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The Actuary Magazine December 2004 - Benchmarking Enterprise Risk Management Practices In A Derivatives Firm

Benchmarking Enterprise Risk Management Practices In A Derivatives Firm

By Donald Mango

Actuaries can become the future of enterprise risk management by enhancing their unique skill sets with practices adopted from other industries and promoting themselves to firm managers.

In "The Seven Pillars of Risk Management Wisdom," (The Actuary newsletter, June 2003), David Ingram outlined seven pillars of the paradigm for insurance company risk management:

  1. An understanding of how financial markets treat risk
  2. The law of one price
  3. A model for viewing the insurance risk transfer portion of insurance company products on an equivalent basis with the market–traded elements of insurance products
  4. An understanding of the interaction between risk and discount rates
  5. A mastery of stochastic scenario generators
  6. A clear metric of risk in insurance companies
  7. Management and communication expertise

Ingram focused on the development of insurance risk management: which techniques should be borrowed from other industries, and which need to be homegrown. Ingram was looking to banking as the benchmark for the risk management industry. To quote the article directly:

"Two forces are advancing the push for risk management in life insurance companies. The first is the progression of risk management in banking. Several prominent insurance companies have brought in executives from banking who have expectations of timely and effective risk management information and processes. At the same time, stock and rating analysts who cover both insurance companies and banks are looking for evidence that insurance companies have as much mastery of their risks as banks seem to portray." [p. 5]

As we actuaries contemplate our future in enterprise risk management (ERM), it will be helpful to benchmark ourselves against sister professions and industries farther down the ERM road. Arguably the closest parallel firm to an insurer is a securities firm, particularly one buying and selling derivatives. In derivatives parlance, insurance contracts would be something like "long–dated, illiquid, over–the–counter (meaning customized) derivatives on untraded underlyings." This is not meant to say that insurance should be accounted for the same way as derivatives, although the fair value accounting standards are certainly moving us closer to that.

A good source of information about derivatives risk management is The Practice of Risk Management, by Goldman Sachs (GS) and Warburg Dillon Read, published by Risk Books in 1996. This excellent industry standard details the functioning of the centralized risk management group of a derivatives dealer. It is highly recommended reading.

Per GS, the five main areas within risk management are:

  • Risk monitoring and analysis
  • Quantitative analysis
  • Price verification
  • Model development
  • Systems development and integration

Actuarial Parallels
The second column in the table shows the detailed roles and responsibilities within each area. The third column translates from derivatives to insurance, revealing the strong parallels with traditional actuarial roles and responsibilities (bold text in the table indicates additions or differences in actuarial roles and responsibilities).

Only one item (monitoring limit violations) has no direct actuarial parallel. The others line up nearly one–for–one, with only minor terminology changes needed. This is startling evidence that traditional actuarial roles are already part of core risk management.

Ingram made the compelling case for why ERM is important for insurers, and why actuaries should be the leaders of that effort. All that is well and good to "self–declare" in our own publications. Where we have to make more inroads though, is in convincing the management of our firms of the same idea. This kind of benchmarking can be a critical factor to advance on that front. It changes the nature of the effort to one of reframing traditional actuarial work as fundamental ERM.

Actuaries as Markets of One

For exchange–traded securities of all kinds, firms will "mark–to–market" (M2M) their portfolio for both risk management and value reporting to investors. M2M means the booked (marked) value of the security is its current market value taken from industry standard sources like Bloomberg or Reuters. M2M reduces the risk of what is known as "self–marking," where a trader may book inflated values for his or her portfolio to boost his or her compensation. Nick Leeson’s self–marked portfolio brought down Barings Bank in a now infamous 1995 derivatives scandal. Therefore, there is a risk management imperative that there be no self–marked portfolios. M2M prevents that, by letting the value be set by the collective wisdom of multiple valuation opinions inherent in an exchange market price.

M2M methods become much more difficult when dealing with non–traded securities, for example, private equity, hedge funds or OTC derivatives. Securities firms cannot allow the conflict of interest of self–marking, so they use the expertise of an independent, centralized risk management team to help value these portfolios. The risk management group may be involved in any number of ways, from sign–off on valuation models and parameters, all the way to individual re–pricing of transactions. Typically this requires risk management personnel to have tremendous expertise and experience, backbone and organizational independence from the trading units. Sound familiar?

Viewed in this light, we now see the valuation (or reserving) exercise of an insurer or pension fund as the "marking" of a complex portfolio by the centralized risk management group. The conflicts that inevitably arise between valuation actuaries and product line advocates should therefore come as no surprise; our derivatives risk management counterparts live with the same organizational tensions. These tensions are healthy, necessary checks and balances. Better communication and trust may reduce the tensions over time, but there may be an irreducible element attributable to the organizational structure and the nature of the role itself.

Actuaries and ERM

What does this mean for ERM? Three things immediately come to mind:

  • Actuaries must learn about ERM. This needs to start today! The actuarial societies can provide learning opportunities, but every member must take it upon him or herself to read, understand and start applying the ERM concepts and terminology. We need to start changing the way we think and communicate. Ingram argued, "Actuaries need to attain a level of rigor and mastery of risk management to be able to support" the risk management needs of insurers.
  • Actuaries must reframe our traditional roles as part of the larger ERM context. This will entail modifying our work products, basic education, continuing education and public communication. This is a reframing exercise where we stake our claim to the ERM leadership of insurance and pensions.
  • Actuaries must prepare to be part of the new risk profession. There is a new profession forming from a convergence of accounting, internal auditing, regulation, actuarial, insurance, "traditional" risk management and more advanced financial risk management in banking, insurance, securities and energy. The opportunity for leadership of this profession is upon us, but the form of that leadership and the nature of our role are not clear. Some feel we merely need to expand the actuarial profession, while others think collaboration is necessary. No matter the tactics we employ, all actuaries must get involved, participate in the debates and support the initiatives as we prepare for this evolutionary step.

Donald Mango, FCAS, MAAA is vice president of research, Casualty Actuarial Society Director of Research and Development, GE Insurance Solutions. He can be contacted at:Don.Mango@ge.com