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Unformatted text preview: Financial Enterprise Risk Management
Financial Enterprise Risk Management provides all the tools needed to build and maintain a comprehensive ERM framework. As well as outlining the construction of such
frameworks, it discusses the internal and external contexts within which risk management must be carried out. It also covers a range of qualitative and quantitative techniques
that can be used to identify, model and measure risks, and describes a range of risk mitigation strategies. Over 100 diagrams are used to help describe the range of approaches
available, and risk management issues are further highlighted by various case studies. A
number of proprietary, advisory and mandatory risk management frameworks are also
discussed, including Solvency II, Basel III and ISO 31000:2009.
This book is an excellent resource for actuarial students studying for examinations, for
risk management practitioners and for any academic looking for an up-to-date reference
to current techniques.
paul s w e e t ing is a Managing Director at JP Morgan Asset Management. Prior to
this, he was a Professor of Actuarial Science at the University of Kent and he still holds
a chair at the university. Before moving to academia, Paul held a number of roles in
pensions, insurance and investment. Most recently he was responsible for developing
the longevity reinsurance strategy for Munich Reinsurance, before which he was Director
of Research at Fidelity Investments’ Retirement Institute.
In his early career, Paul gained extensive experience as a consulting actuary advising
on pensions and investment issues for a range of pension schemes and their corporate
sponsors. He is affiliated to a number of professional bodies being a Fellow of the Institute
of Actuaries, a Fellow of the Royal Statistical Society, a Fellow of the Securities and
Investment Institute and a CFA Charterholder. Paul has written extensively on a range
of pensions, investment and risk issues and is a regular contributor to the print and
broadcast media. Downloaded from . Stockholm University Library, on 27 Aug 2020 at 11:16:18, subject to the Cambridge Core
terms of use, available at . I N T E R N AT I O N A L SER I ES ON AC T U A R I A L S C I E N C E
Editorial Board
Christopher Daykin (Independent Consultant and Actuary)
Angus Macdonald (Heriot-Watt University)
The International Series on Actuarial Science, published by Cambridge University Press
in conjunction with the Institute and Faculty of Actuaries, contains textbooks for students taking courses in or related to actuarial science, as well as more advanced works
designed for continuing professional development or for describing and synthesizing
research. The series is a vehicle for publishing books that reflect changes and developments in the curriculum, that encourage the introduction of courses on actuarial science
in universities, and that show how actuarial science can be used in all areas where there
is long-term financial risk.
A complete list of books in the series can be found at .
Recent titles include the following:
Regression Modeling with Actuarial and Financial Applications
EDWARD W. FREES
Actuarial Mathematics for Life Contingent Risks
DAVID C.M. DICKSON, MARY R. HARDY & HOWARD R. WATERS
Nonlife Actuarial Models
YIU-KUEN TSE
Generalized Linear Models for Insurance Data
PIET DE JONG & GILLIAN Z. HELLER
Market-Valuation Methods in Life and Pension Insurance
THOMAS MØLLER & MOGENS STEFFENSEN
Insurance Risk and Ruin
DAVID C.M. DICKSON Downloaded from . Stockholm University Library, on 27 Aug 2020 at 11:16:18, subject to the Cambridge Core
terms of use, available at . F I NANC I AL E NT E R PR ISE
RISK MANAGEMENT
PAU L S W E E T I N G
University of Kent, Canterbury Downloaded from . Stockholm University Library, on 27 Aug 2020 at 11:16:18, subject to the Cambridge Core
terms of use, available at . c a m br id g e u n ive r s it y p r e s s
Cambridge, New York, Melbourne, Madrid, Cape Town,
Singapore, S˜ao Paulo, Delhi, Tokyo, Mexico City
Cambridge University Press
The Edinburgh Building, Cambridge CB2 8RU, UK
Published in the United States of America by Cambridge University Press, New York
Information on this title:
c P. Sweeting 2011
This publication is in copyright. Subject to statutory exception
and to the provisions of relevant collective licensing agreements,
no reproduction of any part may take place without the written
permission of Cambridge University Press.
First published 2011
Printed in the United Kingdom at the University Press, Cambridge
A catalogue record for this publication is available from the British Library
Library of Congress Cataloguing in Publication data
Sweeting, Paul.
Financial enterprise risk management / Paul Sweeting.
p. cm. – (International series on actuarial science)
Includes bibliographical references and index.
ISBN 978-0-521-11164-5 (hardback)
1. Financial institutions–Risk management. 2. Financial services industry–Risk
management. I. Title.
HG173.S94 2011
332.1068 1–dc23
2011025050
ISBN 978-0-521-11164-5 Hardback
Cambridge University Press has no responsibility for the persistence or
accuracy of URLs for external or third-party internet websites referred to in
this publication, and does not guarantee that any content on such
websites is, or will remain, accurate or appropriate. Downloaded from . Stockholm University Library, on 27 Aug 2020 at 11:16:18, subject to the Cambridge Core
terms of use, available at . Contents Preface page xi 1 An introduction to enterprise risk management
1.1 Definitions and concepts of risk
1.2 Why manage risk?
1.3 Enterprise risk management frameworks
1.4 Corporate governance
1.5 Models of risk management
1.6 The risk management time horizon
1.7 Further reading 1
1
3
5
6
8
9
10 2 Types of financial institution
2.1 Introduction
2.2 Banks
2.3 Insurance companies
2.4 Pension schemes
2.5 Foundations and endowments
2.6 Further reading 11
11
11
14
16
18
18 3 Stakeholders
3.1 Introduction
3.2 Principals
3.3 Agents
3.4 Controlling
3.5 Advisory
3.6 Incidental
3.7 Further reading 20
20
20
31
41
48
51
53
v Downloaded from . Stockholm University Library, on 27 Aug 2020 at 11:16:19, subject to the Cambridge Core
terms of use, available at . vi Contents 4 The internal environment
4.1 Introduction
4.2 Internal stakeholders
4.3 Culture
4.4 Structure
4.5 Capabilities
4.6 Further reading 54
54
54
55
57
60
60 5 The external environment
5.1 Introduction
5.2 External stakeholders
5.3 Political environment
5.4 Economic environment
5.5 Social and cultural environment
5.6 Competitive environment
5.7 Regulatory environment
5.8 Professional environment
5.9 Industry environment
5.10 Further reading 61
61
61
62
62
64
65
66
85
88
90 6 Process overview 91 7 Definitions of risk
7.1 Introduction
7.2 Market and economic risk
7.3 Interest rate risk
7.4 Foreign exchange risk
7.5 Credit risk
7.6 Liquidity risk
7.7 Systemic risk
7.8 Demographic risk
7.9 Non-life insurance risk
7.10 Operational risks
7.11 Residual risks
7.12 Further reading 93
93
93
94
94
95
96
97
99
101
102
110
111 8 Risk identification
8.1 Introduction
8.2 Risk identification tools
8.3 Risk identification techniques 112
112
112
115 Downloaded from . Stockholm University Library, on 27 Aug 2020 at 11:16:19, subject to the Cambridge Core
terms of use, available at . Contents 8.4
8.5
8.6 Assessment of risk nature
Risk register
Further reading vii 119
119
120 9 Some useful statistics
9.1 Location
9.2 Spread
9.3 Skew
9.4 Kurtosis
9.5 Correlation
9.6 Further reading 121
121
122
124
125
126
132 10 Statistical distributions
10.1 Univariate discrete distributions
10.2 Univariate continuous distributions
10.3 Multivariate distributions
10.4 Copulas
10.5 Further reading 134
134
137
171
195
220 11 Modelling techniques
11.1 Introduction
11.2 Fitting data to a distribution
11.3 Fitting data to a model
11.4 Smoothing data
11.5 Using models to classify data
11.6 Uncertainty
11.7 Credibility
11.8 Model validation
11.9 Further reading 221
221
223
228
237
245
259
262
270
271 12 Extreme value theory
12.1 Introduction
12.2 The generalised extreme value distribution
12.3 The generalised Pareto distribution
12.4 Further reading 272
272
272
275
279 13 Modelling time series
13.1 Introduction
13.2 Deterministic modelling
13.3 Stochastic modelling
13.4 Time series processes 280
280
280
281
285 Downloaded from . Stockholm University Library, on 27 Aug 2020 at 11:16:19, subject to the Cambridge Core
terms of use, available at . viii Contents 13.5 Data frequency
13.6 Discounting
13.7 Further reading 305
306
310 14 Quantifying particular risks
14.1 Introduction
14.2 Market and economic risk
14.3 Interest rate risk
14.4 Foreign exchange risk
14.5 Credit risk
14.6 Liquidity risk
14.7 Systemic risks
14.8 Demographic risk
14.9 Non-life insurance risk
14.10 Operational risks
14.11 Further reading 311
311
311
325
337
338
360
362
363
372
379
381 15 Risk assessment
15.1 Introduction
15.2 Risk appetite
15.3 Upside and downside risk
15.4 Risk measures
15.5 Unquantifiable risks
15.6 Return measures
15.7 Optimisation
15.8 Further reading 382
382
383
386
387
401
403
404
411 16 Responses to risk
16.1 Introduction
16.2 Market and economic risk
16.3 Interest rate risk
16.4 Foreign exchange risk
16.5 Credit risk
16.6 Liquidity risk
16.7 Systemic risk
16.8 Demographic risk
16.9 Non-life insurance risk
16.10 Operational risks
16.11 Further reading 413
413
416
430
434
435
442
442
444
446
447
456 Downloaded from . Stockholm University Library, on 27 Aug 2020 at 11:16:19, subject to the Cambridge Core
terms of use, available at . Contents ix 17 Continuous considerations
17.1 Introduction
17.2 Documentation
17.3 Communication
17.4 Audit
17.5 Further reading 457
457
457
458
460
461 18 Economic capital
18.1 Introduction
18.2 Definition of economic capital
18.3 Economic capital models
18.4 Designing an economic capital model
18.5 Running an economic capital model
18.6 Calculating economic capital
18.7 Economic capital and risk optimisation
18.8 Capital allocation
18.9 Further reading 462
462
462
463
464
465
466
467
469
471 19 Risk frameworks
19.1 Mandatory risk frameworks
19.2 Advisory risk frameworks
19.3 Proprietary risk frameworks
19.4 Further reading 472
472
483
499
504 20 Case studies
20.1 Introduction
20.2 The 2007–2011 global financial crisis
20.3 Barings Bank
20.4 Equitable Life
20.5 Korean Air
20.6 Long Term Capital Management
20.7 Bernard Madoff
20.8 Robert Maxwell
20.9 Space Shuttle Challenger
20.10 Conclusion
20.11 Further reading 505
505
505
511
514
517
519
521
522
523
525
525 References
Index 527
540 Downloaded from . Stockholm University Library, on 27 Aug 2020 at 11:16:19, subject to the Cambridge Core
terms of use, available at . Downloaded from . Stockholm University Library, on 27 Aug 2020 at 11:16:19, subject to the Cambridge Core
terms of use, available at . Preface This book began life as a sessional paper presented to the Institute of Actuaries in
Manchester and, some months later, to the Faculty of Actuaries in Edinburgh. Its presentation occurred at around the same time that a new subject on enterprise risk management
was being developed for the UK actuarial exams. This made it a good time to expand
the paper into something more substantial, with detailed information on many of the
techniques that were only mentioned in the initial work. It also means that the book has
benefited greatly from the work done by the syllabus development working party, led
by Andrew Cairns and managed by Lindsay Smitherman.
I found myself writing this book during a time of crisis for financial institutions
around the world. Financial models have been blamed for a large part of this crisis,
and this criticism is, to an extent, well-founded. It is certainly tempting to place far too
much reliance on very complex models, ignoring the fact that they merely represent
rather than replicate the real world. Some senior executives have also been guilty of
seeing the output of these models but not understanding the underlying approaches and
their limitations. Finally, many models have been designed seemingly ignorant of the
fact that the data histories needed to provide parameters for these models are simply not
available. However, at least as big an issue is that many non-financial risks were allowed
to thrive in the years before the crisis.
Many of the techniques described in this book are quantitative, and such risk modelling and management techniques can be very helpful. However, there are a number of
ways in which risk can be quantified. Furthermore, these risk measures do not paint a
complete picture. It is important to appreciate the limitations of these types of models,
the circumstances in which they might fail and the implications of such failure. It is
also crucial to understand that just because a risk is unquantifiable, it does not mean
that it should be ignored. Some of the most important – and dangerous – risks cannot
be modelled; however, they can frequently be identified and often managed.
All risks should be considered together: this holistic approach is fundamental to
enterprise risk management. Whilst identifying the extent – or even the existence –
of individual risks is important, looking at the bigger picture is vital. Looking at the
interaction between risks can highlight concentrations of risk, but also the potential xi
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terms of use, available at . xii Preface diversifying or even hedging effect of different risks. It is also important to recognise
that risk is not necessarily synonymous with uncertainty. Risk is only bad if the outcome
is adverse, and these types of risks can be described as downside risks. Upside risks also
occur – these are opportunities – and without them, there would be no point in taking
risks at all. Downloaded from . Stockholm University Library, on 27 Aug 2020 at 11:16:17, subject to the Cambridge Core
terms of use, available at . 1
An introduction to enterprise risk management 1.1 Definitions and concepts of risk
The word ‘risk’ has a number of meanings, and it is important to avoid ambiguity when risk is referred to. One concept of risk is uncertainty over the range of
possible outcomes. However, in many cases uncertainty is a rather crude measure of risk, and it is important to distinguish between upside and downside
risks.
Risk can also mean the quantifiable probability associated with a particular
outcome or range of outcomes; conversely, it can refer to the unquantifiable
possibility of gains or losses associated with different future events, or even
just the possibility of adverse outcomes.
Rather than the probability of a particular outcome, it can also refer to
the likely severity of a loss, given that a loss occurs. When multiplied, the
probability and the severity give the expected value of a loss.
A similar meaning of risk is exposure to loss, in effect the maximum loss
that could be suffered. This could be regarded as the maximum possible severity, although the two are not necessarily equal. For example, in buildings
insurance, the exposure is the cost of clearing the site of a destroyed house
and building a replacement; however, the severity might be equivalent only to
the cost of repairing the roof.
Risk can also refer to the problems and opportunities that arise as a result of
an outcome not being as expected. In this case, it is the event itself rather than
the likelihood of the event that is the subject of the discussion. Similarly, risk
can refer to the negative impact of an adverse event.
Risks can also be divided into whether or not they depend on future uncertain events, on past events that have yet to be assessed or on past events that
have already been assessed. There is even the risk that another risk has not yet
been identified.
1
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terms of use, available at . 2 An introduction to ERM When dealing with risks it is important to consider the time horizon over
which they occur, in terms of the period during which an organisation is
exposed to a particular risk, or the way in which a risk is likely to change over
time. The link between one risk and others is also important. In particular, it is
crucial to recognise the extent to which any risk involves a concentration with
or can act as a diversifier to other risks.
In the same way that risk can mean different things to different people, so
can enterprise risk management (ERM). The key concept here is the management of all risks on a holistic basis, not just the individual management of each
risk. Furthermore, this should include both easily quantifiable risks such as
those relating to investments and those which are more difficult to assess such
as the risk of loss due to reputational damage.
A part of managing risks on a holistic basis is assessing risks consistently across an organisation. This means recognising both diversifications and
concentrations of risk. Such effects can be lost if a ‘silo’ approach to risk management is used, where risk is managed only within each individual department
or business unit. Not only might enterprise-wide concentration and diversification be missed, but there is also a risk that different levels of risk appetite
might exist in different silos. Furthermore enterprise-wide risks might not be
managed adequately with some risks being missed altogether due to a lack of
ownership.
The term ‘enterprise risk management’ also implies some sort of process –
not just the management of risk itself, but the broader approach of:
•
•
•
•
•
• recognising the context;
identifying the risks;
assessing and comparing the risks with the risk appetite;
deciding on the extent to which risks are managed;
taking the appropriate action; and
reporting on and reviewing the action taken. When formalised into a process, with detail added on how to accomplish
each stage, then the result is an ERM framework. However, the above list
raises another important issue about ERM: that it is not just a one-off event
that is carried out and forgotten, but that it is an ongoing process with constant
monitoring and with the results being fed back into the process.
It is important that ERM is integrated into the everyday way in which a firm
carries out its business and not carried out as an afterthought. This means that
risk management should be incorporated at an early stage into new projects. Downloaded from . Stockholm University Library, on 27 Aug 2020 at 11:16:17, subject to the Cambridge Core
terms of use, available at . 1.2 Why manage risk? 3 Such integration also relates to the way in which risks are treated since it recognises hedging and diversification, and should be applied at an enterprise rather
than at a lower level.
ERM also requires the presence of a central risk function (CRF), headed
by chief risk officer. This function should cover all things risk related, and in
recognition of its importance, the chief risk officer should have access to or,
ideally, be a member of board of the organisation.
Putting an ERM framework into place takes time, and requires commitment from the highest level of an organisation. It is also important to note
that it is not some sort of ‘magic bullet’, and even the best risk management
frameworks can break down or even be deliberately circumvented. However,
an ERM framework can significantly improve the risk and return profile of an
organisation. 1.2 Why manage risk?
With this discussion of ERM, it is important to consider why it might be desirable to manage risk in the first place. At the broadest level, risk management
can benefit society as a whole. The effect on the economy of risk management failures in banking, as shown by the global liquidity crisis, give a clear
illustration of this point.
It could also be argued that risk management is what ...
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