Enterprise Risk Management was a key part of actuarial fellowship exam years ago when I took my fellowship exams.
What differentiate enterprise risk management from non-ERM is the following: ERM perspective is at the company level, outside of individual units. If we may compare a company as a tree (a big company a big tree), ERM looks at the tree as a whole, including the leaves, branches, the trunk, and the root system. Because of this perspective, you may see problems that individual business units do not.
Communicating and coordinating between different business units is essential. But technology, automation, visualization are all important.
Overview of ERM
In his paper on integrated risk managment A Framework for Integrated Risk Management in International Business, Professor Kent D. Miller gives a categorization of uncertainties, which can be seen as the pillars of the risk taxonomy, although some important ones can still be added such as the importance of compliance and regulatory change/risk, and firm reputation risks.
- General environment
- Political uncertainties (changes in relationships between countries, war)
- Government policy (fiscal, monetary changes, regulation)
- Macroeconomic (inflation, interest rate, unemployment, GDP)
- Social (terrorism…)
- Natural (hurricane, earthquake, flood, drought, wild fire)
- Industry
- Input market (supply, quality…)
- Product market (demand…)
- Competitive risk (new entrants, rivalry…)
- Firm specific
- Operating (employees, supply, production…)
- Liability (products, pollution, employment…)
- R&D
- Credit
Enterprise Risk Analysis/Analytics
The purpose of ERA is to understand and quantify the relationship among the risks to the business that arise from its asset, liabiliies,and ongoing underwriting, all of which are affected by internal decisions and external factors.
ERA combine submodels of the many contributing elements to produce an overall risk profile of the business. These helps the firm top management make strategic decisions. For example:
- Study the impact of sustained inflation.
- Exposure to a systematically important company,e.g., the Chinese company Evergrand.
- Managing asset mix for various anticipated macroeconomic enviroment.
ERA are data-hungry, complex and entails sophisticated mathmatics besides business intuition. While they will not produce any magic answers, there are differences between better models and weaker analysis/models.
good analysis: will show, as realistically as possible, the balance between risk and reward from a range of differenct strategies, such as changing the country/region mix, or choosing which industries to invest in.
weak analysis: may exaggerate certain aspects of risk while underestimating others, which may mislead decision making and result in too aggressive or too cautious approaches.
Analysis should include assumptions and what-if in cases of assumptions do not work out.
Stress tests
One of the key methods of risk management is stress test. Many financial organizations have implemented routine internal and regulatory stress tests. The scenarios used for the stress tests are variations of historical crisis, such as the Great Financial Recession in 2008, inflation scenario similar to 1970’s, and so on.
While variations of historical crisis are useful for stress testing, they only cover a subset of the possibilities.
Rapid stress tests, unlike variations of historical scenarios, are tied to recent shock events, for example, the Russia-Ukraine war. It is intended to be executed within days, answering questions such as “what is our exposure at risk if this war causes credit spread to spike to xyz, commodity prices to be doubled,tripled, etc.?”
Limitations of stress tests
Stress tests scenarios are usually informed by historical experiences, which have their own sets of underlying fundamentals that are most likely not true for the current or future situations. In stead of looking at everything through the prism of historical crisis, we should think about the fundamentals and our current vulnerabilities.