Doors of

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opportunity

ERM In The Broader Economic Sector

By Robert Wolf

December 2009/January 2010

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25

This is the final installment of a six-part series on the

Evolution of Risk Management. The previous articles are available
on www.soa.org, publications, The Actuary magazine.

n scouting for flights for family vacations,

I generally have used my favorite airline
Web sites scheduling tools. Looking into
the vast arrays and series of times, dates and
airports, I would plop in arrival and departure dates for certain trips and then gauge
their trends over time. I would monitor fares
from Chicago to my favorite locations to see
which weekends a family getaway was economically feasible as compared to others. It
was just amazing how prices changed from
one week to the nextsometimes daily.

26

In reading a recent article on how airlines

manage the complex flight pricing plans, it
occurred to me how the dynamics truly relate
to how we actuaries price our insurance
coverages. United Airlines develops its global
flight schedule and pricing schematic in an
extensively complex grid that is perpetually
dynamic. The grid considers risks underlying connections, airline partners, customer
demand, supply of planes, the markets, gas
prices, potential revenues, potential losses
and so on to assess risks and opportunities of
charging the most reasonable price possible
given all these factors. Oh, and they also have
to figure out what their competitor airlines
are doing too, for competitive reasons. Price
wars sometimes remind me of the property/
casualty industrys underwriting cyclelower
prices, get market share, bait, then switch.

scheme. If your credit report stinks, your auto

rates are higher. No direct causal relationship,
but rather a correlation of behavior. If you
let your credit report go, chances are you
are a careless driver, etc. Hey, we do this in
insurance. We can do this for the airlines too.
Maybe both industries can learn and grow
from each other. In our evolving roles in the
enterprise risk management evolution, this
very much resembles our roles in our traditional sectors we serve in the insurance industry.
Were advising on competitive prices, considering the many risk variables that go into the
price. These considerations include the likelihood and propensity of underwritten risks to
be subject to potential fortuitous contingent
events such as the likelihood, frequency and
severity of accidents, deaths, lawsuits, sickness, etc., the resultant expected and variable
costs relative to the volatility of the financial
markets, the demands of consumers (insurance buyers) and risk bearers (shareholders). Clearly, our profession has integrated
the skill sets of mathematics, statistics, logic,
value-based management, economics, legal
and behavioral finance, the business of insurance and philosophy to evolve our skill sets
in our traditional venues. We are now in a
great position to apply these evolved skill sets
into new venues, including our predestined
frontier into the non-financial sectors of the
broader economy.

It occurred to me that this process very much

resembles what pricing actuaries do today.
This is especially true with the predictive modeling tools we are using in incorporating an
unlimited vector of risk components in the
interest of determining a competitive pricing

We Are Already There

It can be argued that we are already there.
We already have at least one foot in various
nonfinancial industries today. We have and
continue to consult on employee health and
retirement benefits for clients in the nonfinan-

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December 2009/January 2010

cial sector. Actuaries have and continue to

work with risk professionals, insurance brokers
and traditional risk managers in the airline,
food, energy and other industries in managing
their property and casualty risks via insurance,
alternative markets and self-insurance. Over
the past decade, the actuarial role in these
areas has evolved within the greater enterprise
risk discipline as we have evolved in our skill
sets, transcending into determining optimum
insurance structures, advising on alternative
risk retention/transfer strategies and recommending alternative market products given a
customers risk and reward appetite. Although
we have had one foot in these economic sectors, we have a grand opportunity today to
begin getting that other foot in. That is, we now
have the opportunity to expand our actuarial
skill set in the greater economic sector as key
contributors to strategic business planning with
integration into profit and risk optimization that
extends beyond the work we already do in
these business sectors today.
In Part one of this article series, I cited the
Mercer Management Study that analyzed
the causes of significant stock price drops
amongst the Fortune 1000 companies in
the booming 90s. The causes were generally due to multiple reasons and stemming
from events mostly falling under strategic
and/or operational risk categories. This was
affirmed in a current yet-to-be completed
study sponsored by the SOA/CAS/CIA Joint
Risk Management Section and led by Larry
Rubin, partner at PricewaterhouseCoopers.
This study analyzes the high profiled failures
of recent times (Enron, WorldCom, etc.) since

the Mercer Management Study as they

relate to best practices in risk management
(or lack thereof). The goal of this research
project is to test hypotheses and validate
arguments for enterprise risk management
(ERM) best practices from lessons learned
in these high profiled failures. As indicated
preliminarily in this study and as presented
in a recent session at the SOA 09 Annual
Meeting in Boston, A Case Study of Case
Studies, one or more of four common
themes seem to emerge as a common
denominator in virtually all of these failures, again all generally falling under the
categories of strategic and operational
risks. They are:
1. Business model failure: The failure
of developing and carrying through on
sound strategic planning that prevents
the firm from surviving and thriving in
a highly competitive environment.
2. Lack of proper risk metrics in place
in analyzing the true element of
risks undertaken to achieve company goals: This is consistent to the
lessons learned from the financial crises in which incentive compensation
schemes were not appropriately tied
to the desired performance of company executives. In other words, there
were no general controls in place to
stymie excessive risk taking to achieve
company goals. In some cases, where
there were any considerations of risk
metrics, they were not prudently in
place. In some cases no risk metrics
were even considered.

3. Lack of a truly independent internal audit function: This lack of true
independence has harmed the ability
for firms to prevent traders or executives from harming the company for

individualist opportunity or gain. It also

did not prevent accountants from gaming certain accounting conventions to
shape up an otherwise shaky balance
sheet. Similarly and consistent with the
lessons learned from the financial crises, there are many instances where the
authority to make decisions did not tie
to accountability for decisions made.
4. Inadequate asset/liability management:
In essence this translates to using short-term
assets to fund long-term obligations, resulting in higher long-term liquidity risk. Clearly
asset/liability management is a prudent
discipline needed beyond the financial
services sector. As a profession, we can
take our best practices from our traditional domain to that in the nonfinancial
sector as well. Bottom line, whether we

worked into these new venues in the general economy.

I believe we can all recognize that all risks,
whether in the financial or nonfinancial sectors of the overall economy, will eventually
be manifested on the financial statements as
a threat to cashflow in some form or another.
It is this very notion of Following the Cash
and its corresponding uncertainties that we
as a profession can continue to pioneer per
our actuarial philosophy to the broader business sectors of the economy.
Our Ultimate Frontier
The nonfinancial sectors of our global economy are realistically managed no differently
than the management of our financial sectors
that we currently serve prominently. Pick a
sector, any sector, and there is a general goal

The nonfinancial sectors are realistically managed no differently than

the financial sectors.
are working in the financial services sector, or the nonfinancial sector, all projects
and strategies require adequate means to
be funded, and ultimately cash will eventually be required, when it is needed.
These common themes identified in the
analysis of these high profile failures, in
general terms, arguably compare to the
causes of insurance company failures of
the past. As a profession, we are quite
familiar with them up close, we learned
from our mistakes and have implemented
best practices. As we have been developing
and applying ERM principles in the current
broader financial services sectors that we
serve today, such as solvency management,
we can apply the same strategies that have

in producing a viable product or service,

and selling it at a profitable and competitive
price, given the many risk and opportunity
considerations in a firms strategic business
plan. In which stage is ERM operating in these
opportunistic sectors? In general, with some
exceptions, they are lagging far behind that of
the financial services industry.
In my experiences, there have been three
primary reasons that ERM implementation
in nonfinancial sectors of the economy has
lagged behind the financial services industry. They are as follows:
1.

Lack of a coherent definition, and more

importantly, an understanding of the
philosophy of what ERM is all about.

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Partial Convergence of Definitions

Society of Actuaries (SOA)/Casualty
Actuarial Society (CAS) ERM is the
process by which organizations in all
industries assess, control, exploit, finance
and monitor risks from all sources for the
purpose of increasing the organizations
short- and long-term value to their stakeholders. www.soa.org/www.casact.org

Treadway Commissions Committee of

Sponsoring Organizations (COSO) ERM
is a process, effected by an entitys board of
directors, management and other personnel,
applied in strategy-setting and across the
enterprise, designed to identify potential
events that may affect the entity, and manage risk to within its risk appetite to provide
reasonable assurance regarding the achievement of entity objectives. www.coso.org

Institute of Internal Auditors (IIA)

ERM is a structured and coordinated
entity wide governance approach to identify, quantify, respond to and monitor the
consequences of potential events. www.
theiia.org

Wikipedia ERM in business includes the

methods and processes used by organizations to manage risks and seize opportunities related to the achievement of their
objectives. www.wikipedia.org

Nextgov.com ERM is an integrated or

holistic approach to understand and manage all the risks an organization faces. Its
primary purpose is to improve the quality
of decision-making throughout an organization. www.nextgov.com

University of North CarolinaChapel

Hill ERM is a coordinated approach to
assessing and responding to all risks that
affect the achievement of the Universitys
strategic and financial objectives, including both upside and downside risks.
www.unc.edu

2.

Not knowing where the ERM effort

should be housed within a firm.

3.

Not knowing how to show ERM as creating value.

The Risk and Insurance Management Society

(RIMS), founded in 1950 with a current membership of more than 4,000 entities and more
than 10,500 risk professionals, has recently
developed the concept of an ERM Maturity
Curve, very comparable to how I have identified the three stages of ERM in its evolution

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December 2009/January 2010

in the various sectors in previous articles in

this series. In the RIMS State of ERM Report
of 2008, it reports that true implementation
of ERM is very slow. It also cites evidence of
a beneficial interest in developing an ERM
culture in firms in that there is a significant correlation between companies that score higher
on RIMS risk maturity assessment and higher
credit ratings.
It seems that every profession, sector and
even individual came up with another definition of what indeed ERM really is. Arguably, I

am seeing a partial convergence of the definitions, although I still believe the adopted
definition of both the Society of Actuaries
and Casualty Actuarial Society is best. Our
definition relates to the process, an entity,
the steps, the holistic integration and the
goal of an ERM philosophy, all in one sentence. Risk is opportunity. Creating value is
the goal.
Although I believe most of the definitions
out there are converging, I dont believe the
philosophies and understanding are converging just yet. This is where we, as a profession, can serve this need well.
Another challenge has been the lack of
clarity of how such a discipline should be
implemented in a firm. Generally, firms that
decide to develop an ERM infrastructure
do so by starting first with a handful of
dedicated resources in the firm. Perhaps
as an add-on to the internal audit function
and a check-the-box, OK-we-are-compliant
approach, after a couple of years a chief risk
officer may be appointed with the eventual integration of business unit managers
brought into the strategic risk and opportunity thinking. Ultimately, in the final phase,
there would be full top-down integration,
which incorporates planning and performance, with board oversight over the entire
ERM discipline within the firm. For firms
that have gotten to this stage, this has been
a slow process with a long learning curve,
encompassing anywhere from five to 10
years time.
One of the major challenges in the slow
maturity in implementing ERM in the nonfinancial sectors is the lack of uniform understanding of how ERM brings value to a firm.
Several actuaries in our profession already
are serving this purpose. Sim Segal, U.S.
Leader of ERM Services for Watson Wyatt &

Company, is one of the recognized pioneers

in our profession in applying the actuarial
principles of ERM into new venues, including that of the non-financial sectors of the
economy. Segal attributes his success to a
value-based approach to ERM, which is a
marriage between ERM and value-based
management. ERM is the process of identifying, measuring, managing and disclosing
risks. Value-based management is the process of identifying value drivers and managing them to increase firm value. Linking
the two brings both sides of the risk-return
equation together, which is what business
leaders need to make decisions. Without
this linkage, it is difficult to make the business case for recommendations coming out
of the ERM program ... just as it is difficult to
trust results coming out of the value-based
management program without robustly considering volatility around expectations.
Closing
We, as a profession, have a tremendous opportunity here. The actuarial profession is poised
to provide and expand its evolutionary actuarial skill set and philosophy into new venues. Expanding from our current strongholds
of insurance, investments, pensions, health

care and broader financial services, we have

an opportunity to move our expertise into
the broader economy (e.g., airline industry,
energy, food processing, sports, technology).
We have already made such strides.
At the July American Academy of Actuaries
Financial Summit, a consortium of more
than 60 Academy leaders challenged our
profession to a commitment in the development of a generalized actuarial model
to address the foundation of what a sound
financial security system ought to be. Such a
foundation would incorporate risk systems
plus the incorporation of incentives and
accountability of such a system. This past
August, the Enterprise Risk Management
Institute International (ERM-II) research
summit, supported by both the SOA and the
CAS, went even further and proposed the
development of philosophies and research
needed to fulfill our destiny and obligation
to not only develop a foundation of the
financial systems, but also how such a system should and could interact with the general economy, which this article addresses.

due to the cloudy aspects of the fair value of

prices. We, as a profession, have the ability
to help right the ship and provide a call for
clarity. We have a societal obligation and
opportunity to use the actuarial foundation
of ethics and a broad skill set to make better decisions that consider both risks and
rewards. Risk is Opportunity. In our collective voice, we are in a grand position to
shape the regulation of systemic risk within
the general economy.
Were in the year 2009 today. Compare
where we are today from, say, 1999. By the
year 2019, I foresee actuaries serving as chief
risk officers, risk managers and risk professionals at United Airlines, ConAgra Food and
Marriott Hotels. We have the right expertise
for this. We have much to say. There is
momentum. Lets keep going. Our possibilities and opportunities are endless, our future
is illustrious. As one famous German philosopher once said, The best way to predict the
future is to invent it. -- Immanuel Kant. A
Robert Wolf, ASA, FCAS, CERA, MAAA, is staff
fellow, Risk Management, for the Society of Actuaries.

Capitalism is the very foundation of our

economy. This foundation has been rocked

He can be contacted at rwolf@soa.org.

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