Benchmarking ERM Practices in a Derivatives Firm
By Donald F. Mango
As we move towards the CAS's Centennial Goal of international property-casualty resource and enterprise risk management (ERM) expertise, it is 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 (OTC, 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; you can read a review of it on the CAS ERM Research Committee's Web page.
Per GS, the five main areas within derivative risk management are (see table below):
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).
Really 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.
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 their portfolio to boost their own 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 nontraded securitiesfor 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 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:
1) Actuaries must learn about ERM. This needs to start today! The actuarial societies can provide learning opportunities, but all members must take it upon themselves to read, understand, and start applying the ERM concepts and terminology. We need to start changing the way we think and communicate.
2) Actuaries must reframe their 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 property-casualty insurance.
3) Actuaries must prepare to be part of the new Risk Profession. There is a new profession forming from a convergence of accounting, internal auditing, regulatory, actuarial, insurance, "traditional" risk management, and more advanced financial risk management in banking, insurance, securities, and energy. It will span all areas of human activity. 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 believe we need to expand the actuarial profession, while others believe collaboration is necessary. No matter the leadership tactics we employ, all actuaries must get involved, participate in the debates, prepare for this evolutionary step, and support any initiatives.