Archive for December 2013

Most Popular Posts of 2013

December 30, 2013

RISKVIEWS made 66 new posts in 2013.  You can visit all 66 using the links at the right of the page for Archives, which link to the new posts for each month.

For total traffic in 2013, posts from 2013, 2012, 2011 and 2010 were the most popular,  led by

  1. Getting Started in a Risk Management Career  from November 2012
  2. Avoiding Risk Management  from February 2012
  3. Five components of resilience – robustness, redundancy, resourcefulness, response and recovery  from January 2013
  4. REDUCING MORAL HAZARD  from July 2010
  5. Frequency vs. Likelihood  from June 2011

And here are ten posts that RISKVIEWS recommends that you may have missed:

Inflationary Expectations
Changing Your Attitude
Skating Away on the Thin Ice of the New Day
Full Spectrum Risk Management
Focusing on the Extreme goes Against the Grain
Maybe it is not as obvious as you think…
Capabilities
The World is not the Same – After
Uncertain Decisions
Murphy was a Risk Manager!

The biggest Risk is that the rules keep changing

December 27, 2013

RISKVIEWS played the board game Risk Legacy with the family yesterday.  We were playing for the 8th time.  This game is a version of the board game Risk where the rules are changed by the players after each time playing the game.  Most often, the winner is the person who most quickly adapts to the new rules.  Once the other players see how the rules can be exploited, they can adapt to defend against that particular strategy, but at the same time, the rules have changed again, presenting a new way to win.

This game provides a brilliant metaphor for the real world and the problems faced by business and risk managers in constantly having to adapt both to avoid losing and to find the path to winning.  The biggest risk is that the rules keep changing.  But unlike the game, where the changes are public and happen only once per game, in the real world, the changes to the rules are often hidden and can happen at any time.

Regulators are forced to follow a path very much like the Risk Legacy game of making public changes on a clear timetable, but  competitors can change their prices or their products or their distribution strategy at any time.  Customers can change their behaviors, sometimes drastically, most often gradually without notice.  Even the weather seems to change, but we are not really sure how much.

Meanwhile, risk managers have been forced into a universe of their own design with the movement towards heavy metal complex risk models.  Those models are most often based upon the premise that when it comes to risk, things will not change.  That the future will be much like the past and in fact, that even inquiring about changes may be difficult and may therefore be discouraged due to limited resources.

But risk can be thought of as the tail of the cat.  The exact path of the cat is unpredictable.  The rules for what a cat is trying to accomplish at any point in time keep changing.  Not constantly changing, but changing nonetheless without warning.  So imagine trying to model the path of the cat.  Now shift to the tail of the cat representing the risk.  The tail has a much wider and more unpredictable path than the body of the cat.

That is not to suggest that the path of the tail (the risk) is wildly unpredictable.  But keeping up with the tail requires much more than simply extrapolating the path of the cat from the recent past.  It requires keeping up with the ever changing path of the cat.  And the tail movement will often represent the possibilities for changes in the future path.

Some risk models and risk management programs are created with recognition of the likelihood that the rules will change, sometimes even between the time that the model assumptions are set and when the model results are presented.  In those programs, the models are valued for their insights into the nature of risk, but of the risk as it was in the recent past.  And with recognition that the risk that will be will be somewhat different because the rules will change.

You actually have to run on the treadmill . . .

December 19, 2013

Yes, that is right. Just buying a treadmill has absolutely no health benefits.

Treadmill

And in the same vein, just creating a risk management system does not provide any benefit. You actually have to activate that system and pay attenion to the signals that it sends. 

And you can count on the risk management system being disruptive.  In fact, if it is not disruptive, then you should shut it down. 

The risk management system is a waste of time and money if it just stays out of the way and you end up doing exactly what you would have done without it.  But, in at least 2/3 of the companies that claim to be running a risk management system, they have trouble coming up with even one story of how they changed what they were planning to do because of the risk management system.

Usually, in a company that is really running a risk management system, the stories of the impact of risk management are of major clashes. 

Risk management is a control system that focuses on three things:

  • Riskiness of accepted risks
  • Volume of accepted risks
  • Return from accepted risks

The disruptions caused by an actual active risk management system fall into those three categories:

  • Business that would have been accepted prior to risk management system is now deemed to be unacceptable because it is too risky.  Rejection of business or mitigation of the excess risk is now required. 
  • Growth of risky business that may not have been restricted before the risk management system is now seen to be excessive.  Rejection of business or mitigation of the excess risk is now required. 
  • Return from business where the risk was not previously measured is now seen to be inadequate compared to the risk involved.  Business emphasis is now shifted to alternatives with a better return for risk. 

Some firms will find the disruptions less than others, but there will almost always be disruptions. 

The worst case scenario for a new risk management system is that the system is implemented and then when a major potentially disruptive situation arises, an exception to the new risk management system is granted.  That is worst case because those major disruptive situations are actually where the risk management system pays for itself.  If the risk management only applies to minor business decisions, then the company will experience all of the cost of the system but very little of the benefits.

Free Download of Valuation and Common Sense Book

December 19, 2013

RISKVIEWS recently got the material below in an email.  This material seems quite educational and also somewhat amusing.  The authors keep pointing out the extreme variety of actual detailed approach from any single theory in the academic literature.  

For example, the table following shows a plot of Required Equity Premium by publication date of book. 

Equity Premium

You get a strong impression from reading this book that all of the concepts of modern finance are extremely plastic and/or ill defined in practice. 

RISKVIEWS wonders if that is in any way related to the famous Friedman principle that economics models need not be at all realistic.  See post Friedman Model.

===========================================

Book “Valuation and Common Sense” (3rd edition).  May be downloaded for free

The book has been improved in its 3rd edition. Main changes are:

  1. Tables (with all calculations) and figures are available in excel format in: http://web.iese.edu/PabloFernandez/Book_VaCS/valuation%20CaCS.html
  2. We have added questions at the end of each chapter.
  3. 5 new chapters:

Chapters

Downloadable at:

32 Shareholder Value Creation: A Definition http://ssrn.com/abstract=268129
33 Shareholder value creators in the S&P 500: 1991 – 2010 http://ssrn.com/abstract=1759353
34 EVA and Cash value added do NOT measure shareholder value creation http://ssrn.com/abstract=270799
35 Several shareholder returns. All-period returns and all-shareholders return http://ssrn.com/abstract=2358444
36 339 questions on valuation and finance http://ssrn.com/abstract=2357432

The book explains the nuances of different valuation methods and provides the reader with the tools for analyzing and valuing any business, no matter how complex. The book has 326 tables, 190 diagrams and more than 180 examples to help the reader. It also has 480 readers’ comments of previous editions.

The book has 36 chapters. Each chapter may be downloaded for free at the following links:

Chapters

Downloadable at:

     Table of contents, acknowledgments, glossary http://ssrn.com/abstract=2209089
Company Valuation Methods http://ssrn.com/abstract=274973
Cash Flow is a Fact. Net Income is Just an Opinion http://ssrn.com/abstract=330540
Ten Badly Explained Topics in Most Corporate Finance Books http://ssrn.com/abstract=2044576
Cash Flow Valuation Methods: Perpetuities, Constant Growth and General Case http://ssrn.com/abstract=743229
5   Valuation Using Multiples: How Do Analysts Reach Their Conclusions? http://ssrn.com/abstract=274972
6   Valuing Companies by Cash Flow Discounting: Ten Methods and Nine Theories http://ssrn.com/abstract=256987
7   Three Residual Income Valuation Methods and Discounted Cash Flow Valuation http://ssrn.com/abstract=296945
8   WACC: Definition, Misconceptions and Errors http://ssrn.com/abstract=1620871
Cash Flow Discounting: Fundamental Relationships and Unnecessary Complications http://ssrn.com/abstract=2117765
10 How to Value a Seasonal Company Discounting Cash Flows http://ssrn.com/abstract=406220
11 Optimal Capital Structure: Problems with the Harvard and Damodaran Approaches http://ssrn.com/abstract=270833
12 Equity Premium: Historical, Expected, Required and Implied http://ssrn.com/abstract=933070
13 The Equity Premium in 150 Textbooks http://ssrn.com/abstract=1473225
14 Market Risk Premium Used in 82 Countries in 2012: A Survey with 7,192 Answers http://ssrn.com/abstract=2084213
15 Are Calculated Betas Good for Anything? http://ssrn.com/abstract=504565
16 Beta = 1 Does a Better Job than Calculated Betas http://ssrn.com/abstract=1406923
17 Betas Used by Professors: A Survey with 2,500 Answers http://ssrn.com/abstract=1407464
18 On the Instability of Betas: The Case of Spain http://ssrn.com/abstract=510146
19 Valuation of the Shares after an Expropriation: The Case of ElectraBul http://ssrn.com/abstract=2191044
20 A solution to Valuation of the Shares after an Expropriation: The Case of ElectraBul http://ssrn.com/abstract=2217604
21 Valuation of an Expropriated Company: The Case of YPF and Repsol in Argentina http://ssrn.com/abstract=2176728
22 1,959 valuations of the YPF shares expropriated to Repsol http://ssrn.com/abstract=2226321
23 Internet Valuations: The Case of Terra-Lycos http://ssrn.com/abstract=265608
24 Valuation of Internet-related companies http://ssrn.com/abstract=265609
25 Valuation of Brands and Intellectual Capital http://ssrn.com/abstract=270688
26 Interest rates and company valuation http://ssrn.com/abstract=2215926
27 Price to Earnings ratio, Value to Book ratio and Growth http://ssrn.com/abstract=2212373
28 Dividends and Share Repurchases http://ssrn.com/abstract=2215739
29 How Inflation destroys Value http://ssrn.com/abstract=2215796
30 Valuing Real Options: Frequently Made Errors http://ssrn.com/abstract=274855
31 119 Common Errors in Company Valuations http://ssrn.com/abstract=1025424
32 Shareholder Value Creation: A Definition http://ssrn.com/abstract=268129
33 Shareholder value creators in the S&P 500: 1991 – 2010 http://ssrn.com/abstract=1759353
34 EVA and Cash value added do NOT measure shareholder value creation http://ssrn.com/abstract=270799
35 Several shareholder returns. All-period returns and all-shareholders return http://ssrn.com/abstract=2358444
36 339 questions on valuation and finance http://ssrn.com/abstract=2357432

I would very much appreciate any of your suggestions for improving the book.

Best regards,
Pablo Fernandez

Collective Approaches to Risk in Business: An Introduction to Plural Rationality Theory

December 18, 2013

New Paper Published by the NAAJ
http://www.tandfonline.com/doi/abs/10.1080/10920277.2013.847781#preview

This article initiates a discussion regarding Plural Rationality Theory, which began to be used as a tool for understanding risk 40 years ago in the field of social anthropology. This theory is now widely applied and can provide a powerful paradigm to understand group behaviors. The theory has only recently been utilized in business and finance, where it provides insights into perceptions of risk and the dynamics of firms and markets. Plural Rationality Theory highlights four competing views of risk with corresponding strategies applied in four distinct risk environments. We explain how these rival perspectives are evident on all levels, from roles within organizations to macro level economics. The theory is introduced and the concepts are applied with business terms and examples such as company strategy, where the theory has a particularly strong impact on risk management patterns. The principles are also shown to have been evident in the run up to—and the reactions after—the 2008 financial crisis. Traditional “risk management” is shown to align with only one of these four views of risk, and the consequences of that singular view are discussed. Additional changes needed to make risk management more comprehensive, widely acceptable, and successful are introduced.

Co-Author is Elijah Bush, author of German Muslim Converts: Exploring Patterns of Islamic Integration.

Ingram Looks into ERM – Eight short articles.

December 17, 2013

The magazine of the Society of Actuaries published eight short essays on a variety of ERM topics.

Making Risk Models Collaborative   With our risk models, we make the contribution of managers to the risk management of the company disappear into the mist of probabilities. And then we wonder why so many managers are opposed to “letting a model run the company.”

We Must Legitimize Uncertainty   In a post to the Harvard Business Review blog, “American CEO’s should Stop Complaining about Uncertainty,” Jonathan Berman points out that while African companies are able to cope with their uncertain environment, American CEOs mostly just complain.  Americans must legitimize the Uncertain environment and study how mest to cope.

Finding a Safe Place New ERM and Old School goals for risk management all seek to keep the company safe.

ERM and the Hierarchy of Corporate Needs  The reason that ERM is not given the degree of priority that its proponents desire is that its proponents want is that it is at best third in the hierarchy of corporate needs.

Help Wanted: Risk Tolerance  It is a rare company that can create a risk appetite statement if they do not already have years of experience with the measure of risk that will be used.

What should you do at a Yellow Light?  Companies need to plan in advance what should be happening when their risk reports indicates that they are entering into risky territory.

Are you Sure about that?  Frequently, we ignore the fact that our risk models do NOT produce infomation about our risks that are all consistently reliable.  Yet we still add those numbers to gether as if they were on the exact same basis. 

Creating a Risk Management Culture – Risk Management needs to be embedded into the corporate culture, just as expense management was embedded thirty years ago. 

 

Risk Culture doesn’t come from a memo

December 16, 2013

Nor from a policy, nor from a speech, nor from a mission statement nor a value statement.

Like all of corporate culture, Risk Culture comes from experiences.  Risk Culture comes from experiences with risk.  Corporate Culture is fundamentally the embedded, unspoken assumptions that underlie behaviors and decisions of the management and staff of the firm.  Risk Culture is fundamentally the embedded, unspoken assumptions and beliefs about risk that underlie behaviors and decisions of the management and staff of the firm.

Corporate culture is formed initially when a company is first started.  The new company tries an approach to risk, usually based upon the prior experiences of the first leaders of the firm.  If those approaches are successful, then they become the Risk Culture.  If they are unsuccessful, then the new company often just fails.

In his book, Fooled by Randomness, Nassim Taleb points out that there is a survivor bias involved here.  Some of the companies that survive the early years are managing their risk correctly and some are simply lucky.  Taleb tells the story of mutual fund managers who either beat the market or not each year.  Looking back over 5 years, a fund manager who was one of 30 out of 1000 who beat the market every one of those five years might believe that their performance and therefore their ability was far above average.  However, Taleb points out that if whether a manager beat the market or not each year was determined by a coin toss, statistics tells us to expect 31 to beat the market.

That was for a situation where we assume that the good results were likely 50% of the time.  For risk management, the event that is being managed is often a 1/100 likelihood.  There is a 95% chance of avoiding a 1/100 loss in any five year period, just by showing up with average risk management.  That makes it fairly likely that poor risk management can be easily overcome by just a little bit of luck.

So by the natural process of experience, Risk Culture is formed based upon what worked in the past.

In banks and hedge funds and other financial firms where risk taking is a fundamental part of the business, the Risk Culture often supports those who take risks and win.  Regardless of whether the amount of risk is within limits or tolerances or risk appetite.

You see, all of those ideas (limits, tolerances, appetites) are based upon an opinion about the future.  And the winner just has a different opinion about the future of his/her risk.  The fact that the winner’s opinion proves itself as experience shows that the bad outcome that those worrying risk people said was the future is not the case.  When the winner suddenly makes a bad call (see London Whale), that shows that their ability to see the future better than the risk department’s models may be done.  You see, there are very very few people who can keep the perspective needed to consistently beat the market.  (RISKVIEWS thinks that the fall off might well follow an exponential decay pattern as predicted by statistics!)

The current ideas of a proper Risk Culture (see FSB consultation paper) are doubtless not what most firms set up as their initial response to risk. That paper focuses on four specific aspects of Risk Culture.

  • Tone from the top: The board of directors11 and senior management are the starting point for setting the financial institution’s core values and risk culture, and their behaviour must reflect the values being espoused. As such, the leadership of the institution should systematically develop, monitor, and assess the culture of the financial institution.
  • Accountability: Successful risk management requires employees at all levels to understand the core values of the institutions’ risk culture and its approach to risk, be capable of performing their prescribed roles, and be aware that they are held accountable for their actions in relation to the institution’s risk-taking behaviour. Staff acceptance of risk-related goals and related values is essential.
  • Effective challenge: A sound risk culture promotes an environment of effective challenge in which decision-making processes promote a range of views, allow for testing of current practices, and stimulate a positive, critical attitude among employees and an environment of open and constructive engagement.
  • Incentives: Performance and talent management should encourage and reinforce maintenance of the financial institution’s desired risk management behaviour. Financial and non-financial incentives should support the core values and risk culture at all levels of the financial institution.

(These descriptions are quotes from the paper)

These practices are supported by the Risk Culture for a few very new firms.  As well as a very few other firms (and we will mention why that is in a few paragraphs).  But for at least 80 percent of financial firms, these items, if they are happening, are not at all supported by the Risk Culture.  The true Risk Culture of a successful firm has evolved based upon the original choices of the firm and the decisions and actions taken by the firm that have been successful over the life of the firm.

These aspects of Risk Culture are a part of one of the three layers of culture (see Edgar Schein, The Corporate Culture Survival Guide).  He calls those layers:

  • Artifacts
  • Espoused Values
  • Shared Assumptions

The four aspects of Risk Culture featured by the FSB can all be considered to be “artifacts”.  Those are the outward signs of the culture, but not the whole thing.  Espoused Values are the Memos, policies, speeches, mission and value statements.

Coercion from outside the organization, such as through regulator edict, can force management to change the Espoused Values.  But the real culture will ignore those values.  Those outside edicts can force behaviors, just as prison guards can force prisoners to certain behaviors.  But as soon as the guards are not looking, the existing behavioral standards based upon the shared assumptions will re-emerge.

When the insiders, including top management of an organization, want to change the culture, they are faced with a difficult and arduous task.

That will be the topic of the next post.

ERM on WillisWire

December 3, 2013

Risk Management: Adaptability is Key to Success

swiss-army-knife_645x400

There is no single approach to risk management that will work for all risks nor, for any one risk, is there any one approach to risk management that will work for all times. Rational adaptability is the strategy of altering … Continue reading →


Resilience for the Long Term

Resilient Sprout in Drought

In 1973, CS Holling, a biologist, argued that the “Equilibrium” idea of natural systems that was then popular with ecologists was wrong.He said that natural systems went through drastic, unpredictable changes – such systems were “profoundly affected by random events”.  … Continue reading →


Management is Needed: Not Incentive Compensation

Bizman in Tie

Many theoreticians and more than a few executives take the position that incentive compensation is a powerful motivator. It therefore follows that careful crafting of the incentive compensation program is all that it takes to get the most out of a … Continue reading →


A Gigantic Risk Management Entertainment System

game-controller-in-room_645x400

As video gaming has become more and more sophisticated, and as the hardware to support those games has become capable of playing movies and other media, video game consoles have now become “Entertainment Systems”.  Continue reading →


Panel at ERM Symposium: ERM for Financial Intermediaries

SS Meaning of Risk Mgmt  77408059 April 23 12

Insurance company risk managers need to recognize that traditional activities like underwriting, pricing and reserving are vitally important parts of managing the risks of their firm. Enterprise risk management (ERM) tends to focus upon only two or three of the … Continue reading →


ERM Symposium Panel: Actuarial Professional Risk Management

SS Risk Button - Blank Keys  53606569 April 23

In just a few days, actuaries will be the first group of Enterprise Risk Management (ERM) professionals to make a commitment to specific ERM standards for their work. In 2012, the Actuarial Standards Board passed two new Actuarial Standards of … Continue reading →


Has the Risk Profession Become a Spectator Sport?

The 2013 ERM Symposium goes back to Chicago this year after a side trip to DC for 2012. This is the 11th year for the premier program for financial risk managers. Continue reading →


What to Do About Emerging Risks…

snake-hatching_645x400

WillisWire has on several occasions featured opinions from a large number of our contributors about what might be the next emerging risk in various sectors. But what can be done once you have identified an emerging risk? Continue reading →


U.S. Insurers Need to Get Ready for ORSA

paperwork

Slowly, but surely, and without a lot of fanfare, U.S. insurance regulators have been orchestrating a sea change in their interaction with companies over solvency.  Not as dramatic as Solvency II in Europe, but the U.S. changes are actually happening … Continue reading →


Resiliency vs. Fragility

TREES_645_400(2)

Is there really a choice?  Who would choose to be Fragile over Resilient? Continue reading →

– See more at: http://blog.willis.com/author/daveingram/#sthash.xxAR1QAP.dpuf

Sean Ringsted, ACE Group, Named CRO of the Year

December 2, 2013

Insurance Risk Awards 2013: Chief risk officer of the year: Sean Ringsted, Ace

Sean Ringsted is Chief Risk Officer and Chief Actuary for ACE Limited since 2008.  Ringsted is responsible for the continued development and implementation of ACE’s risk management strategy and processes, and for ensuring a consistent risk management framework across the company. Ringsted also oversees all major actuarial functions, including reserving, pricing, and capital performance measurement. Ringsted’s previous roles at ACE include Chief Actuary for ACE Group from 2004 to 2008, Executive Vice President and Chief Risk Officer for ACE Tempest Re from 2002 to 2004, and Senior Vice President and Chief Actuary for ACE Tempest Re from 1998 to 2002. Mr. Ringsted holds a Bachelor of Science in biochemistry from Bristol University and a doctorate in biochemistry from Oxford University. He also is a Fellow of the Institute of Actuaries (FIA).  Ringsted is also chairman of the North American CRO Council, which has been increasingly active in promoting best practice in risk management and is gaining respect from regulators and standard-setting bodies at a domestic and international level.

The Enterprise Risk Management program at ACE from their annual report.
As an insurer, ACE is in the business of profitably managing risk for its customers. Since risk management must permeate an organization conducting a global insurance business, we have an established Enterprise Risk Management (ERM) framework that is integrated into management of our businesses and is led by ACE’s senior management. As a result, ERM is a part of the day-to-day management of ACE and its operations.

Our global ERM framework is broadly multi-disciplinary and its objectives include:

  • support core risk management responsibilities at division and corporate levels through the identification and management of risks that aggregate and/or correlate across divisions;
  • identify, analyze, and mitigate significant external risks that could impair the financial condition of ACE and/or hinder its business objectives;
  • coordinate accumulation guidelines and actual exposure relative to guidelines, risk codes, and other risk processes;
  • provide analysis and maintain accumulation and economic capital and information systems that enable business leaders to make appropriate and consistent risk/return decisions;
  • identify and assess emerging risk issues; and
  • develop and communicate to our business lines consistent risk management processes

ACE’s Enterprise Risk Management Board (ERMB) reports to and assists the Chief Executive Officer in the oversight and review of the ERM framework which covers the processes and guidelines used to manage insurance risk, financial risk, strategic risk, and operational risk. The ERMB is chaired by ACE’s Chief Risk Officer and Chief Actuary. The ERMB meets at least monthly, and is comprised of ACE’s most senior executives, in addition to the Chair: the Chief Executive Officer, Chief Financial Officer, Chief Investment Officer, Chief Claims Officer, General Counsel, Chief Executive Officer for Insurance – North America, Chief Executive Officer for ACE Overseas General, and our Chief Executive Officer for Global Reinsurance.
The ERMB is provided support from various sources, including the Enterprise Risk Unit (ERU) and Product Boards. The ERU is responsible for the collation and analysis of two types of information. First, external information that provides insight to the ERMB on risks that might significantly impact ACE’s key objectives and second, internal risk aggregations from its business writings and other activities such as investments. The ERU is independent of the operating units and reports to our Chief Risk Officer and Chief Actuary. The Product Boards exist to provide oversight for products that we offer globally. A Product Board currently exists for each of the following products; property/energy, marine, casualty, professional lines, aviation, and political risk. Each Product Board is responsible for ensuring consistency in underwriting and pricing standards, identification of emerg- ing issues, and guidelines for relevant accumulations.
ACE’s Chief Risk Officer and Chief Actuary also reports to the Board’s Risk & Finance Committee, which helps execute the Board’s supervisory responsibilities pertaining to ERM. The role of the Risk & Finance Committee includes evaluation of the integrity and effectiveness of our ERM procedures and systems and information; governance on major policy decisions pertain- ing to risk aggregation and minimization, and assessment of our major decisions and preparedness levels pertaining to perceived material risks. The Audit Committee, which regularly meets with the Risk & Finance Committee, provides oversight of the financial reporting process and safeguarding of assets.
Others within the ERM structure contribute toward accomplishing ACE’s ERM objectives, including regional management, Internal Audit, Compliance, external consultants, and managers of our internal control processes and procedures.

Reinsurance Protection
As part of our risk management strategy, we purchase reinsurance protection to mitigate our exposure to losses, including catastrophes, to an acceptable level. Although reinsurance agreements contractually obligate our reinsurers to reimburse us for an agreed-upon portion of our gross paid losses, this reinsurance does not discharge our primary liability to our insureds and, thus, we ultimately remain liable for the gross direct losses. In certain countries, reinsurer selection is limited by local laws or regulations. In most countries there is more freedom of choice, and the counterparty is selected based upon its financial strength, claims settlement record, management, line of business expertise, and its price for assuming the risk transferred. In support of this process, we maintain an ACE authorized reinsurer list that stratifies these authorized reinsurers by classes of business and acceptable limits. This list is maintained by our Reinsurance Security Committee (RSC), a committee comprising senior management personnel and a dedicated reinsurer security team. Changes to the list are authorized by the RSC and recommended to the Chair of the Enterprise Risk Management Board. The reinsurers on the authorized list and potential new markets are regularly reviewed and the list may be modified following these reviews. In addition to the authorized list, there is a formal exception process that allows authorized reinsurance buyers to use reinsurers already on the authorized list for higher limits or different lines of business, for example, or other reinsurers not on the authorized list if their use is supported by compelling business reasons for a particular reinsurance program.
A separate policy and process exists for captive reinsurance companies. Generally, these reinsurance companies are established by our clients or our clients have an interest in them. It is generally our policy to obtain collateral equal to the expected losses that may be ceded to the captive. Where appropriate, exceptions to the collateral requirement are granted but only after senior management review. Specific collateral guidelines and an exception process are in place for ACE USA and Insurance – Overseas General, both of which have credit management units evaluating the captive’s credit quality and that of their parent company. The credit management units, working with actuaries, determine reasonable exposure estimates (collateral calculations), ensure receipt of collateral in an acceptable form, and coordinate collateral adjustments as and when need-
ed. Currently, financial reviews and expected loss evaluations are performed annually for active captive accounts and as needed for run-off exposures. In addition to collateral, parental guarantees are often used to enhance the credit quality of the captive.
In general, we seek to place our reinsurance with highly rated companies with which we have a strong trading relationship.

Investments
Our objective is to maximize investment income and total return while ensuring an appropriate level of liquidity, investment quality and diversification. As such, ACE’s investment portfolio is invested primarily in investment-grade fixed-income securities as measured by the major rating agencies. We do not allow leverage or complex credit structures in our investment portfolio.
The critical aspects of the investment process are controlled by ACE Asset Management, an indirect wholly-owned subsidiary of ACE. These aspects include asset allocation, portfolio and guideline design, risk management and oversight of external asset managers. In this regard, ACE Asset Management:

  • conducts formal asset allocation modeling for each of the ACE subsidiaries, providing formal recommendations for the portfolio’s structure;
  • establishes recommended investment guidelines that are appropriate to the prescribed asset allocation targets;
  • provides the analysis, evaluation, and selection of our external investment advisors;
  • establishes and develops investment-related analytics to enhance portfolio engineering and risk control;
  • monitors and aggregates the correlated risk of the overall investment portfolio; and
  • provides governance over the investment process for each of our operating companies to ensure consistency of approach and adherence to investment guidelines.

Under our guidance and direction, external asset managers conduct security and sector selection and transaction execution. This use of multiple managers benefits ACE in several ways – it provides us with operational and cost efficiencies, diversity of styles and approaches, innovations in investment research and credit and risk management, all of which enhance the risk adjusted returns of our portfolios.
ACE Asset Management determines the investment portfolio’s allowable, targeted asset allocation and ranges for each of the operating segments. These asset allocation targets are derived from sophisticated asset and liability modeling that measures correlated histories of returns and volatility of returns. Allowable investment classes are further refined through analysis of our operating environment, including expected volatility of cash flows, potential impact on our capital position, as well as regulatory and rating agency considerations.

Under the overall supervision of the Risk & Finance Committee of the Board, ACE’s governance over investment management is rigorous and ongoing. Among its responsibilities, the Risk & Finance Committee of the Board:

  • reviews and approves asset allocation targets and investment policy to ensure that it is consistent with our overall goals, strategies, and objectives;
  • reviews and approves investment guidelines to ensure that appropriate levels of portfolio liquidity, credit quality, diversification, and volatility are maintained; and
  • systematically reviews the portfolio’s exposures including any potential violations of investment guidelines.

We have long-standing global credit limits for our entire portfolio across the organization and for individual obligors. Exposures are aggregated, monitored, and actively managed by our Global Credit Committee, comprised of senior executives, including our Chief Financial Officer, our Chief Risk Officer, our Chief Investment Officer, and our Treasurer. Additionally, the Board has established a Risk & Finance Committee which helps execute the Board’s supervisory responsibilities pertaining to enterprise risk management including investment risk.
Within the guidelines and asset allocation parameters established by the Risk & Finance Committee, individual investment committees of the operating segments determine tactical asset allocation. Additionally, these committees review all investment- related activity that affects their operating company, including the selection of outside investment advisors, proposed asset allocations changes, and the systematic review of investment guidelines.


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