process cycle
 Value-based
V l b
d ERM fframework
k

2
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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
3
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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




4
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ERM process cycle
Risk
Identification

Risk
Quantification

Risk
Messaging

Risk
Ri
k
DecisionMaking

5
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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

6
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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

5
15
26

12

3

25
34

1

16
35 27
2

31

19

28
6

23

30

13

11

4
8
20

All
Risks

14
10
9
7

Likelihood

Key Risk
Scenarios

Correlation

Likelihood

Severitty

33
29

Mostly Objective

X

Enterprise Value

FINANCIAL
Market
Credit
…

STRATEGIC

Key
Risks

Strategy

1+ events / sim

1 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 1

Legislatiion Risk

Process

Loss of Critical EEs

…

M&A Risk
Execution Risk
International Risk 1
Loss of Keyy Supplier
pp
Loss of Key Distributor
IT Risk 2
International Risk 2
Union Negotiations
Competitor Risk 1
Consumer Relations Risk

0.0% -5.0% -10.0% -15.0% -20.0% -25.0%

Identification

Quantification

Decision-Making

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Value-Based ERM Framework – banking scorecard
10
Strategy
Qualitative
Assessment
1) Risks not defined
by source

Risk
Mgmt
Tactics

22

5
15
26

12

3

25
34

1

19

28
6
13

11

4

Key Risk
Scenarios

20
14
10
9
7

Likelihood

Credit
…

STRATEGIC

Correlation

5

Mostly Objective

3

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 1
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

2

OPERATIONAL

ERM
Model

6

8

1 event / sim

Mostly Subjective

Execution

…

Enterprise Risk
Exposure

23

30

8

All
Risks

9

16
35 27
2

31

Value Impact

Likelihood

Severitty

1

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

4

7) Lack of enterprise
value metrics

Loss of Critical EEs
M&A Risk

7

Execution Risk
International Risk 1

Loss of Keyy Supplier
pp

Loss of Key Distributor
IT Risk 2
International Risk 2
Union Negotiations

4) Not measuring/reporting
risk on pre-mitigation basis

Competitor Risk 1
Consumer Relations Risk

0.0% -5.0% -10.0% -15.0% -20.0% -25.0%

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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

9
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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


www.simergy.com

10
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