ERM Flashcards — Part 6 FINAL

ERM Implementation

Final versions: [Pt.1] [Pt.2] [Pt.3] [Pt.4] [Pt.5] [Pt.6]

• [30] Reasons to hold capital (3): 1. manage cashflow (working capital); 2. facilitate growth / new ventures (development capital); 3. cover unexpected losses (risk capital)
• [30] Definition of capital (3): 1. amount meant to provide sufficient surplus to cover adverse outcomes; 2. with a given level of risk tolerance; 3. over a specified time horizon
• [30] Process of capital management (3): 1. quantification; 2. allocation; 3. optimization
• [30] Purpose of generic capital models: Used by capital providers and regulators to gain a consistent assessment of capital requirements across different firms
• [30] Purposes of internal capital models (2): 1. used to simulate company specific view of the capital needed; 2. improve management’s understanding of business dynamics (thus improve decision making)
• [30] Ancillary uses of internal capital models (11): 1. determine risk profile; 2. capital budgeting; 3. determine capital needed for M&A; 4. insurance product pricing; 5. risk tolerances/constraints; 6. set investment strategy; 7. determine RAROC; 8. performance measurement; 9. incentive compensation; 10. alternative to regulatory/rating agency requirements; 11. disaster planning
• [30] Forecast outputs of an internal capital model (3): 1. balance sheets; 2. profit and loss accounts; 3. cashflow
• [30] Desirable features of an internal capital model (4): 1. asset model allows for asset correlations; 2. liability model considers reinsurance and liability correlations; 3. asset and liability models are integrated and allow for correlations between assets and liabilities; 4. model is dynamic
• [30] Meaning of “dynamic” capital model: Asset and liability cashflows are linked by equivalent economic variables (e.g. inflation)
• [30] Benefits of internal capital model being dynamic (8): 1. improved understanding of current strategy; 2. considers impacts of other strategies; 3. examines using other sources of capital; 4. useful for due diligence; 5. assesses risk adjusted performance of business units; 6. determines optimal asset mix; 7. helps understand impact of extreme events; 8. useful for Financial Condition Reports
• [30] Factors discussed in FCR: Financial Condition Report is a formal assessment of the financial viability of the insurer and includes outputs from an internal capital model plus hard to quantify factors (reputational risk, ERM effectiveness)
• [30] Differences between internal and generic capital models (): 1. objectives; 2. calibrations (1 in 500 vs. 1 in 200); 3. volatility views; 4. diversification allowances; 5. inclusion or treatment of different risks; 6. views on availability of certain assets as capital
• [30] Stages in operating a successful capital model (6): 1. identify purpose; 2. identify and rank risks; 3. choose simulation approach for each risk; 4. define risk metrics; 5. select modeling criteria; 6. decide on method of implementation
• [30] Ways capital management can increase shareholder value (4): 1. price competitively; 2. better reserving; 3. performance management; 4. risk management
• [30] Bottom-up process for calculating capital requirements (4): 1. generate stand-alone distributions of changes in the enterprise’s value due to each risk source; 2. combine distributions (allow for diversification); 3. calculate total capital at desired standard for selected risk metric(s); 4. allocate capital to each activity based on amount of risk generated
• [30] Analysis methods used to calculate capital (10): 1. probability of ruin; 2. economic cost of ruin; 3. full economic scenarios; 4. stress test method; 5. factor tables; 6. stochastic models; 7. statistical models; 8. credit risk methods; 9. operational risk methods; 10. option pricing theory
• [30] Tiers of capital under Basel II (3): 1. bank’s equity and disclosed reserves; 2. other reserves and various debt instruments; 3. certain types of short dated capital
• [30] Basel III changes (6): 1. tier 1 plus tier 2 capital at least 8% of RWAs; 2. tier 1 capital at least 6% of RWAs; 3. conservation buffer of 2.5% of RWAs; 4. additional deductions from common equity; 5. reduce pro-cyclicality by allowing capital requirements to fall in times of financial stress; 6. reduce systemic risk by limiting holdings in other banks
• [30] Economic income created: EIC=(RAROC-[hurdle rate])*Capital
• [30] Capital allocation methods (5): 1. use of risk measure (apply Euler principle); 2. marginal approach; 3. game theory approach; 4. pro-rata; 5. stand-alone (remaining capital retained in main corporate business line)
• [31] Major processes to establish in ERM implementation (4): 1. corporate governance; 2. risk assessment and quantification; 3. risk management; 4. reporting and monitoring
• [31] Business applications by stage of ERM maturity (3): 1. loss reduction; 2. uncertainty management; 3. performance optimization
• [31] Key considerations in scoping an ERM implementation (3): 1. resourcing (internal v. external); 2. proportionality (to risks and size and sophistication of business); 3. top down or bottom up
• [31] Key challenges in ERM implementation (2): 1. lack of risk awareness; 2. inappropriate risk culture
• [31] Lam’s ERM maturity model (5): 1. definition and planning; 2. early development; 3. standard practice; 4. business integration; 5. business optimization
• [31] Activities in Lam’s definition and planning stage (4): 1. identify internal and external requirements; 2. obtain Board and management support; 3. develop overall framework; 4. appoint key personnel
• [31] Activities in Lam’s early development stage (4): 1. establish ERM policies and risk functions; 2. identify key risks; 3. coordinate risk and control processes; 4. education
• [31] Activities in Lam’s standard practice stage (4): 1. establish risk database; 2. develop KRIs; 3. establish risk models; 4. measure risk adjusted performance
• [31] Activities in Lam’s business integration stage (7): 1. evaluate business risks; 2. quantify cost of risk; 3. automate risk reporting; 4. allocate capital; 5. use risk triggers to prompt business decisions; 6. measure ERM effectiveness; 7. link to executive compensation
• [31] Activities in Lam’s business optimization stage (3): 1. expand scope of ERM to include strategic risk; 2. integrate ERM into strategic planning; 3. allocate capital to optimize risk-adjusted performance
• [31] McKinsey’s risk maturity model (4): 1. initial risk transparency; 2. systemic loss reduction; 3. risk-return management; 4. risk as competitive advantage
• [31] Deloitte’s risk maturity model (5): 1. unaware / planning; 2. fragmented / specialist silos; 3. top-down; 4. systematic; 5. risk intelligent
• [31] IAA stages of ERM maturity (3): 1. early; 2. intermediate (established); 3. advanced (established, consistent, understood)
• [31] Areas to consider when assessing ERM maturity (4): 1. corporate governance; 2. risk language and culture; 3. competencies and performance management; 4. risk management processes and responsibilities
• [32] Elements of organizational learning (4): 1. be open to discuss own past mistakes; 2. be able to learn from those mistakes; 3. be aware of mistakes of others; 4. adopt industry best practices
• [32] Lam’s lessons learned (7): 1. know your business; 2. establish checks and balances; 3. set limits and boundaries; 4. keep your eye on the cash; 5. use the right yardstick; 6. pay for the performance you want; 7. balance the yin and the yang
• [32] Mistakes leading to the 2008 financial crisis (8): 1. failure to understand and report risks inherent in business activities; 2. complex products were not well understood; 3. over-dependence on cheap debt; 4. remuneration encouraging short term goals; 5. unbundling and outsourcing led to poor sales practices; 6. deregulation of financial sector allowed risk to propagate unchecked; 7. poor corporate governance led to bad decision making at Board level; 8. credit rating agencies struggled to keep pace with complex products and banks that gamed the system
• [32] Lessons learned from Barings case (4): 1. need to internal checks and balances; 2. need for proper supervision of employees with clear reporting lines; 3. auditors and top management should understand the business; 4. bonuses should be based on profits over a longer time horizon
• [32] Examples of rogue traders (6): 1. Barings Bank (1995, Nick Leeson); 2. Morgan Stanley (2008, Matthew Piper); 3. MF Global (2008, unnamed); 4. Societe Generale (2008, Jerome Kerviel); 5. PVM Oil Future (2009, unnamed); 6. USB (2011, unnamed)
• [32] Regulatory failures in Equitable Life case (4): 1. over tolerant attitude in light of GAD warning and complex reinsurance arrangements; 2. shortage of supervisory staff leading to arms-length monitoring; 3. over tolerant attitude by profession in regards to the Appointed Actuary also holding Chief Executive post; 4. failure of prior investigations to identify potential future related risks
• [32] Lessons learned from LTCM case (3): 1. liquidity itself is a risk factor; 2. models must be stress tested and used to inform decisions rather than make them; 3. financial institutions should understand aggregate exposures to common risk factors
• [32] Lessons learned from Madoff case (2): 1. if it looks too good to be true, it probably is; 2. do your due diligence
• [32] Lessons learned from space shuttle Challenger (2): 1. ensure decision makers and leaders understand the risks that are being taken; 2. do not succumb to pressures to hit artificial targets at the cost of good risk management
• [32] Lessons learned from Confederate Life (3): 1. apply checks and balances on the activities of those in positions of power; 2. concentration kills (set limits and establish a balance); 3. understand the business
• [32] Lessons learned from Orange County (6): 1. beware of unconstrained star performers; 2. where there is excess return, there is risk; 3. powerful individuals can hide risk if company structure has gaps; 4. borrowing short and investing long leads to liquidity risk; 5. tie investment objectives to investment actions through framework of policies and oversight; 6. risk reporting should be complete and easily comprehensible to independent professionals