Citationrepuationalrisk by Michel Rochette, MBA, FSA

References for Operational Risk Exam by SOA

Advanced Finance/ERM Exam Final Spring 2012 Important Exam Information:

Exam Date and Time

A read-through time will be given prior to the start of the examâ&#x20AC;&#x201C;15 minutes in the morning session and 15 minutes in the afternoon session.

Exam Registration

Candidates may register online or with an application.

Order Study Notes

Study notes are part of the required syllabus and are not available electronically but may be purchased through the online store.

Introductory Study Note

The Introductory Study Note has a complete listing of all study notes as well as errata and other important information.

Case Study

This case study will also be provided with the examination. Candidates will not be allowed to bring their copy of the case study into the examination room.

Past Exams

Past Exams from 2000-present are available on SOA web site.

Updates

Candidates should be sure to check the Updates page on the exam home page periodically for additional corrections or notices.

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Advanced Finance/ERM Exam Final Spring 2012

Topic: Risk Categories and Identification Learning Objective: 1. The candidate will understand the types of risks faced by an entity and be able to identify and analyze those risks. Learning Outcomes: The candidate will be able to: a) Identify and analyze financial market risks faced by an entity, including but not limited to: currency risk, credit risk, spread risk, liquidity risk, interest rate risk, and equity risk. b) Identify and analyze insurance risks faced by an entity, including but not limited to: mortality risk, morbidity risk, catastrophe risk, product risk, and embedded options. c) Identify and analyze operational risks faced by an entity, including but not limited to: • Market Conduct (e.g., sales practices) • HR risk, e.g., productivity, talent management, employee conduct • Process risk, e.g., supply chain, R&D • Technology risk, e.g., reliability, external attack, internal attack • Judicial risk, e.g., litigation • Compliance risk, e.g., financial reporting • Internal and External fraud • Execution risk • Governance risk • Supplier/partner risk • Disaster risk, e.g., natural disaster, man-made disaster d) Identify and analyze strategic risks faced by an entity including, but not limited to • Product sustainability risk • Distribution sustainability risk • Consumer preferences and demographics • Geopolitical risk • Competitor risk • External relations risk • Legislative/Regulatory risk • Reputation Risk • Sovereign risk e) Indentify and analyze systemic risks faced by an entity, including but not limited to financial contagion

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Advanced Finance/ERM Exam Final Spring 2012 RESOURCES Kalberer, Variable Annuities, 2009 Ch. 1, History and Development of the Variable-Annuity Market (background only) Ch. 2, North American Variable Annuities (background only) Ch.5, Risks Underlying Variable Annuities Tilman, Asset/Liability Management of Financial Institutions, 2003 Ch. 16, Understanding Options Embedded in Insurers’ Balance Sheets, by L. Rubin FE-C102-07: General American Life Can’t Pay Investors, Looks at Suitors FE-C106-07: Mapping of Life Insurance Risks, AAA Report to NAIC FE-C151-08: Ch. 13 (Sections 13.1 – 13.4), Annuity and Investment Products of Atkinson & Dallas, Life Insurance Products and Finance FE-C159-09: Countering the Biggest Risk of All, by Slywotzky and Drzik - Harvard Business Review, April 2005 FE-C175-11: Learning from the 2009 H1N1 Influenza Pandemic FE-C176-11: Chapter 10 “Insuring against Catastrophies” from Diebold et.al., The Known, the Unknown and the Unknowable in Financial Risk Management Operational and Reputational Risks: Essential Components of ERM, by M. Rochette, Risk Management, December 2006. http://www.soa.org/library/newsletters/risk-managementnewsletter/2006/december/RMN0612.pdf

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Advanced Finance/ERM Exam Final Spring 2012 Topic: Accounting and Value Measures Learning Objective: 2. The candidate will understand measures of corporate value and be able to analyze the data in corporate financial statements. Learning Outcomes: The candidate will be able to: a) Explain basic accounting concepts used in producing financial statements: • in insurance companies • in other financial institutions • in non-financial institutions b) Analyze a specific company financial situation by demonstrating advanced knowledge of balance sheet and income statement structures. c) Describe the concept of economic measures of value (e.g. MCEV) and demonstrate their uses in the risk management and corporate decision-making processes. d) Demonstrate an understanding of economic capital as reported by financial institutions RESOURCES Fridson, Alvarez, Financial Statement Analysis: A Practitioners Guide, 2002 (Candidates may also use Fourth Edition, 2011) Ch. 1, The Adversarial Nature of Financial Reporting Ch. 2, The Balance Sheet Ch. 3, The Income Statement Ch. 4, The Statement of Cash Flows Ch. 13, Credit Analysis Tilman, Asset/Liability Management of Financial Institutions, 2003 Ch. 24, Accounting Standards and Requirements, by E. Habayeh & S. Sethi FE-C162-09: “EVA and Strategy” FE-C177-11:CRO Forum “A Market Cost of Capital Approach to Market Value Margins” Paper (sections 1-3 background only) FE-C178-11: Economic Capital Modeling – Practical Considerations - Milliman FE-C179-11:Insurance Industry Mergers & Acquisitions, Toole and Herget,2005

Ch. 4: Valuation Techniques (sections 1-5 only)

Fair Value – Financial Economics Perspective by Babbel, Gold and Merrill, NAAJ, http://www.soa.org/library/journals/north-american-actuarialjournal/2002/january/naaj0201_2.pdf Fair Valuation of Insurance Liabilities: Principles and Methods” AAA Monograph, September 2002 http://www.actuary.org/pdf/finreport/fairval_sept02.pdf

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Advanced Finance/ERM Exam Final Spring 2012

Topic: Risk Quantification and Risk Measures Learning Objective: 3. The candidate will understand how the risks faced by an entity can be quantified and the use of metrics to measure risk. Learning Outcomes: The candidate will be able to: a) Demonstrate how to calculate economic capital • Define the basic elements and explain the uses of economic capital. • Explain the challenges and limits of economic capital calculations and explain how economic capital may differ from external requirements of rating agencies and regulators. b) Demonstrate the use of risk metrics to quantify major types of risk exposure in the context of an integrated risk management process. • Demonstrate how each of the financial risks faced by an entity can be amenable to quantitative analysis including an explanation of the advantages and disadvantages of various techniques such as Value at Risk (VaR), stochastic analysis, scenario analysis and stress testing. • Describe and evaluate risk aggregation techniques, incorporating the use of correlation, integrated risk distributions and copulas. • Describe how and why risks are correlated, and give examples of risks that are positively correlated and risks that are negatively correlated. • Assess the overall corporate risk exposure arising from financial and non-financial risks. c) Evaluate the properties of risk measures and explain their limitations. d) Propose techniques for allocating the cost of risks taken for the purposes of risk adjusting performance measures e) Define and evaluate model and parameter risk f) Understand the theory and applications of extreme value theory in the measuring and modeling of risk RESOURCES: Hardy, Investment Guarantees, 2003, Ch. 9, Risk Measures Ch. 10, Emerging Cost Analysis Ch. 11, Forecast Uncertainty Saunders and Allen, Credit Risk Management In and out of the Financial Crisis Ch. 4, Loans as Options: The Moody’s KMV Model Ch. 5, Reduced Form Models: Kamakura’s Risk Manager Ch. 6, Other Credit Risk Models Ch. 7, A Critical Parameter: Loss Given Default

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Advanced Finance/ERM Exam Final Spring 2012 Segal, Corporate Value of Enterprise Risk Management, Ch. 5, Risk Quantification FE-C143-07: Dynamic Financial Models of Property-Casualty Insurers FE-C166-09: “Black Monday and Black Swans,” J. Bogle, Financial Analysts Journal, 64:2(3040) 2008 FE-C178-11:Economic Capital Modeling – Practical Considerations - Milliman FE-C180-11: Measurement and Modeling of Dependencies in Economic Capital Chapters 1-8 only FE-C181-11: Value-at-Risk: Evolution, Deficiencies and Alternatives CSFB Credit Portfolio Modeling Handbook – Ch. 9, Risk Measures: How Long Is a Risky Piece of String? http://www.csfb.com/institutional/research/CreditPortfolioModeling.pdf Summary of “Variance of the CTE Estimator” ,Risk Management, August 2008 http://www.soa.org/library/newsletters/risk-management-newsletter/2008/august/rmn-2008iss13.pdf Modeling Tail Behavior with Extreme Value Theory, Risk Management, Sept 2009, Damon Levine http://www.soa.org/library/newsletters/risk-management-newsletter/2009/september/jrm-2009iss17-levine.pdf

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Advanced Finance/ERM Exam Final Spring 2012 Topic: Risk Management Learning Objective: 4. The candidate will understand the means available for managing various risks and how an entity makes decisions about appropriate techniques. Learning Outcomes: The candidate will be able to: General a. Explain the rationale for managing risk and demonstrate the selection of the appropriate risk retention level. b. Demonstrate means for transferring risk to a third party, and analyze the costs and benefits of doing so. c. Demonstrate means for reducing risk without transferring it (internal hedges). d. Evaluate the performance of risk transference activities. e. Describe and evaluate risk management techniques that can be used to deal with financial and non-financial risks. f. Develop an appropriate choice of hedging strategy for a given situation (e.g., reinsurance, derivatives, financial contracting), which balances benefits with inherent costs, including exposure to credit risk, basis risk, moral hazard, and other risks. Asset Liability Management g. Analyze the application of Asset Liability Management principles to Investment Policy and Asset Allocation. h. Analyze funding and portfolio management strategies to control equity and interest rate risk, including key rate risks. â&#x20AC;˘ Contrast modified duration and effective duration measures.

â&#x20AC;˘ â&#x20AC;˘

i. j. k.

Calculate effective duration and effective key-rate durations of a portfolio.

Explain the concepts of immunization including modern refinements and practical limitations. Demonstrate how derivatives, synthetic securities, and financial contracting may be used to manage interest rate risk, including key rate risks. Demonstrate how derivatives, synthetic securities, and financial contracting may be used to manage equity risk, in particular, equity market guarantees found in variable annuities. Analyze the practicalities of market risk hedging, including dynamic hedging.

Credit Risk Management l. Define and evaluate credit risk as related to fixed income securities. m. Define and evaluate spread risk as related to fixed income securities n. Explain how to incorporate best practices in credit risk measurement, modeling, and management. o. Define credit risk as related to derivatives, define credit risk as related to reinsurance ceded, define counter-party risk and demonstrate the use of comprehensive due diligence and aggregate counter-party exposure limits. p. Describe and evaluate risk mitigation techniques and practices: credit derivatives, diversification, concentration limits, and credit support agreements.

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Advanced Finance/ERM Exam Final Spring 2012 Liquidity Risk Management q. Define liquidity risk. r. Explain methods for managing this risk, both pre-event and post-event. s. Evaluate examples of company disasters that were the result of these types of risks – what the exposure was, what occurred, the sequence of events, what actions management took, didn’t take and could have / should have taken, what the financial impacts and general consequences were. Strategic Risk Management t. Define strategic risk u. Explain methods for managing this risk, both pre-event and post-event v. Evaluate examples of company disasters that were the result of these types of risks – what the exposure was, what occurred, the sequence of events, what actions management took, didn’t take and could have / should have taken, what the financial impacts and general consequences were. Operational Risk Management w. Define operational risk x. Explain methods for managing this risk, both pre-event and post-event y. Evaluate examples of company disasters that were the result of these types of risks – what the exposure was, what occurred, the sequence of events, what actions management took, didn’t take and could have / should have taken, what the financial impacts and general consequences were RESOURCES Anderson and Schroder, Strategic Risk Management Practice, Ch. 1, The Strategic Nature of Corporate Risk Management Ch. 7, Stategic Risk Analysis Ch. 8, Strategic Risk Management – ammendents to the ERM framework Ch. 9, Stategic Risk Management Kalberer, Variable Annuities, 2009

Saunders and Allen,Credit Risk Management In and out of the Financial Crisis, 2010 Ch. 8, The Credit Risk of Portfolios and Correlations Ch 9, The VAR Approach: CreditMetrics and Other Models Ch. 10, Stress Testing Credit Models: Algorithmics Mark-to-Future Ch. 12, Credit Derivatives

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Advanced Finance/ERM Exam Final Spring 2012 Tiller, Life, Health and Annuity Reinsurance, 3rd Edition, 2005, Ch. 5, Advanced Methods of Reinsurance Ch. 16, Assumption Ch. 17, Special Purpose Reinsurance Companies Tilman, Asset/Liability Management of Financial Institutions, 2003, Ch. 9, Measuring and Marking Counterparty Risk, by E. Canabarro & D. Duffie Ch. 25, Implications of Regulatory and Accounting Requirements for Asset/Liability Management Decisions, by Hida, Habayeb, Yetis, & Sethi. FE-C117-07: Doherty, Integrated Risk Management, 2000 Ch. 1, The Convergence of Insurance Risk Management & Financial Risk Management Ch. 7, Why Is Risk Costly to a Firm? Ch. 8, Risk Management Strategy: Duality and Globality FE-C130-07: Hedging with Derivatives in Traditional Insurance Products FE-C147-07: Derivatives: Practice and Principles, Recommendations 9-24 and Section III FE-C156-09: Key Rate Durations: Measures of Interest Rate Risks FE-C159-09: Countering the Biggest Risk of All, by Slywotzky and Drzik - Harvard Business Review, April 2005 FE-C170-09: â&#x20AC;&#x153;Why COSO Is Flawed,â&#x20AC;? by A. Samed-Khan, January 2005 FE-C174-10: Deciphering the Liquidity and Credit Crunch 2007-2008, Brunnermeier FE-C182-11: Doherty, Integrated Risk Management, Chapter 16 , Case Study: The Securitization of Catastrophe Risk FE-C183-11: Revisiting The Role of Insurance Company ALM within a Risk Management Framework Liquidity Risk Measurement, CIA Educational Note http://www.actuaries.ca/members/publications/1996/9626e.pdf

Measuring and Managing Reputational Risk, Risk Management, March 2008 http://www.soa.org/library/newsletters/risk-management-newsletter/2008/march/rmn2008-iss12-diermeier.pdf Strategic Planning Models, Risk Management, March 2007 http://www.soa.org/library/newsletters/risk-managementnewsletter/2007/march/RMN0703.pdf

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Advanced Finance/ERM Exam Final Spring 2012 Topic: Enterprise Risk Management Framework Learning Objective: 5. The candidate will understand the components of an ERM framework and be able to evaluate the appropriateness of a framework in a given situation. Learning Outcomes: The candidate will be able to: a. Define Enterprise Risk Management and explain the principal terms used in ERM. b. Describe the fundamental concepts of risk management and evaluate a particular given riskmanagement framework. c. Demonstrate how an organization can create a risk management culture including: risk consciousness, accountabilities, discipline, collaboration, incentives, and communication. d. Explain the elements of risk governance, and demonstrate how governance issues are resolved through organizational structure. e. Compare and contrast various regulatory/industry frameworks: Basel, Sarbanes-Oxley Act, , Dodd/Frank, Solvency II, UK FSA guidelines, and COSO. f. Explain the perspectives of regulators, rating agencies, stock analysts, and company stakeholders and how they evaluate the risks and the risk management of an organization. g. Identify regulatory capital requirements and describe how they affect decisions. RESOURCES

Segal, Corporate Value of Enterprise Risk Management, 2011

Chapter 1, ERM Basics and Infrastructure background only Chapter 2, Defining ERM background only Chapter 3, ERM Framework

FE-C117-07: Doherty, Integrated Risk Management, Ch. 1, The Convergence of Insurance Risk Management & Financial Risk Management FE-C172-09: Enterprise Risk Management – Integrated Framework: Executive Summary, COSO, September 2004 FE-C184-11: A Comparative Analysis of U.S., Canadian and Solvency II Capital Adequacy Requirements in Life Insurance FE-C185-11: A Principles-Based Reserves and Capital Standard FE-C186-11: Methodology: Assessing Management's Commitment To And Execution Of Enterprise Risk Management Processes FE-C187-11: Market Consistent Embedded Value Principles Regulatory Capital Standards for Property and Casualty Insurers Under the U.S., Canadian and Proposed Solvency II (Standard) Formulas, Sharara, Hardy, Saunders http://www.soa.org/Files/Research/research-2010-08-regulatory-cap.pdf Actuarial Aspects of SOX 404”, The Financial Reporter, Dec. 2004, http://www.soa.org/library/newsletters/financial-reporter/2004/december/frn-2004-iss59brownehay.pdf Responsibilities of the Actuary for Communicating Sarbanes-Oxley Controls” The Financial Reporter, Dec. 2004, http://www.soa.org/library/newsletters/financial-reporter/2004/december/frn-2004-iss59auvinen.pdf

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Advanced Finance/ERM Exam Final Spring 2012

Topic: Enterprise Risk Management Process Learning Objective: 6. The candidate will understand the structure of an ERM process in an entity and be able to demonstrate best practices in enterprise risk management. Learning Outcomes: The candidate will be able to: a.

Demonstrate the ERM process steps to be followed once the ERM framework is in place:  Risk identification i. Defining and categorizing risk ii. Qualitative risk assessments  Risk quantification i. Scenario development / types of scenarios ii. Individual risk quantification, including inherent vs. residual exposures iii. Quantifying enterprise risk exposure, including correlations of risks  Risk management i. Defining risk appetite ii. Managing enterprise risk exposure towards risk appetite  Internal reporting i. Performance measurement ii. Performance management and incentive compensation  External disclosures i. Shareholders ii. Rating agencies iii. Regulators

Assess how risk and opportunity influence the selection of a firm’s vision and strategy and demonstrate how ERM can be appropriately embedded in an entity’s strategic planning.

Articulate risk objectives; demonstrate how to define and measure an organization’s risk appetite; and demonstrate how an organization uses risk appetite to make strategic decisions.

Determine a desired risk profile and appropriate risk filters, and analyze the risk and return trade-offs that result from changes in the organization’s risk profile.

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Advanced Finance/ERM Exam Final Spring 2012 e.

Demonstrate quantitatively and qualitatively how ERM is able to contribute to shareholder value creation..

Demonstrate how risk metrics can be incorporated into the risk monitoring function as part of an ERM framework.

Explain means for managing risks and demonstrate measures for evaluating their effectiveness.

Describe and assess the elements of a successful risk management function and recommend a structure for an organization's risk management function.

RESOURCES:

Segal, Corporate Value of Enterprise Risk Management, 2011 Chapter 6, Risk Decision-Making Chapter 7, Risk Messaging Chapter 8, Risk Governance and Other Topics FE-C117-07: Doherty, Integrated Risk Management, Ch. 7, Why Is Risk Costly to Firms? Ch. 8, Risk Management Strategy: Duality and Globality FE-C138-07: Managing the Invisible: Measuring Risk, Managing Capital, Maximizing Value, Panning FE-C140-07: Risk Measurement, Risk Management and Capital Adequacy in Financial Conglomerates (exclude appendices) Risk Appetite Statements: Whatâ&#x20AC;&#x2122;s on your Menu, Risk Management, June 2009

http://www.soa.org/library/newsletters/risk-management-newsletter/2009/june/jrm-2009iss16.pdf

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Advanced Finance/ERM Exam FINAL FALL 2011 Important Exam Information:

Exam Date and Time

A read-through time will be given prior to the start of the examâ&#x20AC;&#x201C;15 minutes in the morning session and 15 minutes in the afternoon session.

Exam Registration

Candidates may register online or with an application.

Order Study Notes

Study notes are part of the required syllabus and are not available electronically but may be purchased through the online store.

Introductory Study Note

The Introductory Study Note has a complete listing of all study notes as well as errata and other important information.

Case Study

This case study will also be provided with the examination. Candidates will not be allowed to bring their copy of the case study into the examination room.

Past Exams

Past Exams from 2000-present are available on SOA web site.

Updates

Candidates should be sure to check the Updates page on the exam home page periodically for additional corrections or notices.

1 of 12

Advanced Finance/ERM Exam FINAL FALL 2011

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Advanced Finance/ERM Exam FINAL FALL 2011 RESOURCES Kalberer, Variable Annuities, 2009 Ch. 1, History and Development of the Variable-Annuity Market (background only) Ch. 2, North American Variable Annuities (background only) Ch.5, Risks Underlying Variable Annuities Tilman, Asset/Liability Management of Financial Institutions, 2003 Ch. 16, Understanding Options Embedded in Insurers’ Balance Sheets, by L. Rubin FE-C102-07: General American Life Can’t Pay Investors, Looks at Suitors FE-C106-07: Mapping of Life Insurance Risks, AAA Report to NAIC FE-C151-08: Ch. 13 (Sections 13.1 – 13.4), Annuity and Investment Products of Atkinson & Dallas, Life Insurance Products and Finance FE-C159-09: Countering the Biggest Risk of All, by Slywotzky and Drzik - Harvard Business Review, April 2005 FE-C175-11: Learning from the 2009 H1N1 Influenza Pandemic FE-C176-11: Chapter 10 “Insuring against Catastrophies” from Diebold et.al., The Known, the Unknown and the Unknowable in Financial Risk Management Operational and Reputational Risks: Essential Components of ERM, by M. Rochette, Risk Management, December 2006. http://www.soa.org/library/newsletters/risk-managementnewsletter/2006/december/RMN0612.pdf

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Advanced Finance/ERM Exam FINAL FALL 2011 Topic: Accounting and Value Measures Learning Objective: 2. The candidate will understand measures of corporate value and be able to analyze the data in corporate financial statements. Learning Outcomes: The candidate will be able to: a) Explain basic accounting concepts used in producing financial statements: • in insurance companies • in other financial institutions • in non-financial institutions b) Analyze a specific company financial situation by demonstrating advanced knowledge of balance sheet and income statement structures. c) Describe the concept of economic measures of value (e.g. MCEV) and demonstrate their uses in the risk management and corporate decision-making processes. d) Demonstrate an understanding of economic capital as reported by financial institutions RESOURCES Fridson, Alvarez, Financial Statement Analysis: A Practitioners Guide, 2002 (Candidates may also use Fourth Edition, 2011) Ch. 1, The Adversarial Nature of Financial Reporting Ch. 2, The Balance Sheet Ch. 3, The Income Statement Ch. 4, The Statement of Cash Flows Ch. 13, Credit Analysis Tilman, Asset/Liability Management of Financial Institutions, 2003 Ch. 24, Accounting Standards and Requirements, by E. Habayeh & S. Sethi FE-C162-09: “EVA and Strategy” FE-C177-11:CRO Forum “A Market Cost of Capital Approach to Market Value Margins” Paper (sections 1-3 background only) FE-C178-11: Economic Capital Modeling – Practical Considerations - Milliman FE-C179-11:Insurance Industry Mergers & Acquisitions, Toole and Herget,2005

Ch. 4: Valuation Techniques (sections 1-5 only) Fair Value – Financial Economics Perspective by Babbel, Gold and Merrill, NAAJ, http://www.soa.org/library/journals/north-american-actuarialjournal/2002/january/naaj0201_2.pdf Fair Valuation of Insurance Liabilities: Principles and Methods” AAA Monograph, September 2002 http://www.actuary.org/pdf/finreport/fairval_sept02.pdf

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Advanced Finance/ERM Exam FINAL FALL 2011

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Advanced Finance/ERM Exam FINAL FALL 2011 Segal, Corporate Value of Enterprise Risk Management, Ch. 5, Risk Quantification FE-C143-07: Dynamic Financial Models of Property-Casualty Insurers FE-C166-09: “Black Monday and Black Swans,” J. Bogle, Financial Analysts Journal, 64:2(3040) 2008 FE-C178-11:Economic Capital Modeling – Practical Considerations - Milliman FE-C180-11: Measurement and Modeling of Dependencies in Economic Capital Chapters 1-8 only FE-C181-11: Value-at-Risk: Evolution, Deficiencies and Alternatives CSFB Credit Portfolio Modeling Handbook – Ch. 9, Risk Measures: How Long Is a Risky Piece of String? http://www.csfb.com/institutional/research/CreditPortfolioModeling.pdf Summary of “Variance of the CTE Estimator” ,Risk Management, August 2008 http://www.soa.org/library/newsletters/risk-management-newsletter/2008/august/rmn-2008iss13.pdf Modeling Tail Behavior with Extreme Value Theory, Risk Management, Sept 2009, Damon Levine http://www.soa.org/library/newsletters/risk-management-newsletter/2009/september/jrm-2009iss17-levine.pdf

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Advanced Finance/ERM Exam FINAL FALL 2011 Topic: Risk Management Learning Objective: 4. The candidate will understand the means available for managing various risks and how an entity makes decisions about appropriate techniques. Learning Outcomes: The candidate will be able to: General a. Explain the rationale for managing risk and demonstrate the selection of the appropriate risk retention level. b. Demonstrate means for transferring risk to a third party, and analyze the costs and benefits of doing so. c. Demonstrate means for reducing risk without transferring it (internal hedges). d. Evaluate the performance of risk transference activities. e. Describe and evaluate risk management techniques that can be used to deal with financial and non-financial risks. f. Develop an appropriate choice of hedging strategy for a given situation (e.g., reinsurance, derivatives, financial contracting), which balances benefits with inherent costs, including exposure to credit risk, basis risk, moral hazard, and other risks. Asset Liability Management g. Analyze the application of Asset Liability Management principles to Investment Policy and Asset Allocation. h. Analyze funding and portfolio management strategies to control equity and interest rate risk, including key rate risks. â&#x20AC;˘ Contrast modified duration and effective duration measures.

â&#x20AC;˘ â&#x20AC;˘

i. j. k.

Calculate effective duration and effective key-rate durations of a portfolio.

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Advanced Finance/ERM Exam FINAL FALL 2011 Liquidity Risk Management q. Define liquidity risk. r. Explain methods for managing this risk, both pre-event and post-event. s. Evaluate examples of company disasters that were the result of these types of risks – what the exposure was, what occurred, the sequence of events, what actions management took, didn’t take and could have / should have taken, what the financial impacts and general consequences were. Strategic Risk Management t. Define strategic risk u. Explain methods for managing this risk, both pre-event and post-event v. Evaluate examples of company disasters that were the result of these types of risks – what the exposure was, what occurred, the sequence of events, what actions management took, didn’t take and could have / should have taken, what the financial impacts and general consequences were. Operational Risk Management w. Define operational risk x. Explain methods for managing this risk, both pre-event and post-event y. Evaluate examples of company disasters that were the result of these types of risks – what the exposure was, what occurred, the sequence of events, what actions management took, didn’t take and could have / should have taken, what the financial impacts and general consequences were RESOURCES Anderson and Schroder, Strategic Risk Management Practice, Ch. 1, The Strategic Nature of Corporate Risk Management Ch. 7, Stategic Risk Analysis Ch. 8, Strategic Risk Management – ammendents to the ERM framework Ch. 9, Stategic Risk Management Kalberer, Variable Annuities, 2009

Section 3, Introduction Chapter 10, Overview of Commonly Used Risk Management Strategies Chapter 11, Using Product Development to Manage Risks Chapter 12, Using Reinsurance to Manage Risks Chapter 13, Using Capital Markets to Manage Risks Chapter 14, Putting It All Together: From Dynamic to Static Saunders and Allen,Credit Risk Management In and out of the Financial Crisis, 2010 Ch. 8, The Credit Risk of Portfolios and Correlations Ch 9, The VAR Approach: CreditMetrics and Other Models Ch. 10, Stress Testing Credit Models: Algorithmics Mark-to-Future Ch. 12, Credit Derivatives

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Advanced Finance/ERM Exam FINAL FALL 2011 Tiller, Life, Health and Annuity Reinsurance, 3rd Edition, 2005, Ch. 5, Advanced Methods of Reinsurance Ch. 16, Assumption Ch. 17, Special Purpose Reinsurance Companies Tilman, Asset/Liability Management of Financial Institutions, 2003, Ch. 9, Measuring and Marking Counterparty Risk, by E. Canabarro & D. Duffie Ch. 25, Implications of Regulatory and Accounting Requirements for Asset/Liability Management Decisions, by Hida, Habayeb, Yetis, & Sethi. FE-C117-07: Doherty, Integrated Risk Management, 2000 Ch. 1, The Convergence of Insurance Risk Management & Financial Risk Management Ch. 7, Why Is Risk Costly to a Firm? Ch. 8, Risk Management Strategy: Duality and Globality FE-C130-07: Hedging with Derivatives in Traditional Insurance Products FE-C147-07: Derivatives: Practice and Principles, Recommendations 9-24 and Section III FE-C156-09: Key Rate Durations: Measures of Interest Rate Risks FE-C159-09: Countering the Biggest Risk of All, by Slywotzky and Drzik - Harvard Business Review, April 2005 FE-C170-09: â&#x20AC;&#x153;Why COSO Is Flawed,â&#x20AC;? by A. Samed-Khan, January 2005 FE-C174-10: Deciphering the Liquidity and Credit Crunch 2007-2008, Brunnermeier FE-C182-11: Doherty, Integrated Risk Management, Chapter 16 , Case Study: The Securitization of Catastrophe Risk FE-C183-11: Revisiting The Role of Insurance Company ALM within a Risk Management Framework Liquidity Risk Measurement, CIA Educational Note http://www.actuaries.ca/members/publications/1996/9626e.pdf

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Advanced Finance/ERM Exam FINAL FALL 2011 Topic: Enterprise Risk Management Framework Learning Objective: 5. The candidate will understand the components of an ERM framework and be able to evaluate the appropriateness of a framework in a given situation. Learning Outcomes: The candidate will be able to: a. Define Enterprise Risk Management and explain the principal terms used in ERM. b. Describe the fundamental concepts of risk management and evaluate a particular given riskmanagement framework. c. Demonstrate how an organization can create a risk management culture including: risk consciousness, accountabilities, discipline, collaboration, incentives, and communication. d. Explain the elements of risk governance, and demonstrate how governance issues are resolved through organizational structure. e. Compare and contrast various regulatory/industry frameworks: Basel, Sarbanes-Oxley Act, , Dodd/Frank, Solvency II, UK FSA guidelines, and COSO. f. Explain the perspectives of regulators, rating agencies, stock analysts, and company stakeholders and how they evaluate the risks and the risk management of an organization. g. Identify regulatory capital requirements and describe how they affect decisions. RESOURCES

Segal, Corporate Value of Enterprise Risk Management, 2011 Chapter 1, ERM Basics and Infrastructure background only Chapter 2, Defining ERM background only Chapter 3, ERM Framework FE-C117-07: Doherty, Integrated Risk Management, Ch. 1, The Convergence of Insurance Risk Management & Financial Risk Management FE-C172-09: Enterprise Risk Management – Integrated Framework: Executive Summary, COSO, September 2004 FE-C184-11: A Comparative Analysis of U.S., Canadian and Solvency II Capital Adequacy Requirements in Life Insurance FE-C185-11: A Principles-Based Reserves and Capital Standard FE-C186-11: Methodology: Assessing Management's Commitment To And Execution Of Enterprise Risk Management Processes FE-C187-11: Market Consistent Embedded Value Principles Regulatory Capital Standards for Property and Casualty Insurers Under the U.S., Canadian and Proposed Solvency II (Standard) Formulas, Sharara, Hardy, Saunders http://www.soa.org/files/pdf/research-2010-08-regulatory-cap.pdf Actuarial Aspects of SOX 404”, The Financial Reporter, Dec. 2004, http://www.soa.org/library/newsletters/financial-reporter/2004/december/frn-2004-iss59brownehay.pdf Responsibilities of the Actuary for Communicating Sarbanes-Oxley Controls” The Financial Reporter, Dec. 2004, http://www.soa.org/library/newsletters/financial-reporter/2004/december/frn-2004-iss59auvinen.pdf

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Advanced Finance/ERM Exam FINAL FALL 2011

Assess how risk and opportunity influence the selection of a firm’s vision and strategy and demonstrate how ERM can be appropriately embedded in an entity’s strategic planning.

Articulate risk objectives; demonstrate how to define and measure an organization’s risk appetite; and demonstrate how an organization uses risk appetite to make strategic decisions.

Determine a desired risk profile and appropriate risk filters, and analyze the risk and return trade-offs that result from changes in the organization’s risk profile.

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Advanced Finance/ERM Exam FINAL FALL 2011 e.

Demonstrate quantitatively and qualitatively how ERM is able to contribute to shareholder value creation..

Demonstrate how risk metrics can be incorporated into the risk monitoring function as part of an ERM framework.

Explain means for managing risks and demonstrate measures for evaluating their effectiveness.

Describe and assess the elements of a successful risk management function and recommend a structure for an organization's risk management function.

RESOURCES:

http://www.soa.org/library/newsletters/risk-management-newsletter/2009/june/jrm-2009iss16.pdf

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AFE Complete Illustrative Solutions Fall 2011

Learning Objectives: 1. The candidate will understand the types of risks faced by an entity and be able to identify and analyze those risks. 4.

The candidate will understand the means available for managing various risks and how an entity makes decisions about appropriate techniques.

Learning Outcomes: (1a) Identify and analyze financial market risks faced by an entity, including but not limited to: currency risk, credit risk, spread risk, liquidity risk, interest rate risk, and equity risk. (1e)

Indentify and analyze systemic risks faced by an entity, including but not limited to financial contagion.

(4e)

Describe and evaluate risk management techniques that can be used to deal with financial and non-financial risks.

(4q)

Define liquidity risk.

(4r)

Explain methods for managing this risk, both pre-event and post-event.

(4s)

Evaluate examples of company disasters that were the result of these types of risks â&#x20AC;&#x201C; what the exposure was, what occurred, the sequence of events, what actions management took, didnâ&#x20AC;&#x2122;t take and could have / should have taken, what the financial impacts and general consequences were.

Sources: FE-C174-10: Deciphering the Liquidity and Credit Crunch 2007-2008, Brunnermeier Liquidity Risk Measurement, CIA Educational Note FE-C102-07: General American Life Canâ&#x20AC;&#x2122;t Pay Investors, Looks at Suitors Operational and Reputational Risks: Essential Components of ERM by M. Rochette, Risk Management, December 2006

AFE Fall 2011 Solutions

Page 1

Continued Commentary on Question: This question was focused on liquidity risk. Candidates generally did well on this question. Part (a) is retrieval, parts (b) and (c) move up in cognitive level to analysis, and part (d) is knowledge utilization. Solution: (a) Define liquidity risk. Commentary on Question: Most candidates were able to give the basic definition of liquidity risk. However, many candidates ignored the means of meeting financial commitments through ongoing cash flow.  (b)

Inability to meet financial commitments as they fall due through ongoing cash flow or asset sale at fair market value.

Evaluate the liquidity risk for each of Zoolander’s four lines of business. Commentary on Question: Candidates were able to describe the liquidity risk either from the perspectives of product feature or asset allocation. Not many candidates were able to evaluate the liquidity risks from both perspectives for all four product lines. For the variable annuity line of business, many candidates missed the point that VA is a separate account product. 



GIC: o Downgrade put option greatly increases liquidity risk o Surrender charge decreases liquidity risk o High allocation to illiquid assets o Asset/Liability mismatch Disability: o Base policy poses little liquidity risk due to not having a cash-out position o Return of premium rider increases liquidity risk o Base policy is reinsured but the ROP rider is not o Less allocation to illiquid assets Term: o Non-cashable o Reinsurer was downgraded o High allocation to illiquid assets

AFE Fall 2011 Solutions

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Continued 

(c)

VA: o Separate account product o Guarantees increase liquidity risk o High allocation to illiquid assets

For each scenario: (i)

Classify the scenario as a reputational or a market-wide liquidity crunch event. Commentary on Question: Many candidates misinterpreted this part of the question, which was supposed to be classifying two different types of liquidity crunch events.  

(ii)

The first scenario is a reputational liquidity event since it impacts Zoolander only. The second scenario is a market-wide liquidity event since it impacts the entire market.

Describe the risks to Zoolander’s ability to operate as a going concern and the consequences if those risks materialize. Commentary on Question: For the first scenario, many candidates did not address the consequences from the ratings perspective. Most candidates did better for the first scenario than the second scenario. 



(d)

Scenario I: o Lower new sales o Surrenders increase o Possible downgrade, which might trigger the put option on the GIC Scenario II: o Unable to liquidate any assets for normally occurring cash outflows o ROP or GICs may cause crisis due to not being able to sell any assets besides government bonds o Be forced to liquidate all its government securities

Evaluate the appropriateness of each action as a means of Zoolander improving its liquidity risk profile. Commentary on Question: Most candidates were able to identify the pros of each option, not the cons.

AFE Fall 2011 Solutions

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Continued ď&#x201A;ˇ

ď&#x201A;ˇ

Revise product design to increase surrender charges o Improves the liquidity risk profile through deterring surrenders o Might be less competitive in the market o Appropriate from the long-term perspective Reallocate the fixed income portfolio to hold more Treasury securities o Treasury securities are more liquid and have low risk o Might lower asset returns, thus lowering crediting rate (making GICs less competitive) o Appropriate since the current allocation percentage is low Establish a $2 million line of credit with a bank at a cost of $20,000 per annum o Would be able to alleviate some liquidity risk o There would be additional counterparty risk o Might not be enough in case of liquidity crisis o Appropriate for reputational liquidity crunch but not appropriate for market-wide liquidity crunch events

AFE Fall 2011 Solutions

Page 4

Learning Objectives: 1. The candidate will understand the types of risks faced by an entity and be able to identify and analyze those risks. 4.

The candidate will understand the means available for managing various risks and how an entity makes decisions about appropriate techniques.

The candidate will understand the components of an ERM framework and be able to evaluate the appropriateness of a framework in a given situation.

The candidate will understand the structure of an ERM process in an entity and be able to demonstrate best practices in enterprise risk management.

Learning Outcomes: (1d) Identify and analyze strategic risks faced by an entity including, but not limited to  Product sustainability risk  Distribution sustainability risk  Consumer preferences and demographics  Geopolitical risk  Competitor risk  External relations risk  Legislative/Regulatory risk  Reputation Risk  Sovereign risk (4t)

Define strategic risk.

(4u)

Explain methods for managing this risk, both pre-event and post-event.

(4w)

Define operational risk.

(4x)

Explain methods for managing this risk, both pre-event and post-event

(5b)

Describe the fundamental concepts of risk management and evaluate a particular given risk-management framework.

(5c)

Demonstrate how an organization can create a risk management culture including: risk consciousness, accountabilities, discipline, collaboration, incentives, and communication.

(6a)

Demonstrate the ERM process steps to be followed once the ERM framework is in place:  Risk identification (i) Defining and categorizing risk (ii) Qualitative risk assessments

AFE Fall 2011 Solutions

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Continued 

  

(6c)

Risk quantification (i) Scenario development / types of scenarios (ii) Individual risk quantification, including inherent vs. residual exposures (iii)Quantifying enterprise risk exposure, including correlations of risks Risk management (i) Defining risk appetite (ii) Managing enterprise risk exposure towards risk appetite Internal reporting (i) Performance measurement (ii) Performance management and incentive compensation External disclosures (i) Shareholders (ii) Rating agencies (iii)Regulators

Articulate risk objectives; demonstrate how to define and measure an organization’s risk appetite; and demonstrate how an organization uses risk appetite to make strategic decisions.

Sources: Segal, Corporate Value of Enterprise Risk Management, Ch. 3 FE-C159-09: Countering the Biggest Risk of All, by Slywotzky and Drzik - Harvard Business Review, April 2005 Economic Capital Modeling – Practical Considerations - Milliman FE-C106-07: Mapping of Life Insurance Risks, AAA Report to NAIC Operational and Reputational Risks: Essential Components of ERM, by M. Rochette, Risk Management, December 2006 Commentary on Question: The question was trying to test the candidates’ understanding of a value-based risk measurement approach and applying it in a real-world case (using the case study). Parts (a) and (d) of this question were retrieval. Part (b) was comprehension. Part (c) was analysis. Part (e) was knowledge utilization. Candidates did not elaborate on their responses especially for sections that were worth more points (such as part (e)). Candidates also often provided generic responses versus addressing the issue at hand that was related to Zoolander. Candidates did well in identifying the strategic risks and providing recommendations on how to mitigate this risk. Most candidates were successful in identifying the major components of the FMEA technique. AFE Fall 2011 Solutions

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Continued Solution: (a) Define and describe both operational risk and strategic risk. Commentary on Question: Candidates did well on this part of the question. 

Operational risk is the risk of loss due to failure in the course of operating business such as human resources/people, technology/systems, or processes.



Operational risk can also be due to ineffective internal control policies, inadequate information systems, fraudulent or unforeseen circumstances, or blind reliance on third parties or vendors.



Strategic risk is the risk of loss due to external factors that change the business paradigm and affect a company’s trajectory and shareholder value. This risk can also be caused by the company’s choices as it relates to: o Products to sell o Distribution channel to use o Customer markets to sell/cater to o Value proposition to offer Strategic risk can also arise from an entity's inability to implement appropriate business plans, to make decisions, to allocate resources or to adapt to changes in the business environment.

(b)

Explain the benefits of a value-based ERM approach in measuring operational and strategic risks. Commentary on Question: There were two main sources that candidates used to respond to this question and credit was given for either case. In general, candidates did not expand on their answers and often outlined comparisons to the Traditional approach that the question did not ask. Source 1: Segal, Corporate Value of Enterprise Risk Management, Ch.3, p.93 

Ability of Metrics to Support Decision Making o The value-based approach quantifies all key risks o The value-based approach quantifies them in terms of the impact on company value, which robustly supports decision-making

AFE Fall 2011 Solutions

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Continued 



Availability and Appropriateness of Data o The data is available, by definition, since the company is developing its own data primarily using internal personnel o The data developed is company and culture specific, since it is based on the specific situation within the firm Risk-Based Approach o The value-based ERM approach is risk-based, since it begins with the company-specific risk scenarios, and the exposures properly rise and fall with the level of exposures Ability to Fully Quantify Risk Impacts o The value-based approach allows for full quantification of the risks, since the baseline company value captures the full projection of future revenues, expenses and other distributable cash flows, and risk is measured as shocks to the baseline

Alternate solution Source 2: Segal, Corporate Value of Enterprise Risk Management, Ch.3, p83-108 A value-based approach satisfies the 10 key criteria of an ERM program:  Criteria 1: A value-based approach offers a metric that can work across both financial and non-financial services operations  Criteria 2: A value-based approach includes all risk categories o A value-based approach gives a balanced focus to all risk categories including strategic and operational o A value-based approach uses FMEA for quantification, which more accurately reflects the risk compared to percentage of revenue or just giving qualitative treatment o Advantages of FMEA include using risk's subject-matter-experts' guesses, giving a range of results, reducing bias, and allowing for relative comparisons  Criteria 3: A value-based approach focuses management on the key risks  Criteria 4: A value-based approach allows for integration across risk types that leads to completeness, efficiency, and internal consistency  Criteria 5: A value-based approach allows enterprise-wide aggregation of metrics and facilitates the appropriate top-down allocation of risk appetite to risk limits  Criteria 6: A value-based approach can be integrated into decision-making through: o Robust metrics for all types of risks o Metrics with both risk and return information o Practical models with regards to reliability, speed, transparency, and balance of significant digits AFE Fall 2011 Solutions

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Continued

    (c)

o Appropriate level of input from business segments o Support of business segment goals and initiatives Criteria7: A value-based approach balances risk and return management Criteria 8: A value-based approach can inform risk disclosures Criteria 9: A value-based approach measures value impacts Criteria 10: A value-based approach focuses on the primary stakeholder

Based on Cobalt’s assessment of the strategic risks faced by Zoolander and Zoolander’s proposed risk appetite statement: (i)

Identify four of the major strategic risks facing Zoolander. Support your answer. Commentary on Question: Candidates generally did well on this part of the question. There were instances where candidates did not factor in Zoolander’s proposed risk appetite statement and/or did not provide the rationale behind their selections. Another common response that did not receive full credit was to only identify the category of risk (such as Industry, Technology, Brand, Competitor) versus the type of risk (such as Margin Squeeze, Commoditization). There were types of risks within these categories that were within the risk appetite and would not qualify as an appropriate answer. Candidates were only given credit for four strategic risks identified. Major strategic risks must have a greater than 25% loss of earnings with a greater than 20% probability of being outside the risk appetite statement's allowable earnings loss. 



Project: New Product Development Failure o This risk has a 50% probability of earnings loss outside risk appetite with a 70% probability of occurrence o The expected timing of this risk occurring is less than 1 year Stagnation: Flat or declining volume o This risk has a 50% probability of earnings loss outside risk appetite with a 70% probability of occurrence o The expected timing of this risk occurring is less than 1 year

AFE Fall 2011 Solutions

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Continued         

(ii)

Industry: Commoditization o This risk has a 50% probability of earnings loss outside risk appetite with a 50% probability of occurrence Industry: Margin Squeeze o This risk has a 50% probability of earnings loss outside risk appetite with a 40% probability of occurrence Industry: New Regulations o This risk has a 40% probability of earnings loss outside risk appetite with a 30% probability of occurrence Stagnation: Volume up, margin down o This risk has a 30% probability of earnings loss outside risk appetite with a 65% probability of occurrence Customer: Overreliance on a few customers o This risk has a 30% probability of earnings loss outside risk appetite with a 40% probability of occurrence Project: Business development failure o This risk has a 30% probability of earnings loss outside risk appetite with a 40% probability of occurrence Competitor: Gradual market share gainer o This risk has a 30% probability of earnings loss outside risk appetite with a 30% probability of occurrence Customer: Customer priority shift o This risk has a 60% probability of earnings loss outside risk appetite with a 25% probability of occurrence Project: Merger or acquisition failure o This risk has a 30% probability of earnings loss outside risk appetite with a 25% probability of occurrence

For each of the strategic risks identified in part (i), recommend an approach to manage it, and explain why your recommendation is appropriate for Zoolander. Commentary on Question: Candidates that identified the appropriate strategic risk (in part (i)) of this question did well on this section. Candidates used their background/knowledge when providing responses to this part. Answers outside those summarized here were also accepted and given credit as long as they were appropriate for the given strategic risk.

AFE Fall 2011 Solutions

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Continued 

     

   

Project: New Product Development Failure o Smart sequencing - take on most likely to be successful parts of VA project first, such as adding a small number of new funds and GMDB (as opposed to all funds and GMDB and GMIB) o Stepping-stone - release early version of GMDB/GMIB and then better version later once more market share is there Stagnation: Flat or declining volume o Generate “demand innovation”; understand GIC clients' needs Industry: Commoditization o Encourage product innovation – introduce distinctive features such as a 30-year ROP Industry: Margin Squeeze o Shift from competition to collaboration o Work with reinsurer on new updates to term product Industry: New Regulations o Redesign product to counter regulation change o Work with reinsurer to counter regulation change Stagnation: Volume up, margin down o Change in business design to avoid direct competition with Periwinkle and other entrants Customer: Overreliance on a few customers o In-market testing to aid in experimentation with new product design o Get feedback from producers on new product features that could open up different sectors of the market Project: Business development failure o Develop designs for different GMIBs/GMDBs and then pick best option Competitor: Gradual market share gainer o Encourage product innovation to counter competitors o Shift in business design to minimize product overlap Customer: Customer priority shift o Shift in product offering to respond to customers’ behavioral change Project: Merger or acquisition failure o Develop controls to manage surplus/capital more closely o Perform thorough due diligence of opportunities prior to closing any transaction/deal(s)

AFE Fall 2011 Solutions

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Continued (d)

Identify the major components of the FMEA technique. Commentary on Question: Majority of the candidates successfully answered this question and received maximum points. The value-based ERM approach uses a technique, called Failure Modes and Effects Analysis (FMEA) to develop the individual deterministic risk scenarios for strategic and operational risks.    

(e)

Identify Interviewees/ subject-matter experts for the risk in question Develop Risk Scenarios Assign Likelihood to Risk Scenarios Estimate Quantitative Impacts of Risk Scenarios

Apply the FMEA technique to the operational risk in the disability claims process. Use estimated values as needed. Commentary on Question: Most candidates provided a generic response to this question versus paying heed to the disability claims process. Candidates also did not always provide sufficient explanation despite the weight of this part relative to the overall question. The expectation was of candidates to demonstrate their understanding of the FMEA technique. The solution included here is one of several ways a candidate can show that; however, most candidates did not successfully demonstrate this. 



Identify Interviewees/ subject-matter experts for the risk in question o Head of claims, admin, IT and actuarial o Claudette Dove, Odette Bird, Frances Seal, Wanda Fox o Claims and admin are important because these are the two areas impacted by doing manual processes. Thus, they are the most important to interview for potential impact since they are closest to the risk Develop risk scenarios o Understand from the interviewees a set of risk scenarios for the key risk in question  Upside: Upside of manual claims processing for disability: No outlay of cash for system upgrade; no errors are made.  Moderate downside: Several small errors slip through undetected. Errors turn out to be immaterial but time is spent reconciling and correcting; system upgrade commences.

AFE Fall 2011 Solutions

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Continued 



Severe downside: Large errors slip through undetected. Restatement of financial filings; fraying of relationship with Kelly and reinsurer; system upgrade required immediately to pacify Kelly so have to hire consultants to implement.  Catastrophic downside: Large errors slip through undetected. Errors include certain claims not being paid as well as not being reserved for. Claimants sue Zoolander; Kelly downgrades Zoolander for lack of controls; system upgrade required immediately by legal team to prevent further errors so have to hire consultants to implement; liquidity spiral due to downgrade provision in GICs. Assign Likelihood o This is another area where skill in conducting the FMEA process is required to bridge the gap between the qualitative “language” used by the interviewees and the quantitative language needed for the ERM model o Interviewers can provide qualitative responses such as:  Upside very unlikely and optimistic  Moderate downside most likely by far  Severe downside somewhat likely  Catastrophic downside very unlikely o These responses will need to be translated into probabilities such as:  Upside – 5%  Moderate downside – 75%  Severe – 15%  Catastrophic – 5% Estimate Quantitative Impacts of Risk Scenarios o The final step in the FMEA interview is to develop estimates of the quantitative impacts of each deterministic risk scenario on the baseline company value.  Upside: Frances Seal may be able to comment on the cost of the system upgrade, which would be a saved expense in this scenario.  Moderate downside: Reserves increase by $0.5 Million; system upgrade expensed.  Severe downside: Reserves increase by $15 Million; system upgrade is expensed immediately and have to hire consultants to implement, which doubles cost.

AFE Fall 2011 Solutions

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Continued ď&#x201A;§

AFE Fall 2011 Solutions

Catastrophic downside: Expense system upgrades immediately and costs double due to implementing with consultants; reserves increase by $50 Million; unpaid benefits are $3 million and lawsuit results in another $3 million in damages. Liquidity spiral could send Zoolander into DOI supervision.

Page 14

Learning Objectives: 2. The candidate will understand measures of corporate value and be able to analyze the data in corporate financial statements. 5.

The candidate will understand the components of an ERM framework and be able to evaluate the appropriateness of a framework in a given situation.

The candidate will understand the structure of an ERM process in an entity and be able to demonstrate best practices in enterprise risk management.

Learning Outcomes: (2c) Describe the concept of economic measures of value (e.g. MCEV) and demonstrate their uses in the risk management and corporate decision-making processes. (5d)

Explain the elements of risk governance, and demonstrate how governance issues are resolved through organizational structure.

(5f)

Explain the perspectives of regulators, rating agencies, stock analysts, and company stakeholders and how they evaluate the risks and the risk management of an organization.

(6a)

Demonstrate the ERM process steps to be followed once the ERM framework is in place:  Risk identification (i) Defining and categorizing risk (ii) Qualitative risk assessments  Risk quantification (i) Scenario development/types of scenarios (ii) Individual risk quantification, including inherent vs. residual exposures (iii) Quantifying enterprise risk exposure, including correlations of risks  Risk management (i) Defining risk appetite (ii) Managing enterprise risk exposure towards risk appetite  Internal reporting (i) Performance measurement (ii) Performance management and incentive compensation  External disclosures (i) Shareholders (ii) Rating agencies (iii) Regulators

Sources: Segal, Corporate Value of Enterprise Risk Management, Ch. 7

AFE Fall 2011 Solutions

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Continued FE-C117-07: Doherty, Integrated Risk Management, Ch. 7, Why Is Risk Costly to a Firm? FE-C186-11: Methodology: Assessing Management’s Commitment to and Execution of Enterprise Risk Management Processes – S&P publication Commentary on Question: This question was designed to test the candidates’ ability to link compensation to risk/reward trade-off and value creation at Zoolander. The question required the candidates to demonstrate Analysis and Knowledge Utilization cognitive skill levels by asking them to relate concepts from the readings to the case study. Candidates performed adequately on this question, but could have earned more credit if they had shown more familiarity with the case study by applying the theory to provide specific examples. Solution: (a) (i)

Describe concerns regarding Zoolander’s incentive compensation program as an effective tool to align management and shareholder objectives. 



Mismatch of information between management and shareholders - can be exploited by management. o 100% stock options, vested immediately o Only in the money if stock price of Zoolander can rise above the exercise price of the stock options (encourage risk) o Discourages hedging There are poor metrics used to calculate stock option awards. o The amount of stock options allocated is determined by comparing past single-period financial results against Plan results (accounting-based) o Arbitrary weights applied to each factor  Result in lower increase in value than if weights had been determined to maximize company value o CIO sets stock option price o Examples of flaws with current formulae:  Marketing: premium over plan, regardless of value added  Investments: bonus is like an option on investment return (encourage risk by CIO)

AFE Fall 2011 Solutions

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Continued (ii)

Recommend improvements to Zoolander’s incentive compensation program to mitigate the concerns identified in part (i). Justify your recommendations. 



Replace the actual stock with phantom stock. o Baseline company value calculation is used as the basis for the phantom stock value. o Unit in charge of calculating the phantom stock value should have high level of independence. o Zoolander should not have 100% incentive compensation based on either stocks or stock options.  Stocks ownership encourages management to hedge.  Stock options encourage some risk. Use ERM metrics to determine value of award. o Superior alignment between management and shareholders – amount and value of award based on baseline company value. o Should not be a percentage based on balance sheet/income statement items - does not represent the true value of Zoolander. o Use some economic measures that incorporate risk/returns characteristics and are a better measure of Zoolander's value.

(b) (i)

Assess how the new incentive program may alter the behavior of senior management.  

 



Company Value captures changes that altered the projection of future distributable cashflows. Danielle Wolfe's marketing area will be more focused on profitable sales instead of just more sales in general. o Rewarded based on whether new sales generate positive distributable cashflows. No longer discourages investments that need an initial outlay of capital but are still positive NPV projects. Future benefits are now captured. o Encourages increase in baseline company value. CIO Peter will make better risk/return decisions since Company Value will change when Zoolander is riskier o Company value captures changes that may alter the riskiness of Zoolander. Wanda's incentive compensation is related more closely to Zoolander's risk profile and now is linked to value creation of Zoolander. o Previously was formulaic statutory RBC.

AFE Fall 2011 Solutions

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Continued (ii)

Evaluate the new incentive program from the perspective of Kelly Ratings & Analysis. Commentary: Candidates were expected to apply the S&P paper and relate the criteria back to the case study. Candidates could have performed better by being more familiar with the case study and commenting on how the new program would generally positively affect each of the criteria. Kelly evaluates Zoolander's compensation with the following criteria: 



ERM culture or policies o Incentive compensation rewards managers based on analysis of risk/return tradeoffs and value creation. o Additional risk taking will lower Company Value through higher discount rate. Peter and Wanda will be discouraged by risk taking activities that do not increase Company Value. Risk Controls o Kelly is looking for relationship between management performance and their risk limits. o Wanda is no longer compensated based on statutory RBC. Strategic risk management o Management compensation programs should be designed consistently with company goals and be consistent across business or functional groups. o In the new incentive compensation program, all senior management incentive compensation is based on the same driver: Company Value creation. So, it is consistent. Risk models o Kelly is looking for evidence the models are robust and well documented. o It is not clear whether Zoolander currently has Company Value models or what state they are in. It is something Zoolander should look into.

Overall, Kelly would look favorably on the new incentive program. (c)

Describe two advantages and two disadvantages of using an Economic Capital model in support of Zoolander’s incentive compensation program.

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Continued Commentary: This part of the question was intended to determine whether candidates could apply information in the case study and recognize benefits and flaws of using an economic capital model as a base for incentive compensation. Credit was given for alternate responses. Advantages:  EC incorporates company-specific approach to measuring risk. o Alignment between Zoolander’s risk/return profile and management actions.  Zoolander is developing an EC model. o Saves time and resources to use the same model for incentive compensation. Disadvantages:  Zoolander is ignoring some risk exposures that are not currently reflected in the EC model. o Management could maximize their utilization by taking on risks that are not modeled.  EC does not capture future new business and thus may not reflect future risks taken on. o May encourage management to take on risky projects to improve returns.

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Learning Objectives: 1. The candidate will understand the types of risks faced by an entity and be able to identify and analyze those risks. 4.

The candidate will understand the means available for managing various risks and how an entity makes decisions about appropriate techniques.

Demonstrate means for transferring risk to a third party and analyze the costs and benefits of doing so.

(4d)

Evaluate the performance of risk transference activities.

(4e)

Describe and evaluate risk management techniques that can be used to deal with financial and non-financial risks.

(4f)

Develop an appropriate choice of hedging strategy for a given situation (e.g., reinsurance, derivatives, financial contracting), which balances benefits with inherent costs, including exposure to credit risk, basis risk, moral hazard and other risks.

(4k)

Analyze the practicalities of market risk hedging, including dynamic hedging.

Sources: Kalberer, Variable Annuities, Chapters 11-14 Commentary on Question: This question aims to test the candidateâ&#x20AC;&#x2122;s understanding of the various risk management strategies that can be used to manage Variable Annuitiesâ&#x20AC;&#x2122; equity exposure. In addition, this question tests whether the candidate can apply these risk management strategies to the case study, Zoolander. Solution: (a) John Badger suggests that his dynamic hedging program will be an effective tool in managing the VA equity risk exposure. (i)

Describe three challenges VA writers face in dynamically hedging their VA guarantee risks. Commentary on Question: Candidates did well when recalling general challenges VA writers face in this retrieval question.

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Continued 1. Optimizing trade frequency to balance transaction costs and hedge breakage 2. Addressing basis risk between VA funds and hedging instruments 3. Adjusting hedge positions for deviations from policyholder behavior assumptions Other answers were also accepted. (ii)

For each challenge in part (i), explain the specific concerns Zoolander faces in dynamically hedging its VA Plus product. Commentary on Question: Most candidates gave general answers about each challenge; candidates who did well in this comprehension question targeted their answers specifically to Zoolander. 1. Optimizing trade frequency: transaction costs on Zoolanderâ&#x20AC;&#x2122;s relatively small block (about $4 billion) are relatively significant and could have a large impact on profit margins. Also, the limited computer power Wanda is concerned about may not allow for daily liability Greek calculations in a timely manner. 2. Addressing basis risk: the proprietary funds offered in VA Plus (ZooBalanced, ZooEquity500, etc.) are not actively traded on public stock exchanges. Also, John Badgerâ&#x20AC;&#x2122;s model for these funds assumes management charges are zero, affecting the calculation of Delta used for hedging. 3. Policyholder behavior: Zoolander has little history selling guarantees on its VA block, compromising its ability to set meaningful policyholder behavior assumptions. Other answers were also accepted.

(b)

Danielle Wolfe suggests altering the product design to reduce VA equity risk exposure. (i)

Recommend product features that would reduce equity risk exposure on a typical VA guarantee. Justify your recommendations.

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Continued Commentary on Question: Candidates who did well on this knowledge-utilization question elaborated on the product features, rather than simply listing them. 1. Fund investment restrictions: by limiting the amount invested in highrisk funds and/or requiring the investment in allocated funds (“funds of funds”), the likelihood of large drops in account value are lessened, reducing the risk of the VA guarantee. 2. Less generous guarantees: lowering the guarantee level or reducing the frequency of ratchets/resets would result in fewer expected claims overall, reducing the equity risk exposure. 3. Apply guarantee charge to guarantee value: when the guarantee charge is a percentage of the account value, a reduction in account value both increases the value of the guarantee and decreases the charges to pay for it; changing the charge basis to the guarantee value removes this second equity risk factor. Other answers were also accepted. (ii)

Evaluate the feasibility of Zoolander implementing each feature recommended in part (i). Commentary on Question: Many candidates struggled to relate the recommendations specifically to Zoolander in this analysis question. 1. Fund investment restrictions: due to system challenges, Zoolander is adding funds one family at a time, so it may take a while for Zoolander to add enough funds to enable allocated funds across fund families. Adding investment restrictions is unlikely given the current system challenges. 2. Less generous guarantees: Zoolander’s distributors are clamoring for living benefit guarantees, and it could be difficult for Zoolander to retract quickly on its recent decision to offer a generous GMDB. In light of recent experience, management may need to revisit how generous the guarantees are despite disappointing distribution partners.

AFE Fall 2011 Solutions

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Continued 3. Guarantee charge on guarantee value: Zoolander management and distribution are both unlikely to have issues with this change, but there are concerns already about the VA admin system, and this would compete with other projects such as adding funds. Other answers were also accepted. (c)

The following two reinsurance premium structures are available: I. Premium equals (constant factor) x (account value) II. Premium equals (YRT mortality rate) x (net amount at risk) (i)

Define the amount reimbursed by the reinsurer in a typical GMDB reinsurance treaty. Commentary on Question: Most candidates did well on this retrieval question. The reinsurance benefit is the GMDB net amount at risk, specifically the positive difference between the death benefit guarantee value and the actual account value at the time of claim.

(ii)

For each of the following scenarios: Scenario 1: Scenario 2:

Up equity market Down equity market

Describe the premium and benefit cash flows for the two reinsurance structures, I and II. Commentary on Question: Candidates had more trouble with this comprehension question. The benefit cash flows are the same for structures I and II: ď&#x201A;ˇ Up equity market: positive difference between guarantee and account value is smaller, so reinsurance benefit is smaller or zero if out-of-themoney. ď&#x201A;ˇ Down equity market: positive difference between guarantee and account value is greater, so reinsurance benefit is larger if in-themoney.

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Continued Premium cash flows for structure I:  Up equity market: account value is higher, so reinsurance premium is higher.  Down equity market: account value is lower, so reinsurance premium is lower. Premium cash flows for structure II:  Up equity market: positive difference between guarantee and account value is smaller, so net amount at risk and hence reinsurance premium are smaller.  Down equity market: positive difference between guarantee and account value is larger, so net amount at risk and hence reinsurance premium are larger. (iii)

Recommend one of the two reinsurance premium structures. Justify your response. Commentary on Question: Either premium structure could have been recommended with appropriate justification, but candidates generally did not justify their recommendation well in this knowledge-utilization question. Either of the following was acceptable: Structure I is recommended because, when equity markets are down, reinsurance premiums also decrease, leaving more cash available to cover the corresponding increase in statutory reserves and reducing surplus strain for Zoolander. Or, It is likely that the reinsurer will give a better deal on the YRT premium rate for Structure II because they will have less premium risk in down equity market scenarios. Therefore, Structure II is recommended.

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Learning Objectives: 2. The candidate will understand measures of corporate value and be able to analyze the data in corporate financial statements. 6.

The candidate will understand the structure of an ERM process in an entity and be able to demonstrate best practices in enterprise risk management.

Learning Outcomes: (2b) Analyze a specific company financial situation by demonstrating advanced knowledge of balance sheet and income statement structures. (6d)

Determine a desired risk profile and appropriate risk filters, and analyze the risk and return trade-offs that result from changes in the organizationâ&#x20AC;&#x2122;s risk profile.

(6e)

Demonstrate quantitatively and qualitatively how ERM is able to contribute to shareholder value creation.

Sources: FE-C138-07: Managing the Invisible: Measuring Risk, Managing Capital, Maximizing Value Segal, Corporate Value of Enterprise Risk Management, Ch. 6 Commentary on Question: This question was designed to test candidatesâ&#x20AC;&#x2122; understanding of how a simple ERM model can be used to determine the level of surplus that maximizes shareholder value for a given set of risk exposures. Part (b) was retrieval. Parts (a), (c) and (d) were analysis. Solution: (a) Calculate the value added of SRC. Commentary on Question: Most candidates were able to correctly calculate the single period after-tax income for the firm, but many only considered current period earnings in determining value. Finally, many candidates did not subtract current surplus from the total value of the firm to determine the value added. Probability of Firm Survival = 1- Probability of Default Probability of Firm Survival (for C = 5) = 1 - 0.7/(21*5 - 14) = .9923 Discount Factor = D = (Probability of Firm Survival)/(1 + risk-free rate) D =.9923/(1 + .05) = .9451 Income Statement for CRC (all values in $ millions) Premiums = 100 C.Losses = Premium * Projected Loss Ratio = 100 * 70% = 70 Expenses = Premium * Expense Ratio = 100 * 20% = 20 AFE Fall 2011 Solutions

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Continued UW Income = Premium - C.Losses - Expenses = 100 - 70 - 20 = 10 Investment Income = Yield * (Premium - Expense + Capital) = 5% * (100 - 20 + 5) = 4.25 Net Income = UW Income + Investment Income = 10 + 4.25 = 14.25 After-tax Net Income = (1-Tax Rate) * Net Income = (1 - 20%)*14.25 = 11.4 After-tax Value of Firm = (After-tax Net Income) * D/(1-D) = (11.4)*(.9451)/(1 - .9451) = $196.25M Value-added = After-tax Value of Firm - Capital = $196.25M - $5M = $191.25M (b)

List the steps to accomplish each of I and II. Commentary on Question: Most candidates were able to identify at least some of the steps of the process. Recalculate Risk and Return Metrics Revise distributable cash flows Revise discount rate Re-calculate baseline company value Revise key risk scenarios Recalculate Enterprise risk exposure Evaluate Risk-return Tradeoff Evaluate the impact on Enterprise Risk Exposure Evaluate the impact on downside standard deviation Evaluate the impact on Baseline Company Value Evaluate the impact on Probabilistic Expectation of Company Value

(c)

Calculate the optimal level of capital. Commentary on Question: As with part (a), many candidates did not use a multi-period model. Candidates who recognized the need to take the first derivative of the value function to determine the capital value that maximizes firm value were able to distinguish themselves. Probability of Firm Survival = 1 - 0.7/(21C - 14) = (21C - 14.7)/(21C - 14) D = [(21C - 14.7)/(21C - 14)]/(1 + 0.05) = (20C - 14)/(21C - 14) 1 - D = 1 - (20C - 14)/(21C - 14) = C/(21C - 14) D/(1 - D) = [(20C - 14)/(21C - 14)] / [C/(21C - 14)] = 20 - 14/C Income Statement for CRC (all values in $ millions) UW Income = 10 (not affected by capital) Investment Income = Yield * (Premium - Expense + Capital) = 5% x (100 - 20 + C) = 4 + 0.05C

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Continued Net Income = UW Income + Investment Income = 10 + 4 + 0.05C = 14 + 0.05C After-Tax Net Income = (1-Tax Rate) * Net Income = (1 - 20%) x (14 + 0.05C) = 11.2 + 0.04C After-tax Value of Firm = (After-tax Net Income) * D/(1-D) = (11.2 + 0.04C)*(20 - 14/C) = 0.8C + 223.44 - 156.8/C Value-added = After-tax Value of Firm - Capital = 0.8C +223.44 -156.8/C - C = -0.2C + 223.44 - 156.8/C The optimal capital level occurs when value-added is maximized. To find the optimal capital, set d(Value-added)/dC = 0 d(Value-added)/dC = -0.2 + 156.8/C^2 = 0 C = 28 The optimal level of capital is $28 million. (d)

Evaluate whether SRC should implement the new claims management system. Commentary on Question: Candidates had similar issues to those described in part (a). In addition, some candidates did not include a recommendation as required by the question. Of those who did, either recommendation was supportable depending on the capital assumption made. Some candidates assumed C = 5 (from part (a)), leading to a recommendation to implement: Probability of Firm Survival (for C = 5) = 1 - 0.1/(21*5 - 2) = .9990 D =.9990/(1 + .05) = .9515 Income Statement for CRC (all values in $ millions) Only change to After-tax Net Income is from Expenses increasing from 20 to 21, with the following effects:   

UW Income decreased by 1 from 10 to 9; Investment Income decreased by 5% * 1 = 0.05 from 4.25 to 4.20; and hence Net Income decreased by 1.05 and After-tax Net Income decreased by 80% * 1.05 = 0.84 from 11.4 to 10.56.

After-tax Value of Firm = (after-tax net income) * D/(1-D) = (10.56)*(.9515)/(1 - .9515) = 207.17 Value-added = After-tax Value of Firm - capital = 207.17 - 5 = 202.17

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Continued Since the value-added after adopting the new claims management system ($202 million) is more than the value-added at the original capital level ($191 million), SRC should adopt the new claims management system. Commentary on Question: Other candidates assumed capital should be optimized again (from part (c)), leading to a recommendation not to implement: Before adopting the new claims management system: From part (c), optimal capital level = $28 million Value added at optimal capital level = -0.2*28 + 223.44 - 156.8/28 = $212.24 million Recalculate value added if new claims management system is adopted: Probability of Firm Survival = 1 - 0.1/(21C – 2) = (21C-2.1)/(21C-2) D = [(21C -2.1)/(21C - 2)]/(1+0.05) = (20C-2)/(21C-2) 1-D = 1 - (20C - 2)/(21C - 2) = C/(21C - 2) D/(1 - D) = [(20C - 2)/(21C - 2)] / [C/(21C - 2)] = 20 - 2/C Income Statement for CRC (all values in $ millions) Only change to After-tax Net Income is from Expenses increasing from 20 to 21, with the following effects:   

UW Income decreased by 1 from 10 to 9; Investment Income decreased by 5% * 1 = 0.05 from 4 + 0.05C to 3.95 + 0.05C; and hence Net Income decreased by 1.05 and After-tax Net Income decreased by 80% * 1.05 = 0.84 from 11.2 + 0.04C to 10.36 + 0.04C.

After-tax Value of Firm = (After-tax Net Income) * D/(1-D) = (10.36 + 0.04C)*(20 - 2/C) = 0.8C + 207.12 – 20.72/C Value-added = After-tax Value of Firm - Capital = 0.8C +207.12 -20.72/C - C = -0.2C + 207.12 – 20.72/C The optimal capital level occurs when value-added is maximized. To find the optimal capital, set d(Value-added)/dC = 0 d(Value-added)/dC = -0.2 + 20.72/C^2 = 0 C = 10.18 With C = 10.18, Value added = -0.2*10.18 + 207.12 - 20.72/10.18 = $203.05 million

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Continued Since the value-added after adopting the new claims management system ($203 million) is less than the value-added at the original capital level ($212 million), SRC should not adopt the new claims management system. A counterargument is that much less capital would need to be raised to optimize value-added, perhaps a benefit if capital sources are limited or increasingly expensive as more is raised.

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Learning Objectives: 3. The candidate will understand how the financial risks faced by an entity can be quantified and the use of metrics to measure risk. 5.

The candidate will understand the components of an ERM framework and be able to evaluate the appropriateness of a framework in a given situation.

Learning Outcomes: (3b) Demonstrate the use of risk metrics to quantify major types of risk exposure in the context of integrated risk management process.  Demonstrate how each of the financial risks faced by an entity can be amenable to quantitative analysis including an explanation of the advantages and disadvantages of various techniques such as Value at Risk (VaR), stochastic analysis, scenario analysis, and stress testing.  Describe and evaluate risk aggregation techniques, incorporating the use of correlation, integrated risk distributions and copulas.  Describe how and why risks are correlated and give examples of risks that are positively correlated and risks that are negatively correlated.  Assess the overall corporate risk exposure arising from financial and nonfinancial risks. (5e)

Compare and contrast various regulatory/industry frameworks: Basel, SarbanesOxley Act, Dodd/Frank, Solvency II, UK FSA guidelines, and COSO.

(5f)

Explain the perspectives of regulators, rating agencies, stock analysts, and company stakeholders and how they evaluate the risks and the risk management of an organization.

(5g)

Identify regulatory capital requirements and describe how they affect decisions.

Sources: FE-C184-11: A Comparative Analysis of U.S., Canadian and Solvency II Capital Adequacy in Life Insurance Regulatory Capital Standards for Property and Casualty Insurers Under the U.S., Canadian and Proposed Solvency II (Standard) Formulas, Sharara, Hardy, Saunders Commentary on Question: The question was generally testing understanding of the different capital regimes. It was a little off-the-wall in that it “allows” the company to decide which capital regime it will use. It also tested both the property/casualty side and life side. Note, the question was trying to test a very unique situation that is not based in regulatory reality. Quoting that because the company is European it should adopt the Solvency II (or pointing out that CALM is moving to Solvency II so why adopt the Canadian regime) is irrelevant to the question. AFE Fall 2011 Solutions

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Continued Candidates missed the requirement that defining a term broadly that doesnâ&#x20AC;&#x2122;t really apply to each of the various regulatory systems is not satisfactory. Candidates overall did well in parts (a), (d) and (e), but struggled with parts (b) and (c). The cognitive skill level for this question ranged from retrieval to knowledge utilization. Retrieval and Comprehension type questions are (b)(i) and (d), while knowledge utilization questions were the rest. Solution: Question Wording: (a) Rank the level of diversification benefits allowed in each of the three capital regimes, U.S., Canadian and Solvency II, for the life and annuity business. Support your ranking Commentary on Question: This section was done well overall. Points were given for ranking the results as well as explaining the rationale behind which is most beneficial. Solvency II>US RBC>Canadian regime Solvency II has largest diversification benefit due to recognition of correlation amongst risks. US RBS has a bit of diversification benefit due to the covariance adjustment in the RBC formula. Canadian regime has no diversification benefit and is the sum of the underlying required capital. (b)

For each of the following components of the total balance sheet requirement for life and annuity business: I. Best estimate liability II. Solvency margin III. Interest rate risk amount (i)

Describe the component. Commentary on Question: This section was weaker than the other sections. Overall candidates gave a general description of the components but did not define them within the context of the capital regimes being asked about. Best estimate liability (BEL) is the present value of expected cash flows using a best estimate discount rate.

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Continued Solvency margin: Under solvency II, this is calculated at the 99.5% CI level over a one-year period at the enterprise level. Other than cost of capital, all solvency margins are included in capital. Under Canadian regime, the solvency margin is included in margins for adverse deviations. In US, the solvency margin is implicit due to conservative nature of assumptions. Interest Rate Risk amount: The Canadian and US regimes use a factor approach. The Solvency II calculation is based on the change in economic surplus under adverse, non-parallel movements of the yield curve. (ii)

Compare the relative size of the component across the three capital regimes. Commentary on Question: The answers below are examples, but other justified responses were accepted. BEL: Same under all regimes. Solvency Margin: Solvency II > Canadian regime > US regime (other answers accepted with justification) Interest Rate Risk: Solvency II> US Regime> Canadian Regime

(c)

Evaluate which of the three capital regimes will be the most beneficial from the perspective of Slavicâ&#x20AC;&#x2122;s life and annuity business head. Commentary on Question: Multiple answers were accepted based on arguments given. Diversification benefit is maximized under Solvency II. The US and Canadian regime are more conservative than Solvency II, so US or Canadian regimes are options to maximize reserve.

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Continued To minimize the total balance sheet requirement, the US and Canadian regimes have factors applied to calculate margins, which are smaller than the Solvency II regime. Consider US and Canadian regimes. Best option is US regime, since it has some diversification benefit, maximizes reserves and minimizes total balance sheet. (d)

Describe the charges for the following risks under each of the three capital regimes for the auto insurance business: (i) (ii) (iii)

Catastrophe risk Operational risk Interest rate risk

Commentary on Question: Candidates needed to realize that auto insurance has slightly different capital requirements than traditional life blocks. Canada and Solvency II charge for catastrophe risk. The US regime doesn’t. Only Solvency II charges for operational risk. Solvency II charges a variable amount for interest rate risk. The US regime doesn’t change with interest rates (e)

Evaluate which of the three capital regimes will be the most beneficial from the perspective of Slavic’s auto insurance business head. Commentary on Question: This section was done well. US doesn’t charge for catastrophe and operational risk. Canada charges for catastrophe and Solvency II charges for both, so the recommendation is the US regime.

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Learning Objectives: 3. The candidate will understand how the financial risks faced by an entity can be quantified and the use of metrics to measure risk. Learning Outcomes: (3b) Demonstrate the use of risk metrics to quantify major types of risk exposure in the context of integrated risk management process.  Demonstrate how each of the financial risks faced by an entity can be amenable to quantitative analysis including an explanation of the advantages and disadvantages of various techniques such as Value at Risk (VaR), stochastic analysis, scenario analysis, and stress testing.  Describe and evaluate risk aggregation techniques, incorporating the use of correlation, integrated risk distributions and copulas.  Describe how and why risks are correlated and give examples of risks that are positively correlated and risks that are negatively correlated.  Assess the overall corporate risk exposure arising from financial and nonfinancial risks. (3c)

Evaluate the properties of risk measures and explain their limitations.

(3e)

Define and evaluate model and parameter risk.

Sources: Hardy, Investment Guarantees, Ch 9 and Ch 11 Summary of “Variance of the CTE Estimator”, Risk Management, August 2008 Commentary on Question: This question was meant to emphasis the quantitative skill in estimating risk measures along with qualitative discussion on those risk measures. Cognitive levels tested were retrieval (part (a)), comprehension (parts (b) and (d)), and analysis (parts (c), (e) and (f)). Candidates did well defining VaR and CTE in section (a) and applying the definition in section (b). There were very few candidates that answered section (c) correctly. Solution: (a) Define VaR and CTE with parameter α (0 < α < 1) and explain how to estimate these metrics from the simulations. Commentary on Question: The majority of candidates were successfully able to define VaR and CTE. Several candidates described VaR and CTE in the discrete form instead of continuously. If the discrete definition was provided, candidates received full credit.

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Continued     (b)

VaR α = inf(V: Pr[L0 ≤ V] ≥ α) VaR takes a single ordered outcome from many simulations. In this case it is equal to the (-1000αth) value of the ordered liabilities. CTE at α = E[L0|L0>VaR α] CTE takes an average of the largest ordered outcomes. In this case it is the average of the largest ordered liabilities greater than the VaR (1000α) above.

Explain why less sampling error is expected for the CTE 90 as compared to the VaR 95. Commentary on Question: Most candidates were able to expand on the definitions of VaR and CTE to explain why there is less sampling error with CTE. Because CTE takes an average of the largest outcomes, it is less sensitive to sampling variability or outliers than a point estimate (like VaR). Because the average will converge faster than a point estimate, fewer simulations are needed to converge to CTE than VaR.

(c)

Assess whether the methodology used in calculating the CI for CTE fully captures the uncertainty associated with this risk measure. Commentary on Question: This section was answered poorly by most candidates. There were very few candidates that were able to identify why the methodology did not capture the uncertainty with the risk measure. With simulation output, the estimate will have uncertainty attached from sampling variability. The standard deviation of the CTE, computed from the sample standard deviation of loss exceeding the estimated VaR, is biased low due to this uncertainty. Additional uncertainty of VaR will increase the estimated standard deviation.

(d)

Determine the number of simulations needed to reduce the standard deviation of the CTE to 20% of its current level. Commentary on Question: This calculation seemed to be straight forward as most candidates were able to successfully calculate the number of simulations needed to reduce the standard deviation of the CTE. VAR(CTE) is proportional to 1/n StDev(CTE) is proportional to

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Continued Solve for 20% of current standard deviation: .2 = Increase sample size by 25 times to reduce the standard deviation. Original sample size is 1000. New sample size = 1000 * 25 = 25,000 simulations. (e)

Define control variate, and explain whether using the estimated VaR as a control variate can significantly reduce the variance of the estimated CTE. Commentary on Question: Most candidates were able to define the control variate. However, in order to get full credit for this sections the candidate needed to explain whether using the estimated VaR as a control variate could reduce the variance of the estimated CTE. Often candidates were unable to correctly explain whether using the control variate method could reduce the variance of the estimated CTE based on the definition. Control variate is a function of the projected scenarios with the following characteristics: 1. The value of the control variate can be analytically calculated. 2. The value of the control variate is highly correlated with the value of the output variable. The control variate acts to calibrate the simulation. In this case, you cannot use the estimated VaR as a control variate. The control variate method requires the control variateâ&#x20AC;&#x2122;s value to be available analytically, but the quantile is not available in analytical form. The quantile is positively correlated to CTE as seen in the covariance formula, but that is only half of what is needed.

(f)

Define antithetic variate, and explain whether use of an antithetic variate can significantly reduce the variance of the estimated CTE. Commentary on Question: This section was similar to section (e) in that candidates were able to define antithetic variate, but often made incorrect recommendations to use the antithetic variate method to reduce variance of the estimated CTE. The antithetic variate method is a variance reduction technique related to moment matching. It is commonly used with normal or uniform distributions.

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Continued Let us denote an input Z and an output E. If we take -Z to get E', we may take the average of E and E', denoted by E*. The idea is that since Z and -Z are negatively correlated, so are E and E', leading to a more efficient estimate, E*. Antithetic variates work well when: 1. Output is a monotonic function of underlying random numbers 2. Focus is the middle of the distribution It does not do well for deep out-of-the-money options. For this purpose, I do not recommend using it as a variance reduction technique because we are looking at the GMWB tail events and they are not necessarily a monotonic function.

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Learning Objectives: 1. The candidate will understand the types of risks faced by an entity and be able to identify and analyze those risks. 2.

The candidate will understand measures of corporate value and be able to analyze the data in corporate financial statements.

The candidate will understand how the financial risks faced by an entity can be quantified and the use of metrics to measure risk.

The candidate will understand the means available for managing various risks and how an entity makes decisions about appropriate techniques.

Describe the concept of economic measures of value (e.g. MCEV) and demonstrate their uses in the risk management and corporate decision-making processes.

(3b)

Demonstrate the use of risk metrics to quantify major types of risk exposure in the context of integrated risk management process.  Demonstrate how each of the financial risks faced by an entity can be amenable to quantitative analysis including an explanation of the advantages and disadvantages of various techniques such as Value at Risk (VaR), stochastic analysis, scenario analysis, and stress testing.  Describe and evaluate risk aggregation techniques, incorporating the use of correlation, integrated risk distributions and copulas.  Describe how and why risks are correlated and give examples of risks that are positively correlated and risks that are negatively correlated.  Assess the overall corporate risk exposure arising from financial and nonfinancial risks.

(3c)

Evaluate the properties of risk measures and explain their limitations.

(4f)

(4j)

Demonstrate how derivatives, synthetic securities, and financial contracting may be used to manage equity risk, in particular, equity market guarantees found in variable annuities.

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Continued (4k)

Analyze the practicalities of market risk hedging, including dynamic hedging.

Sources: Kalberer, Variable Annuities, Ch. 5 FE-C177-11: CRO Forum, “A Market Cost of Capital Approach to Market Value Margins” Milliman – Economic Capital Modeling – Practical Considerations FE-C140-07 –Risk Measurement, Risk Management, and Capital Adequacy in Financial Conglomerates Commentary on Question: The concept of MVM on liabilities with a focus on calculating it using the MCOC method recommended by the CRO forum in the context of a company acquisition is tested. The required candidate cognitive skills for answering this question properly span Retrieval to Knowledge Utilization. Part (a) was Retrieval, part (b) was Analysis, part (c) was Comprehension and the last two sections were Knowledge Utilization. The most distinguishing criteria between candidates were the abilities to explain the reasons for or against acquisition and successfully organize the thought process behind the MVM using MCOC. Generally candidates did well in the MVM calculation and could list the reasons why the MCOC approach is preferred to the percentile approach. They generally knew which types of risk (credit, business, insurance, and operation) were hedgeable. Candidates had more trouble with part (d), where they are asked for the different levels of diversification. Generally, they either didn’t answer it at all or tried to do some kind of calculation of the diversification effect that was not appropriate. The final part, where they were asked to recommend a course of action on an acquisition, was a mixed bag with many candidates writing something but often failing to put into words what they really meant or not explaining it as well as they could have. Solution: (a) (i)

Define Market Value Margin (MVM). The MVM is a margin added to the present value of liability cash flows that accounts for the risk required to manage the business on an ongoing basis. It applies only to non-hedgeable risks.

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Continued (ii)

Compare and contrast the Market Cost of Capital (MCoC) approach and the Percentile approach to calculating MVM. There are two distinct approaches to calculating the MVM. The percentile approach holds enough capital to meet liabilities at a given confidence level while the MCoC holds enough to run off the inforce business MCoC is preferred by the forum because it supports and reflects risk management better, allows better crisis response, is easy and transparent and passes the use test.

(b)

All applicable risks of Blossom are shown in Table 2. (i)

Market risk has already been classified as hedgeable. Classify the remaining risk categories as hedgeable or non-hedgeable. Business, insurance, and operational risks are non-hedgeable; no market instruments exist to replicate those risks. Credit risk is hedgeable; there are CDS type instruments that can be used.

(ii)

Calculate the MVM using the MCoC approach. Diversified SCR = SCR(i) * DiversificationFactor(i) for all non-hedgeable risks, and MVM = Diversified SCR * COC. This includes the business, insurance, and operation risk categories above: Diversified SCR = 15% *(230 * 70% + 50 * 55% + 10 * 15%) = 28.5

(iii)

Calculate available economic capital (defined as market value of assets less market value of liabilities). Market Value of Liability = PV of liability cash flows + MVM = 900 + 28.5 = 928.5. EC = MVA-MVL = 1,000 â&#x20AC;&#x201C; 928.5 = 71.5.

(c)

Provide two reasons why market risk may not always be hedgeable for variable annuities. There is basis risk on fund options and policyholder behavior risk. A high basis risk on the fund options can exceed the benefit of hedging, and policyholders may behave differently than assumed.

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Continued (d)

Describe the levels of diversification benefits that would apply if Huckleberry acquired Blossom. There are three levels: within a single risk factor, across factors in a line of business, and across different business lines. Level III is applicable for this merger (combining Life and Annuity).

(e) (i)

Based on the information above, recommend whether Huckleberry should acquire Blossom at a price of 70 million USD. Justify your recommendation. Huckleberry should acquire Blossom. Blossomâ&#x20AC;&#x2122;s MCEV of 71.5 million is higher than the purchase prices of 70 million. It is also apparent that there will be some diversification benefit at the holding company level.

(ii)

List three additional significant considerations that you would want to evaluate before making the acquisition decision. Different regulatory environments across companies, shareholder perspective, and operational environment differences. Other answers were also accepted.

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Learning Objectives: 3. The candidate will understand how the financial risks faced by an entity can be quantified and the use of metrics to measure risk. 4.

The candidate will understand the means available for managing various risks and how an entity makes decisions about appropriate techniques.

Define and evaluate credit risk as related to fixed income securities.

Sources: Saunders and Allen, Credit Risk Management: In and Out of the Financial Crisis, Chapters 5 and 7 Commentary on Question: This question tests the candidate's ability to apply a reduced form model to hypothetical credit spreads in determining the probability of default. The first part of the question was comprehension. The rest of the sections were calculation-type analysis. To receive maximum points, the candidate should have clearly labeled and defined the variables and formulas being used, in addition to the steps in the backward recursion calculation process. There are two methods that can be used to arrive at the correct answers for parts (b), (c), and (d), with one being much more efficient than the other. In an effort to not bias against either method, full credit was awarded for a right answer under either approach. However, exam points were allocated to these sections based on the less efficient method. Candidates generally scored very well in section (a), moderately well in section (b), and tended to struggle in sections (c) and (d). Many candidates did not use the risk-free rates or the backward recursion approach needed for the calculations. Solution: (a) Identify three factors that can affect the Loss Given Default (LGD) for a bond. For each factor, state whether the correlation with LGD is positive or negative. AFE Fall 2011 Solutions

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Continued Commentary on Question: Although only three factors are identified here, there were other answers that were acceptable. Note that recovery rate was not an acceptable answer as this is part of the definition of loss given default, not a factor that impacts it.    (b)

Value of the collateral backing the bond - negative correlation External credit ratings – negative correlation Short term default-risk-free interest rates –positive correlation

Calculate the two-year cumulative probability of default for both an HQ-rated and an LQ-rated two-year, zero-coupon bond. Assume LGD is 100% and that the bonds cannot change in rating aside from defaulting. One year forward rate on treasury bond: (1 + two-year spot rate)^2 = (1 + r)(1 + one-year spot rate) (1 + 7%)^2 = (1 + r)(1 + 5%) r = 9.04% HQ Bond One year forward rate: (1 + 12%)^2 = (1 + a)(1 + 8%) a = 16.15% Probability of default (PD) in year one: (1 + one-year treasury spot rate) = (1 - PDA1)(1 + one-year HQ spot rate) (1 + 5%) = (1 - PDA1)(1 + 8%) PDA1 = 2.78% PD in year two: (1 + one-year treasury forward rate) = (1 - PDA2)(1 + one-year HQ forward rate) (1 + r) = (1 - PDA2)(1 + a) PDA2 = 6.12% Cumulative PD on HQ bond = 1 – (1 - PDA1)(1 - PDA2) = 8.73% LQ bond One year forward rate: (1 + 13.5%)^2 = (1 + b)(1 + 10.5%) b = 16.58% PD in year one: (1 + 5%) = (1 - PDB1)(1 + 10.5%) PDB1 = 4.98%

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Continued PD in year two: 1 + 9.04% = (1 - PDB2)(1 + 16.58%) PDB2 = 6.47% Cumulative PD on LQ bond = 1 – (1 - PDB1)(1 - PDB2) = 11.13% An alternate solution: HQ Bond 1.12^2 * (1 – PD) = 1.07^2 PD = 8.73% LQ Bond 1.135^2 * (1 – PD) = 1.07^2 PD = 11.13% (c)

Calculate the credit spread of a two-year, zero-coupon LQ-rated bond assuming LGD is 100%. B0

100

Using backward recursion risk neutral valuation, A1 = 90% * (100/1.0904) + 8% * (100/1.0904) + 2% * (0/1.0904) = 89.88; r = 9.04% in year 2 from part (b) B1 = 5% * (100/1.0904) + 85% * (100/1.0904) + 10% * (0/1.0904) = 82.54 B0 = 5% * (A1/1.05) + 85% * (B1/1.05) + 10% * (0/1.05) = 71.10 To find the credit spread, B0 = 100 / [ (1+ .05 + CS) * (1 + .0904 + CS) ] CS^2 + 2.14CS -.26 = 0 CS = 11.59% An alternate solution: Find the total PD for the LQ Bond = .1 + .05*.02 + .85 * .1 = .186 Then 1 – PD = 1.07^2 / ( 1 + .07 + CS)^2 PD = 11.59%

AFE Fall 2011 Solutions

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Continued (d)

Calculate the value of a two-year, zero-coupon LQ-rated bond assuming LGD is 40% and the par value is $100 million.

100

Using backward recursion risk neutral valuation, A1 = 90% * (100/1.0904) + 8% * (100/1.0904) + 2% * (60/1.0904) = 90.98; r = 9.04% in year 2 from part (b) B1 = 5% * (100/1.0904) + 85% * (100/1.0904) + 10% * (60/1.0904) = 88.04 B0 = 5% * (A1/1.05) + 85% * (B1/1.05) + 10% * (60/1.05) = 81.32 Alternate solution: Determine expected payout at each time t and discount to time 0 at risk free rates: Time 2 discounted: [100*(1-PD) + 60*(PD-.1)] / 1.07^2 =75.60, where PD=.186 Time 1 discounted: 60 * (.1) / 1.05 = 5.71 Sum = 81.32

AFE Fall 2011 Solutions

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10.

Learning Objectives: 1. The candidate will understand the types of risks faced by an entity and be able to identify and analyze those risks. 2.

The candidate will understand measures of corporate value and be able to analyze the data in corporate financial statements.

The candidate will understand how the financial risks faced by an entity can be quantified and the use of metrics to measure risk.

Identify and analyze insurance risks faced by an entity, including but not limited to: mortality risk, morbidity risk, catastrophe risk, product risk, and embedded options.

(1c)

Identify and analyze operation risks faced by an entity, including but not limited to:  Market Conduct (e.g., sales practices)  HR risk, e.g., productivity, talent management, employee conduct  Process risk, e.g., supply chain R&D  Technology risk, e.g., reliability, external attack, internal attack  Judicial risk, e.g., litigation  Compliance risk, e.g., financial reporting  Internal and external fraud  Execution risk  Governance risk  Supplier/partner risk  Disaster risk, e.g., natural disaster, man-made disaster

(2d)

Demonstrate an understanding of economic capital as reported by financial institutions.

(3a)

Demonstrate how to calculate required capital on an economic capital basis:  Define the basic elements and explain the uses of economic capital.  Explain the challenges and limits of economic capital calculations and explain how economic capital may differ from external requirements of rating agencies and regulators.

AFE Fall 2011 Solutions

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10.

Continued (3b)

Sources: FE-C178-11: Economic Capital Modeling – Practical Considerations - Milliman FE-C151-08: Ch. 13 (Sections 13.1 – 13.4), Annuity and Investment Products of Atkinson & Dallas, Life Insurance Products and Finance Commentary on Question: Commentary listed underneath question component. Solution: (a) For each product, SPIA and EIA, describe the exposure to the following risks: (i) Pricing Risk (ii) Market Risk (iii) Operational Risk Commentary on Question: This question was a Comprehension question that tested the candidates’ understanding of the risks that a SPIA and EIA are exposed to. To get full credit, a candidate had to identify the pricing risks, market risks and operational risks that apply to the product and describe how they apply. This question did not require candidates to rank the risks. This part of the question was not answered well; the common errors were as follows:  Lack of understanding of the risks that a SPIA and EIA are exposed to.  Simply ranking Pricing, Market and Operational Risks as Low, Medium and High.  Not listing how the risk applies to the product; for example, it is not sufficient to list Mortality as a risk. Candidates need to expand on how Mortality is a risk for a SPIA.  Lapse risk is not a pricing risk for SPIA products. AFE Fall 2011 Solutions

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10.

Continued SPIA Pricing Risk:  (Pricing risk is risk that prices charged for insurance contracts are insufficient to cover liabilities.)  Longevity risk, the risk that annuitants will live longer than priced for, is the primary SPIA pricing risk.  SPIAs are exposed to anti-selection as healthy lives are more likely to choose life annuities than unhealthy lives. Market Risk  (Market Risk is risk of potential fluctuations in interest rates, equity markets and foreign exchange and the impact on liabilities.)  There is market risk for SPIAs if interest rates fluctuate or change and there is an asset / liability cash flow mismatch.  Reduction in asset returns will cause reinvestment risk, which is the risk of cash flows being reinvested at lower rates than expected. Operational Risk  (Operation risk is the risk of loss from inadequate or failed internal process, people or systems.)  Examples of possible SPIA operational risk are: o System error in calculating SPIA annuity rates. o Erroneous investment selection and inadequate investment management process. EIA Pricing Risk  Risk of offering interest rate guarantee higher than can be supported by fixed income investments.  Risk of mispricing participation rate, cap and/or indexing method.  Pricing risk arising from company's inability to purchase appropriate hedging securities.  Difficult to set assumption for policyholder behavior since behavior linked to interest rates and equity rates. Market Risk  Risk of fluctuating interest rates since guaranteed rate is fixed.  Risk of higher hedge costs due to market volatility and lower than expected fixed income return.  Risk of asset cash flows not matching liability cash flows. Liability cash flows are hard to predict. Operational Risk – Examples are:  Hedging Operation risk failure  Incorrect hedging strategy for EIA AFE Fall 2011 Solutions

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10.

Continued (b)

Describe three potential deficiencies of a formulaic internal capital requirement. Commentary on Question: This is a knowledge utilization question. Candidates were able to provide deficiencies of a formulaic approach to economic capital.   

There is no link in a formulaic approach to the company's risk management and risk mitigation strategies. Formulaic approaches do not deal with all types of risks. Formulaic approaches do not adapt to changing market conditions and financial environment.

Other acceptable answers:  Formulaic approaches do not accurately measure and optimize the business’ capital resources.  Formulaic approaches generally do not give credit for a hedging program.  Formulaic approaches generally do not allow for the benefit of diversification. (c)

Calculate the Required Economic Capital for each of the two products, SPIA and EIA, separately. Commentary on Question: This was an analysis part of the question that tested candidates’ ability to calculate economic capital. Candidates were able to calculate CTE 95, but very few candidates calculated the Market Value of Liabilities (CTE 0) or the correct Required Economic Capital. The question marks were weighted equally between CTE 95, CTE 0 and the final Economic Capital calculation. Market Value of Liabilities = CTE 0 CTE 0 = Average of the 100 Scenarios SPIA: Market Value of Liabilities = (340+250+315+375+275+320+225+330+230+290+75*90)/100 CTE 0 =97.0 M CTE 95 = Average of worst 5 scenarios = (340+315+375+320+330)/5 CTE 95 = 336M EIA: Market Value of Liabilities= 700+1250+650+900+1100+850+675+1350+925+800+250*90)/100 CTE 0 = 317.0M

AFE Fall 2011 Solutions

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10.

Continued CTE 95 = Average of worst 5 scenarios = (1250+900+1100+1350+925)/5 CTE 95 = 1105M Economic Capital is additional capital in excess of the Market Value of Liabilities Economic Capital = CTE 95 - CTE 0 Economic Capital SPIA = (336- 97) Economic Capital SPIA = $239M Economic Capital EIA = 1105 - 317 Economic Capital EIA = $788M (d) (i)

Explain why a diversification benefit might exist from combining SPIA and EIA. Commentary on Question: This was a difficult analysis question, where candidates had to think about how a diversification benefit could exist between a SPIA and EIA. Candidates did not fare well on this part, and were unable to provide examples of where a diversification benefit could exist.     

(ii)

Diversification benefit exists because the worst outcomes do not all happen at the same time. Diversifiable component of mortality and longevity (volatility risk) decreases as policies increase; combining EIA and SPIA diversifies mortality. For SPIA, higher mortality rates are more profitable and reduce benefits. For EIA, higher mortality requires liquidation of assets which may be less profitable and reduces future fee income. Policyholder behavior risk is significant for EIAs, but not for SPIAs. Adding more unrelated risks to the portfolio reduces volatility of results.

Calculate the diversification benefit from combining SPIA and EIA in the Required Economic Capital calculation. Commentary on Question: This was an analysis question that tested the candidates’ ability to recognize the diversification benefit that exists between SPIAs and EIAs. Candidates did well in this question, and were able to make the connection on how a scenario can affect each product differently providing a diversification benefit.

AFE Fall 2011 Solutions

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10.

Continued Scenario 1: 340 + 700 = 1040 Scenario 2: 250 + 1250 = 1500 Scenario 3: 315 + 650 = 965 Scenario 4: 375 + 900 = 1275 Scenario 5: 275 + 1100 = 1375 Scenario 6: 320 + 850 = 1170 Scenario 7: 225 + 675 = 900 Scenario 8: 330 + 1350 = 1680 Scenario 9: 230 + 925 = 1155 Scenario 10: 290 + 800 = 1090 Worst 5 Scenarios: Scenario 2, 4, 5, 8 & 9 CTE 95 = (1500+1275+1375+1170+1680)/5 CTE 95 =1400 Economic Capital = CTE 95 - CTE 0 Economic Capital = 1400 - (97+317) Economic Capital = 986.0 Diversification Benefit = 1027- 986 = $41M

AFE Fall 2011 Solutions

Page 51

Advanced Finance/ERM Exam Fall 2010

Important Exam Information:

Exam Date and Time

A read-through time will be given prior to the start of the examâ&#x20AC;&#x201C;15 minutes in the morning session and 15 minutes in the afternoon session.

Exam Registration

Candidates may register online or with an application.

Study Note Order Form

Study notes are part of the required syllabus and are not available electronically.

Introductory Study Note

The Introductory Study Note has a complete listing of all study notes as well as errata and other important information.

Case Study - updated 8.18.10 This case study will also be provided with the examination.

Candidates will not be allowed to bring their copy of the case study into the examination room.

Past Exams

Past Exams from 2000-present are available on SOA web site.

Updates

Candidates should be sure to check the Updates page on the exam home page periodically for additional corrections or notices.

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Advanced Finance/ERM Exam Fall 2010

RESOURCES

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Advanced Finance/ERM Exam Fall 2010

Hardy, Investment Guarantees, 2003 Ch. 1, Investment Guarantees Ch. 6, Modeling the Guarantee Liability Tilman, Asset/Liability Management of Financial Institutions, 2003 Ch. 1, The Task of Asset/Liability Management, by L. Tilman Ch. 16, Understanding Options Embedded in Insurers’ Balance Sheets, by L. Rubin FE-C102-07: General American Life Can’t Pay Investors, Looks at Suitors FE-C104-07: Insurance OP Risk: The Big Unknown FE-C106-07: Mapping of Life Insurance Risks, AAA Report to NAIC FE-C137-07: Moody’s Looks at Risk Management and the New Life Insurance Risks FE-C154-09: Life Insurance Pricing and the Measurement of the Duration of Liabilities FE-C151-08: Ch. 13 (Sections 13.1 – 13.4), Annuity and Investment Products of Atkinson & Dallas, Life Insurance Products and Finance FE-C153-09: Variable Annuity – “No Loss” PropositionsFE-C159-09: Countering the Biggest Risk of All, by Slywotzky and Drzik - Harvard Business Review, April 2005 FE-C160-09: Moody’s Looks at Terrorism Risk in the U. S. Life Insurance Industry, February 2006 FE-C169-09: Ch. 3, Pricing Assumptions of Atkinson & Dallas, Life Insurance Products and Finance Influenza Pandemics: Are We Ready for the Next One, by Max Rudolph, Risk Management section newsletter, July 2004 http://www.soa.org/library/newsletters/risk-managementnewsletter/2004/july/rm-2004-iss02-rudolph.pdf Fixed Annuities in a Low Interest Rate Environment, Product Development newsletter, April 2003 http://www.soa.org/library/newsletters/product-developmentnews/2003/april/pdn0304.pdf Managing Variable Policyholder Behavior Risk, Product Development newsletter, March 2005 http://www.soa.org/library/newsletters/product-developmentnews/2005/march/pdn0503.pdf Death Benefit Focused UL, Product Development section newsletter, April 2003 http://www.soa.org/library/newsletters/product-development-news/2003/april/pdn0304.pdf Whither the Variable Annuity, Product Development section newsletter, November 2003 http://www.soa.org/library/newsletters/product-developmentnews/2003/november/pdn0311.pdf Operational and Reputational Risks: Essential Components of ERM”, by M. Rochette, Risk Management, December 2006. http://www.soa.org/library/newsletters/risk-managementnewsletter/2006/december/RMN0612.pdf Enterprise Risk Management Specialty Guide, SOA 2006 http://www.soa.org/library/professional-actuarial-specialty-guides/enterprise-risk-

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Advanced Finance/ERM Exam Fall 2010

management/2005/august/spg0605erm.pdf

4 of 16

Advanced Finance/ERM Exam Fall 2010

Topic: Accounting and Value Measures Learning Objective: 2. The candidate will understand measures of corporate value and be able to analyze the data in corporate financial statements. Learning Outcomes: The candidate will be able to: a)

b) c) d)

Explain basic accounting concepts used in producing financial statements: • in insurance companies • in other financial institutions • in non-financial institutions Analyze a specific company financial situation by demonstrating advanced knowledge of balance sheet and income statement structures. Describe the concept of economic measures of value (e.g. EVA; embedded value) and demonstrate their uses in the risk management and corporate decision-making processes. Demonstrate how to calculate required capital on an economic capital basis: • Define the basic elements and explain the uses of economic capital. • Explain the challenges and limits of economic capital calculations and explain how economic capital may differ from external requirements of rating agencies and regulators. • Demonstrate the ability to develop an economic capital model for a representative financial firm. RESOURCES Fridson, Alvarez, Financial Statement Analysis: A Practitioners Guide, 2002 Ch. 1, The Adversarial Nature of Financial Reporting Ch. 13, Credit Analysis Background only: Ch. 2, The Balance Sheet Ch. 3, The Income Statement Ch. 4, The Statement of Cash Flows Tilman, Asset/Liability Management of Financial Institutions, 2003 Ch. 24, Accounting Standards and Requirements, by E. Habayeh & S. Sethi FE-C149-07: Use of Stochastic Techniques to Value Liabilities under Canadian GAAP FE-C162-09: “EVA and Strategy” FE-C163-09: “Modern Valuation Techniques,” Staple Inn Actuarial Society, February 2001 Fair Value – Financial Economics Perspective by Babbel, Gold and Merrill, NAAJ, http://www.soa.org/library/journals/north-american-actuarialjournal/2002/january/naaj0201_2.pdf

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Advanced Finance/ERM Exam Fall 2010

Fair Valuation of Insurance Liabilities: Principles and Methodsâ&#x20AC;? AAA Monograph, September 2002 http://www.actuary.org/pdf/finreport/fairval_sept02.pdf An Overview of Embedded Value, H. Mueller, Financial Reporter, Sept. 2003. http://www.soa.org/library/newsletters/financial-reporter/2003/november/frn-2003-iss55mueller.pdf Economic Capital for Life Insurance Companies, SOA Monograph, 2008 http://www.soa.org/files/pdf/research-ec-report.pdf

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Advanced Finance/ERM Exam Fall 2010

Topic: Risk Quantification and Risk Measures Learning Objective: 3. The candidate will understand how the financial risks faced by an entity can be quantified and the use of metrics to measure risk. Learning Outcomes: The candidate will be able to: a) Demonstrate the use of risk metrics to quantify major types of risk exposure in the context of an integrated risk management process. • Demonstrate how each of the financial risks faced by an entity can be amenable to quantitative analysis including an explanation of the advantages and disadvantages of various techniques such as Value at Risk (VaR), stochastic analysis, scenario analysis and stress testing. • Describe and evaluate risk aggregation techniques, incorporating the use of correlation, integrated risk distributions and copulas. • Describe how and why risks are correlated, and give examples of risks that are positively correlated and risks that are negatively correlated. • Assess the overall corporate risk exposure arising from financial and non-financial risks. b) Evaluate the properties of risk measures and explain their limitations. c) Define and evaluate model and parameter risk RESOURCES: Crouhy, Galai, & Mark, Risk Management, 2001 Ch. 5, Measuring Market Risk: The VaR Approach Ch. 6, Measuring Market Risk: Extensions of the VaR Approach and Testing the Models Ch. 15, Model Risk Hardy, Investment Guarantees, 2003, Ch. 9, Risk Measures Ch. 10, Emerging Cost Analysis Ch. 11, Forecast Uncertainty FE-C142-07: “Theory and Practice of Model Risk Management,” Ricardo Rebonato FE-C143-07: Dynamic Financial Models of Property-Casualty Insurers FE-C166-09: “Black Monday and Black Swans,” J. Bogle, Financial Analysts Journal, 64:2(3040) 2008 CSFB Credit Portfolio Modeling Handbook – Ch. 2, The Default/No-Default World and Factor Model Ch. 4, Demystifying Copulas

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Advanced Finance/ERM Exam Fall 2010

Ch. 9, Risk Measures: How Long Is a Risky Piece of String? http://www.csfb.com/institutional/research/CreditPortfolioModeling.pdf Actuaries, Stochasticity and Risk Management: The Real Lessons of Long-term Capital Managementâ&#x20AC;?, B. Crompton, The Actuary, September 2007. http://www.soa.org/library/newsletters/the-actuary-magazine/2007/august/act2007aug.aspx Risk Aggregation for Capital Requirements Using the Copula Techniqueâ&#x20AC;?, Song Zhang, Risk Management Newsletter, March 2005, Issue #4 http://www.soa.org/library/newsletters/risk-management-newsletter/2005/march/rmn0503.pdf

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Advanced Finance/ERM Exam Fall 2010

Topic: Risk Management Learning Objective: 4. The candidate will understand the means available for managing various risks and how an entity makes decisions about appropriate techniques. Learning Outcomes: The candidate will be able to: General a. Explain the rationale for managing risk and demonstrate the selection of the appropriate risk retention level. b. Demonstrate means for transferring risk to a third party, and analyze the costs and benefits of doing so. c. Demonstrate means for reducing risk without transferring it (internal hedges). d. Evaluate the performance of risk transference activities. e. Describe and evaluate risk management techniques that can be used to deal with financial and non-financial risks. f. Develop an appropriate choice of hedging strategy for a given situation (e.g., reinsurance, derivatives, financial contracting), which balances benefits with inherent costs, including exposure to credit risk, basis risk, moral hazard, and other risks. Asset Liability Management g. Analyze funding and portfolio management strategies to control equity and interest rate risk, including key rate risks. â&#x20AC;˘ Contrast modified duration and effective duration measures.

â&#x20AC;˘ â&#x20AC;˘

h. i. j.

Calculate effective duration and effective key-rate durations of a portfolio.

Credit Risk Management k. Define and evaluate credit risk as related to fixed income securities. l. Define and evaluate spread risk as related to fixed income securities m. Explain how to incorporate best practices in credit risk measurement, modeling, and management. n. Define credit risk as related to derivatives, define credit risk as related to reinsurance ceded, define counter-party risk and demonstrate the use of comprehensive due diligence and aggregate counter-party exposure limits. o. Describe and evaluate risk mitigation techniques and practices: credit derivatives, diversification, concentration limits, and credit support agreements.

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Advanced Finance/ERM Exam Fall 2010

Liquidity Risk Management p. Define liquidity risk. q. Explain methods for managing this risk, both pre-event and post-event. r. Evaluate examples of company disasters that were the result of these types of risks – what the exposure was, what occurred, the sequence of events, what actions management took, didn’t take and could have / should have taken, what the financial impacts and general consequences were. Strategic Risk Management s. Define strategic risk t. Explain methods for managing this risk, both pre-event and post-event u. Evaluate examples of company disasters that were the result of these types of risks – what the exposure was, what occurred, the sequence of events, what actions management took, didn’t take and could have / should have taken, what the financial impacts and general consequences were.

Operational Risk Management v. Define operational risk w. Explain methods for managing this risk, both pre-event and post-event x. Evaluate examples of company disasters that were the result of these types of risks – what the exposure was, what occurred, the sequence of events, what actions management took, didn’t take and could have / should have taken, what the financial impacts and general consequences were RESOURCES Crouhy, Galai, & Mark, Risk Management, 2001 Ch. 7, Credit Rating Systems Ch. 8, Credit Migration Approach to Measuring Credit Risk Ch. 9, The Contingent Claim Approach to Measuring Credit Risk Ch. 10, Other Approaches: The Actuarial and Reduced-Form Approaches to Measuring Credit Risk Ch. 12, Hedging Credit Risk Ch. 13, Managing Operational Risk Damoradan, Strategic Risk-Taking, 2007 Ch. 9, Risk Management: The Big Picture Ch. 10, Risk Management: Profiling and Hedging Ch. 11, Strategic Risk Management Ch. 12, Risk Management: First Principle Hardy, Investment Guarantees, 2003,

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Advanced Finance/ERM Exam Fall 2010

Ch. 8, Dynamic Hedging for Separate Account Guarantees Ch. 12, Guaranteed Annuity Options Tiller, Life, Health and Annuity Reinsurance, 3rd Edition, 2005, Ch. 5, Advanced Methods of Reinsurance Ch. 16, Assumption Ch. 17, Special Purpose Reinsurance Companies Tilman, Asset/Liability Management of Financial Institutions, 2003, Ch. 9, Measuring and Marking Counterparty Risk, by E. Canabarro & D. Duffie Ch. 25, Implications of Regulatory and Accounting Requirements for Asset/Liability Management Decisions, by Hida, Habayeb, Yetis, & Sethi. FE-C102-07: General American Life Can’t Pay Investors, Looks at Suitors FE-C117-07: Doherty, Integrated Risk Management, Ch. 1, The Convergence of Insurance Risk Management & Financial Risk Management Ch. 7, Why Is Risk Costly to a Firm? Ch. 8, Risk Management Strategy: Duality and Globality FE-C118-07: Securitization of Life Insurance Assets and Liabilities FE-C127-07: Asset Liability Management for Insurers FE-C128-07: Asset/ Liability Management, IASA Handbook FE-C129-07: Principles for the Management of Interest Rate Risk FE-C130-07: Hedging with Derivatives in Traditional Insurance Products FE-C135-07: Financial Oversight of Enron: The SEC and Private-Sector Watchdogs (pp. 97127 only) FE-C141-07. Letter to SEC Regarding Fitch Ratings’ View on the Role and Function of Rating Agencies in the Operation of Securities FE-C145-07: Dynamic Financial Condition Analysis Handbook, Ch. 1 (background only), 8 and Appendix A FE-C147-07: Derivatives: Practice and Principles, Recommendations 9-24 and Section III FE-C155-09: Babbel & Fabozzi, Investment Management for Insurers, 1999 Ch. 1, “Risk Management by Insurers: An Analysis of the Process”, Babbel & Santomero FE-C156-09: Key Rate Durations: Measures of Interest Rate Risks FE-C157-09: Long-Term Economic and Market Trends and Their Implications for AssetLiability Management of Insurance Companies FE-C158-09: Variable Product Hedging Practical Considerations FE-C167-09: Hedging the Bet: Variable Annuity “Bells and Whistles”, Moody’s October 2005 FE-C168-09: C. Smithson, Credit Portfolio Management Ch. 1, The Revolution in Credit – Capital Is the Key FE-C170-09: “Why COSO Is Flawed,” by A. Samed-Khan, www.operationalriskonline.com, January 2005 FE-C174-10: Deciphering the Liquidity and Credit Crunch 2007-2008, Brunnermeier Liquidity Risk Measurement, CIA Educational Note http://www.actuaries.ca/members/publications/1996/9626e.pdf

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Advanced Finance/ERM Exam Fall 2010

Topic: Enterprise Risk Management Framework Learning Objective: 5. The candidate will understand the components of an ERM framework and be able to evaluate the appropriateness of a framework in a given situation. Learning Outcomes: The candidate will be able to: a. Define Enterprise Risk Management and explain the principal terms used in ERM. b. Describe the fundamental concepts of financial and non-financial risk management and evaluate a particular given risk-management framework. c. Demonstrate how an organization can create a risk management culture including: risk consciousness, accountabilities, discipline, collaboration, incentives, and communication. d. Explain the elements of risk governance, and demonstrate how governance issues are resolved through organizational structure. e. Compare and contrast various regulatory/industry frameworks: Basle II, Sarbanes-Oxley Act, OSFI Supervisory Framework, OSFI Standard of Sound Financial and Business Practices, UK FSA guidelines, and COSO. f. Explain the perspectives of regulators, rating agencies, stock analysts, and company stakeholders and how they evaluate the risks and the risk management of an organization. RESOURCES Crouhy, Galai, & Mark, Risk Management, 2001, Ch. 2, The New Regulatory and Corporate Environment” Ch. 3, Structuring and Managing the Risk Management Function in a Bank Ch. 17, Risk Management in the Future FE-C117-07: Doherty, Integrated Risk Management, Ch. 1, The Convergence of Insurance Risk Management & Financial Risk Management Ch. 7, Why Is Risk Costly to a Firm? Ch. 8, Risk Management Strategy: Duality and Globality FE-C129-07: Principles for the Management of Interest Rate Risk FE-C133-07: Internal Control – Guidance for Directors on the Combined Code FE-C134-07: Supervisory Framework – 1999 and Beyond (OSFI – Canadian) FE-C139-07: No Assurance of Good Governance: Observations on Corporate Governance in the U.S. Insurance Sector FE-C171-09: Insurance Criteria: Refining the Focus of Insurer Enterprise Risk Management Criteria, Standard & Poor’s, June 2006 FE-C172-09: Enterprise Risk Management – Integrated Framework: Executive Summary, COSO, September 2004 FE-C173-09: Risk Management and the Rating Process for Insurance Companies, Best Rating Methodology, January 2008 “Actuarial Aspects of SOX 404”, The Financial Reporter, Dec. 2004, http://www.soa.org/library/newsletters/financial-reporter/2004/december/frn-2004-iss59-

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Advanced Finance/ERM Exam Fall 2010

brownehay.pdf â&#x20AC;&#x153;Responsibilities of the Actuary for Communicating Sarbanes-Oxley Controlsâ&#x20AC;? The Financial Reporter, Dec. 2004, http://www.soa.org/library/newsletters/financial-reporter/2004/december/frn-2004-iss59auvinen.pdf Enterprise Risk Management Specialty Guide, SOA 2006 http://www.soa.org/library/professional-actuarial-specialty-guides/enterprise-riskmanagement/2005/august/spg0605erm.pdf

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Advanced Finance/ERM Exam Fall 2010

Assess how risk and opportunity influence the selection of a firm’s vision and strategy and demonstrate how ERM can be appropriately embedded in an entity’s strategic planning.

Articulate risk objectives; demonstrate how to define and measure an organization’s risk appetite; and demonstrate how an organization uses risk appetite to make strategic decisions.

Determine a desired risk profile and appropriate risk filters, and analyze the risk and return trade-offs that result from changes in the organization’s risk profile.

Demonstrate how ERM is able to contribute to shareholder value creation and how the performance of a given firm or venture may be evaluated against its objectives including total returns.

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Advanced Finance/ERM Exam Fall 2010

Demonstrate how risk metrics can be incorporated into the risk monitoring function as part of an ERM framework.

Explain means for managing risks and demonstrate measures for evaluating their effectiveness.

Describe and assess the elements of a successful risk management function and recommend a structure for an organization's risk management function.

RESOURCES: Crouhy, Galai, & Mark, Risk Management, 2001, Ch. 3, Structuring and Managing the Risk Management Function in a Bank

Ch. 13, Managing Operational Risk Ch. 14, Capital Allocation and Performance Measurement

Hardy, Investment Guarantees, 2003 Ch. 6, Modeling the Guarantee Liability Ch. 9, Risk Measures Ch. 12, Guaranteed Annuity Options FE-C117-07: Doherty, Integrated Risk Management, Ch. 7, Why Is Risk Costly to Firms? Ch. 8, Risk Management Strategy: Duality and Globality FE-C124-07: Performance Measurement Using Transfer Pricing, M. Wallace FE-C125-07: Total Return Approach to Performance Measurement FE-C133-07: Internal Control â&#x20AC;&#x201C; Guidance for Directors on the Combined Code FE-C138-07: Managing the Invisible: Measuring Risk, Managing Capital, Maximizing Value, Panning FE-C140-07: Risk Measurement, Risk Management and Capital Adequacy in Financial Conglomerates (exclude appendices) FE-C143-07: Dynamic Financial Models of Property-Casualty Insurers FE-C145-07: Dynamic Financial Condition Analysis Handbook, Ch. 1 (background only), Ch. 8 and Appendix A FE-C171-09: Insurance Criteria: Refining the Focus of Insurer Enterprise Risk Management Criteria, Standard & Poorâ&#x20AC;&#x2122;s, June 2006 Risk Management: The Total Return Approach and Beyond, Ho, Risk Management Newsletter, November, 2004, Issue #3 http://www.soa.org/library/newsletters/risk-managementnewsletter/2004/november/rmn0411.pdf

Enterprise Risk Management Specialty Guide, SOA 2006 http://www.soa.org/library/professional-actuarial-specialty-guides/enterprise-riskmanagement/2005/august/spg0605erm.pdf 15 of 16

Advanced Finance/ERM Exam Fall 2010

Application of Coherent Risk Measures to Capital Requirements in Insuranceâ&#x20AC;?, Artzner, NAAJ, Vol 3, No 2 http://www.soa.org/library/journals/north-american-actuarialjournal/1999/april/naaj9904_1.pdf

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Advanced Finance/ERM Exam Spring 2009

Important Exam Information:

Exam Date and Time

A read-through time will be given prior to the start of the examâ&#x20AC;&#x201C;15 minutes in the morning session and 15 minutes in the afternoon session.

Exam Registration

Candidates may register online or with an application.

Study Note Order Form

Study notes are part of the required syllabus and are not available electronically.

Introductory Study Note

The Introductory Study Note has a complete listing of all study notes as well as errata and other important information.

Case Study

The Case Study will also be distributed in the Study Note package. A copy of the case study will be provided with the examinations. Candidates will not be allowed to bring their copy of the case study into the examination room.

Past Exams

Past Exams from 2000-present are available on SOA web site.

Updates

Candidates should be sure to check the Updates page on the exam home page periodically for additional corrections or notices.

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Advanced Finance/ERM Exam Spring 2009 Syllabus for Advanced Finance/ERM: The candidate should be very familiar with the Learning Objectives as described in this syllabus document. These Learning Objectives are the first ingredient in developing the syllabus and also guide the examination committee when writing questions. The Learning Objectives set out the cognitive level needed to pass this exam. You will notice that the candidates are expected to “analyze,” “explain,” “calculate,” “describe,” “apply,” etc. While studying the syllabus material, candidates may want to refer to the Learning Objectives to remain focused on the goals of the exam.

1) Risk Definitions, Categories, and Identification a) Identify and describe financial market risks faced by an entity, including but not limited to currency risk, credit risk, spread risk, liquidity risk, interest rate risk, and equity risk. b) Identify and describe insurance risks faced by an entity, including but not limited to: mortality risk, morbidity risk, catastrophe risk, product risk, embedded options c) Identify and describe operational risks faced by an entity, including but not limited to: • Market Conduct (e.g., sales practices) • HR risk, e.g., productivity, talent management, employee conduct • Process risk, e.g., supply chain, R&D • Technology risk, e.g., reliability, external attack, internal attack • Judicial risk, e.g., litigation • Compliance risk, e.g., financial reporting • Internal and External fraud • Execution risk • Governance risk • Supplier/partner risk • Disaster risk, e.g., natural disaster, man-made disaster d) Identify and describe strategic risks faced by an entity including, but not limited to • Product sustainability risk • Distribution sustainability risk • Consumer preferences and demographics • Geopolitical risk • Competitor risk • External relations risk • Legislative/Regulatory risk • Reputation Risk • Sovereign risk

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Advanced Finance/ERM Exam Spring 2009 SYLLABUS RESOURCES •

•

Hardy, Investment Guarantees, 2003 o Ch. 1, Investment Guarantees, o Ch. 6, Modeling the Guarantee Liability Tilman, Asset/Liability Management of Financial Institutions, 2003 o Ch. 1, The Task of Asset/Liability Management, by L. Tilman o Ch. 16, Understanding Options Embedded in Insurers’ Balance Sheets, by L. Rubin. • • • • • • • • • •

FE-C102-07: General American Life Can’t Pay Investors, Looks at Suitors FE-C104-07: Insurance OP Risk: The Big Unknown FE-C106-07: Mapping of Life Insurance Risks, AAA Report to NAIC FE-C137-07: Moody’s Looks at Risk Management and the New Life Insurance Risks FE-C151-08: Atkinson and Dallas, Ch. 13 (Sections 13.1 – 13.4), Annuity and Investment Products FE-C153-09 : Variable Annuity – “No Loss” Propositions FE-C154-09 : Life Insurance Pricing and the Measurement of the Duration of Liabilities FE-C159-09: Countering the Biggest Risk of All by Slywotzky and Drzik FE-C160-09: Moody’s Looks at Terrorism Risk in the U. S. Life Insurance Industry February 2006. FE-C169-09: Atkinson and Dallas, Ch. 3, Pricing Assumption

•

“Death Benefit Focused UL”, Product Development section newsletter, April 2003 http://www.soa.org/library/newsletters/product-developmentnews/2003/april/pdn0304.pdf • Enterprise Risk Management Specialty Guide, SOA 2006 http://www.soa.org/library/professional-actuarial-specialty-guides/enterprise-riskmanagement/2005/august/spg0605erm.pdf • “Fixed Annuities in Low Interest Rate Environment”, Product Development newsletter, April 2003 http://www.soa.org/library/newsletters/product-developmentnews/2003/april/pdn0304.pdf • “Influenza Pandemics: Are We Ready for the Next One”, by Max Rudolph, Risk Management section newsletter, July 2004 http://www.soa.org/library/newsletters/risk-managementnewsletter/2004/july/rmn0407.pdf • “Managing Variable Policyholder Behavior Risk”, Product Development newsletter, March 2005 http://www.soa.org/library/newsletters/product-developmentnews/2005/march/pdn0503.pdf • “Whither the Variable Annuity”, Product Development section newsletter, November 2003 http://www.soa.org/library/newsletters/product-developmentnews/2003/november/pdn0311.pdf • “Operational and Reputational Risks: Essential Components of ERM”, by M. Rochette, Risk Management, December 2006. http://www.soa.org/library/newsletters/riskmanagement-newsletter/2006/december/RMN0612.pdf

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Advanced Finance/ERM Exam Spring 2009 2. Value, Accounting Measures, and Risk Quantification a.

b. c. d.

Describe basic accounting concepts used in producing financial statements: • in insurance companies • in other financial institutions • in non-financial institutions Analyze a specific company financial situation by demonstrating advanced knowledge of balance sheet and income statement structures. Describe economic measures of value (e.g. EVA; embedded value) and their uses in corporate decision-making process. For companies with capital requirements, define and describe how to calculate required capital on an economic capital basis. • Define the basic elements and explain the uses of economic capital. • Explain the challenges and limits of economic capital calculations and explain how it may differ from external requirements of rating agencies and regulators. Define risk metrics to quantify major types of risk exposure in the context of an integrated risk management process. • Describe risk aggregation techniques incorporating the use of correlation • Describe how and why risks are correlated, and give examples of risks that are positively correlated and risks that are negatively correlated. • Assess the overall corporate risk exposure arising from financial and non-financial risks. Explain the limitations of risk metrics

g. Define and explain model risk

SYLLABUS RESOURCES Crouhy, Galai, & Mark, Risk Management, 2001 Ch. 5, “Measuring Market Risk: The VaR Approach Ch. 6, “Measuring Market Risk: Extensions of the VaR Approach and Testing the Models Ch. 15, Model Risk Fridson, Alvarez Financial Statement Analysis: A Practitioners Guide Ch. 1, The Adversarial Nature of Financial Reporting Ch. 13, Credit Analysis Background only: Ch. 2, The Balance Sheet Ch. 3, The Income Statement Ch. 4, The Statement of Cash Flows

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Advanced Finance/ERM Exam Spring 2009 Hardy, Investment Guarantees, 2003, Ch. 9, “Risk Measures” Ch. 10, “Emerging Cost Analysis” Ch. 11, “Forecast Uncertainty” Tilman, Asset/Liability Management of Financial Institutions, 2003 Ch. 24, Accounting Standards and Requirements, by E. Habayeh & S. Sethi • • • • • • • • •

FE-C142-07: “Theory and Practice of Model Risk Management” Ricardo Rebonato FE-C143-07: Dynamic Financial Models of Property-Casualty Insurers FE-C149-07: Use of Stochastic Techniques to Value Liabilities under Canadian GAAP FE-C161-09: E&Y presentation on Fair Value Measurements Standard (FAS 157) FE-C162-09: EVA and Strategy FE-C163-09: Modern Valuation Techniques, Staple Inn Actuarial Society, February 2001. FE-C164-09: CSFB Credit Portfolio Modeling Handbook – Ch. 4 “Demystifying copulas” FE-C165-09: CSFB Credit Portfolio Modeling Handbook – Ch. 9 “Risk measures: how long is a risky piece of string?” FE-C166-09: Black Monday and Black Swans

•

Actuaries, Stochasticity and Risk Management: The Real Lessons of Long-term Capital Management,” by B. Crompton, The Actuary, September 2007. http://www.soa.org/library/newsletters/the-actuary-magazine/2007/august/act2007aug.aspx

•

“An Overview of Embedded Value,” H. Mueller, Financial Reporter, Sept. 2003. http://www.soa.org/library/newsletters/financial-reporter/2003/november/frn-2003-iss55mueller.pdf

•

Economic Capital for Life Insurance Companies, SOA Monograph, 2008 http://www.soa.org/files/pdf/research-ec-report.pdf

•

“Fair Value – Financial Economics Perspective,” by Babbel, Gold and Merrill NAAJ, http://www.soa.org/library/journals/north-american-actuarial-journal/2002/january/naaj0201_2.pdf

•

“Fair Valuation of Insurance Liabilities: Principles and Methods,” AAA Monograph, September 2002 http://www.actuary.org/pdf/finreport/fairval_sept02.pdf

•

FASB Summary of FAS 157 -- http://www.fasb.org/st/summary/stsum157.shtml

•

Risk Aggregation for Capital Requirements Using the Copula Technique”, Song Zhang, Risk Management Newsletter, March 2005, Issue #4 http://www.soa.org/library/newsletters/riskmanagement-newsletter/2005/march/rmn0503.pdf

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Advanced Finance/ERM Exam Spring 2009 3. Risk Management General a. Explain the rationale for managing risk and for the selection of the appropriate risk retention level. b. Identify and describe means for transferring risk to a third party, and identify the costs and benefits of doing so. c. Identify and describe means for reducing risk without transferring it (internal hedges) d. Describe how the performance of risk transference activities may be evaluated. e. Describe risk management techniques that can be used to deal with financial and nonfinancial risks. Asset Liability Management f. Describe how derivatives, synthetic securities, and financial contracting may be used to manage interest rate risk , including key rate risks. • Contrast modified duration and effective duration measures.

• •

Calculate effective duration and effective key-rate durations of a portfolio.

Explain the concepts of immunization including modern refinements and practical limitations. Describe how derivatives, synthetic securities, and financial contracting may be used to manage equity risk, in particular, equity market guarantees found in variable annuities.

Credit Risk Management h. Define and evaluate credit risk as related to fixed income securities. i. Define and evaluate spread risk as related to fixed income securities j. Describe best practices in credit risk measurement, modeling, and management. k. Define credit risk as related to derivatives, define credit risk as related to reinsurance ceded, define counter-party risk and describe the use of comprehensive due diligence and aggregate counter-party exposure limits. l. Describe risk mitigation techniques and practices: credit derivatives, diversification, concentration limits, and credit support agreements. Liquidity Risk Management m. Define liquidity risk. n. Describe methods for managing this risk, both pre-event and post-event

Understand examples of company disasters that were the result of these types of risks – what the exposure was, what occurred, the sequence of events, what actions management took, didn’t take and could have / should have taken, what the financial impacts and general consequences were.

Strategic Risk Management p. Define strategic risk q. Describe methods for managing this risk, both pre-event and post-event

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Advanced Finance/ERM Exam Spring 2009 r.

Operational Risk Management s. Define operational risk t. Describe methods for managing this risk, both pre-event and post-event u. Understand examples of company disasters that were the result of these types of risks – what the exposure was, what occurred, the sequence of events, what actions management took, didn’t take and could have / should have taken, what the financial impacts and general consequences were.

SYLLABUS RESOURCES: Crouhy, Galai, & Mark, Risk Management, 2001 • Ch. 7, Credit Rating Systems • Ch. 8, Credit Migration Approach to Measuring Credit Risk • Ch. 9, The Contingent Claim Approach to Measuring Credit Risk • Ch. 10, Other Approaches: The Actuarial and Reduced-Form Approaches to Measuring Credit Risk • Ch. 12, Hedging Credit Risk • Ch. 13, Managing Operational Risk Damoradan, Strategic Risk-Taking, 2007 • Ch. 9, Risk Management: The Big Picture • Ch. 10, Risk Management: Profiling and Hedging • Ch. 11, Strategic Risk Management • Ch. 12, Risk Management: First Principles Hardy, Investment Guarantees, 2003, • Ch. 8, “Dynamic Hedging for Separate Account Guarantees” • Ch. 12, “Guaranteed Annuity Options” Tiller, Life, Health and Annuity Reinsurance, 3rd Edition., 2005, • Ch. 5, “Advanced Methods of Reinsurance” • Ch. 16, “Assumption” • Ch. 17, “Special Purpose Reinsurance Companies” Tilman, Asset/Liability Management of Financial Institutions, 2003 • Ch. 9, “Measuring and Marking Counterparty Risk,” by E. Canabarro & D. Duffie • Ch. 25, Implications of Regulatory and Accounting Requirements for Asset/Liability Management Decisions, by Hida, Habayeb, Yetis, & Sethi. •

FE-C117-07: Integrated Risk Management, Doherty, Chapters 1, 7, and 8

7 of 11

Advanced Finance/ERM Exam Spring 2009 • • • • • • • •

• • • • •

FE-C102-07: General American Life Can’t Pay Investors, Looks at Suitors FE-C118-07: Securitization of Life Insurance Assets and Liabilities FE-C127-07: Asset Liability Management for Insurers FE-C128-07: Asset/ Liability Management, IASA Handbook FE-C129-07: Principles for the Management of Interest Rate Risk FE-C130-07: Hedging with Derivatives in Traditional Insurance Products FE-C135-07: Financial Oversight of Enron: The SEC and Private-Sector Watchdogs (pp. 97-127 only) FE-C141-07. Letter to SEC Regarding Fitch Ratings’ View on the Role and Function of Rating Agencies in the Operation of Securities FE-C145-07: Dynamic Financial Condition Analysis Handbook, Ch. 1 (background only), 8 and Appendix A FE-C147-07: Derivatives: Practice and Principles, (Recommendations 9–24 and Section III, Assessing and Managing the Risks of Derivatives) FE-C155-09: Chapter 1 of, Investment Management for Insurers, Babbel & Fabozzi FE-C156-09: Key Rate Durations: Measures of Interest Rate Risks FE-C157-09: Long-Term Economic and Market Trends and Their Implications for Asset-Liability Management of Insurance Companies FE-C158-09: Variable Product Hedging Practical Considerations FE-C167-09: Hedging the Bet: Variable Annuity “Bells and Whistles” FE-C168-09: Chapter 1 of Credit Portfolio Management, C. Smithson, FE-C170-09: Why COSO Is Flawed, by A. Samed-Khan “Liquidity Risk Measurement,” CIA Educational Note http://www.actuaries.ca/members/publications/1996/9626e.pdf

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Advanced Finance/ERM Exam Spring 2009 4. Enterprise Risk Management Framework a. b. c. d. e.

Define Enterprise Risk Management. Describe the fundamental concepts of financial and non-financial risk management and evaluate a particular given risk-management framework. Describe how an organization can create a risk management culture including: risk consciousness, accountabilities, discipline, collaboration, and communication. Describe elements of risk governance, and how these issues are resolved through organizational structure. Describe various regulatory/industry frameworks: Basle II, Sarbanes-Oxley Act, OSFI Supervisory Framework, OSFI Standard of Sound Financial and Business Practices, UK FSA guidelines, and COSO. Understand the perspectives of regulators, rating agencies, stock analysts, and company stakeholders and describe how they evaluate the risks and the risk management of an organization.

SYLLABUS RESOURCES Crouhy, Galai, & Mark, Risk Management, 2001, • Ch. 2, The New Regulatory and Corporate Environment” • Ch. 3, Structuring and Managing the Risk Management Function in a Bank • Ch. 17, Risk Management in the Future • • • • • • • •

FE-C117-07: Chapter 1, 7 and 8 of Integrated Risk Management, Doherty FE-C129-07: Principles for the Management of Interest Rate Risk FE-C133-07: Internal Control – Guidance for Directors on the Combined Code FE-C134-07: Supervisory Framework – 1999 and Beyond (OSFI – Canadian) FE-C139-07: No Assurance of Good Governance: Observations on Corporate Governance in the U.S. Insurance Sector FE-C171-09: Insurance Criteria: Refining the Focus of Insurer Enterprise Risk Management Criteria, Standard & Poor’s, June 2006. FE-C172-09: Enterprise Risk Management – Integrated Framework: Executive Summary, COSO, September 2004. FE-C173-09: Risk Management and the Rating Process for Insurance Companies, Best Rating Methodology, January 2008.

•

“Actuarial Aspects of SOX 404”, The Financial Reporter, Dec. 2004, http://www.soa.org/library/newsletters/financial-reporter/2004/december/frn0412.pdf

•

Enterprise Risk Management Specialty Guide, SOA 2006 http://www.soa.org/library/professional-actuarial-specialty-guides/enterprise-riskmanagement/2005/august/spg0605erm.pdf

•

“Responsibilities of the Actuary for Communicating Sarbanes-Oxley Controls” The Financial Reporter, Dec. 2004, http://www.soa.org/library/newsletters/financial-reporter/2004/december/frn0412.pdf

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Advanced Finance/ERM Exam Spring 2009

5. Enterprise Risk Management Process a.

Explain the ERM process steps to be followed once the ERM framework is in place: Risk identification i. Defining and categorizing risk ii. Qualitative risk assessments Risk quantification i. Scenario development / types of scenarios ii. Individual risk quantification, including inherent vs. residual exposures

iii. Quantifying enterprise risk exposure, including correlations of risks Risk management i. Defining risk appetite ii. Managing enterprise risk exposure towards risk appetite Internal reporting i. Performance measurement ii. Performance management and incentive compensation External disclosures i. Shareholders ii. Rating agencies

iii. Regulators b.

Describe how risk and opportunity influence the selection of a firm’s vision and strategy.

Articulate risk objectives and a risk philosophy.

d. e.

Describe a desired risk profile and appropriate risk filters. Describe how ERM is able to contribute to shareholder value creation. •

Describe how the performance of a given firm or venture may be evaluated against its objectives including total returns

Explain how risk metrics can be incorporated into the risk monitoring function as part of an ERM framework.

Describe means for managing risks and measures for evaluating their effectiveness.

Describe and assess the elements of a successful risk management function and recommend a structure for an organization's risk management function.

SYLLABUS RESOUCES Crouhy, Galai, & Mark, Risk Management, 2001, • Ch. 3, Structuring and Managing the Risk Management Function in a Bank

10 of 11

Advanced Finance/ERM Exam Spring 2009 • •

Ch.13, Managing Operational Risk Ch. 14, Capital Allocation and Performance Measurement

Hardy, Investment Guarantees, 2003 • Ch. 6, Modeling the Guarantee Liability • Ch. 9, “Risk Measures” • Ch. 12, “Guaranteed Annuity Options”

• • • • •

FE-C117-07: Chapters 7 and 8 of Integrated Risk Management, Doherty FE-C124-07: Performance Measurement Using Transfer Pricing, by M. Wallace FE-C125-07: Total Return Approach to Performance Measurement FE-C133-07: Internal Control – Guidance for Directors on the Combined Code FE-C138-07: Managing the Invisible: Measuring Risk, Managing Capital, Maximizing Value, Panning

•

FE-C140-07: Risk Measurement, Risk Management and Capital Adequacy in Financial Conglomerates (excl Appendices)

• •

FE-C143-07: Dynamic Financial Models of Property-Casualty Insurers FE-C145-07: Dynamic Financial Condition Analysis Handbook, Ch. 1 (background only), 8 and Appendix A FE-C171-09: Insurance Criteria: Refining the Focus of Insurer Enterprise Risk Management Criteria, Standard & Poor’s, June 2006.

• •

“Application of Coherent Risk Measures to Capital Requirements in Insurance”, Artzner, -NAAJ, Vol 3, No 2 http://www.soa.org/library/journals/north-american-actuarialjournal/1999/april/naaj9904_1.pdf

•

Enterprise Risk Management Specialty Guide, SOA 2006 http://www.soa.org/library/professional-actuarial-specialty-guides/enterprise-riskmanagement/2005/august/spg0605erm.pdf

•

“Risk Management: The Total Return Approach and Beyond”, Ho, Risk Management Newsletter, November 2004, Issue #3 http://www.soa.org/library/newsletters/risk-managementnewsletter/2004/november/rmn0411.pdf

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Advanced Finance/ERM Exam Fall 2009

Important Exam Information:

Exam Date and Time

A read-through time will be given prior to the start of the examâ&#x20AC;&#x201C;15 minutes in the morning session and 15 minutes in the afternoon session.

Exam Registration

Candidates may register online or with an application.

Study Note Order Form

Study notes are part of the required syllabus and are not available electronically.

Introductory Study Note

The Introductory Study Note has a complete listing of all study notes as well as errata and other important information.

Case Study

This case study will also be provided with the examination. Candidates will not be allowed to bring their copy of the case study into the examination room.

Past Exams

Past Exams from 2000-present are available on SOA web site.

Updates

Candidates should be sure to check the Updates page on the exam home page periodically for additional corrections or notices.

1 of 11

Advanced Finance/ERM Exam Fall 2009 Syllabus for Advanced Finance/ERM: The candidate should be very familiar with the Learning Objectives as described in the Basic Education Catalog. These Learning Objectives are the first ingredient in developing the syllabus and also guide the examination committee when writing questions. The Learning Objectives set out the cognitive level needed to pass this exam. You will notice that the candidates are expected to “analyze,” “explain,” “calculate,” “describe,” “apply,” etc. While studying the syllabus material, candidates may want to refer back to the Learning Objectives to remain focused on the goals of the exam.

2 of 11

Advanced Finance/ERM Exam Fall 2009 SYLLABUS RESOURCES •

•

3 of 11

Advanced Finance/ERM Exam Fall 2009 2. Value, Accounting Measures, and Risk Quantification a.

b. c. d.

g. Define and explain model risk

4 of 11

Advanced Finance/ERM Exam Fall 2009 Hardy, Investment Guarantees, 2003, Ch. 9, “Risk Measures” Ch. 10, “Emerging Cost Analysis” Ch. 11, “Forecast Uncertainty” Tilman, Asset/Liability Management of Financial Institutions, 2003 Ch. 24, Accounting Standards and Requirements, by E. Habayeh & S. Sethi • • • • • • • •

FE-C142-07: “Theory and Practice of Model Risk Management” Ricardo Rebonato FE-C143-07: Dynamic Financial Models of Property-Casualty Insurers FE-C149-07: Use of Stochastic Techniques to Value Liabilities under Canadian GAAP FE-C162-09: EVA and Strategy FE-C163-09: Modern Valuation Techniques, Staple Inn Actuarial Society, February 2001. FE-C164-09: CSFB Credit Portfolio Modeling Handbook – Ch. 4 “Demystifying copulas” FE-C165-09: CSFB Credit Portfolio Modeling Handbook – Ch. 9 “Risk measures: how long is a risky piece of string?” FE-C166-09: Black Monday and Black Swans

•

“An Overview of Embedded Value,” H. Mueller, Financial Reporter, Sept. 2003. http://www.soa.org/library/newsletters/financial-reporter/2003/november/frn-2003-iss55mueller.pdf

•

Economic Capital for Life Insurance Companies, SOA Monograph, 2008 http://www.soa.org/files/pdf/research-ec-report.pdf

•

“Fair Value – Financial Economics Perspective,” by Babbel, Gold and Merrill NAAJ, http://www.soa.org/library/journals/north-american-actuarialjournal/2002/january/naaj0201_2.pdf

•

“Fair Valuation of Insurance Liabilities: Principles and Methods,” AAA Monograph, September 2002 http://www.actuary.org/pdf/finreport/fairval_sept02.pdf

•

FASB Summary of FAS 157 -- http://www.fasb.org/st/summary/stsum157.shtml

•

5 of 11

Advanced Finance/ERM Exam Fall 2009 3. Risk Management General a. Explain the rationale for managing risk and for the selection of the appropriate risk retention level. b. Identify and describe means for transferring risk to a third party, and identify the costs and benefits of doing so. c. Identify and describe means for reducing risk without transferring it (internal hedges) d. Describe how the performance of risk transference activities may be evaluated. e. Describe risk management techniques that can be used to deal with financial and nonfinancial risks. Asset Liability Management f. Describe how derivatives, synthetic securities, and financial contracting may be used to manage interest rate risk , including key rate risks. • Contrast modified duration and effective duration measures.

• •

Calculate effective duration and effective key-rate durations of a portfolio.

Strategic Risk Management p. Define strategic risk q. Describe methods for managing this risk, both pre-event and post-event

6 of 11

Advanced Finance/ERM Exam Fall 2009 r.

FE-C117-07: Integrated Risk Management, Doherty, Chapters 1, 7, and 8

7 of 11

Advanced Finance/ERM Exam Fall 2009 • • • • • • • •

• • • • •

FE-C102-07: General American Life Can’t Pay Investors, Looks at Suitors FE-C118-07: Securitization of Life Insurance Assets and Liabilities FE-C127-07: Asset Liability Management for Insurers FE-C128-07: Asset/ Liability Management, IASA Handbook FE-C129-07: Principles for the Management of Interest Rate Risk FE-C130-07: Hedging with Derivatives in Traditional Insurance Products FE-C135-07: Financial Oversight of Enron: The SEC and Private-Sector Watchdogs (pp. 97-127 only) FE-C141-07. Letter to SEC Regarding Fitch Ratings’ View on the Role and Function of Rating Agencies in the Operation of Securities FE-C145-07: Dynamic Financial Condition Analysis Handbook, Ch. 1 (background only), 8 and Appendix A FE-C147-07: Derivatives: Practice and Principles, pp. 13-24 and 43-52 FE-C155-09: Chapter 1 of, Investment Management for Insurers, Babbel & Fabozzi FE-C156-09: Key Rate Durations: Measures of Interest Rate Risks FE-C157-09: Long-Term Economic and Market Trends and Their Implications for Asset-Liability Management of Insurance Companies FE-C158-09: Variable Product Hedging Practical Considerations FE-C167-09: Hedging the Bet: Variable Annuity “Bells and Whistles” FE-C168-09: Chapter 1 of Credit Portfolio Management, C. Smithson, FE-C170-09: Why COSO Is Flawed, by A. Samed-Khan “Liquidity Risk Measurement,” CIA Educational Note http://www.actuaries.ca/members/publications/1996/9626e.pdf

8 of 11

Advanced Finance/ERM Exam Fall 2009 4. Enterprise Risk Management Framework a. b. c. d. e.

•

“Actuarial Aspects of SOX 404”, The Financial Reporter, Dec. 2004, http://www.soa.org/library/newsletters/financial-reporter/2004/december/frn0412.pdf

•

Enterprise Risk Management Specialty Guide, SOA 2006 http://www.soa.org/library/professional-actuarial-specialty-guides/enterprise-riskmanagement/2005/august/spg0605erm.pdf

•

“Responsibilities of the Actuary for Communicating Sarbanes-Oxley Controls” The Financial Reporter, Dec. 2004, http://www.soa.org/library/newsletters/financial-reporter/2004/december/frn0412.pdf

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Advanced Finance/ERM Exam Fall 2009

5. Enterprise Risk Management Process a.

iii. Regulators b.

Describe how risk and opportunity influence the selection of a firm’s vision and strategy.

Articulate risk objectives and a risk philosophy.

d. e.

Describe a desired risk profile and appropriate risk filters. Describe how ERM is able to contribute to shareholder value creation. •

Describe how the performance of a given firm or venture may be evaluated against its objectives including total returns

Explain how risk metrics can be incorporated into the risk monitoring function as part of an ERM framework.

Describe means for managing risks and measures for evaluating their effectiveness.

Describe and assess the elements of a successful risk management function and recommend a structure for an organization's risk management function.

SYLLABUS RESOUCES Crouhy, Galai, & Mark, Risk Management, 2001, • Ch. 3, Structuring and Managing the Risk Management Function in a Bank

10 of 11

Advanced Finance/ERM Exam Fall 2009 • •

Ch.13, Managing Operational Risk Ch. 14, Capital Allocation and Performance Measurement

Hardy, Investment Guarantees, 2003 • Ch. 6, Modeling the Guarantee Liability • Ch. 9, “Risk Measures” • Ch. 12, “Guaranteed Annuity Options”

• • • • •

•

FE-C140-07: Risk Measurement, Risk Management and Capital Adequacy in Financial Conglomerates (excl Appendices)

• •

•

Enterprise Risk Management Specialty Guide, SOA 2006 http://www.soa.org/library/professional-actuarial-specialty-guides/enterprise-riskmanagement/2005/august/spg0605erm.pdf

•

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Advanced Finance/ERM Exam Spring 2011

Important Exam Information:

Exam Date and Time

A read-through time will be given prior to the start of the examâ&#x20AC;&#x201C;15 minutes in the morning session and 15 minutes in the afternoon session.

Exam Registration

Candidates may register online or with an application.

Order Study Notes

Study notes are part of the required syllabus and are not available electronically but may be purchased through the online store

Introductory Study Note

The Introductory Study Note has a complete listing of all study notes as well as errata and other important information.

Case Study

This case study will also be provided with the examination.

Past Exams

Past Exams from 2000-present are available on SOA web site.

Updates

Candidates should be sure to check the Updates page on the exam home page periodically for additional corrections or notices.

Candidates will not be allowed to bring their copy of the case study into the examination room.

1 of 16

Advanced Finance/ERM Exam Spring 2011

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Advanced Finance/ERM Exam Spring 2011 RESOURCES Hardy, Investment Guarantees, 2003 Ch. 1, Investment Guarantees Ch. 6, Modeling the Guarantee Liability Tilman, Asset/Liability Management of Financial Institutions, 2003 Ch. 1, The Task of Asset/Liability Management, by L. Tilman Ch. 16, Understanding Options Embedded in Insurers’ Balance Sheets, by L. Rubin FE-C102-07: General American Life Can’t Pay Investors, Looks at Suitors FE-C104-07: Insurance OP Risk: The Big Unknown FE-C106-07: Mapping of Life Insurance Risks, AAA Report to NAIC FE-C137-07: Moody’s Looks at Risk Management and the New Life Insurance Risks FE-C154-09: Life Insurance Pricing and the Measurement of the Duration of Liabilities FE-C151-08: Ch. 13 (Sections 13.1 – 13.4), Annuity and Investment Products of Atkinson & Dallas, Life Insurance Products and Finance FE-C153-09: Variable Annuity – “No Loss” Propositions FE-C159-09: Countering the Biggest Risk of All, by Slywotzky and Drzik - Harvard Business Review, April 2005 FE-C160-09: Moody’s Looks at Terrorism Risk in the U. S. Life Insurance Industry, February 2006 FE-C169-09: Ch. 3, Pricing Assumptions of Atkinson & Dallas, Life Insurance Products and Finance Influenza Pandemics: Are We Ready for the Next One, by Max Rudolph, Risk Management section newsletter, July 2004 http://www.soa.org/library/newsletters/risk-managementnewsletter/2004/july/rm-2004-iss02-rudolph.pdf Fixed Annuities in a Low Interest Rate Environment, Product Development newsletter, April 2003 http://www.soa.org/library/newsletters/product-developmentnews/2003/april/pdn0304.pdf Managing Variable Policyholder Behavior Risk, Product Development newsletter, March 2005 http://www.soa.org/library/newsletters/product-developmentnews/2005/march/pdn0503.pdf Death Benefit Focused UL, Product Development section newsletter, April 2003 http://www.soa.org/library/newsletters/product-development-news/2003/april/pdn0304.pdf Whither the Variable Annuity, Product Development section newsletter, November 2003 http://www.soa.org/library/newsletters/product-developmentnews/2003/november/pdn0311.pdf Operational and Reputational Risks: Essential Components of ERM”, by M. Rochette, Risk Management, December 2006. http://www.soa.org/library/newsletters/risk-managementnewsletter/2006/december/RMN0612.pdf Enterprise Risk Management Specialty Guide, SOA 2006 http://www.soa.org/library/professional-actuarial-specialty-guides/enterprise-risk-

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Advanced Finance/ERM Exam Spring 2011

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b) c) d)

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h. i. j.

Calculate effective duration and effective key-rate durations of a portfolio.

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Advanced Finance/ERM Exam Spring 2011

Assess how risk and opportunity influence the selection of a firm’s vision and strategy and demonstrate how ERM can be appropriately embedded in an entity’s strategic planning.

Articulate risk objectives; demonstrate how to define and measure an organization’s risk appetite; and demonstrate how an organization uses risk appetite to make strategic decisions.

Determine a desired risk profile and appropriate risk filters, and analyze the risk and return trade-offs that result from changes in the organization’s risk profile.

Demonstrate how ERM is able to contribute to shareholder value creation and how the performance of a given firm or venture may be evaluated against its objectives including total returns.

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Advanced Finance/ERM Exam Spring 2011

Demonstrate how risk metrics can be incorporated into the risk monitoring function as part of an ERM framework.

Explain means for managing risks and demonstrate measures for evaluating their effectiveness.

Describe and assess the elements of a successful risk management function and recommend a structure for an organization's risk management function.

RESOURCES: Crouhy, Galai, & Mark, Risk Management, 2001, Ch. 3, Structuring and Managing the Risk Management Function in a Bank

Ch. 13, Managing Operational Risk Ch. 14, Capital Allocation and Performance Measurement

Enterprise Risk Management Specialty Guide, SOA 2006 http://www.soa.org/library/professional-actuarial-specialty-guides/enterprise-riskmanagement/2005/august/spg0605erm.pdf 15 of 16

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AFE Complete Illustrative Solutions Spring 2010 AFE Examination: Overall, the pool of candidates performed very well on this exam relative to past sittings. While it’s impossible to explain entirely the strong performance, we can speculate as to contributing factors. For instance, we think that perhaps the November 2009 exam’s relatively challenging candidate performance provided our pool of candidates a good indication of what is expected from this examination in terms of depth of knowledge and the ability to apply it. Hence, we believe that this pool of candidates was perhaps better prepared in this regard. Another contributing factor may be that some of the questions asked in our exam were fairly straight forward. Definitions and basic descriptions were asked in a number of questions, which have historically exhibited stronger performance in the past. Additionally, application of syllabus material was generally relegated to situations and circumstances that were extendable from the subject material. Finally, changes in the committee infrastructure regarding exam review resulted in a closer inspection to question interpretation and exam points allocated to each question. We believe that these enhancements resulted in better time management by the candidates.

Question 1 Learning Objectives: 4. The candidate will understand the means available for managing various risks and how an entity makes decisions about appropriate techniques. 5.

The candidate will understand the components of an ERM framework and be able to evaluate the appropriateness of a framework in a given situation

Learning Outcomes: (4s) Define strategic risk. (5c)

Demonstrate how an organization can create a risk management culture including: risk consciousness, accountabilities, discipline, collaboration, incentives and communication.

(5d)

Explain the elements of risk governance, and demonstrate how governance issues are resolved through organizational structure.

AFE Spring 2010 Solutions

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Continued Sources: Damoradan Ch. 11, Strategic Risk Management FE-C171-09: Insurance Criteria: Refining the Focus of Insurer Enterprise Risk Management Criteria, Standard & Poor's, June 2006. ERM Specialty Guide, SOA 2006 FE-C139-07: No Assurance of Good Governance: Observations on Corporate Governance in the U.S. Insurance Sector General Commentary on Question: The five point question covered enterprise risk management at the corporate level and challenged the candidate to indentify certain risk management issues within the case study. The Cognitive Skills tested were Retrieval for part (a) by asking for definitions and descriptions of strategic risk and the strategic risk process, respectively. Part (b) tested a mix of Comprehension and Knowledge Utilization skills in analyzing Zoolander’s strategic risk issues. The candidate is required to list key elements related to ERM in part A of the question, and then relate case study specifics to ERM principles in part B of the question. Candidates typically struggled with the definition of strategic risk; however, most candidates could provide a partial or full listing of the key steps of the strategic risk management process. Most candidates were also able to indentify at least some of the short comings and recommendations, but credit was only given for the first three in each category. Some candidates failed to achieve full credit by supplying shortcomings without corresponding recommendations. Solution: (a)

(i)

Define strategic risk. Strategic Risk - risks from damage to reputation, competition, demographic trends, technological innovation, capital availability, or regulatory trends.

AFE Spring 2010 Solutions

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Continued (ii)

Describe the strategic risk management process. Strategic Risk Process • Economic Capital

(b)

•

Risk adjusted product pricing

•

Capital Budgeting

•

Risk adjusted performance measurement (RAPM)

For each of the following, provide three shortcomings specific to Zoolander and recommend an action to address each shortcoming: (i)

Corporate Governance Shortcoming •

The board is made up of mostly employees / insiders.

•

The board is too small.

•

The company ERM leader report reports ineffectively.

Recommendation • Add independent members to the board.

(ii)

•

Raise the board size from 5 to 9-12.

•

Have ERM leader report through CFO or to board.

Reward / Punishment mechanisms Shortcoming • CEO sets his own salary. •

Stock awards vest immediately.

•

No apparent punishment mechanisms in place.

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Continued Recommendation • Remove CEO from compensation board or add independent members to comp board.

(iii)

•

Delay vesting of stock awards.

•

Put specific punishment mechanisms in place.

Risk Management Culture Shortcoming • CEO wants to disband ERM committee. •

No active role by senior management in enforcing policies / procedures.

•

Difference in opinions not tolerated, encouraged or reconciled.

Recommendation • Keep ERM committee in place. •

Senior management must be involved in reinforcement of risk management culture.

•

Board and senior management must be more open minded and set the proper tone from the top.

AFE Spring 2010 Solutions

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Question 2 Learning Objectives: 2 The candidate will understand measures of corporate value and be able to analyze the data in corporate financial statements. Learning Outcomes: (2c) Describe the concept of economic measures of value (e.g. EVA; embedded value) and demonstrate their uses in the risk management and corporate decision-making processes. Sources: An Overview of Embedded Value, H. Mueller, Sept 2003, p. 23-26 FE-C162-09 - EVA & Strategy, Stern Stewart & Co., April 2000, p. 4 General Commentary on Question: • Nine point integrated Case Study question tested Embedded Value (EV) principles and the use of EV results •

This question tested candidates on multiple Cognitive Skill levels mostly varying by subpart. Parts (a) and (b) required Retrieval skills from the student in asking for definitions and descriptions of EV and its components. The rest of the question mixed Comprehension and Analysis cognitive skills by requiring candidates to identify EV components, apply/calculate EV for a Term Life block using information in the Case Study, interpret the results in terms of an acquisition offer on the block, and then determine how changes in EV inputs would change the answer.

•

Candidates did well on parts (a), (d), and (c)(ii). Very few got part (c)(i) completely correct as the Cost of Capital calculation tripped up most people, but most got partial points. Part (e) was the weakest area of performance as few candidates could interpret how changes in EV inputs would impact the final EV result.

•

General comment: It was surprising how inconsistent candidates would be across the different parts of the question. Some would be able to calculate Cost of Capital which was one of the more difficult parts of the question, but not be able to understand how it would change if inputs changed in part (d). Others would not be able to identify parts of EV but be able to calculate it.

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Continued Solution: Commentary on Question: This is a straightforward question. Most candidates did well but didn’t include the adjustments to ANW or that VIF is reduced for the cost of holding capital. (a)

Define and describe the two major elements of EV. EV = ANW + VIF ANW: Adjusted Net Worth • Equals statutory capital & surplus, adjusted for certain items VIF: Value of Inforce • Equals PV of future after-tax profits on existing business, less cost of holding capital

Commentary on Question: This is a straightforward question. Most candidates did fairly well, but many confused risk neutral valuation with adjusting for risks through the discount rate. (b)

Describe the Risk Discount Rate (RDR) used in the EV calculation. Identify two methods which may be used to determine the RDR. RDR is the risk-adjusted discount rate used in EV to calculate VIF • should reflect riskiness of business producing the profits Method 1: Risk Free Rate + Risk Premium Method 2: Weighted Average Cost of Capital (WACC)

Commentary on Question: Most candidates got partial points on part (i) but very few got the Cost of Capital calculation correct. Most candidates got part (ii) correct regardless of their answer to part (i), although a few were confused and argued to accept any offer if EV > 0. (c)

Assuming no IMR or AVR is attributed to the term life block and that the shareholder equity for each line of business equals the statutory required surplus (all free surplus is allocated to “Corporate”): (i.)

Calculate the EV of Zoolander’s term life block using the projections provided by Sam Otter and Zoolander’s balance sheet. Show your work. EV = ANW + VIF ANW = Regulatory Capital & Surplus = 15

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Continued VIF = PV After-Tax Profits less Cost of Capital PV After-Tax Profits = 60.3 CoC = PV Capital Release + PV AT Income on Capital – Required Capital = 11 + 2.6 – 15 = 1.4 VIF = 60.3 – 1.4 = 58.9 EV = 15 + 58.9 = 73.9M (ii.)

Based solely on the results in (i), recommend whether to accept or reject Purchaser Life’s offer. Since EV = 73.9M > 65M offer from Purchaser Life, reject offer

Commentary on Question: Many candidates did very well on this part. Particularly, it seemed the candidates who did poorly on other parts of the question did very well here, as they could make a long list of things that would cause EV differences and sometimes seem to revert to a list of why two models would produce different results. Difference in assumptions and discount rates were the most popular answers. (d)

Explain why Purchaser Life may calculate a different EV amount than Zoolander. •

Different Risk Discount Rate (RDR) due to different view on riskiness of business, or may require a different rate of return on the business

•

Different assumptions used to project future profits in VIF o mortality, expenses, lapses

•

Purchaser Life may hold different level of capital than Zoolander

•

Purchaser Life may gain diversification benefits from the block when combined with its existing business (synergies)

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Continued Commentary on Question: Many candidates struggled with this section offering explanations that were irrelevant, contradictory or just wrong. In part (i) several candidates confused cost of capital in terms of the discount rate with cost of capital that is a drag on EV. In part (ii) several candidates assumed an increase in the assumed pre-tax asset yield would change the Risk Discount Rate as well, or that it would change the Adjusted Net Worth (ANW). (e)

Zoolander recently completed a review of the assumptions for the term life block of business. Determine the direction and relative magnitude of the impact that each of the following assumption changes will have on the EV of the term life block. Explain your answers. (i)

Capital requirements on the block should be 20% lower than currently assumed. Impact: Increase EV Magnitude: Small Reason: The decrease in capital can be distributed immediately, so the decrease in ANW is exactly offset by the increase in PV Capital Released. Since less capital is held going forward, lower cost of holding capital in the future so higher VIF, which increases EV. Since change in capital is only 3M, it is relatively small compared to total EV.

(ii)

Pre-tax asset yield should be 0.25% higher than currently assumed. Impact: Increase EV Magnitude: Small Reason: Higher pre-tax asset yield increases projected investment income in the future, which increases VIF. Impact will be small since value of block is insensitive to the asset yields projected, as stated in the Case Study.

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Question 3 Learning Objectives: 4. The candidate will understand the means available for managing various risks and how an entity makes decisions about appropriate techniques. Learning Outcomes: (4i) Demonstrate how derivatives may be used to manage equity risk. (4j)

Analyze the practicalities of market risk hedging, including dynamic hedging.

Sources: Hardy Ch. 8 FE-C167-09: Hedging the Bet: Variable Annuity "Bells and Whistles", Moody's October 2005 FE-C158-09: Variable Product Hedging Practical Considerations General Commentary on Question: This 10 point focused Case Study question primarily tested the candidates knowledge regarding variable annuities with guarantees and the hedging thereof. This question tests multiple Cognitive Skill levels mostly varying by subpart. Part (b) of the question was worth two points and required mostly Knowledge Utilization cognitive skills in requiring the student to recommend and describe appropriate risk mitigation techniques. Part (d) of the question was worth two points and utilized a mix of Retrieval and Comprehension cognitive skills in asking the candidate to compare Case Study statements and source information. The rest of the question required a mix of Comprehension and Analysis cognitive skills in asking the student to understand the VA product and guarantees and calculate the option value of the product guarantee. Most candidates were able to successfully answer at least part of this question with most candidates earning points on several parts. For part (a), the key distinction was to note that tail risk resides in such a benefit design. For part (b), most candidates were able to state a recommendation, however not all advantages and disadvantages given were consistent with the recommendation. Most candidates attempted the calculation section of this question in part (c) and earned at least some partial credit. The calculations were straightforward and the formulas were given in part (i).

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Continued A majority of candidates did not fully attempt to answer part (d). Most candidates struggled with recalling the study note source material that covered the best practices of modeling GMXB products. Solution: (a)

Evaluate Lyon’s claim. Past returns are not a guarantee of future performance. While the liability may only be in the money a small percentage of the time, it can be very costly to the company when it is. Even if deaths and negative market returns are not correlated, benefit payments will occur when market has a downturn and the payments can be large if the downtown is sharp.

Commentary on Question: Other recommendations such as reinsurance, actuarial approach/self insurance and securitization were accepted with corresponding advantages and disadvantages. (b)

Recommend a risk mitigation approach, 2 advantages and 2 disadvantages. One recommendation is dynamic hedging to reduce the financial risk to Zoolander from the VA Plus line of business. Advantages: Transfers market risk to derivative counterparties. More stable earnings stream than unhedged company. Disadvantages: Derivatives can be expensive to purchase and market volatility may lead to excessive rebalancing costs. Zoolander does not currently have sufficient expertise or systems to implement a program.

Calculate BSP(10) for ZooEquity500 fund. From case study concerning ZooEquity500 sigma = 25% m = 1.25% G = (1.02)^10 = 1.219 r = 6%

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Continued Calculate d1 d1 = [1n((1 − 0.0125)10 /(1.02)10 ) + (0.06 + 0.252 / 2)(10)] /[0.25* 10]

d1 = (−0.32382 + 0.9125) / 0.79057 d1 = 0.74464 N (− d1) = 0.228 [N represents the standar normal cumulative distribution] Calculate d2 d 2 = 0.74464 − 0.25* 10

d 2 = 0.74464 − 0.79057 d 2 = −0.046 N (− de) = 0.518 Calculate BSP(10) BSP(10) = (1.02)10 *exp(−0.6*10) * N (− d 2) − (1 − 0.0125)10 * N (− d1)

BSP(10) = 0.34675 − 0.20127 BSP(10) = 0.145 Commentary on Question: Some candidates tried to calculate a combined GMAB and GMDB joint benefit in part (c)(ii) instead of just the GMAB benefit, making the formulas much more complicated.

(ii)

Calculate the hedge cost for the GMAB survival benefit.

GMAB survival hedge cost =BSP (10) *10 px + BSP (20) *20 px + BSP (30) *30 px GMAB survival hedge cost =0.033*0.35 + 0.018*0.25 + 0.007 *0.05 GMAB survival hedge cost =0.0164 (d)

Evaluate these recommendations: (i)

Group policies with similar characteristics together Policies with similar characteristics should not be grouped for dynamic hedging. Many input variables have non-linear impacts on valuations. While it may limit the amount of data and run time needed, it won’t be as accurate.

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Continued

(ii)

Vary random scenarios by policy to ensure faster convergence This is a good recommendation as varying random scenarios by policy can increase convergence. It has the effect of increasing your sample size.

(iii)

Use static policyholder behavior assumptions to increase accuracy and speed It is not a good idea to use static policyholder behavior assumptions, dynamic assumptions should be used. Customer behavior will impact the value of the guarantees we are trying to model. As the option becomes more valuable to the client, we should assume persistency will increase. Speed may increase, but loss of accuracy of option value will occur.

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Question 4 Learning Objectives: 1. The candidate will understand the types of risks faced by an entity and be able to identify and analyze those risks.

The candidate will understand the means available for managing various risks and how an entity makes decisions about appropriate techniques.

The candidate will understand the structure of ERM process in an entity and be able to demonstrate best practices in enterprise management.

Learning Outcomes: (1c) Identify and analyze operational risks faced by an entity.

(4v)

Define operational risk.

(4w)

Explain methods for managing this risk, both pre-event and post-event.

(6g)

Explain means for managing risks and demonstrate measures for evaluating their effectiveness.

Sources: Managing Operational Risk, Risk Management Ch. 13, Crouhy

ERM Specialty Guide, SOA 2006 FE 137-07 Moody’s Looks at Risk Management FE 145-07 Dynamic Financial Conditional Analysis FE-C104-07 Insurance Op Risk: The Big Unknown, Shay & Longley-Cook Operational and Reputational Risks: Essential Components of ERM”, by M. Rochette, Risk Management, December 2006. General Commentary on Question: This six point integrated Case Study question was designed to test the candidate’s comprehension of how operational decisions change the risk profile of a company.

This question tested on various Cognitive Skill levels varying mostly by subpart. Parts (a) and (b) were worth three points in aggregate and used mostly Retrieval type cognitive skills as these were mostly list-type questions asking for definitions and listing a risk assessment framework. The rest of the question required a mix of Comprehension and Analysis cognitive skills in requiring the candidate to understand various risks to Zoolander and their resultant impact. AFE Spring 2010 Solutions

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Continued

Simple definitions were required for Part (a) so candidates generally did well. Part (b) was a list-type question but candidates were too general in their responses. Most candidates received some points but few answered the question fully. Both Part (c) and (d) were weighted higher because analysis was required. In Part (c)(i), some candidates responded with what the outcome would be if a rating downgrade occurred instead of explaining why the likelihood increased. Most students did well however as any reasonable answer that was supported by the case study was accepted. In section (ii), students provided fewer examples than section (i) and they were often too general in their responses. Partial credit was given where appropriate. In Part (d), most students only provided 2-3 potential impacts where more where needed to fully answer the question. Solution:

(a)

Define operational risk, operational strategic risk and operational failure risk. •

Operational risk – risk of direct or indirect loss from failed internal processes, people or systems or from external events

•

Operational strategic risk – arises from an inappropriate strategy from external environmental factors such as political, taxation, regulation or competition

•

Operational failure risk – arises from failure in normal course of operating a business such as people, process and technology which should be accounted

[Note – Candidates received credit for relevant additional details provided for each risk] (b)

List and explain the steps of the general risk framework that Zoolander should use to create a complete risk assessment report. •

Categorize losses due to operational failures in people, process and technology and external dependencies

•

Examine connectivity and interdependencies across risk categories

•

Sources that drives risk categories falls under change, complexity and complacency

•

Assess the net likelihood of operational failure within one year for each risk

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Continued

•

Assess the severity for each exposure

•

Combine likelihood and severity into overall risk assessment

•

Define cause and effect of losses

•

Develop a risk summary report

[Note – Candidates received partial credit for referencing other measurements or risk calculation techniques.] (c)

Explain why the likelihood for each of the following risks is higher now than in the past. (i)

Risk of rating agency downgrade •

Received informal warnings from regulators and rating agencies

•

Currently A- with negative implication which is rare for two consecutive years

•

Only one reinsurer for term and reinsurer is deteriorating financially

•

Quick liquidity and current liquidity ratios trended down over the past four years

•

Risk management culture weak due to limited focus on internal controls and processes

[Note – Candidates received partial credit for other issues identified that are supported by case study material.] (ii)

Modeling risk relating to the hedge fund initiative •

Hedge fund initiative peer review includes a straightforward interest rate swap for potentially complex strategies

•

“Rules of thumb” used to estimate credit-risk exposure instead of modeling risk

•

Model builder reviewed and tested his own model

•

Validation of model limited to a particular type of derivative

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Continued

• (d)

Model is from wound-down company

Describe the potential impact to Zoolander of a rating agency downgrade. •

“Run on the bank” may occur due to GIC rating provision

•

Potential reduction in future new business or increased lapses of current business

•

Reduction in brand value and increased reputational risk

•

Capital and other financing costs may increase

•

Reduction in stock price

[Note – Candidates received partial credit for other issues identified that are supported by case study material.]

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Question 5 Learning Objectives: 2. The candidate will understand measures of corporate value and be able to analyze the data in corporate financial statements

The candidate will understand the means available for managing various risks and how an entity makes decisions about appropriate techniques.

Learning Outcomes: (2c) Describe the concept of economic measures of value (e.g. EVA; embedded value) and demonstrate their uses in the risk management and corporate decision-making processes.

(4b)

Demonstrate means for transferring risk to a third party and analyze the costs and benefits of doing so.

(4d)

Evaluate the performance of risk transference activities.

(4e)

Describe and evaluate risk management techniques that can be used to deal with financial and non-financial risks.

Sources: FE-C117-07: Doherty, Integrated Risk Management, Ch. 7, Why Is Risk Costly to a Firm?

Tiller, Life, Health and Annuity Reinsurance, 3rd Edition, 2005, Tiller Ch. 5, "Advanced Methods of Reinsurance" “Fair Value – Financial Economics Perspective,” by Babbel, Gold and Merrill NAAJ “Fair Valuation of Insurance Liabilities: Principles and Methods,” AAA Monograph, September 2002 General Commentary on Question: This 14 point integrated question tested candidates’ ability to understand and calculate a fair value of a liability and their ability to develop a basic balance sheet and income statement. It also tested the candidates’ understanding of how considerations such as the limited downside risk of equity holders, non-linearity of taxes, deadweight loss in the event of financial distress, and declining marginal utility can influence the incentives of different parties to accept and manage risk.

AFE Spring 2010 Solutions

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Continued

This question tested different cognitive skills based mainly on the question subparts. There were roughly two points worth of mixed Retrieval and Comprehension type questions part (b). There was about a point worth of Knowledge Utilization type questions part (e), whereby the candidate is asked to make a recommendation based on results in other parts of the question. The rest of the question is spread between Comprehension and Analysis (more of the latter), whereby the candidate is requested to construct financial statements and perform other financial statement-based calculations and analyses. The primary challenge of this question for the candidate is to apply what should be familiar concepts to an unfamiliar situation. Candidates who attempted each portion of the question were usually able to begin setting up the problem to at least earn partial credit. However, many candidates incorporated errors into the formulas used, and few were able to complete the calculations accurately. In particular, most candidates failed to consider some of the revenue and expense items that are required to complete part (d), and many candidates completed part (a) using a traditional discounted cash flow method rather than the risk-neutral approach that was requested. Finally, some students showed confusion between a balance sheet and an income statement in parts (c) and (d). Solution:

Commentary on Question: Most students understood the concept of calculating a net present value of risky cash flows, but only a minority attempted to calculate the fair value using the martingale approach requested. Applying the traditional risk-adjusted discount rate was more common. Those that did attempt the martingale approach often showed adequate knowledge with the appropriate formulas.

(a)

Calculate the fair value of the insurance liability Safari has sold to its customers as of January 1, 2010 using the risk-neutral (martingale) approach. Show your work. Normal Lions: 75% probability > 0.1% mortality $100,000 claims Hungry Lions: 25% probability > 0.5% mortality $500,000 claims

AFE Spring 2010 Solutions

1,000 * 100,000 * 0.1% = 1,000 * 100,000 * 0.5% =

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Continued

With risk-neutral approach Su = normal claims S d = hungry claims

π = risk - neutral probability = p − λ * p (1 − p ) = .75 − .02 .75(.25) = 74.13% p = real - world probability λ = market price of risk FV =

Suπ + S d (1 − π ) 100, 000*.7413 + 500, 000*.2587 = = $195, 638.56 1 + rf 1.04

Commentary on Question: Students performed fairly well on this question. Many were able to identify the appropriate methods and associated formulae. Many candidates lost points by failing to present the formulas. Other common missteps included describing market values and simulations as ways of calculating fair value in this context.

(b)

Describe two alternate methods which can be used to calculate the fair value of the insurance liability. Explain how the results might differ from the current risk neutral method when using either of these alternate methods. Alternate methods of calculating fair value: 1) Discount cash flows using real-world probabilities and a risk-adjusted discount rate FV =

Su p + S d (1 − p ) 1 + rf + λσ

σ = standard deviation of claims distribution 2) Adjust cash flows by a certainty equivalent and discount using real-world probabilities and a risk free rate

FV =

Su p + S d (1 − p) − Z 1 + rf

All methods will yield the same result, which can be used to determine the value of the certainty equivalent, Z. AFE Spring 2010 Solutions

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Continued Commentary on Question: Common mistakes on this question included calculating an income statement rather than a balance sheet, and failing to include the future operating costs as a liability. Still, most candidates received substantial credit for this question.

(c)

Assume that both the life insurance liability and a reserve for the tour operating costs are calculated with the risk neutral (martingale) approach to fair value. Construct the balance sheet for Safari as of January 1, 2010 ignoring taxes, showing assets, liabilities and surplus: (i) without reinsurance, (ii) with reinsurance. Show your work. (i)

Balance Sheet as of 12/31/2010 without reinsurance Assets $150,000 $1,000,000 $1,150,000 Liabilities $195,639 $697,116 $892,754

Starting Assets Revenue from tours

FV of insurance liability (from a) Reserve for operating costs

Surplus = Assets – Liabilities = $257,246 (ii)

Balance Sheet as of 12/31/2010 with reinsurance Assets $150,000 $1,000,000 ($200,000) $950,000 Liabilities $19,564 $697,116 $716,679

Starting Assets Revenue from tours Paid to reinsurer

FV of insurance liability after 90% ceded Reserve for operating costs

Surplus = Assets – Liabilities = $233,321

AFE Spring 2010 Solutions

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Continued Commentary on Question: Most students accurately began to calculate an income statement under each scenario. However, many forgot to include the expenses or revenues such as investment income, taxes, or the reinsurance payments. In addition, many students did not realize that the loss to shareholders was limited to their starting equity value. Some students also did not understand that the loss to tourists is the amount of their death claims that would go unpaid. The number of calculations necessary to complete this question also likely contributed to its difficulty.

(d)

Tourist loss is defined to be uncollected death benefits. Fill in the values for the table below by computing the gain or loss for the shareholders and the tourists. Show your work. Sum cash flows under each scenario

Tour revenue Payment to reinsurer Claims Investment income Operating Costs EBIT (subtotal) Taxes = max(0, 25%*(EBIT-25,000)) Net income Shareholder G/L= max(starting assets, NI) Bankruptcy Costs Claim pay shortfall= Shareholder G/L-NI+ bankruptcy costs

Without Reinsurance Normal Lions Hungry Lions 1,000,000 1,000,000 0 0

With Reinsurance Normal Lions Hungry Lions 1,000,000 1,000,000 200,000 200,000

100,000*1,000*0.1%= 100,000

100,000*1,000*0.5% =500,000

100,000*1,000*0.1% *10%=10,000

100,000*1,000*0.1% *10%=50,000

1,150,000*5% =57,500 725,000 232,500

1,150,000*5% =57,500 725,000 (167,500)

950,000*5% =47,500 725,000 112,500

950,000*5% =47,500 725,000 72,500

51,875

21,875

11,875

180,625

(167,500)

90,625

60,625

180,625

(150,000)

90,625

60,625

10,000

27,500

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Continued Commentary on Question: Most candidates understood that an expected value calculation across the scenarios calculated in part (d) was the correct approach to this question. However, very few fully described the implications of the tourists and shareholders conflict of interest.

(e)

Based upon your calculations above, determine if conflict exists between the shareholders and the tourists regarding whether Safari should enter into the reinsurance agreement. Compare expected G/L for shareholders and tourists calculated in (d) both with and without reinsurance. Shareholders expected gain without reinsurance: .75*180, 625 + 0.25* (−150, 000) = $97,969

Shareholders expected gain with reinsurance: 0.75*90, 625 + 0.25* 60, 625 = $83,125

Shareholders will opt not to reinsure. Tourist expected loss with reinsurance: 0.75* 0 + 0.25* 27,500 = $6,875

Tourist expected loss with reinsurance:

0.75*0 + 0.25*0 = $0 Tourists can only experiences losses without the reinsurance so they will prefer if Safari reinsures. However, since it is in the incentives of the Safari shareholders not to reinsure the tourists will assume the reinsurance is foregone, and they will not be willing to pay as much for the tour.

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Continued Commentary on Question: Most candidates approached this problem correctly by calculating the expected CEO utility. The only common mistake was students calculating the utility of the expected wealth rather than the expected utility. The former will not capture the implications of decreasing marginal utility on risk incentives.

(f)

The CEO of Safari owns 40% of the outstanding company shares and has no other assets. She seeks to maximize her expected utility and has the following utility function: U(wealth) = wealth^1/2. Determine whether the CEO favors the reinsurance agreement. Show your work. CEO wealth = 40% of ending equity = 40% *(150, 000 +

G to shareholders) L

CEO utility = CEO Wealth

Compare CEO utility across each scenario

CEO Wealth CEO Utility Expected Utility

Without Reinsurance Normal Lions Hungry Lions $330,625 $0 364 0 .75*364 + .25*0 = 273

With Reinsurance Normal Lions Hungry Lions $240,625 $210,625 310 290 .75*310 + .25*290 = 305

Due to risk aversion, CEO will prefer to reinsure.

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Question 6 Learning Objectives: 3. The candidate will understand how the financial risks faced by an entity can be quantified and the use of metrics to measure risk. Learning Outcomes: (3a) Demonstrate the use of risk metrics to quantify major types of risk exposure in the context of an integrated risk management process.

•

Demonstrate how each of the financial risks faced by an entity can be amenable to quantitative analysis including an explanation of the advantages and disadvantages of various techniques such as Value at Risk (VaR), stochastic analysis, scenario analysis and stress testing.

•

Describe and evaluate risk aggregation techniques, incorporating the use of correlation, integrated risk distributions and copulas.

•

Describe how and why risks are correlated and give examples of risks that are positively correlated and risks that are negatively correlated.

•

Assess the overall corporate risk exposure arising from financial and nonfinancial risks.

Sources: FE‐C143‐07: Dynamic Financial Models of Property‐Casualty Insurers General Commentary on Question: This eight point focus question tested Dynamic Financial Analysis (DFA) and Dynamic Financial Models (DFM). The Cognitive Skills tested varied by subpart, but this question used more Retrieval type skills compared to other questions. Roughly one half of this question fell into the Retrieval type question, where the candidate was asked to describe various attributes of DFA and DFM. The rest of the question fell into the Analysis cognitive skill category, where the candidate was asked to apply the DFA/DFM theory to private mortgage insurance (PMI) specifically.

This proved to be a very challenging question for most of the candidates, illustrated by several candidates skipping this question entirely. Numerous candidates were able to do well on a single section, but very few did well on all sections.

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Continued

There were two sources from which candidates pulled their answers. Part (b) asked for the “primary considerations” of DFM model design, identified in study note FE-C143-07. Several candidates wrote about the “Other Considerations” or listed the five components of the DFA report from the study note FE-C127-07, “Asset Liability Management for Insurers.” Candidates who correctly identified the primary factors for model design received full credit; those who submitted either non-primary considerations or components of the report, received partial credit. There were a couple of question parts where the candidate was asked to apply theory by recommending a course of action or describing how a situation should be viewed in light of the theory. There were many candidates who were able to retrieve the theory part (i), but weren’t able to apply it effectively as requested part (ii). These candidates did not receive full credit unless he/she made a specific recommendation for or against a particular course of action, which shows a higher level of cognitive understanding and is an integral part of the question. Solution: Commentary on Question: There were two possible definitions to use for dynamic financial analysis; nearly all candidates used the definition from the study note FE-C127-07. Candidates did very well on the definition but struggled with the key points in part (ii).

(a)

For insurance applications: (i)

Describe Dynamic Financial Analysis DFA is the process of assessing the entire financial condition of the company over time, taking into account interrelationships between the risk factors & the dynamic nature of risks.

(ii)

Describe how using a DFM may help you accomplish your objective. •

Illustrates link between strategies and results.

•

Reflects the interplay of assets and liabilities and the resultant risks to income and cash flows.

•

Models help identify problems early.

•

Models distinguish between short and long term problems.

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Continued Commentary on Question: Part (b) was by far where candidates performed the best. As described above, candidates mixed the considerations between two sources. Candidates who listed the four primary considerations of model design received full credit; alternate answers regarding nonprimary considerations and/or components of the report received only partial credit. Candidates who based their answers on FE-C127-07 typically performed worse on part (ii) as well.

(b)

Regarding DFM design: (i)

Describe the 4 primary DFM model design considerations; Stochastic vs. Deterministic • Important to model variable interaction • If certain variables exhibit random behavior, incorporate the stochastic features in the model Time Horizon • The length of modeling period critical for existing business runoff and new business • The time intervals are important Feedback Loops / Adapting to Change • Reflects automatic decisions already built into the model Relationship with external environment • Constraints are rating agencies and regulations

(ii)

For each, recommend & justify approach to modeling PMI Stochastic vs. Deterministic • Defaults are a function of unemployment • Location parameters are integral to the default assumption • Recommend using stochastic scenarios because the future is uncertain Time Horizon • 95% of PMI policies closed in 10 years so I would recommend 10 years for existing business • May consider additional 5 years for new business Feedback Loops / Adapting to Change • May need to change the premium rates in the future if Harbourside has poor experience

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Continued

Relationship with external environment • Constraint - Harbourside invested in Treasuries and high grade corporate bonds Commentary on Question: Overall, candidates performed worst on part (c). Most candidates did fairly well acknowledging that the model or assumptions may be wrong, but they weren’t able to talk about scenarios, defaults, unemployment or model change. The stem of the question was intended to provide sufficient information for candidates to recognize what was being asked of them here. Generally, candidates who performed poorly on parts (a) and (b) also performed poorly on part (c).

Describe three potential modeling dangers/pitfalls for Dynamic Financial Analysis. 1. The range of scenarios may not reflect the user's intent of the model. • Scenarios link model parameters to the assumptions. • May need to stress test additional scenarios. • Scenarios determined by management or regulators. 2. The model may be incomplete or incorrectly specified for its intended purpose. • Validate the model to actual historical results. • Reconcile the differences between the model and actuals. • A good model will reproduce the historical actuals. 3. The model may become obsolete if it’s not adaptable to change. • New insurance products or new regulatory / tax laws are examples of change.

(ii)

For each of these, describe the implication for modeling Harbourside’s PMI business. 1. Harbourside’s model purpose is for internal reasons. • Need to understand the potential PMI earnings in the future due to uncertainty. • Recent mortgage meltdown after 2007 was not captured by scenarios.

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Continued

2. Unemployment must be tied to the economic scenarios. • Were default rates predicted well based on mortgages, unemployment, and location? • Are mortgage refinancing and prepayments reasonable with historical experience? • The model may need to be adjusted as experience emerges. 3. Harbourside’s model purpose is for internal reasons. • Need to understand the potential PMI earnings in the future.

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Question 7 Learning Objectives: 5. The candidate will understand the components of an ERM framework and be able to evaluate the appropriateness of a framework in a given situation. Learning Outcomes: (5e) Compare and contrast various regulatory/industry frameworks: Basle II, Sarbanes-Oxley Act, OSFI Supervisory Framework, OSFI Standard of Sound Financial and Business Practices, UK FSA guidelines and COSO. Sources: Crouhy Ch. 2, The New Regulatory and Corporate Environment

FE-C129-07: Principles for the Management of Interest Rate Risk FE-C134-07: Supervisory Framework - 1999 and Beyond (OSFI - Canadian) FE-C172-09: Enterprise Risk Management - Integrated Framework: Executive Summary, COSO, September 2004. General Commentary on Question: This eight point focus question required candidates to know key principles/aspects of the Basle (II), OSFI, COSO and G-30 risk management frameworks, and then apply them to four scenarios of risk management practices. When assessing the scenarios, candidates should have noted the deficiency in each one and apply and briefly discuss the applicable principles. Thus, the Cognitive Skills tested were mixed between Comprehension and Analysis.

Performance on this question was poor, perhaps because of poor time management or fatigue, as this was the last question in the morning session. Many candidates did not match the principles to the frameworks as the question asked. Additional credit was given if the candidate recommended corrections to the deficiencies. Solution:

(i)

Scenario 1: The Board meets once every 12 months. The deficiency is the infrequency of Board meetings; the Board should meet more frequently. (a)

COSO - Principle 7 : information and communication • Relevant information is identified, captured and communicated in a form and timeframe that enable people to carry out their responsibilities

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Continued

(ii)

(b)

Basle (II) - Principle 1 : Board of Directors' responsibilities • Should be informed regularly of the risk exposure • Understand and assess the performance of senior management regularly • Periodically re-evaluate IRRM strategies and policies

(c)

OSFI – • Review and approve policies and procedures for the institution’s major activities • Review and approve strategic and business plans

Scenario 2: Summary reports (including supporting detail) are compiled quarterly and presented to the CIO. The deficiency is that the reports are only reviewed by the CIO; the reports should be reviewed by all senior management, especially the Chief Risk Officer (CRO).

(iii)

(a)

Basle (II) - Principle 2 : Senior management's responsibilities • Aggregate information as well as sufficient supporting detail should be reviewed regularly by senior management • Manage the structure of the business and the level of risk • Ensure that resources/expertise are available for evaluating and controlling risk

(b)

OSFI - Report the results of risk monitoring to management

(c)

COSO - Principle 7 : information and communication • Relevant information is identified, captured, and communicated in a form and timeframe that enable people to carry out their responsibilities • Risks are analyzed, considering likelihood and impact, as a basis for determining how they should be managed

Scenario 3: The Board defines appropriate limits on risk taking for a large multiline insurance company. The deficiency here is that the Board should not be defining the risk limits for the company; senior management should define the limits, and the Board should approve the limits. (a)

Basle (II) - Principle 1 : Board of Directors' responsibilities • Approve risk management strategies and policies • Ensure that senior management monitors and controls these risks

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Continued

(iv)

(b)

Basle (II) - Principle 2 : Senior management's responsibilities • Establish appropriate policies and procedures to control and limit these risks • Manage the structure of the business and the level of risk

(c)

OSFI – • Review and approve organizational and procedural controls • Review and approve policies and procedures for the institution’s major activities

(d)

G-30 – Principle 1: The role of senior management • Ensure risk controlled consistent with the risk management and capital policies

Scenario 4: A bank measures its credit risk on the largest 90% of its derivative holdings, and ignores netting arrangements. There are two deficiencies in this scenario: the bank should use all derivative holdings when measuring its credit risk and should recognize netting arrangements. (a)

G-30 - 10. Measuring credit exposure • For each derivative transaction based on both current and potential credit exposure

(b)

G-30 - 11. Aggregating credit exposures • All credit exposures to a counterparty, should be aggregated, taking into consideration enforceable netting arrangements

(c)

COSO – Principle 4 : risk assessment • Risks analyzed, considering likelihood and impact, as a basis for determining how they should be managed

(d)

OSFI – Principle 2 • Exercise of sound judgment in identifying and evaluating risks is central to the effectiveness of the framework

(e)

Basle (II) - Principle 6 : risk measurement systems • Capture all material sources of risk • Basle (II) also notes that netting arrangements should be recognized

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Question 8 Learning Objectives: 1. The candidate will understand the types of risks faced by an entity and be able to identify and analyze those risks.

The candidate will understand the structure of an ERM process in an entity and be able to demonstrate best practices in enterprise risk management.

Learning Outcomes: (1b) Identify & analyze insurance risks faced by an entity, including but not limited to: mortality, morbidity, catastrophe and product risks and embedded options.

(6e)

Demonstrate how ERM is able to contribute to shareholder value creation, and how the performance of a given firm/venture may be evaluated against its objectives including total returns.

Sources: FE-C124-07: Performance Measurement Using Transfer Pricing, by M. Wallace

FE-C151-08: Atkinson 13.1 - 13.4, Annuity and Investment Products General Commentary on Question: This 10 point integrated question tested the candidate’s ability to apply the Transfer Pricing concept to a practical situation involving a Single Premium Deferred Annuity (SPDA) block.

The Cognitive Skills tested varied across question subparts. The one point part (a) question was mostly a Retrieval type of question, where the student was asked for a list describing benefits of Transfer Pricing. The four point Part (b) was a mix of Comprehension and Analysis type questions, whereby the candidate was asked to perform a Transfer Pricing analysis on the SPDA block. The five point part (c) was an Analysis type question, whereby the candidate was asked to assess the impact on Transfer Pricing results of five separate scenarios involving the SPDA block. Solution: Commentary on Question: Candidates did fairly well on this part of the question. Some students mentioned bonuses and compensation.

(a)

List 5 benefits of Transfer Pricing for performance measurement and attribution. •

Improved measurement of product profitability which can lead to improved pricing

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Continued

•

Improved measurement asset portfolio performance on a risk adjusted basis leading to better investment decisions

•

Provides viable investment alternative when returns on actual assets don't match benchmark performance over time

•

Permits separate measurement of residual A/L mismatch impact

•

Allows for improved risk management

Commentary on Question: Candidates did well on part (i) but were weak on interpreting and stating implications of the results. Students did not pick up on the opportunity to improve ALM and credit results by adding duration and/or spread.

(b) (i) Use Transfer Pricing to allocate income for the SPDA across I, II and III. Total Income = Product Income + ALM Income + Credit & Security Selection Income Product Income = Benchmark #1 - Payment on Liabilities Income from Interest Rate Risk = Benchmark #2 - Benchmark #1 = ALM income Income from Credit Risk & Security Selection = Inv Income - Benchmark #2 Income Benchmark #1 = Benchmark #1 rate x Reserves = 5% x 100 million = 5 million Income Benchmark #2 = Benchmark #2 rate x Reserves = 6% x 100 million = 6 million Income from Credit Risk and Security Selection = 7 million – 6 million = 1 million Income from Interest Rate Risk = 6 mil – 5 mil = 1 mil Product Income = Total income – ALM income – Credit & Security Selection Income = 1.95 mil – 1 mil – 1 mil = -0.05 mil

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Continued

Alternative Calculation: Payment on Liabilities = Investment Income - Pre-Tax Income = 7 million – 1.95 million = 5.05 million Product Income = 5 million – 5.05 million = -0.05 million (ii)

Identify the conclusions that can be drawn about sources of profit. •

The predominant source of SPDA profit comes from the asset side (2M vs. 50K)

•

SPDA is predominantly a spread product, thus the asset side is very important

•

ALM Income may come from longer assets than liabilities or higher actual asset portfolio convexity than that of the benchmark

•

Income from Credit Risk/Security may come from portfolio assets with credit spreads larger than the benchmark's

•

Product Income mostly drives off of crediting rate strategy and expense management

Commentary on Question: The key to part (c) is to analyze the impact on the benchmarks and the resulting effect on the three transfer pricing measures. Candidate responses seemed to focus on risk instead of profit. For instance, many said things like "Interest Rate Risk increased," which doesn't answer the question. They should have said whether the Income from Interest Rate Risk increased, and they should have described how the change in Benchmarks caused the income to increase.

(c)

Olympic is considering each of the following independent actions analyze the transfer pricing implications.

Commentary on Question: Candidates were able to identify the increased return volatility and Credit risk / security selection income for Olympic, but had a harder time with the ALM and product income.

I. Non-investment grade securities •

BENCHMARK #2 will increase to include non-investment grade bonds which have higher risk.

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Continued

•

Non-investment grade securities will have lower default rates in "good credit" years, so will provide enhanced returns relative to investment grade bonds.

•

Benchmark 1 is not affected.

•

Income for total SPDA and Credit Risk/Selection are expected to increase in "good credit" years, decrease in "poor credit' years with the riskier assets.

•

Income from Interest Rate Risk should increase since BENCHMARK #2 is increasing.

•

Product Income is not affected since Liability Payments and BENCHMARK #1 are not changing.

Commentary on Question: Candidates were able to identify the decreased return volatility and Credit / security selection income for Olympic, but had a harder time with the ALM and product income.

II. Hedging interest rate risks •

BENCHMARK #2 will probably decrease due to hedging cost.

•

BENCHMARK #1 doesn't change.

•

Income for total SPDA and Credit/Selection is expected to decrease in nonsevere interest environment years due to net hedge cost and remain somewhat flat for severe years due to hedge payoffs.

•

During harsh economic environments, hedging will also help meet Min Guarantee Crediting Rate.

•

Product Income is not affected since Liability Payments and BENCHMARK #1 are not changing.

•

Income due to Interest Rate Risk will decrease since BENCHMARK #2 has decreased.

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Continued

Commentary on Question: Candidates often confused decrease in credit spreads due to asset selection with increasing crediting rate.

III. Increasing the Crediting Rate which lowers credit spread •

Higher crediting rate means, higher reserves, higher benefits paid out and probably increased persistency, potentially acting as an offset to benefit earnings.

•

Total SPDA income and Product Income - it is unclear whether the increased investment income from better persistency will overcome the resultant increased reserves.

•

Higher persistency translates into a longer duration for the liabilities resulting in BENCHMARK #1 change (and will probably be increased assuming a positive yield curve), to maintain equality in sensitivity to interest rate changes.

•

BENCHMARK #2 should remain unchanged.

•

Income rate due to Interest Rate Risk should decrease since BENCHMARK #1 is increasing.

•

Income due to Credit Risk/Selection should increase since better persistency means more assets invested.

Commentary on Question: Candidates most often picked up on the change in persistency; however they did not translate that into a change in Benchmark #1.

IV. Layoffs and Increased Efficiency •

Expenses are reduced and total SPDA income increases. However benchmarks do not change.

•

Product Income increases since expense in Liability Payments will decrease.

•

Income due to Interest Rate Risk should not change because benchmarks are not changing.

•

Income due to credit risk/selection should not change since investment income and BENCHMARK #2 will not change.

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Continued Commentary on Question: Candidates mostly did well on the initial impact on decreased expenses and increased income. Unfortunately some thought the improvements needed to be allocated.

V. Reduce Surrender Charge period for New Business •

Total SPDA income will probably decrease due to decreased persistency, which means smaller asset base and will probably reduce duration of liabilities.

•

BENCHMARK #1 will need to be adjusted to assets with lower duration to match liabilities. It probably will decrease, assuming positively sloped yield curve.

•

BENCHMARK #2 won't change.

•

Product Income will decrease due to BENCHMARK #1 decrease.

•

Income due to Interest Rate Risk will probably increase due to BENCHMARK #1 decrease.

•

Income due to Credit Risk/Selection may decrease due to lower persistency.

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Question 9 Learning Objectives: 1. The candidate will understand the types of risks faced by an entity and be able to identify and analyze those risks.

The candidate will understand how the financial risks faced by an entity can be quantified and the use of metrics to measure risk.

Learning Outcomes: (1b) Identify and analyze insurance risks faced by an entity including but not limited to: mortality risk, morbidity risk, catastrophe risk, product risk and embedded options.

(1d)

Identify and analyze strategic risks faced by an entity including but not limited to: • Product sustainability risk • Distribution sustainability risk • Consumer preferences and demographics • Geopolitical risk • Competitor risk • External relations risk • Legislative/Regulatory risk • Reputation risk • Sovereign risk

(3a)

Demonstrate the use of risk metrics to quantify major types of risk exposure in the context of an integrated risk management process. • Demonstrate how each of the financial risks faced by an entity can be amenable to quantitative analysis including an explanation of the advantages and disadvantages of various techniques such as Value at Risk (VaR), stochastic analysis, scenario analysis and stress testing. •

Describe and evaluate risk aggregation techniques incorporating the use of correlation, integrated risk distributions and copulas.

•

Describe how and why risks are correlated and give examples of risks that are positively correlated and risks that are negatively correlated.

•

Assess the overall corporate risk exposure arising from financial and nonfinancial risks.

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Continued Sources: FE-C169-09: Atkinson & Dallas, Life Insurance Products and Finance Ch. 3, Pricing Assumptions

FE-C164-09: CSFB Credit Portfolio Modeling Handbook Ch. 2, “The Default/No-Default World and Factor Models” Ch. 4 “Demystifying copulas” FE-C160-09: “Moody’s Looks at Terrorism Risk in the U. S. Life Insurance Industry,” February 2006. General Commentary on Question: Question 9 was a 17 point integrated question that challenged students to apply the 1factor Gaussian copula to terrorist events instead of bond credit losses as was illustrated in source FE-C164-09. In addition, underwriting criteria and methods from source FEC169-09 were tested. Lastly, details on the Terrorism Study Note FE-C160-09 were highlighted.

The cognitive skills tested varied from part to part. Approximately three points were attributed to Retrieval type questions (parts (a), (b) and (c)). Roughly three points were attributed to Knowledge Utilization type questions, whereby candidates were required to suggest latent variables for use in the Gaussian copula model (part (e)) and were required to recommend actions to take to manage specified risks (part (f)). The rest of the exam points were spread between Comprehension and Analysis type questions, whereby the candidates were expected to calculate Value at Risk (VaR) losses for specified risks and model. In addition to this, the candidate had to understand and apply the attributes of this model in part (e). Although students often didn’t make it all the way through the 1-factor Gaussian copula, many made it partially through. Common errors included not knowing V, not calculating the denominator correctly or forgetting to weight the results by the exposure. In parts (a) and (b), the most common error included discussing different pricing assumptions rather than underwriting methods and criteria. In general, students performed well on parts (c) and (f).

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Continued Solution:

(a)

(b)

Contrast underwriting for group term contracts with typical individual life underwriting. •

When selling to large groups of insureds, especially employee groups, it is common to use a streamlined approach to underwriting.

•

Group contracts can be either guarantee issue or simplified issue.

•

There is a reduced opportunity for anti-selection in group context as compared to individual insurance.

•

Guaranteed Issue underwriting has less rigorous underwriting requirements, but COI is higher.

•

Simplified Issue similar to Guaranteed Issue but includes some medical questions.

Propose underwriting criteria that Wigan should use when issuing group term contracts. •

Death benefit should be multiple of salary or an objective formula.

•

Minimum hours worked per week to be eligible for coverage.

•

Require minimum number of employees to elect coverage.

•

New employees eligible upon hire will require full underwriting if initially decline coverage and seek coverage later.

•

Major issues can be more fully underwritten, minor issues usually passed on.

•

Choose simplified issue with a short questionnaire.

•

Require a period with no medical leave or absences.

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Continued

(c)

Identify seven factors that would affect the lapse rate assumption for Wigan’s individual UL policies. For each of these factors, explain whether and how it would apply for the Wigan group term contracts. •

Manner in which policy is sold - Higher lapse will characterize individuals who were pressured to buy. - Since the group clients have expressed interest (i.e. not pressured by Wigan), lapse is less likely.

•

Perceived Value - If customer perceives policy to be a “good deal”, lapse rate will tend to be low. - This is the same for individual and group business.

•

Degree of Understanding - Individual policy persistency improves when benefits of policy are understood. - For a group product, the decision to purchase will be made by HR or executives i.e. the decision makers are well-equipped to make informed decision.

•

Ability to pay - Corporate clients who are financially distressed will pose higher lapse risk. - However, as premium is paid in full at BOY, not an issue, employer pays the premium.

•

Distribution/agent attitude - Individual policy persistency affected by agent “churning” or commission structures (chargebacks, level versus heaped). - Not an issue for group term as premium is non-refundable; employer decision to lapse/switch carriers is a big undertaking.

•

Customer commitment - For an individual, if the policy is part of a financial plan or broader objectives, persistency is increased. - Same is true for group term, if benefit is offered as part of a well thought out benefits package, it will likely be maintained.

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Continued

•

Ease of premium payments - For individuals, automatic payment options increase persistency. - Not as relevant here as premium is annual, corporate function and paid in full beginning of year.

Evaluate the relative importance of the lapse assumption of Wigan’s individual UL policies compared to the group term contracts.

(d)

•

Lapse Rates are very important for individual life.

•

Lapse Rates are not important for this group term product.

•

For individual, lapse rates determine the period and policies over which expenses are spread.

•

For individual, lapse rates reflect customer satisfaction/company reputation.

•

For group, there aren’t large upfront costs that need to be recouped.

Calculate the 97.5% VAR loss for terrorism-related losses for this portfolio of group term contracts using a one factor Gaussian copula model.

P( Z < ζ V ) = Φ[ζ − αV ) / SQRT (1 − α 2 )] Client Location Name Walcott Capital City Denilson Beaverton Hamsik Capital City Lavezzi Capital City Inter Ruviano

Employee Count 400 120 200 150 50

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Total Exposure 450 400 300 275 270

Prob of loss 0.01% 0.005% 0.01% 0.01% 0.005%

Inverse Alpha Normal -3.72 0.5 -3.89 0.2 -3.72 0.5 -3.72 0.5 -3.89 0.2

Alpha x V 0.5 x (1.96) 0.2 x (1.96) 0.5 x (1.96) 0.5 x (1.96) 0.2 x (1.96)

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Continued

Client Name Walcott Denilson Hamsik Lavezzi Inter

Numerator (inverse N - αV) (2.74) (3.50) (2.74) (2.74) (3.50)

Denominato r (1-α2).5 0.866 0.980 0.866 0.866 0.980

x = Num / Denom (3.164) (3.570) (3.164) (3.164) (3.570)

Phi (x) (nearest value) 0.068% 0.010% 0.068% 0.068% 0.010%

Weighted by Exposure 0.306 0.040 0.204 0.187 0.027

Sum of Phi (x) weighted by exposure = 0.764 million (e)

Explain what the α values imply about the underlying risk of loss. •

The high alpha value for Capital City locations suggests a high correlation between potential terrorist events in this city and the common factor V.

•

Capital City is more likely to be the center of a terrorist event if in fact there is an event.

•

The low alpha values for cities outside of Capital City indicate less correlation between potential terrorist events in these locations and common factor V.

Justify your decision to not use the Archimedian copula model. •

Archimedian copula is characterized by latent variable defining correlation / distribution.

•

Cannot have any two exposures more or less correlated than any other two exposures.

•

This seems inappropriate for Wigan given the relationship between geographical location and terror risk.

•

Can be difficult to use (with more latent variables).

Describe the advantages and disadvantages of using a student-t copula. •

T copula has stochastic volatility unlike Gaussian, which has static volatility (advantage) - works well for modeling assets.

•

This is helpful in modeling financial events which has "bursty" behaviour (high and low periods of volatility).

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Continued

•

T copula exhibits tail dependence (advantage).

•

Benefits offset by increased complexity.

Suggest two potential latent variables. •

Homeland security threat level

•

Premiums for stand-alone terror coverage

Both of these describe the state of the world relating to potential for terror events. (f)

Recommend actions that Wigan can undertake to manage the exposure to potential catastrophic losses on its group term portfolio due to terrorist acts. •

Collect exposure data to allow for monitoring and assessment of risk

•

Define concentration limits

•

Map larger exposures by geographic region

•

Manage exposure through highly rated counterparties

•

Greater use of mortality reinsurance

•

Enforce lower limits on group policies

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Question 10 Learning Objectives: 2. The candidate will understand measures of corporate value and be able to analyze the data in corporate financial statements.

The candidate will understand how the financial risks faced by an entity can be quantified and the use of metrics to measure risk.

Learning Outcomes: (2d) Explain the challenges and limits of economic capital calculations and explain how economic capital may differ from external requirements of rating agencies and regulators.

(3a)

Demonstrate the use of risk metrics to quantify major types of risk exposure in the context of an integrated risk management process.

(3b)

Evaluate the properties of risk measures and explain their limitations.

Sources: Crouhy, Galai, & Mark, Risk Management, 2001, Ch. 5, “Measuring Market Risk: The VaR Approach

Crouhy, Galai, & Mark, Risk Management, 2001, Ch. 6, “Measuring Market Risk: Extensions of the VaR Approach and Testing the Models General Commentary on Question: This question was valued at 12 exam points and tested the candidates’ knowledge of market risk and their ability to apply such risk metrics as Value at Risk (VaR) and Incremental VaR (IVaR) to assess this risk.

This question tested a variety of cognitive skill levels. Four points were mixed between the Retrieval and Comprehension varieties (parts (a) and (c)). These parts had the candidate identify and describe the applicable market risks for the given portfolio and explain how different VaR methods result in different results. Another exam point was of the Knowledge Utilization category in that the candidate was asked to make a recommendation part (d). The rest of the marks were mixed between Comprehension and Analysis in that the candidate was requested to calculate VaR and IVaR using given information in the stem.

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10.

Continued

Solution: Commentary on Question: Students who scored well on this section described (not just listed) each source of market risk and identified which stocks in the portfolio contributed to each type of market risk.

The four types of market risk are listed in the model solution in the order of student performance (best to worst). (a)

Identify and describe four major sources of market risk associated with this portfolio. Market Risk - Risk that changes in financial market prices and rates will reduce the value of a security or a portfolio. Types of Market Risk • Interest Rate Risk: Risk the value of a fixed-income security will fall as a result of a change in market interest rates. (EMB) •

Commodity Price Risk: Generic and specific components. The concentration of supply can magnify price volatility and fluctuations in market liquidity often exacerbate price volatility. (GSG)

•

Foreign Exchange Risk: Includes imperfect correlations in the movement of currency prices and fluctuations in international interest rates. (EMB, VNQ)

•

Equity Price Risk: Includes sensitivity to changes in the level of broad stock market indices & volatility that is firm specific. (All)

Commentary on Question: It was very evident which students knew how to calculate VaR using the variancecovariance method. Many students failed to understand the relationship between the generic VaR formula (see (b)(ii) below) and the variance-covariance method VaR calculation. Students who did not successfully apply the variance-covariance method but identified the correct confidence level and displayed knowledge of how to convert 1-day VaR to 10-day VaR received partial credit.

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10.

Continued

(b) (i)

Using the variance-covariance method calculate the 10 day VAR of the portfolio at a 99% confidence level. Monthly Projections 1Ω1* Per Stock Weight (w) Variance (1Ω1 * w2) 0.0027 1/3 0.0300% *1Ω1 denotes the sum of the elements in the variance covariance matrix

VaRV (10;99) = 10VaRV (1;99) = 2.33 10 σ V V 99% Confidence

10 Day^.5

2.33

3.16

Standard Deviation 1.73%

Portfolio Value

VaR

1,000,000,000

$127,468,250

Yearly Projections 1Ω1 Per Stock Weight (w) Variance (1Ω1 * w2) 0.0115 1/3 0.1278% VaRV (10;99) = 10VaRV (1;99) = 2.33 10 σ V V 99% Confidence

10 Day^.5

2.33

3.16

Standard Deviation 3.57%

Portfolio Value

VaR

1,000,000,000

$263,041,418

Commentary on Question: The question stem provided the necessary components to calculate VaR using the historical simulation method by applying the generic VaR formula. The most common mistakes students made were to calculate the Absolute VaR (worst case loss at the 99 percent confidence interval) or use the historical standard deviation (provided in the stem, but not used for the historical simulation method).

(ii)

Using the historical simulation method calculate the 10 day VAR of the portfolio at a 99% confidence level.

Mean

1%tile

-0.12%

-10.65%

Mean1%tile 10.53%

Portfolio Value

1 Day VaR

1,000,000,000

105,300,000

10 Day^.5 3.16

VaR $332,987,838

VaR = Expected profit/loss Worst case loss at the 99 percent confidence level

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10.

Continued Commentary on Question: Top performing students outlined key differences between the variance-covariance method and the historical simulation method.

(c)

Explain why the VaR amounts computed above differ. Variance – Covariance • Parametric VaR - Assume returns have an analytic density function. Projection data is used to estimate the parameters of the assumed distribution function. •

Does not cope well with "fat tail" distributions - actual data appears to have extreme outcomes / cover period of high volatility.

•

Difference due to variance in experience over different time periods (one month, one year and 200 trading days).

Historical Simulation • Non-parametric VaR - Derived from a distribution that is constructed using historical data. •

Short data set may lead to biased and imprecise estimation of VaR.

•

Complete dependence on a particular historical data set.

•

Fat tails and other extreme events are captured as long as they are in the data set.

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10.

Continued Commentary on Question: Students performed very poorly on this section. Typically, students recommended an amount of capital but failed to identify key considerations. Unsupported recommendations received little to no credit.

(d)

Recommend the amount of capital to be held by Banaca Napoli and identify the considerations taken in arriving at your recommendations. Traditional Method (10 day VaR computed using the variance-covariance method at a 99% confidence interval based on the yearly projection information) Variance – Covariance 2007 $57,700,000 2008 $76,600,000 2009 $67,600,000 2010 $263,041,418 Non-Traditional Methods Monthly Projections Historical Simulations

2010 / 200x 456% 343% 389%

$127,468,250 $332,987,838

Recommendation: • The traditional method and the historical simulation method are both indicative of stress scenarios. •

When using monthly projections (based on historical data) in the traditional method, calculated VaR is less indicative of a stress scenario.

•

Hold capital half way in between the traditional method using monthly projections and annual projections.

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10.

Continued Commentary on Question: A majority of students knew the IVaR formula, but did not know how to calculate VaR using the variance-covariance method.

(e)

Determine which stock to remove using 10-day IVaR at a 99% confidence level. Yearly Projections Remove GSG Remove VNQ Remove EMB

1Ω1* 0.0079 0.0046 0.0043

Per Stock Weight (w) 1/2 1/2 1/2

Variance (1Ω1 * w2) 0.1975% 0.1150% 0.1075%

*1Ω1 denotes the sum of the elements in the variance covariance matrix

VaRV (10;99) = 10VaRV (1;99) = 2.33 10 σ V V

Remove GSG Remove VNQ Remove EMB

99% Confidence 2.33

10 Day^.5

Portfolio Value 1 Billion

VaR (with)

VaR (without)

IVAR

3.16

Standard Deviation 4.44%

$263,041,418

$327,143,948

$64,102,530

2.33

3.16

3.39%

1Billion

$263,041,418

$249,778,826

$13,262,593

2.33

3.16

3.28%

1 Billion

$263,041,418

$241,673,908

$21,367,510

Decision: Remove EMB Note that Incremental VaR (IVaR) = VaR With the position less VaR without position

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Question 11 Learning Objectives: 3. The candidate will understand how the financial risks faced by an entity can be quantified and the use of metrics to measure risk.

The candidate will understand the structure of an ERM process in an entity and be able to demonstrate best practices in enterprise risk management.

Learning Outcomes: (3b) Evaluate the properties of risk measures and explain their limitations.

(6g)

Explain means for managing risks and demonstrate measures for evaluating their effectiveness.

Sources: Application of Coherent Risk Measures to Capital Requirements in Insurance, Artzner, NAAJ, Vol 3, No 2

Hardy, Investment Guarantees, 2003 -- Ch. 9, Risk Measures General Commentary on Question: This 11 point integrated question tested for recognition and understanding of various axioms related to risk measures and the ability to explain the meaning of these axioms. The question tested the ability to apply the axioms to a given risk measure by mathematically demonstrating whether the given risk measure met each of the axioms. In addition, the question also tested the concept of coherence as it relates to risk measures, by requiring the candidate to apply the coherence concept to a specified risk measure.

The Cognitive Skills tested were a mix between Comprehension and Analysis. Parts (a) and (b) were worth five points together and were mostly Comprehension type questions, whereby the candidate was asked to identify and explain the listed axioms. The one point Part (d) was also a Comprehension type question, in that the candidate mostly needed to know the definition of Coherence to get much of the credit. The five point Part (c) fell into the Analysis category, whereby the candidate had to mathematically apply the axioms to a specified risk measure. In general, candidates did quite well on this question. Candidates demonstrated a strong understanding of the Translation Invariance, Positive Homogeneity, Monotonicity and Subadditivity Axioms; most candidates were able to give good explanations of the meanings of these axioms and were able to apply these axioms to the given risk measure. The Relevance and Conservatism Axioms were not as well understood by some of the candidates, as many struggled to explain and apply these axioms.

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11.

Continued

The Hardy source uses a slightly different framework for risk measures than does the Artzner source, resulting in some of the axioms being stated in a slightly different manner; Hardy also has a slightly different definition of coherence. Full credit was awarded for answers referencing either source. Where applicable, solutions from both perspectives are included. Solution: Commentary on Question: In general, candidates did well on this part and were able to distinguish the various axioms.

(a)

The following mathematical axioms have been proposed in relation to a risk measure ρ(X), where X represents a loss random variable, and α and λ represent real numbers. (A)

ρ(X) = ρ(max(X,0))

(B)

ρ(λX) = λρ(X), for λ ≥ 0

(C)

ρ(X1 + X2) ≤ ρ(X1) + ρ(X2)

(D)

If Pr[X > 0] ≠ 0, then ρ(X) > 0

(E)

ρ(X + α) = ρ(X) + α

(F)

If X1 is always ≤ X2, then ρ(X1) ≤ ρ(X2)

Associate each axiom (i) through (vi) below with the appropriate mathematical expression (A) through (F) above. (i)

Translation Invariance Axiom

(ii)

Positive Homogeneity Axiom

(iii)

Monotonicity Axiom

(iv)

Relevance Axiom

(v)

Conservatism Axiom

(vi)

Subadditivity Axiom

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11.

Continued

(i) (ii) (iii) (iv) (v) (vi)

E B F D A C

Commentary on Question: While most candidates understood the meaning of the Translation Invariance, Positive Homogeneity, Monotonicity and Subadditivity Axioms, some candidates struggled to explain these axioms clearly in the context of a risk measure (i.e., some candidates simply put the mathematical expressions into words without explicitly mentioning the meaning of the variables and quantities in the expressions). The Relevance and Conservatism Axioms were the most frequently misunderstood axioms. Some candidates explained Relevance as pertaining to a situation where a loss random variable always showed a loss (as opposed to ever showing a loss). Many candidates misinterpreted the Conservatism Axiom as flooring the risk measure at 0, rather than flooring the argument to the risk measure at 0. Also, some candidates confused the Conservatism Axiom with the idea that the risk measure should be bounded above by the maximum loss.

(b)

Explain briefly in words the meaning of each of the axioms above, in the context of a risk measure used to determine capital adequacy. Translation Invariance Axiom: This axiom means that adding a known certain (fixed) amount of loss α to a loss random variable X increases the risk by exactly that amount. (Or equivalently, adding a fixed cash position α to the position X reduces the amount of capital needed by α.) Positive Homogeneity Axiom: This axiom means that scaling the loss random variable X by a fixed multiple λ scales the risk proportionately. (Equivalently, scaling the position X by a fixed multiple λ scales the capital required proportionately.) One implication/interpretation of this is that the units we use should not affect the total risk measure -- e.g., moving from measuring in $ to measuring in $000s. It also implies that we can neither create nor eliminate risk by combining/dividing risks that are perfectly correlated. Monotonicity Axiom: Under this axiom we require that if one loss is always greater than another -- i.e., in any state of the world -- then that ordering should be reflected in the ordering of their respective risk measures. (Equivalently, if in all cases, a position X is greater than a position Y, then X is ``less risky'', i.e., should have a lower value for the risk measure than Y.)

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11.

Continued

Relevance Axiom: Under this axiom we require that any possibility of a loss (or negative outcome) should be reflected in a positive risk measure, even if the bulk of the distribution lies on the profit side. Conservatism Axiom: Under this axiom we require that profits (i.e., positive outcomes) should not be taken into consideration in measuring risk, only losses (negative outcomes). Subadditivity Axiom: Under this axiom we require that combining risks does not increase the overall measure of total risk; it will not be less risky to treat any two risks separately than it is to treat them together, and potentially benefit from diversification. Combining multiple risks could possibly decrease (but could not increase) their combined risk. Likewise, we cannot decrease overall risk by dividing a risk among, say, subsidiaries of the same corporation. Commentary on Question: In general, candidates did very well with the demonstration of the Translation Invariance and Positive Homogeneity Axioms. The proofs of these axioms relied on basic properties of the expectation and standard deviation operators. Most candidates were also able to demonstrate the Subadditivity Axiom and the (failure of the) Monotonicity Axiom, at least in principle. The Subadditivity Axiom required reasoning about the standard deviation of a sum of two random variables, whereas the Monotonicity Axiom required construction of a counterexample, or the ability to explain why this property fails for the given risk measure. Many candidates struggled with the Relevance and Conservatism axioms, neither of which were met by the given risk measure.

(iii)

Determine whether each of the axioms above is satisfied by the standard deviation principle: ρ ( X ) = Ε[ X ] + βσ [ X ], β > 0 Translation Invariance: This property does indeed hold for this risk measure, so we want to show that ρ ( X + α ) = ρ ( X ) + α .

ρ ( X + α ) = Ε[ X + α ] + βα [ X + α ] = Ε[ X ] + α + βα [ X ] = Ε[ X ] + βα [ X ] + α = ρ(X ) +α, so this property does indeed hold.

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11.

Continued

Positive Homogeneity: This property does indeed hold for this risk measure, so we want to show that ρ (λ X ) = λρ ( X ), for λ ≥ 0.

ρ (λ X ) = Ε[λ X ] + βα [λ X ] = λΕ[ X ] + βλα [ X ] = λ (Ε[ X ] + βα ) = λρ ( X ), so this property does indeed hold for any λ ≥ 0. Monotonicity: This property DOES NOT hold for the standard deviation risk measure given. Consider the following counterexample: Let X 1 = {5,9} each with probability ½ and let X 2 ≡ 10. Note that X 1 is always ≤ X 2 . Then ρ ( X 2 ) = Ε[ X 2 ] + βσ [ X 2 ] = 10 + β • 0 = 10 and ρ ( X 1 ) = Ε[ X 1 ] + βσ [ X 1 ] = 7 + βα [ X 1 ]. Since σ [ X 1 ] > 0 , then for a sufficiently large value of β , we will have βσ [ X 1 ] > 3 so that ρ ( X 1 ) = 7 + βσ [ X 1 ] > 10. Thus, this property does not hold. Relevance: This property DOES NOT hold for this risk measure. Consider the following counterexample: Let X = {−9,1} each with probability ½. Then Pr[ X > 0] ≠ 0. Ε[ X ] = −4 , and σ [ X ] > 0 , so for some sufficiently small β , we will have ρ ( X ) < 0. Thus, this property does not hold. Conservatism: This property DOES NOT hold for this risk measure. Consider the following counterexample: If X is any loss random variable that takes both positive and negative values with positive probabilities, then Ε[max( X , 0)] > Ε[ X ] , whereas σ ( X , 0) < σ ( X ) , so that there exists some positive value of β which makes ρ ( X ) ≠ ρ (max( X , 0)) . Thus, this property does not hold.

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11.

Continued

Subadditivity: This property does indeed hold for this risk measure, so we want to show that ρ ( X 1 + X 2 ) ≤ ρ ( X 1 ) + ( X 2 ) :

ρ ( X 1 + X 2 ) = Ε[ X 1 + X 2 ] + βσ [ X 1 + X 2 ] ρ = Ε[ X 1 ] + Ε[ X 2 ] + βσ [ X 1 + X 2 ] ≤ Ε[ X 1 ] + Ε[ X 2 ] + β (σ [ X 1 ] + σ [ X 2 ]) = (Ε[ X 1 ] + βσ [ X 1 ]) + (Ε[ X 2 ] + βσ [ X 2 ] = ρ ( X 1 ) + ρ ( X 2 ), so this property does indeed hold. We can see that σ [ X 1 + X 2 ] ≤ σ [ X 1 ] + σ [ X 2 ] as follows: (σ [ X 1 ] + σ [ X 2 ]) 2 = (σ [ X 1 ]) 2 + (σ [ X 2 ]) 2 + 2(σ [ X 1 ]σ [ X 2 ) ≥ (σ [ X 1 ]2 + (σ [ X 2 ]) 2 + 2σ [ X 1 ]σ [ X 2 ]ρ12 = Var ( X 1 + X 2 )

(since ρ12 ≤ 1 )

= (σ [ X 1 + X 2 ]) 2

so that σ [ X 1 + X 2 ] ≤ σ [ X 1 ] + σ [ X 2 ]. Commentary on Question: Candidates did a good job of identifying the requirements for a coherent risk measure and applying them to the standard deviation principle. Candidates were generally able to use the determinations made in the previous parts (even if that work was incorrect) to make an appropriate conclusion regarding the coherence of the given risk measure. As the definition of coherence varied slightly between the Hardy and Artzner sources, full credit was given for either answer.

(iv)

State with reasons whether the standard deviation principle is coherent. (Using the definition of coherence given in Artzner:) A risk measure is coherent if it has the properties of Positive Homogeneity, Translation Invariance, Subadditivity and Monotonicity. While the standard deviation principle has the first three of these properties (as shown in the previous part), it is not Monotonic, and hence is not coherent. (Using the definition of coherence given in Hardy:)

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11.

Continued

A risk measure to be coherent if it is bounded above by the maximum loss, bounded below by the mean, Scalar multiplicative and additive and Subadditive. It has been shown above that the standard deviation measure is Scalar multiplicative and additive (in the Translation Invariance and Positive Homogeneity portions of the previous part), and also is Subadditive. It is clear that the standard deviation measure is bounded below by the mean. However, this measure is NOT bounded above by the maximum loss. For a sufficiently large value of β (and positive standard deviation), the standard deviation term will cause the measure to be greater than the maximum value of X. Thus, this measure is NOT bounded above by the maximum, and hence is not coherent.

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Question 12 Learning Objectives: 2. The candidate will understand measures of corporate value and be able to analyze the data in corporate financial statements. Learning Outcomes: (2a) Explain basic accounting concepts used to produce financial statements in insurance companies, other financial institutions, and non-financial institutions.

(2b)

Analyze a specific company financial situation by demonstrating advanced knowledge of balance sheet and income statement structures.

Sources: Fridson, Alvarez Financial Statement Analysis: A Practitioners Guide, Ch 13

Crouhy, Risk Management, Ch 7, p302-303 General Commentary on Question: This 10 point focus question was a relatively straightforward one testing the candidate’s understanding of financial ratios, how to calculate them, and how to use them to analyze a company’s financial strength.

The Cognitive Skill levels tested varied by question subpart. The four point part (a) tested mixed Comprehension and Analysis cognitive skills in requiring the student to calculate a financial ratio based on specified changes to the financial statements. The four point part (b) tested cognitive skills ranging from Retrieval (subparts (i) and (iii)) to Analysis cognitive skills in subpart (ii). The final two point part of the question tested Knowledge Utilization cognitive skills by requiring the candidate to recommend and justify a capital structure based on their analysis in the prior question parts. Solution: Commentary on Question: In general, candidates did not include enough detail in the calculation of the components of ROE in part (a). Candidates generally calculated ROE based on beginning-of-period equity, rather than end-of-period, which meant they did not take into account retained earnings.

Candidates did not demonstrate a thorough understanding of the relationships among Retained Earnings, Net Income and Dividends in the calculation of ROE. The numerator in ROE is Net Income, which is calculated before dividends; the denominator is Retained Earnings which is the amount retained after payment of dividends.

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12.

Continued

Many candidates did not use appropriate terminology to distinguish between the income from operations and net income. The latter reflects deduction of interest expenses and tax. (a)

Calculate the impact on ROE resulting from the proposed change in capital structure. Show your work. ROE = Net Income / Total Equity Total Equity = End of Year (EOY) Equity = Beginning Equity + Retained Earnings Average Equity (average of BOY and EOY Equity) received full credit as well. Interest Expense Current Structure: Interest Expense = 1 (given) New Structure: Interest Expense = current Interest Expense + (New bond rate) x (New bond issues) New bond issues = amount required to increase debt from 20% to 50% of capital, or 30% of capital New bond issues = 30% x 100 = 30 New bond rate = 7% (given) Interest Expense = 1 + (7% x 30) = 3.1 Pre-Tax Income = Operating Income - Interest Expense Operating Income = Sales - Operating Expenses Operating Income = 100 - 80 = 20 Operating Income is same in both capital structures. Current Structure: Pre-Tax Income = 20 - 1 = 19 New Structure: Pre-Tax Income = 20 - 3.1 = 16.9 Income Taxes = Tax Rate x Pre-Tax Income Current Structure: Income Taxes = 30% x 19 = 5.70 New Structure: Income Taxes = 30% x 16.9 = 5.07 Net Income = Pre-Tax Income - Income Taxes Current Structure: Net Income = 19 - 5.7 = 13.3 New Structure: Net Income = 16.9 - 5.07 = 11.83 Dividends = Dividend Rate x Net Income Current Structure: Dividends = 25% x 13.3 = 3.325 New Structure: Dividends = 25% x 11.83 = 2.9575

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12.

Continued

Retained Earnings = Net Income - Dividends Current Structure: Retained Earnings = 13.3 - 3.325 = 9.975 New Structure: Retained Earnings = 11.83 - 2.9575 = 8.8725 Final Equity = Beginning Equity + Retained Earnings Current Structure: Final Equity = 80 + 9.975 = 89.975 New Structure: Final Equity = 50 + 8.8725 = 58.8725 Return on Equity = Net Income / Total Equity Current Structure: ROE = 13.3 / 89.975 = 14.78% New Structure: ROE = 11.83 / 58.8725 = 20.09% ROE will increase in new capital structure. Commentary on Question: Parts (i) and (ii) required knowledge of specific ratios relating to credit rating. Thus, credit was only given for ratios affected by the increase in debt and ratios demonstrating the impact on the credit rating. Credit was given for appropriate ratios from both the Fridson and Crouhy sources.

(b)

You are concerned that the proposed change in capital structure will impact TelCo's credit quality and ability to issue future debt at reasonable costs. (i)

Identify three additional financial ratios that you would consider in determining the effect of the change in capital structure on TelCo's credit standing. Income statement ratios Net Margin = Net Income / Sales Fixed Charge Coverage = (Net Income + Income Taxes + Interest Expense) / Interest Expense Income statement & balance sheet ratios Return on Total Capital = (Net Income + Income Taxes + Interest Expense) / (Total Debt + Total Equity) Funds from operation / Total debt = Net Income / Total Debt Total Debt / Capitalization = Total Debt / (Total Debt + Total Equity)

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12.

Continued

(ii)

Calculate the impact of the proposed change in capital structure on these ratios. Interpret your results. Net Margin = Net Income / Sales Current Structure: Net Margin = 13.3 / 100 = 13.3% New Structure: Net Margin = 11.83 / 100 = 11.83% Net Margin reflects the lower income due to debt servicing for the new (more-highly-leveraged) scenario, thereby resulting in a lower ratio value for the new structure. This ratio reflects management's control of the profitability of the enterprise. Fixed Charge Coverage = (Net Income + Income Taxes + Interest Expense) / Interest Expense Current Structure: Fixed Charge Coverage = (13.3 + 5.7 + 1) / 1 = 20 New Structure: Fixed Charge Coverage = (11.83 + 5.07 +3.1) / 3.1 = 6.45 Fixed Charge Coverage demonstrates that company’s ability to meet the interest payments through its earnings. The lower value of the ratio for the new structure indicates that increasing the debt reduces the company’s capacity to cover the higher debt servicing cost. Return on Total Capital = (Net Income + Income Taxes + Interest Expense) / (Total Debt + Total Equity) Current Structure: Return on Total Capital = ( 13.3 + 5.7 + 1) / (20 + 89.975) = 18.19% New Structure: Return on Total Capital = (11.83 + 5.07 +3.1) / (50 + 58.8725) = 18.37% Return on Total Capital will equalize the difference in capital structures. This comparison avoids distortion of using only ROE as the measure for this new structure, because it takes Retained Earnings into consideration. Total Capital declines slightly, even though ROE has increased. Funds from operation / Total debt = Net Income / Total Debt Current Structure: Funds from operation / Total debt = 13.3 / 20 = 66.5% New Structure: Funds from operation / Total debt = 11.83 / 50 =23.66% The lower ratio for the new structure indicates that TelCo will have a harder time carrying the increased debt.

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12.

Continued

Total Debt / Capitalization = Total Debt / (Total Debt + Total Equity) Current Structure: Total Debt / (Total Debt + Total Equity) = 20 / (20 + 80) = 20% New Structure: Total Debt / (Total Debt + Total Equity) = 50 / (50 + 50) = 50% The higher ratio for the new structure reflects the more highly-leveraged scenario, which may indicate that the company has taken on more debt than it can handle. Commentary on Question: Candidates performed poorly on part (iii), not recognizing that comparative ratio analyses measure a company against its peers, either comparing companies within an industry, or companies with similar ratings across industries.

(iii)

Identify and describe two Comparative Ratio Analyses that you can use to evaluate your company's competitive credit position. TelCo’s ratios should be compared with companies in an industry peer group. The specificity in this market reduces the comparison to a small number of similar companies in the same industry. Ratios must be examined and averaged over a set of years to avoid unrepresentative fluctuations in a single year. The ratios are interrelated for a given company, which allows the analysis to be limited to only a few ratios. TelCo's ratios should also be compared within a ratings peer group – that is, other companies (across industries) with the same credit rating. The limitation here is that rating agencies (Moody’s and Standard & Poor's) consider factors beyond the financial statements, so the comparisons may not be as useful.

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12.

Continued Commentary on Question: Most candidates identified the negative effect of the proposed new capital structure, but they did not relate it to the ratios identified in part (b) and the calculation in part (a). Candidates did recognize that it would be inappropriate to recommend the new structure because although it increased ROE as desired, it weakened the company’s position overall.

(c)

Recommend whether to adopt the proposed capital structure based solely on your analysis in part (a) and (b) above. Justify your recommendation. If the goal is to increase the ROE without considering other financial burdens, the new structure should be adopted. However, while shareholders appreciate the increased ROE, increasing the debt burden deteriorates the financial position of the company. The change in the net margin and fixed charge coverage ratios with the proposed capital structure indicate that the company’s overall position will be weakened. Thus, adopting this new structure is not recommended.

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A PROJECT REPORT ON REPUTATION RISK MANAGEMENT IN INDIA Submitted by:Mercy

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA]

TABLE OF CONTENT

1. 2. 3. 4. 5. 6. 7. 8. 9.

Research Executive Summary. Introduction Objective of study. Research Methodology. Analysis. Conclusions. Annexure Bibliography.

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA]

ABOUT TH RESEARCH The Reputation Risk Management in India is a research Project to take an insight, How companies are managing reputation risk and the research of this project is based on online survey of various companies and corporate indulging in reputation related activities and interviews with executives and management persons. Our thanks to everyone who shared their time and insight in this report.

June 2010.

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA]

EXECUTIVE SUMMARY Protecting a firm’s reputation is the most important and difficult task facing senior risk managers. In a survey of 20 Companies, reputational risk emerged as the most significant threat to business out of various choices of categories of risk. Corporate leadership teams are the guardians of an organization’s stability and financial well-being. The growth of profits and protection of assets are always prominent concerns. Yet, while numerous factors posing a potential risk to a Company’s equilibrium are routinely evaluated and addressed accordingly, one Critical threat is too often overlooked: the company’s reputation. Unless the Key elements of reputational risk are identified, prioritized and monitored, an Enterprise is not fully protected against the impact of potential negative events and issues. Reputational distress can be the result. The report’s findings include: Reputation ins prized, and highly vulnerable, corporate asset. Reputation is one of the most important corporate assets, and also one of the most difficult to protect, according to executives in the survey. Companies struggle to categorize- let alone quantify- reputational risk. Risk managers are divided on whether reputational risk is an issue in its own right or simply a consequence of other risks. Compliance failures are the big source of reputational risk. Failure to comply with regulatory or legal obligations is a reason behind reputation risk. Failure to deliver minimum standards is another reason. The CEO, CFO and higher management is the principle guardian of Reputation. The good communication is very vital in managing reputation risk.

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA]

INTRODUCTION “Reputation risk is risk of indirect loss (current or prospective) arising from one or multiple stake holder's adverse experience while dealing with the institution or which resulted in an adverse perception of the institution (as a standalone entity or as a part of major corporate group).” Also “Reputation is public information regarding a players’ trustworthiness. A players’ reputation reflects the information that third parties have on how trustworthy his behavior has been in the past”. (Ripperger 1998) Although shortage of cash or finance can bring a company to its knees, it is more frequently a loss of reputation that deals the final blow. It is curious, then, that while tools and techniques proliferate for managing monetary risks, the art of protecting reputations is poorly developed and understood. Most respondents to our survey agree that reputation is a primary asset of their organization, and that the risks facing reputation have grown in recent years. However, they also acknowledge that reputational risk is harder to manage than other sorts of risk, largely because of a lack of established tools and techniques and confusion about who is responsible. An organization’s reputation resides with a wide range of interested parties. Most important are the customers and investors, who between them provide the wherewithal that allows the organization to function. SOME QUOTATIONS: “It takes twenty years to build a reputation and five minutes to destroy it.” (W. Buffet) “If you lose dollars for the firm, I will understand. If you lose reputation, I will be ruthless.” (W. Buffet) “Our assets are our people, capital and reputation. If any of these are ever diminished, the last is the most difficult to restore.” (Goldman Sachs Business Principles).

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA]

IMPORTANCE OF REPUTATION: Information asymmetry: Outsiders don’t know as much about a company as insiders, so a good reputation alleviates and allow customers to make a choice. Important for all companies but crucial and vital to insurers as they sell distant promises: Insurers exchange money for future and unknown promises Employees: Are more loyal to a company with good reputation. Help with recruiting. Investors and business partners: Will take risk in a company that they can thrust based upon its reputation. Lawmakers and regulators: Reputation can help lessen the legal burden on a company. Public at large: Preserve “social license” to operate Customers and suppliers: Support loyalty to company. Competition: Barrier to entry.

OBJECTIVE OF STUDY: To study The Reputation risk management covering how reputation risk is identified, measured, managed and resolved if any events take place.  Reputation risk in today's world is a very important risk factors and the larger and more complex the organization, the greater the reputational risks.  Insight on what is the different risk management practices that companies are using. How companies manage risks arising out of damage to reputation?

RESEARCH METHODOLOGY: PRIMARY DATA: To collect primary data best way is to interact with people directly it can be through direct interviews and questionnaires. Both these methods have used for collection of primary data. With the help of articles and understanding a questionnaire was designed online and gets filled from corporate and telephonic interviews and personal visits were also taken. SECONDARY DATA: Secondary data is collected from article on reputation risk on websites and various Literature reviews.

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA]

ANALYSIS 1. Respondents filled the questionnaire online. 2. Among the Respondents mostly were from Finance and I.T departments (27% each). Others include public relations, Hr, Marketing/sales and others.

3. Among the industries surveyed Most were from I.T and Manufacturing, others include Service and Software.

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA]

4. Max. ie., 78% of the companies think that reputation risk is the most imp. Risk as compared to regulatory, credit, finance etc.

5. 60% of the companies think reputation risk is a separate risk, while others say it is a consequence of other risks.

6. Most of the companies think reputation as a source of competitive advantage and Bad news of their cos. in media has a major impact on organization.

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA]

7. According to the companies the Loss of HR, IT failure, Employee fraud and reputation loss are the reasons for their failure in recent past.

8. In response to what can damage reputation of their cos., they say

9. In response to practices followed at the organizations to manage reputation risk companies answers were

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA]

10. In response to how many times they check perception of their company among stakeholders and customers, most cos. Said regularly.

11. In response to who has contributed max. in managing reputation risks, corporate were confused and their answers were scattered. Some said CEo, others Said marketing managers, CFos etc.

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA]

12. In response to “How good their company in different areas”, the responses were

13. In response to “Are they agree or disagree” with various things their response were

14. In response to an obstacle in managing reputation risk, most companies said there is lack of established tool and technique to tackle this.

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA]

15. In response to whether the Reputation Risk well described in the ICAAP Document (Pillar II of Basel II), most respondents said they are unaware and others as

16. In response to “Do you think that your organization should more to manage reputation” most said maybe and others as.

17. In response to “Does your company have media monitoring aspects in place”, most said they do have to some extent.

18. About their valuable thoughts they said: Reputation has always been important. However, it may have been looked at in isolation thus far. Organizations have now begun to realize that reputation risk can be a consequence of various other risks and activities. Reputation risk management programs cannot be 'one size fits all'. They are unique and dependent on the respective objectives, industry, nature of business and other socio-economic-political growth factors. And it’s necessary.

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA]

CONCLUSION:  Opinion is divided as to whether reputational risk is a category of risk in its own right, or merely the Consequence of a failure to manage others. Whatever position companies take on this, almost all executives agree that corporate reputation is a hugely valuable asset that needs to be protected. It is also clear that serious reputational damage can occur simply as a result of perceived failures, even if those Perceptions are not grounded in fact. Understanding how different aspects of an organization’s activities impinge on stakeholder perceptions is therefore a vital aspect of protecting a company’s reputation.  There are three distinct tasks to managing reputational risk: establishing reputation to begin with, maintaining it through the rough and tumble of business operations, and restoring it when it has been damaged. The latter two, especially, call for very different actions (and actors). Whereas establishing and maintaining reputation may be considered a matter of successful risk control in other areas, reputational repair clearly cannot.  The CEO plays the vital co-coordinating role, but must also personify the values and conduct that ensure a company’s good standing. Other members of the reputational risk team include the chief risk officer, who tends to be more focused on the more technical task of monitoring, mitigating and, where possible, quantifying reputational threats. Communications, service and sales staff are involved in mitigating the reputational fallout of everything from a negative news story to a break down in customer service. Above all, good companies create a culture where employees take responsibility for enhancing corporate reputation through their everyday activities, like for e.g. Filling time-sheets daily to avoid any confusion and stick to deadlines to fulfill the orders, etc. Responsibility for corporate reputation, and the threats that can undermine it, extend from top to bottom in today’s organizations.  Currently, many companies feel that their capabilities in managing reputational risk leave much room for improvement, but the high rewards of success should provide strong motivation for progress in this area. Incurring reputational damage can be fatal, but establishing a robust reputation can provide a strong competitive advantage.

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA]

 A good reputation strengthens market position, reduces the price of capital and increases shareholder value. It insulates the brand, permits higher prices and helps to attract top talent. It protects public companies from unwelcome takeover bids, and raises the potential returns from share offerings. In times when the issue of trust is under particular scrutiny, these are prizes well worth attaining.  ROOM FOR IMPROVEMENT: The lack of consensus regarding reputational risk management strategies and the shortage of established tools for the job are reflected in the patchy levels of satisfaction expressed by managers in their efforts in this area.  Some of the practices which help in enhancing the reputation of an organization are Good Corporate Governance. Effective Board of Directors. Dept to address customer complaints. Fraud risk management policy. Shareholder surveys. Customer feedback. Legal dept handling legal cases to avoid litigation. Media Communication Policy to control releasing news to press Crisis Management committees. Internal communication with employees to keep them satisfied. Corporate Social Responsibilities activities – Donations, social cause activities, viz. save tiger campaign, save tree campaigns, save girl child campaign etc.

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA]

ANNEXURE: Questionnaire Q.1 Please enter your name and email address:

Q.2 Please select your role/dept. in the organization. Finance dept. PR/media communication. Risk dept. Compliance dept. Legal. HR. IT. Marketing/Sales. Others. Q.3 Please select the industry of your company. Manufacturing. Banking. Retail. Hospitality. Service. Software. Telecommunications. IT. BPO. Others. Q.4 Keeping in view your company rate the following risk as Major Minor or negligible. MAJOR MINOR NEGLIGIBLE 1. Reputational risk 2. Regulatory Risk 3. Credit Risk 4. Financing Risk 5. Market risk 6. Human Capital 7. IT Network 8. Political Risk ANY COMMENTSâ&#x20AC;Ś

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA] Q.5 Reputation risk in view of your company is: 1. A separate risk 2. Consequence of other risks ANY COMMENTS… Q.6 Rate the following according to the impact they have on your organization. Major Minor 1. Reputation as a source of competitive advantage 2. Bad news in media about the organization 3. Consumer: brand switching 4. Government Intervention 5. Compliance with ethics

Negligible.

ANY COMMENTS… Q.7 which of the following by any way caused loss to your company in recent past? YES No 1. Loss of reputation 2. Loss of skilled HR 3. Employee Fraud 4. IT Failure/electronic security breach 5. Damage to Infrastructure 6. Loss or theft of Intellectual Property ANY COMMENTS… Q.8 which of the following you consider can damage reputation of your company YES 1. Non compliance with regulatory and legal obligations 2. Unethical practices 3. Security Breach 4. Failure to deliver 5. Poor crisis management 6. Failure to achieve targets 7. Association with people or organization of poor repute 8. Failure to hold social responsibility ANY COMMENTS…

Q.9 which of the following activities are being followed at your company to manage Reputational Risk? YES NO 1. Crisis management process is planned and documented 2. External news n perceptions about the organization are measured on regular basis 3. A broad program for corporate social responsibility to address possible Sources of reputational risk is developed 4. Reputational threats are symmetrically tracked 5. Employees are trained to identify and manage reputational risk 6. A separate department or team handles reputational risk 7. Relationships and trust with pressure groups and other potential crisis of your firm are established.

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA] Q.10 How often do you check perceptions about your company with corporate stake holders? 1. 2. 3. 4. 5. 6.

Regularly Once in a month Four times a year Once in a year Occasionally very rare Never ANY COMMENTS…

Q.11 which of the following has contributed to managing reputation risk in your company? 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

CEO/President/Chairman Board of Directors Chief risk Officer Head of Business units PR Person CFO Compliance officer Marketing manager Head of country operations Brand manager Media ANY COMMENTS…

Q.12 How good your company is in following area Above avg. 1. 2. 3. 4. 5.

Avg.

Below avg.

No efforts

Communication with customers Enforcing strong controls on governance and compliance Monitoring threats to reputation Ensuring ethical practices Communicating with external stakeholders ANY COMMENTS…

Q. 13 Do you agree or disagree with the following statements? Agree Disagree Neutral 1. Corporate reputation is one of the primary assets of my firm 2. The risks involving an organization’s reputation have increased Significantly over the past five years Reputational risk is harder to manage than other forms of risk 3. My firm is proactive in enhancing and protecting its reputation 4. It is impossible to quantify the impact of reputational risks 5. Our program for corporate social responsibility is reputational Risk management by another name 6. My firm usually thinks about its reputation only when things go wrong 7. A well-run business doesn’t t need to invest extra resources into guarding Against reputational risk ANY COMMNTS...

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA]

Q. 14 Rate each of the following as an obstacle to Managing reputational risk in your organization?

Major

Minor

Negligible

1. Lack of established tools and techniques to manage reputational risk 2. No one has taken formal responsibility for reputational risk 3. Poor co-ordination between the board, risk function, corporate Communications, etc 4. Poor communications with external stakeholders 5. Too many reputational threats to manage 6. Management is too internally focused/unaware of external perceptions 7. Weak governance/internal controls ANY COMMENTS... Q.15 If you are into banking is Reputation Risk well described in the ICAAP Document (Pillar II of Basel II)? YES NO I donâ&#x20AC;&#x2122;t know Others (please specify). Q.16Do you think that your organization should more to manage reputation? Yes May be No Others (please specify). Q.17 Media monitoring is a means by which the impact of the media coverage is assessed as positive, negative or neutral. Appropriate action can be taken if it is negative. Does your company have media monitoring aspects in place? Yes. No. Somewhat. Others (please specify). Q.18 your valuable opinion/thoughts/suggestions regarding reputation risk.

[Risk-Pro Professionals] [REPUTATION RISK MANAGEMENT IN INDIA]

BIBLIOGRAPHY: http://en.wikipedia.org/wiki/Reputational_risk http://www.soa.org/files/pdf/lsprng07-001-rochette.pdf http://findarticles.com/p/articles/mi_m0ITW/is_1_85/ai_n14897163/ Reputational_Risk_White_Paper.pdf Various companies websites viz. www.hul.co.in www.havells.com

FACOLTA' DI ECONOMIA CORSO DI LAUREA IN ECONOMIA E DIREZIONE DELLE IMPRESE

TESI DI LAUREA IN METODI QUANTITATIVI PER IL MANAGEMENT

L’IMPATTO DEL RISCHIO REPUTAZIONALE SUI PREZZI AZIONARI

Relatore Prof. Marco Micocci

Candidata Prezioso Eleonora Matr. 617741

Correlatore Prof. Giovanni Fiori

Anno Accademico 2009 - 2010

Parte I – La reputazione e il rischio

1. L’importanza della reputazione d’impresa

«Ci vogliono 20 anni per creare una reputazione e cinque minuti per distruggerla» diceva Warren Buffet. La reputazione è l’asset più prezioso e più fragile, sia pure intangibile, della maggior parte delle aziende di oggi. Una buona reputazione, faticosamente guadagnata nel tempo, può essere sorprendentemente fragile nel XXI secolo globalizzato e interconnesso. La fiducia e la sicurezza che ne sono alla base possono essere irrimediabilmente danneggiate da una momentanea perdita di giudizio o da un commento involontario. Le notizie di tali defaillance circolano in pochi minuti in tutto il mondo veicolati dai media, generando “pandemie

mediatiche”

che

arrivano

distruggere

anche

irrimediabilmente la capacità dell’impresa di creare valore. Vi è una forte correlazione tra l'organizzazione, la reputazione e la sua capacità di commercializzare con successo i propri prodotti. Commercializzare con successo significa che le comunicazioni di marketing dell’organizzazione saranno più efficaci, i consumatori saranno più disposti a provare prodotti venduti sotto il marchio della società, e l’organizzazione disporrà inoltre di maggiori capacità di rendere accettabile per i suoi clienti un premium price. La reputazione interviene anche nel processo d’acquisto, rappresentando in molti casi l’ultimo elemento decisivo per convincere l’acquirente. 1.1

La reputazione i portatori di interessi

Vi sono diversi orientamenti in merito alla definizione di “reputazione”. Nella teoria dei giochi la reputazione è ritenuta un fondamentale segnale in presenza di asimmetria informativa per i consumatori/clienti che posseggono informazioni limitate sul comportamento dell’impresa. «Essi hanno minori informazioni 7

rispetto ai manager circa il commitment della società nel fornire prodotti con determinate caratteristiche in termini di qualità e sicurezza1»: una buona reputazione dell’impresa permette la scelta, chi non ha agito correttamente viene punito. Da un punto di vista prettamente manageriale si sono diffuse teorie che identificano nei c.d. portatori di interesse, o stakeholder, il punto di arrivo, con importanti feedback di ritorno, del processo di creazione e mantenimento della reputazione. Gli stakeholder sono gruppi sociali che rappresentano “forze” in grado di influenzare, secondo diversi gradienti di intensità, la dinamica evolutiva

dell’impresa,

soggetti

loro

volta

dell’influenza

dell’impresa stessa2. Nella tabella a seguire gli stakeholder sono raggruppati in base al grado di influenza da e sull’impresa.

Stakeholder primari Proprietà e finanziatori Dirigenti Dipendenti Clienti Fornitori Business partner Concorrenti

Stakeholder secondari

Istituzioni Comunità locale Gruppi di pressione Pubblica opinione e media Gruppi di rappresentanza Gruppi di pressione

Tabella 1 - Stakeholder primari e secondari

Gli stakeholder primari sono coloro che influenzano direttamente il comportamento dell’impresa, le sue scelte strategiche e senza i quali l’impresa stessa non potrebbe esistere. Gli stakeholder secondari non hanno un rapporto diretto e non sono essenziali per la sua sopravvivenza, tuttavia giocano un ruolo fondamentale nella costruzione “globale” della reputazione. Le aziende dovrebbero prendere in considerazione non solo i rischi sotto il loro diretto controllo, ma anche i rischi riguardanti fornitori, subappaltatori,

Fombrum C., Van Riel C., The Reputational Landscape, “Corporate Reputation Review”, vol. 1, N.1-2, 2000, pag. 6, 2 Cfr. Pastore A., Vernuccio M., Impresa e Comunicazione, p.7-8, Apogeo, Milano, 2008

partner commerciali, consulenti, e altri soggetti interessati, soggetti compresi nella c.d. «struttura ampliata» (che prescindendo dai confini giuridici dell’impresa, comprende tutti i soggetti che, sviluppando effetti sinergici, partecipano al processo di creazione del valore nell’ambito di un sistema coordinato e finalizzato di capacità3). L’impresa costruisce la propria reputazione attraverso la corporate identity (ciò che vuole essere) che «si connette alla mission, al posizionamento strategico e alla proposta di valore che l’impresa rivolge ai diversi portatori di interesse4». Sono gli stakeholder stessi a fare propria quell’identità attraverso la corporate image (come

l’impresa

appare

all’esterno)

rielaborare

una

reputazione in base alle loro esperienze e alle loro aspettative nel lungo

periodo.

«Il

coinvolgimento

degli

stakeholder

fondamentale nell’affrontare il rischio di reputazione in quanto […] una buona reputazione si costruisce nel confronto tra esperienze ed aspettative quando l’organizzazione si rende capace di allinearsi ed eventualmente eccellere nel soddisfacimento delle attese dei principali stakeholder5.» Il concetto di reputazione non va naturalmente confuso con altri due elementi chiave nella teoria manageriale dell’impresa, quali il brand e l’immagine. La corporate image riguarda infatti convinzioni personali legate direttamente all’impresa stessa più che ai suoi comportamenti. Se l’immagine è positiva anche la reputazione crescerà, ma a ritmi molto meno sostenuti dell’immage stessa. Il brand nella sua concezione ristretta di “marchio” è ciò che differenzia l’impresa dalle altre e comprende elementi visibili dell’impresa, quali il nome e il logo; la reputazione non può migliorare solo per il cambiamento del nome, inoltre comprende

Cfr. Golinelli G., L’approccio sistemico vitale al governo dell’impresa. Verso la scientificazione dell’azione di governo, Volume II, Cedam, Padova, 2008 4 Pastore A., Vernuccio M. (2008), Op.cit., p.28 5 Harpur Oonagh M., cit. in Corporate Social Responsibility Monitor, London: Gee Publishing, Chapter B4, in Rayner, Managing Reputational Risk. Curbing Threats, Leveraging Opportunities, New York, Wiley & Sons, pp. 13, 69, 2003

una serie di concetti molto più ampia dei segni visibili legati al brand. Possiamo dunque intendere la reputazione d’impresa come il giudizio diffuso e sedimentato nel tempo che i diversi interlocutori danno della credibilità delle sue affermazioni, della qualità e affidabilità dei suoi prodotti e della responsabilità delle sue azioni 6; essa riguarda la capacità dell’impresa di creare valore per le molteplici categorie di portatori di interesse7. In quanto elemento distintivo dell’impresa nel suo contesto competitivo la reputazione non è imitabile, poiché deriva da caratteristiche intrinseche dell’organizzazione e si forma nel tempo a seguito dello stratificarsi delle interazioni tra questa e stakeholder. A causa dei molteplici punti di contatto tra impresa e stakeholder, possono esistere differenti “reputazioni” presso differenti categorie di stakeholder, diverse fino a livello individuale, in quanto la percezione, seppure influenzata dall’unitarietà (auspicata) dei segnali inviati dall’impresa è pur sempre soggettiva. Proprio questo,

insieme

alla

sua

immaterialità,

rende

difficile

misurazione del capitale reputazionale di un’impresa. Anche se la voce reputazione non apparirà nel bilancio, rappresenta una parte significativa della differenza tra il valore attribuito dal mercato e i valori contabili. Dato che i beni intangibili rappresentano in genere oltre il 70% del valore di mercato, la reputazione è spesso un asset enorme del business8. «In un’economia dove il 70-80% del valore di mercato viene da asset intangibili difficili da valutare come brand equity, capitale intellettuale e una buona reputazione, le organizzazioni sono particolarmente vulnerabili verso qualunque cosa possa danneggiare la loro reputazione.9»

Cfr. Ravasi D., Gabbioneta C., Le componenti della reputazione aziendale. Indicazioni dalla ricerca RQ Italy, Economia e Management, n.3, 2004, pag.78 7 adattamento da Fombrum C. J., Foss C. B., The Reputation Quotient, in “The Gauge”, vol. 14, n. 3, 14 maggio 2001 8 Cfr. Rayner J., Understanding reputation risk and its importance, QFinance, www.qfinance.com, 2010 9 Eccles R. et al., Reputation and Its Risks, Harvard Business Review, Feb. 2007

1.2

I driver della corporate reputation

La fase più cruciale del processo di gestione della reputazione del rischio è l’identificazione dei suoi fattori di origine da valutare al fine un’analisi quantitativa. I rischi devono essere riconosciuti e compresi prima di poter essere gestiti. Una buona reputazione dipende da come un’impresa vive concretamente i valori che comunica di condividere e dalla costante interazione positiva con gli stakeholder. Il perseguimento di vantaggi a breve termine a spese della reputazione a lungo termine, non è pratica accettabile. Gestire con successo il rischio reputazionale è sia una sfida dall’interno verso l’esterno che viceversa. Sul versante interno la sfida

richiede

business

leader

capaci

che

stabiliscano

un’appropriata mission, i valori e gli obiettivi strategici che guideranno le azioni ed i comportamenti di tutta l'organizzazione. Queste componenti sono strettamente immanenti all’impresa stessa e si sviluppano sul lungo periodo. La sfida verso esterno richiede un continuo monitoraggio dell'ambiente esterno e in particolare degli stakeholder per assicurarsi che l’impresa sia sulla strada che ne assicura il sostegno continuo e la fiducia. Considerare i sette drivers della reputazione10 è un utile punto di partenza, in quanto questi sono anche fertili fonti di minacce nonchè di opportunità per la reputazione11.

10 11

Rayner J.(2010), Op.cit. Rochette M., Reputation risk: also know the Cinderella asset, Society of Actuarial (www.soa.org), 2007

Figura 1 - Valori driver della corporate reputation

Il perseguimento dell’obiettivo di performance finanziarie di lungo periodo induce gli shareholder, gli investitori, a mantenere la loro partecipazione se l’impresa ha mostrato di essere degna di fiducia e ha un buon capitale reputazionale. L’effetto “alone” (corporate halo) di un business può aiutare a differenziare i prodotti in un settore altamente competitivo, può generare premium prices, e può essere l'ultimo fattore decisivo per un eventuale acquirente di servizi12. Ciò le consente di mantenere un prezzo piuttosto stabile ed eventualmente di assicurarsi un premium price, invece di ridurlo per attrarre i clienti. Una forte reputazione può aiutare ad attrarre e trattenere il personale di talento e può scoraggiare nuovi concorrenti, fungendo anche da barriera all'ingresso sul mercato. La capacità di mantenere buoni rapporti con l’opinione pubblica e i media è fondamentale soprattutto per preservare e difendere la reputazione nei momenti di crisi. La reputazione può anche formare l'atteggiamento delle autorità di regolamentazione, gruppi di pressione, e dei media nei confronti di un business e può influenzare il suo costo del capitale. Forse il più grande beneficio che una buona reputazione apporta all’impresa è il “cuscinetto” di benevolenza che forma attorno ad essa, che permette ad un 12

cfr. Pride W. M., Ferrell O.C., Concetti di prodotti, branding e packaging, dalla collana “Management”, n.1, 2006, Università Bocconi Editore, p. 324.

business di resistere a shock futuri. Questo capitale reputazionale o “reputation equity” rafforza la fiducia degli stakeholder e può persuadere gli interlocutori dell’impresa a darle il beneficio del dubbio o una seconda chance quando una crisi imprevista la colpisce. Vedremo più nel dettaglio nella seconda parte come alcuni di questi driver siano fondamentali nella gestione del rischio reputazionale, nella mitigazione e la minimizzazione dei danni reputazionali. Il problema sempre più incalzante per le aziende è come misurare la reputazione e il rischio ad essa connesso. Le aziende spendono milioni per assicurare gli asset tangibili contro perdite e danni, ma spendono molto poco per comprendere cosa sia la propria reputazione e quali perdite, o anche vantaggi, da essa possano derivare. La valutazione della reputazione è un terreno molto ambiguo, ma da diversi anni aziende come “Interbrand” si sono specializzate in metodologie di valutazione e stilano annualmente classifiche internazionali. La comprensione dei rischi legati alla reputazione, della loro misurazione e degli strumenti manageriali per prevenirli o mitigarne gli impatti costituisce il collegamento tra le funzioni di marketing

comunicazione

risk

management.

Una

professionale attività di comunicazione istituzionale può mitigare il rischio reputazionale o anche minimizzarne i danni. Il risk management fornisce le metodologie, derivanti prevalentemente dall’approccio ad altre tipologie di rischio, che permettono di quantificare per quanto possibile ciò che per eccellenza è intangibile. Dal punto di vista organizzativo l’attenzione nei confronti delle aspettative dei diversi portatori di interessi si inserisce all’interno di una struttura di governo che adotti un formale orientamento alla responsabilità sociale, un coeso sistema di risk management, un indipendente sistema di controllo interno e una chiara e trasparente comunicazione finanziaria.

2. Il risk management E’ importante ricostruire il contesto all’interno del quale è, o perlomeno dovrebbe essere, inquadrata la gestione del rischio reputazionale nelle aziende. Analogamente alla definizione di reputazione, il concetto di “rischio” non è univocamente definito nell’ambito accademico. Accomuna i diversi orientamenti il riferimento ai concetti di variabilità e incertezza dei risultati. «Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected13» secondo la definizione di Vaughan: le deviazioni dal risultato atteso possono essere sia sfavorevoli che favorevoli in certi contesti e solo sfavorevoli in altri, dunque si è consolidata la tendenza a distinguere le due tipologie di rischio in rischi “puri” e rischi “speculativi”14.

Alla

prima

categoria

appartengono

rischi

“assicurabili”, ossia quei rischi (puri) che possono essere gestiti mediante procedimento assicurativo; nella seconda categoria rientrano i rischi “finanziari” e i rischi “industriali”, ovvero quei rischi la cui fonte di aleatorietà deriva dall’andamento di tutte le altre variabili rilevanti dell’attività produttiva. Una seconda importante classificazione dei rischi divide i rischi d’impresa in core risk e noncore risk15: i primi sono rischi che l’impresa non può trasferire (e tra essi collochiamo certamente il rischio reputazionale), in quanto connaturati al tipo di attività svolta, e in corrispondenza dei quali è possibile conseguire un extrarendimento rispetto al tasso privo di rischio; i secondi sono rischi cui l’impresa è esposta in forza del tipo di attività svolta, ma che possono essere eliminati attraverso opportune strategie di copertura senza che questo modifichi la natura e le caratteristiche dell’attività stessa d’impresa. I rischi core possono essere gestiti esclusivamente attraverso scelte di strategia aziendale, mentre i 13

Vaughan E., Risk management, New York, Wiley, 1997 cfr. Nocera G., Dal financial risk management all’enterprise risk management, in Forestieri G.(2007), Corporate e investment banking, Egea, Milano 15 Culp C.L., The ART of Risk Management, pp.193-194, New York, Riley, 2002 14

rischi noncore, in cui rientrano i rischi assicurabili e finanziari della classificazione precedente, presentano la possibilità di essere gestiti anche, ma non solo, attraverso soluzioni che non condizionino le scelte strategiche e operative dell’impresa. In particolare la logica prevalente di gestione “esterna” dei rischi noncore è quella hedging, di copertura fornita tipicamente dalle banche di investimento. La natura unidirezionale e asimmetrica dei rischi puri, invece, costituisce un ostacolo alla possibilità di fronteggiarli applicando l’approccio hedging dei rischi finanziari: un rischio puro non può essere annullato assumendo una posizione contraria su un rischio con uguali caratteristiche. Tuttavia, l’incertezza sui risultati cui un rischio puro dà luogo si attenua sensibilmente quando esso è considerato all’interno di una più ampia logica di portafoglio di rischi ad esso omogenei e tra loro indipendenti, che sfrutti meccanismi di diversificazione spazio-temporali (la cosiddetta ritenzione attiva) per eliminare l’incertezza rispetto all’entità delle perdite, invece che l’eliminazione dell’eventualità delle perdite. Un tale approccio ai rischi a livello organizzativo, finchè adottato, prevedeva singole divisioni per i rischi operativi, il c.d.a. era responsabile dei rischi core, la tesoreria dei rischi finanziari, il risk manager, se previsto, dei rapporti con le imprese di assicurazione. Questa dimensione dell’attività di risk management si può definire “tattica” in quanto orientata alla gestione di una sola classe di rischio per volta e affidata a staff altamente specializzato su ognuna. A livello operativo il risk management era improntato sull’adozione di un orizzonte temporale breve, trascurando le esposizioni al rischio di più lungo periodo e le relazioni che esistono tra le varie esposizioni. Inoltre la ritenzione attiva opera una trasformazione, non l’annullamento, del rischio puro originario in una combinazione di nuovi rischi, alcuni di natura speculativa: 

rischio attuariale: il rischio che la previsione delle perdite generate dall’esposizione originaria si riveli inadeguata;



rischio di investimento: il rischio che il rendimento ottenuto dall’investimento delle risorse accantonate per fronteggiare le perdite previste sia inferiore a quello atteso;



rischio temporale: il rischio che le perdite previste si manifestino più velocemente del previsto



rischio di credito: il rischio che l’emittente degli strumenti finanziari nei quali siano investite le risorse accantonate sia insolvente

Se un rischio speculativo fosse gestito attraverso una strategia di hedging con strumenti derivati, l’esposizione originaria potrebbe essere formalmente annullata, ma a essa si sostituirebbe un rischio di credito, quello di inadempienza della controparte dello strumento derivato, che ha natura di rischio puro e non speculativo. Tale visione del risk management evidenzia la labilità delle classificazioni

tra

tipologie

rischi

conseguente

inadeguatezza di un approccio tattico e specialistico al risk management e ha reso necessario, negli ultimi anni, l’adozione di una visione più ampia e integrata, chiamata Enterprise Risk Management (ERM): l’ERM viene definito come «un processo, effettuato dall’Alta direzione, dal management e dal personale, formalizzato in strategie e strutturato, per identificare qualsiasi potenziale evento che può influenzare l’organizzazione. Tale approccio permette una gestione dei rischi entro il livello di propensione al rischio stesso dell’impresa e garantisce una ragionevole sicurezza circa il raggiungimento degli obiettivi aziendali.16» L’ERM si caratterizza per l’applicazione di strumenti di calcolo sempre più sofisticati, la nascita di contratti, strutture e soluzioni alternative di gestione di rischi (detti prodotti ART, Alternative

Risk

Transfer).

livello

organizzativo

ciò

comportato l’attribuzione delle responsabilità della funzione del risk management ai più elevati livelli nelle gerarchie d’impresa, 16

Committee of Sponsoring Organizations of the Treadway Commission, Enterprise Risk Management Framework, 2004

con la costituzione di un risk management team e talora di un chief risk officer, un collegamento tra il processo di creazione di valore, formalizzato per obiettivi, alle fasi di gestione del rischio.

2.1 Il rischio finanziario Sebbene gli ultimi anni abbiano visto emergere fortemente l’esigenza di un approccio integrato al risk management, è pur vero che il processo di identificazione delle categorie di rischi cui è esposta l’impresa resta fondamentale. Tra queste categorie, dai confini molto labili, il rischio finanziario fornisce indicazioni importanti ai fini della nostra analisi. Esso può essere suddiviso in tre principali categorie17:

 Rischio di mercato: si riferisce alla possibilità di subire delle perdite dovute a variazioni nei prezzi delle attività finanziarie (fluttuazioni dei prezzi azionari), ma anche a variazioni negative dei tassi d’interesse (rischio di tasso) e dei tassi di cambio (rischio di cambio). La sua misura è un indicatore, chiamato Value at Risk (VaR), la misura della massima perdita potenziale nella quale può incorrere il portafoglio, scaturita dall’evoluzione dei prezzi di mercato in un determinato periodo. Esso dipende da diversi parametri:

 l’holding period: periodo di tempo per il quale si ritiene di tenere fissa la composizione del portafoglio

 l’orizzonte temporale  il livello di confidenza α  la stima delle volatilità future  la stima delle correlazioni tra gli strumenti finanziari che costituiscono il portafoglio La definizione generale di VaR è la seguente:

P  Perdita(n)  VaR (n)   1  

Cfr. Micocci M., Risk Management, materiale didattico corso Metodi Quantitativi per il Management, Luiss Guido Carli, a.a. 2008/2009

La definizione di VaR sarà approfondita nell’analisi delle specifiche problematiche legate alla misurazione del rischio reputazionale.

 Rischio di credito: è connesso all’inadempienza della controparte nel soddisfare un obbligo contrattuale (per esempio in caso

d’insolvenza

dell’emittente

un’obbligazione).

Un’obbligazione può essere soggetta contemporaneamente al rischio di credito e al rischio di mercato (sotto forma di rischio di tasso).

 Rischio operativo: «the risk of loss resulting from inadequate or failed internal processes, people and system or from external events18». Questa definizione include il rischio connesso a variazioni legislative e regolamentari ma esclude il rischio reputazionale e il rischio derivante dalle scelte strategiche operate dagli amministratori

(rischio strategico). Nella definizione del

Comitato Basilea il Rischio Operativo comprende vari rischi eterogenei legati principalmente a quattro fattori:

 Processi

interni:

inadeguatezza

delle

procedure,

insufficienza dei controlli interni, errori di contabilizzazione, errori nel regolamento delle operazioni

 Errori umani: errori involontari dei dipendenti, frodi, violazioni di regole e procedure interne

 Blocco dei sistemi: malfunzionamento dei sistemi informativi, errori nei programmi informatici, perdita di dati, interruzione della struttura di rete

 Eventi esterni: eventi catastrofici, variazioni nel panorama economico-politico del Paese Nello specifico sono sette i fattori individuati dal Comitato Basilea all’origine di perdite classificate come rischio operativo: 1. Interruzione dell’attività e disfunzione dei sistemi informatici 2. Clienti, prodotti e prassi operative 3. Danni ad attività materiali

Basel Committe on Banking Supervision “Working Paper on the Regulatory Treatment of Operational Risk”, Settembre 2001

4. Rapporto di impiego e sicurezza sul posto di lavoro 5. Esecuzione e gestione dei processi 6. Frode esterna 7. Frode interna Più

avanti

analizzeremo

misurazione

del

rischio

nel

dettaglio

operativo

metodologie

(principalmente

Loss

Distribution Approach), utili, con opportuni adattamenti, a fornire una misura del rischio reputazionale.

3. Il rischio reputazionale

«La natura del rischio reputazionale non sembra essere davvero compresa. Di conseguenza, quando si tratta di gestione del rischio, la reputazione non è accettata come una categoria di rischio indipendente – una che meriterebbe approcci di gestione su misura – ma è semplicemente etichettata come una conseguenza e un rischio secondario19». Il rischio reputazionale dunque è considerato un rischio secondario, talvolta neanche assimilato alla categoria di rischio. La stessa definizione della Commissione Basilea nel 1997 aveva fornito indicazioni in tal senso «Reputational risk arises from operational failures, failure to comply with relevant laws and regulations, or other sources.20» come derivante, dunque, da fattori di rischio operativi, legali e strategici. Oltre questi fattori altre due condizioni dovrebbero giocare perché si possa parlare di rischio reputazionale: 

responsabilità diretta dell’impresa o almeno di uno dei suoi manager (anche se, è stato già accennato, l’impresa può essere

danneggiata

anche

“di

riflesso”

dai

danni

reputazionali ad altri player del suo settore o del suo Paese);

Cutler A., Zollinger P., Stealth Risks Evade Corporate Radar in “Sustainability Radar”, October 2001 Gabbi G., Reputation, Corporate Governance and Ethical Choices, p.213, in S. Capece (a cura di), Ethical choices in economics, society and the environment, Luiss University Press, Roma, 2009 20



presenza di specifiche variabili (c.d. “variabili reputazionali”) capaci di trasformare i fattori di origine in un cambiamento della reputazione dell’impresa.

Nella

letteratura

prevalente

l’orientamento

del

“rischio

reputazionale” come concetto che abbraccia rischi, da qualsiasi fonte, che possono avere un impatto sulla reputazione, e non come una categoria di rischio in sé21. Solo negli ultimi anni, a causa

soprattutto

dell’aumentata

percezione

dell’impatto

gravissimo che può avere il rischio reputazionale sugli asset tangibili e intangibili delle imprese, si è stati costretti a isolarlo come categoria a sè, con tutte le problematiche metodologiche che può comportare la “misura dell’intangibile”. Innegabile in ogni caso appare la stretta correlazione tra rischio operativo e rischio reputazionale. Una mancanza grave dell’impresa sotto il profilo operativo è immediatamente evidente e costituisce un segnale inequivocabilmente negativo per la reputazione presso gli stakeholder. Il rischio operativo della rottura di una piattaforma petrolifera,

oltre

danni

materiali

stimabili

con

buona

approssimazione grazie alle note metodologie di gestione del rischio, ha provocato nel recente caso della British Petroleum – che verrà analizzato più avanti – un danno reputazionale gravissimo. Il rischio reputazionale, tuttavia, a differenza dei rischi da cui lo si fa derivare che possono produrre perdite gravi ma circoscritte, è caratterizzato da una sproporzione tra l’evento originario e le conseguenze che nei casi peggiori possono arrivare a danneggiare l’intera impresa. Nella seguente tabella22 sono riassunte le differenze tra rischio reputazionale e rischio finanziario entro il quale, lo ricordiamo, sono ricompresi sia il rischio operativo che il rischio di mercato.

21 22

Cfr. Rayner J. (2010), Op.cit. adattamento da Gabbi G. (2009), Op.cit., p. 212

CORPORATE CULTURE, CORPORATE REPUTATION, COLLABORATIVE RELATIONSHIPS AND ORGANIZATIONAL PERFORMANCE, A CASE OF PRIVATE TERTIARY INSTITUTIONS IN UGANDA

CHAPTER ONE INTRODUCTION 1.1 Background to the Study In the past, a number of studies have demonstrated that non-financial factors such as corporate culture and corporate reputation have become increasingly important in determining the corporate value (Kraus, 2004). Corporate culture refers to the core organizational values, which underpin decisions and behavior. They influence the way people behave in many ways such as treatment of customers (Flamholtz, 2006). Corporate culture determines organizational success as it influences goal attainment because of the believed link to motivation of employees (Flamholtz, 2006).

Organization’s reputation can be influenced by its culture particularly relative to public expectations (Greyser, 1999). Corporate reputation is a perceptual representation of the company’s past actions and future prospects – describing the company’s overall appeal to the key constituents compared to other leading rivals (Dolphin, 2004). A strong reputation leads to customer satisfaction, quality output, grows revenue, profits, and generally increases organizational performance (Rochette, 2007). However, when Organization’s culture runs counter to public expectation, the organization will suffer a major loss of reputation and consequently a decline in performance. Stakeholders’ trust in

the organization declines due to the exposure of its failure to live up to public expectations (Greyser, 1999). In Uganda, certain cultural notions in the private tertiary institutions may present the context in which their reputations are formed. A drive for quick returns has compromised standard performance in these institutions to the extent that many of them operate on provisional licenses and there are few institutions to which students can go without fear of getting illegal awards (NCHE, 2006). In 2005, Namasagali University was closed for operating without a governing council and appointments board (The Monitor, 2005).

These Institutions are also reported to have limited orientation towards their employees with poor remuneration packages and career prospects (NCHE, 2004). In addition; there is limited transparency especially in their communication. They seem to be dishonest and unethical in nature. For example when KIU advertised nursing courses, it was found not to have any facilities for clinical practice (The Monitor, 2004). Other Institutions have only big sign posts and names which sound attractive but nothing more. They have compromised quality control systems to the extent that programs and exams are simplified not to fail students who are the adored customers. A number of these Institutions in town operate with inadequate physical facilities, unreliable teaching staff and unresponsive systems of administration.

There seems to be a failure of Private Tertiary Institutions in Uganda to live up to stakeholdersâ&#x20AC;&#x2122; expectations and this has compromised their reputation. Due to unfavorable reputation, these institutions find it hard to attract the bright students, attract and retain

talented and qualified staff, and winning research grants which are important inputs for quality education. Consequently, the quality of education they claim to offer is questionable (The Monitor). In 2005, the NCHE closed Namasagali University, Uganda Pentecostal University, Fairland University, and Kigezi International School of Medicine when their operations were found to fall below the quality indicators of quality education.

In Addition, Private Tertiary Institutions find it hard to collaborate with each other and with the industry. There is limited trust and respect towards these Institutions and most of them seem to operate in isolation. Perhaps this is why most companies are willing to collaborate with them far as long as they pay for all costs of research projects, and student internships. Few Institutions are willing to do this and as a result graduates are churned out without proper training (NCHE, 2006). 1.2 Statement of the Problem In Uganda, corporate culture and unfavorable reputation is still a challenge for Private Tertiary Institutions and as a result their performance is still contested by stakeholders. Between 2004 and 2006, there were over 50 articles in the press about these institutions and most of these articles focused on conflict with NCHE as regards standards and operations in these institutions, as well as discrimination of their graduates in the labour market for employment. The closure of some Universities like Uganda Pentecostal University, and Namasagali University in 2005 was attributed to the failure of these institutions to meet standards of quality education (NCHE, 2005). In the past, studies about Private Tertiary Institutions in Uganda have focused on quality assurance and financing of these institutions. However, the relationship between corporate culture,

corporate reputation and the extent to which these variables affect the performance of Private Tertiary Institutions in Uganda had not been explored and this was the basis of the study. 1.3 Purpose of the Study The purpose of the study was to examine the relationship between Corporate Culture, Corporate Reputation, Collaborative relationships and Performance of Uganda Private Tertiary Institutions. 1.4 Study Objectives. The study was guided by the following objectives; i) To establish the relationship between corporate culture and corporate reputation in Uganda Private Tertiary Institutions. ii) To establish the relationship between corporate reputation and performance in Uganda Private Tertiary Institutions. iii) To establish the relationship between corporate culture and performance in Uganda Private Tertiary Institutions. iv) To establish the relationship between corporate reputation and collaborative relationships in Uganda Private Tertiary Institutions. v) To establish the relationship between collaborative relationships and performance in Uganda Private Tertiary Institutions. 1.5 Research Questions i) What is the relationship between corporate culture and corporate reputation in Uganda Private Tertiary Institutions?

ii) What is the relationship between corporate reputation and performance in Uganda Private Tertiary Institutions? iii) What is the relationship between corporate culture and performance in Uganda Private Tertiary Institutions? iv) What is the relationship between corporate reputation, collaborative relationships and performance in Uganda Private Tertiary Institutions? v) What is the relationship between collaborative relationships and performance in Uganda Private Tertiary Institutions? 1.6 Significance of the Study Loss of a cultural driven reputation is seen as the biggest threat to market acceptance of private tertiary Institutions in Uganda and it is therefore anticipated the study will; 

Provide Institutional Leaders with knowledge of how to build a cultural driven reputation that will create and enhance trust in the minds of all stakeholders including regulators (NCHE). Only this way, they are capable of advancing to the stage of being accredited and chartered. Thus capable of attaining recognition and merit just like public Institutions.



Make recommendations that will go a long way in improving the corporate culture, reputation and collaborative relationships of Uganda Private Tertiary Institutions, which will increase their worth in the labour market.



Through the resultant interaction between the researcher and the respondents, the researcher’s knowledge, skills and understanding of research will improve.



Identify other areas of research in corporate culture, corporate reputation and collaborative relationships where not much research has been done.

1.7 Scope of the Study Geographical Scope The study focused on the staff members and students of Private Tertiary Institutions in Uganda. Time scope. The period under study was 2007 to 2008

Conceptual Scope The study addressed the components of corporate culture, and examined its relationship with corporate reputation and organizational performance. In addition, the study addressed the components of corporate reputation and examined its relationship with collaborative relationships and organization performance. The study was limited to the following components of the study variables; Corporate culture: Its components included; process oriented, Employee oriented, Parochial oriented, Professional oriented, open, and closed organizational systems. Corporate Reputation: Its components included; Service quality, Trust, and social responsibility, and communication. Collaborative relationships: Its components included; Institution â&#x20AC;&#x201C; Institution collaboration and Institution â&#x20AC;&#x201C; Industry collaboration. Organizational performance: Its components included; Outcome performance, Process performance, and Input performance.

1.8 The Conceptual Frame work

The frame work identifies the study variables which explain the research problem when they are connected together and related to one another. In the conceptual frame work of this study (figure1) below , Corporate culture and Corporate reputation are the independent variables, Collaborative relationships is the moderating variable between corporate reputation and Organizational performance and Organizational performance is the dependent variable. Figure 1: Conceptual framework.

Corporate Culture

Corporate Reputation

Collaborative relationships

Organizational Performance

Source; Constructed after reviewing existing literature on the variables, according to; Flamholtz (2006), Hofstede (2003), Greyser (1999), Lawson (2004).

Explanation of the model Corporate culture influences the way people behave in many ways such as; treatment of customers, standard performance, open communication, professionalism and ethics

among others (Flamholtz, 2006). In turn, this determines organizational performance i.e. leads to enhanced coordination and control, improved goal alignment, and increased employee effort resulting into increased output (Flatt & Kowalczyk, 2006). However, a Companyâ&#x20AC;&#x2122;s reputation can be influenced by its culture particularly relative to public expectations. A societyâ&#x20AC;&#x2122;s expectation of good corporate culture can enhance its corporate reputation that is to say good corporate behavior creates public confidence in a company and increases its credibility among stakeholders (Greyser, 1999). A favorable reputation leads, customer satisfaction and loyalty, a strategic advantage such as reducing competitive rivalry and mobility barriers to deter market entry, charging premium prices, reducing operating costs and attracting talent to the organization (Rochette,2007). A reputable organization finds it easier to collaborate with other institutions and the industry because of being gauged by stakeholders as a credible organization that has built trust and respect overtime (Cigdem, 2006). Collaborative relationships results into cost savings, economies of scale, support for research programs, and a cost effective way of achieving output (Lawson, 2004). 1.9 Organization of the Report. The report is organized in five chapters. Chapter one gives an introduction to the study by highlighting the origins of the research, contextualizing the situation in which the problem is occurring, and the conceptual framework that identifies, connect and relate the study variables. Chapter two focuses on the review of literature on the variables used in the study and the relationship among these variables. Chapter three explains the methodology adopted when carrying out the study. Chapter four covers presentation and

analysis of data and Chapter five presents a summary and discussion of the research findings, conclusions and recommendations in relation to the research findings.

CHAPTER TWO LITERATURE REVIEW 2.0 Introduction The literature reviewed focused on the variables used in the study and the relationship among these variables. 2.1.1 Corporate Culture. Corporate culture is generally recognized to comprise the attitudes, values, beliefs, norms and customs of an organization (Bradfield, 2006). Culture is shared values, norms, and expectations that govern the way people approach their work and interact with each other (Gourley, 2002). Bellou (2007) argue that culture is a unique amalgam of Symbols, values, attitudes and behavior patterns, associated practices, and ways of conducting business, creating a distinct identity. Siew & Yu (2004) believe that culture is an internal variable of the organization consisting of shared values. Eschneider (2000) argue that culture is an organizationâ&#x20AC;&#x2122;s way of behaving, identity, and pattern of dynamic relationships, reality or genetic code. It has every thing to do with implementation and how success is actually achieved.

Organizational cultures are developed over time, influenced initially by the owners of the organization. The ownership hires senior management to steer the organization and

develop its values (Elashmawi, 2000). Therefore, a set of values specific to a work unit embody certain assumptions about work, and how things should be done given a specific context. In turn, behavioral choices of employees are driven in relation to known values, attitudes, and beliefs particularly when time is short and when no formal policy exists to guide the action (Mallak, Lyth, Olson, Ulshfer & Sardone, 2003). Similarly, organizational culture can be a pattern of basic assumptions invented, discovered or developed by a given group as it learns to cope with its problems of external adaptation and internal integration. These values are then taught to new members in the organization as the correct way to think and feel in relation to those problems (Zabid, Sambasivan, & Johari, 2003).

Hofstede (2003) identifies a pattern of twelve orientations underlying cultures of most organizations. These are; process orientation, result orientation, job orientation, employee orientation, parochial orientation, professionalism, open systems, closed systems, loose control systems, tight control systems, pragmatic orientation and normative orientation. Hofstede argue that organizational culture is the collective programming of the mind which distinguishes the members of one organization from another and that the dominance and coherence of culture proves to be an essential quality of excellent organizations. Besides, the stronger the culture and the more it is directed towards the market place, the less is the need for policy manuals, organization charts, or detailed procedures and rules. Therefore, mentioning about organizational culture has become a fad among managers, among consultants and among academicians with different concerns.

2.1.2 Corporate Reputation. This is a collective representation of organization’s past actions and results that describes its ability to deliver outcomes to multiple stakeholders. It gauges the organization’s relative standing both internally and externally (Rochette, 2007). It is a perceptual representation of an organization’s past actions and future prospects that describe its over all appeal to all key constituents when compared to other leading rivals (Inglis, Morky, & Sammut, 2006). Corporate reputation is a multidimensional Variable, where a firm’s reputation emerges from multiple constituent groups (Flatt & Kowalczyk, 2006). It’s the totality of enduring images that key stakeholders form on the basis of how they perceive the performance of the organization and its behaviors. This makes reputation a mosaic of various factors with different weights and impacts (Katinka & Moser,2006).It is a many-sided component and the components are the history of human experiences with the actions and activities the organization perform in a specified time (Cigdem, 2006). Stakeholders evaluate the organization overtime basing on direct experiences, any other form of communication and symbolism that provides information about the firm’s actions and or a comparison with the actions of other leading rivals (Eberl & Swarger, 2004).

The key drivers of reputation may include; quality products and or services, social and environmental responsibility, compliance with the regulators, trust treatment of staff, communication among others. These factors change overtime; reflecting changes in society and the organization in particular (Katinka & Moser,2006). Therefore, reputation becomes the outcome of repeated interactions and cumulative experiences stakeholders

build over a period of time. It is bestowed upon the organization by stakeholders and it is formed on the basis of direct and indirect experiences. It is the reflection of an organization over time as seen through the eyes of its stakeholders and expressed through their thoughts and words. Therefore, it is rooted in trust and ethically shaped over time (Dolphin, 2004). It forms the external manifestation of the organizationâ&#x20AC;&#x2122;s people, culture, management talent, and the overall competitiveness as these are the critical factors that determine the leaders and laggards in the world of business (Jeffrey, 2004). According to Cigdem (2006), the reputation of service organizations is related to their activities, quality of services and the ability to fulfill their social responsibilities towards society to earn a social license to operate. 2.1.3 Collaborative Relationships. According to Luana & Burlingame (2002) Collaboration is a relationship that provides opportunities for mutual benefits and results beyond those any single organization or sector may realize alone. It is a system where individuals in one organization work together with other individuals in another organization in order to achieve some form of mutual benefit (Kayaga, 2007). Collaboration is a strategy used by public, private, and non profit institutions to achieve both small-scale, short-term and long-term, organizational goals. Collaborations in institutions of higher education can be sub-divided into single University/industry collaboration, single University- multi- industry collaboration,

multi-university/industry

collaboration

and

University

consultant

collaboration. All these involve education and training activities including; classes, seminars, conferences, workshops, certificate, diploma and degree programs (Kathy et al, 2008). Tertiary institutions world-wide have become more internationally active through

increased student mobility, staff exchange and the increasingly international dimension of curriculum. For example in USA, inter-University co-operation covers student exchanges, staff exchanges, curriculum development initiatives, joint research projects and development in distance learning (Ayoubi& Al- Habaibeh, 2006). In Uganda, the existing collaborative activities typically involve industrial training and or applied research undertaken by students. Most of the collaborations are informal and are in most cases initiated by individual students. In case of industrial training attachments, there is no exchange of information between the industry and the academics apart from the general letter of introduction from the institutions to the participating organization (Kayaga). 2.1.4 Organizational Performance. Organizational performance is reflected in the number of goals it sets out to fulfill. Measuring organizational Performance involves assessment of the level of achievement made from the actual performance as compared to its benchmark (thatâ&#x20AC;&#x2122;s to say Mission, goals, plans among others). Performance measurement should always be undertaken in conjunction with appropriate investigation and follow up actions in order to contribute in the aspect of crystallization of goals. Measuring organizational performance clarifies the objectives of the organization, helps to develop agreed measures of activity, ensures greater understanding of the processes and facilitates comparison of performance in different organizations (Tibaijuka, 2005).

Performance measures indicate the success of management in fulfillment of those goals (Megan, 1999). According to Ittner & Larcker (2000) much emphasis should not only be

put on financial measures such; as earnings and accounting returns like in case of commercial organizations, but also on drivers of organizational value such as; customer and employee satisfaction, quality, organization’s intellectual capital ,supplier relations, alliances, community and environment. These can be used to monitor and control activities without any accounting input (Tibaijuka, 2004). Performance of Tertiary institutions like other non-profit seeking organizations cannot be assessed by economic measures but rather in a way that is generally agreed to be meaningful. Increase in knowledge through research and development, the instruction to students that enhance the quality of graduates, and the professional staff training and development that produce skilled academicians (intellectual capital) are the generally accepted input-output measures of tertiary institutions(Oregon Business plan,2003). 2.2 Corporate Culture and Corporate Reputation While organizations often cite their own specific efforts to implement “best practices”, it is not clear what they are doing to develop a culture that supports a desired reputation (Firestein, 2006). Organization’s reputation, sits on the bedrock of its cultural values such as employee orientation, job orientation, professionalism, normative orientation among others (Hofstede 2003, Flatt & Kowalczyk, 2006). These are at the core of the perceptual representation of the organization’s reputation. Therefore, reputation develops from the organization’s uniqueness and from identity- shaping practices, maintained over time, that lead to stakeholders to perceive the organization as credible, responsible and trustworthy(Flatt & Kowalczyk).

Harrison (2007) argues that it is the operational practices that shape organizationâ&#x20AC;&#x2122;s reputation. The relationship between stakeholders and the organization is influenced by its practices especially when these are conducted on a two way symmetric basis, which involves treating stakeholders with respect. Grahame (2006) argues that corporate behaviors speak louder than words. The stakeholders may be affected the organizationâ&#x20AC;&#x2122;s actions directly or indirectly, and may respond unfavorably if they feel their interests are prejudiced (Economic Intelligence Unit, 2005). Promising a customer or any stakeholder something that sounds good, but which does not reflect the firmâ&#x20AC;&#x2122;s reality in terms of its conduct and behaviors is dangerous (Gary, 2005). When Arthur Andersen and company admitted to covering up financial irregularities that occurred at its client Enron, little was done to help the world forget the image of a group of faithful accounting consultants lined up at paper shredders in the Enron accounting department (Firestein, 2006).

In Uganda, the reputation of Kampala International University was compromised when it advertised and registered students for nursing courses yet they did not have facilities for clinical practices (The Monitor, 2004). Every thing an organization has to do and does not do it, has a direct impact on its reputation (Rochette, 2007). Grahame argues that a failure to have fair treatment of employees would reduce employee productivity, and the morale they would gain when providing services to customers on daily basis. This is because they would feel ignored in the areas of welfare, work conditions and availability of training and opportunity for advancement and since they are the human face value of the organization, the quality of services provided, will gradually decline. Besides, failure

to build a culture of attentive engagement and a tight control system can prove devastating (Economic Intelligence Unit, 2005).

An organization characterized by a loose control system breeds cases of thievery and fraud. Some universities in Uganda do not enjoy reputation for good management and cost consciousness. A case in point is Makerere University Kampala with reported cases of financial mismanagement and the Government has always looked to reinventing its systems of operations (The Monitor, 2007). Building and managing a good reputation, takes into greater consideration the need for the organization to develop a unifying corporate culture that fully discloses execution of the desired corporate image (Hofstede 2003). Firestein (2006) argues that leaders who have built a strong corporate reputation know what it takes; an internal culture that forges a positive opinion of the organization by successfully coping with expected and unanticipated challenges and that every organization solution must be unique.

Every organization should emphasize but not to exaggerate the aspects of their corporate character in their internal and external actions and conduct. They should understand what their real values are and seek only to promote these in order to build and sustain a face value perceived by all their stakeholders (Gary, 2005). Besides, communication programs conducted on a two way symmetric basis are very fundamental. These should involve such mechanisms like regular cycle of perception studies and forums that elicit the views of significant constituencies (Grahame, 2001). Essential also is a tight control system that recognizes adherence to stakeholder values as a pillar of organizationâ&#x20AC;&#x2122;s

sustainability. Merck, Marsh, Andersen and Monsanto companies whose reputations were compromised, were clearly lacking the kind of information that would have identified unsustainable behaviors and an effective internal control mechanism to overcome them (Firestein, 2006). It is worthy noting to argue that reputations are built on the inside of the organizations, it doesn’t occur by chance, but it relates to leadership, management , the processes of operations, the quality of products or services and the crucial relationships with stakeholders. This is why organizations should develop cultures that would emphasize these aspects in their organizational values (Gary, 2005).When the organization’s behaviors runs counter to the public expectations; the organization will suffer a major loss of reputation. Stakeholders’ trust in the organization will gradually decline when the organization fail to live up to public expectations -“what may be termed as the promise expectation gap (Greyser, 1999). Organizations with a sold strategy, good values, norms, beliefs, attitudes, will create, sustain and communicate a good reputation (Grahame, 2001). Corporate reputation becomes a window to the fundamental character of the organization and its leaders, and as such, it is relevant to all stakeholders; simply believe it or not, management can choose to proactively, shape and nature its corporate reputation or become the victim of assailant’s negative reputation arrows (Ewing, Carvan, and Rinson, 1999). Today consumers seem more interested in what lies behind the appealing advertisements and the attractive business premises. Stakeholders want to know that the organization does not exploit child labor, sell unnecessary warranties and treats its employees well. They want to see organizations playing their part in local communities through charity

and environmental concern (Caruana, 1997). This gives a general concern that organizations must engage societies that surrounds them rather than trying to manipulate them through the so called public relations. They ought to do this in a proper and carefully structured, intentional manner by building a culture which emphasizes stakeholdersâ&#x20AC;&#x2122; values and interests (Firestein, 2006).

2.3 Corporate Reputation and Organizational Performance.

Although corporate reputation is an intangible concept, research universally shows that it demonstrably increases organization worth and provides sustained competitive advantage (Harrison, 2007).It is identified as one of the valuable, rare, inimitable, and nonsubstitutable intangible resources which can provide a sustainable competitive advantage. A well respected reputation communicates the firmâ&#x20AC;&#x2122;s mission, the professionalism of its leadership, the caliber of its employees, and its roles within the marketing environment. It is a strategic asset that is highly critical for successful project development in the new markets (Ewing, Carvana, & Rinson, 1999). It is developed over a long period of time that cannot be easily shortened by competitors (Inglis, Morley & Sammut, 2006). Business objectives can be achieved more easily with good reputation especially among key business stakeholders such as customers, suppliers, current and potential employees among others (Rochette, 2007).

A favorable reputation leads to higher financial performance and a strategic advantage such as reducing competitive rivalry and mobility barriers to deter market entry (Flatt& Kowalczk, 2006). Corporate reputation affects stakeholdersâ&#x20AC;&#x2122; resource allocation decisions 18

(Benjamin, Bell, & Menguc, 2005). A consumer’s decision to purchase a product or service may be based on a media report regarding organization’s responsibility to community (Hill and Knowlton, 2004). Sherwood, Saxton, Inkpen, & Holzinger (2006) argues that quality management team with attributes of sound decision making and responsible behaviors, add value to the organization by reducing monitoring and overall transaction costs. Organizations with a focus on social and or environment responsibility build stakeholder loyalty, creating a sustainable competitive advantage and generate superior stock market valuations and economic performance (Guyer, 2006).

Reputation is a powerful means of measuring the overall performance of an organization in the market place. It is a highly visible signal of an organization’s capabilities and reliability –providing information about its future performance (Dolphin, 2004). Corporations that are reputable for social responsibility have marginally higher priceearnings ratios (Benjamin, Bell, & Menguc, 2005). According to Walsh & Wiedmann (2006) a firm’s reputation may influence its stock market performance via profitability and growth with regard to consumers’ behaviors. They argue that reputation exerts influence on perceived risk and loyalty, all of which can positively or negatively affect the firm’s profits. Organization’s reputation affects customers’ buying intentions, supplier choices, and support superior profit outcomes over time (Hinton, 2007).

According to Ewing, Carvana, & Rinson (1999) client loyalty and retention are much easier established if the firm is reputable for its service excellence in the industry. Consumers happen to deal with one reputable organization a head of others since

reputation is a good indicator of product or service quality when consumers are faced with a choice between competing products. This leads to increased sales, premium prices and customer retention. (Inglis, Morley, & Sammut, 2006). Consequently, the organization realizes higher incomes as well as lower costs via a reduction of both capital and personnel costs through reduced personnel fluctuations. Employees are more loyal and prefer to be retained by the organization with a good reputation compared with an employer who may have an equivocal reputation (Eberl & schwager, 2004). Being seen as a reputable organization means that recruitment costs are reduced because better employees seek you out (Gary, 2005). The organization has the ability to attract and motivate its employees who can even be willing to gain hands-on experience in charitable activities (Katinka & Moser, 2006).

For academic institutions, reputation affects their ability to attract the best and brightest students. In turn this affects the quality of graduates they output to the labour market. There is usually high pay premium enjoyed by graduates from reputable universities and colleges. The quality and prestige of an institution culminates into financial success of its graduates. According to the job competition theory, graduates from reputable institutions do not compete for pay in the labour markets; rather they compete through their qualifications for the job opportunity (Ping, Shinn, Tang& Cindy, 2004). In Uganda, the labour market has absorbed most graduates from Uganda Management institute due to its reputation for excellent academic instructional formats (NCHE, 2005).

It is unlikely that any organization can grow through its business cycle without one or more negative reputation events. Itâ&#x20AC;&#x2122;s the nature of the world in which organizations operate. One would say that bad news sells more than good news. To day, organization executives especially in the North America, Europe among others, strongly believe that 63% of the organizationâ&#x20AC;&#x2122;s market value is attributable to reputation (Jeffrely & Resnick, 2004). Reputation was, is, and always will be of immense importance to organizations whether commercial, Government or not-for-profit. To reach their goals, stay competitive and prosper, reputation paves the organizational path to acceptance and approval by stakeholders (Watson, 2004). Reputation has fostered continued expansion of companies like Johnson & Johnson, Phillips among others who have been ranked as the most respected organizations in the United States of America and Europe. In Uganda the academic reputation of Makerere University Business School has fostered the expansion of the institution from being a constituent college of Makerere University to a public tertiary institution affiliated to Makerere University Kampala (MUBS Prospectus, 2007).

Therefore reputation is a critical factor in how organizations are valued to day â&#x20AC;&#x201C;the consequences of a damaged reputation runs far and deep. It is argued that loss of confidence and trust among investors, customers, and other stakeholders potentially devastate the long-term survival of the organization (Jeffrely & Resnick, 2004). Therefore, good reputation makes a vital contribution to value creation and in bad times, it can be a pillar for the survival of any organization. In good times, it allows organizations to score a premium in the relationships with its different stakeholders (Katinka &Moser, 2006).

2.4 Corporate Culture and Organizational Performance. Although, most research in the past about organizational culture has produced results that are more academic than practical, to day the concept of culture is no longer a purely academic concept. Tools now exist to measure the behaviors associated with organizational culture, assessing how one organization compares with the other in terms of performance such that resources can be focused in ways that gives the greatest return (Bradfield, 2006). Since culture concentrates on a set of values and beliefs held by employees, it is a valuable intangible asset that improves commitment, loyalty and reduces bureaucratic costs through social control. The organization therefore achieves a competitive advantage through its people (Lee &Yu, 2004).

Corporate culture has a significant impact on the long-term economic organizational performance far as long as the organization emphasizes all the key managerial constituencies (Customers, stockholders and employees) as well as leadership from managers at all levels (Zabid, Sambasivan, & Johari, 2003). Elashmawi (2000) argues that a culture that emphasizes quality products or services usually reduces consumersâ&#x20AC;&#x2122; complaints significantly. This expands the market share of the firm resulting into increased sales. It shapes the organizationâ&#x20AC;&#x2122;s marketing or sales strategies, locally and globally Sew and Yu, 2004).

Corporate culture is a key driver of staff and customer satisfaction (Quentin, 2005). It leads to employee loyalty not to a particular boss, but to a set of organizational values they believe in and find satisfying. Thus they become committed, dedicated or

emotionally attached to a particular organization (Sew and Yu, 2004). Corporate culture is a key component for attracting and retaining talented employees. Prospective employees are now selective than ever for which organization to join. Best people need more than a salary and good benefits to show their desire to stay. Actual employees will always stay even though they would have been with other alternative entities to work for (Eikenberry, 2007). Widely shared and strongly held norms and values, increase behavioral consistency across employees in the organization, which lead to improved goal alignment and increased employee efforts (Flatt & Kowalczy, 2006). Failure to build a culture of attentive engagement can prove devastating, and the world has witnessed spectacular organizational collapses over recent years. Enron and WorldCom are the best known, (Firestein, 2006). Besides, to day, customer satisfaction is the new standard by which customers are measuring business performance especially in service organizations. But customer satisfaction is influenced by the operating organizational culture reflected in employee behaviors (Bellou, 2007). Employee behaviors that are creative and innovative will focus on the market and solving customer problems (Martins & Terblanche, 2003).

Although a coherent and distinctive organizational culture can provide the basis for a competitive advantage, it can also be a burden when introducing initiatives. It is therefore important that the strength of the culture is examined before the firm making suggestions about the importance of culture in securing high-quality service (Bellou, 2007).Corporate culture has every thing to do with implementation of all management ideas and decisions and how success is achieved. No management idea, no matter how good it is, will work in practice if it does not fit the culture. An organization can have the most superb 23

strategy, but if its culture is not aligned with and supportive of that strategy, it will stall or fail (Schneider, 2000). Therefore organizational culture is central to the functioning of the organization, forming the nuclear centre for how it operates in order to succeed. Without it, focus is lost and energy is wasted as people, systems and processes work at cross purposes with one another (Schneider, 2000).

2.5 Corporate Reputation and Collaborative Relationships. Reputation and collaborations have been linked theoretically in the past research. For the two institutions to collaborate there must be mutual respect, understanding and trust. Reputation is based on work style, knowledge, team contribution, and integrity among other factors. It is becoming easier for one institution to connect and collaborate with others based on their reputations (Luana & Burlingame, 2006). Corporate reputation is an indispensable social capital that must be constituted, protected and managed as a strategic factor for collaborative relationships (Cigdem, 2006). Firms with foreign partnerships are preferred over local ones because they are deemed to be reputable for international expertise in offering clients with better services in the long run (Ewing, Carvana & Rinson, 1999).

Institutions of higher education which are reputable for high research quality, finds it easier to attract inward investors, potential partners and individual researchers who are excited and stimulated to work with an institution of superior viewpoints, career , and resources . There fore, reputation creates and enhances good relationships with various

fellow Universities and other academic institutions (Thomas, 2008). Dooley & Kirk (2007) argue that collaborations in institutions of higher learning are possible when there is a long â&#x20AC;&#x201C;outstanding reputation of the institution for research and generally quality education. Therefore, in the absence of direct experience with an institution, reputation may provide a signaling mechanism as to its expected behaviors in a collaborative relationship (Sherwood, Saxton, Holzinger, 2006).

2.6 Collaborative Relationships and Organizational Performance. According to Luana & Burlingame (2006) collaboration leads to maximization of resources and it is a key to high-performing organizations with the impetus to succeed in an evolving, highly competitive global world. Collaborations help to integrate programs and services that better serve complex needs of the society. Planning, research and training costs are lessened as two or more organizations pool resources to accomplish a shared goal (IUC, 2005). According to Lawson (2004) collaboration has the potential to yield multiple benefits including; enhanced problem-solving competence, efficiency gains like elimination of redundancy, resource gains like more funding, work force retention, and social developments like catalyzing social movements.

For education institutions, collaborations help to build and sustain networks of scholars, enhance teaching and learning opportunities, create efficiencies in administrative processes, accelerate the adoption of best practices in a wide range of areas, and aggregate resources as common goods (CIC, 2007). Collaborations have facilitated educational exchanges including exchanges of faculty and students, promoted

collaborative research and facilitating activities relating to teaching and training as well as fostering an understanding of history, cultures and values (Thomas, 2008). According to Suwanwela (2007) collaboration in higher education institutions has led to reduction in redundancy and thus reduction in costs. In addition, there has been strict quality control in higher education and this has created stimulating and challenging atmosphere for students and faculty members as well. In areas of research, collaborations are fulfilling the requirements of international experience and culture- specific local experts. In other aspects of higher education especially in relation to students, collaborations have led to increased access to higher education by students in areas of off-shore courses, multi-cultural compasses and internationalized curricula (Hatakenaka, 2004) The collaboration of tertiary institutions with the industry clusters is one of the best ways to ensure that they are responsive to their customers. It provides a constant reality check to the value added by the post secondary education system as well as an early warning system for identifying emerging issues and problems. Institutions can understand the challenges faced by the industry and design learning and teaching programs accordingly. (Dooley & Kirk, 2007).Besides, collaborations in higher Education institutions lead to increased support for research programs, extend the reach of the institution and reduce staff training costs as well as increasing the revenue for the institution (Kathy et al, 2008). In the world over, tertiary institutions are emphasizing innovative collaborations to build political support and increase financial flexibility and for industry clusters, collaborations produce better trained workers with shorter learning curves (Ewing, Carvana & Rinson). In addition, there is improved quality of industry professionals at the

time of absorption and during employment in form of continued professional development (Kayaga, 2007).

CHAPTER THREE

RESEARCH METHODOLOGY 3.0 Introduction This Chapter presents the Research methodology adopted to carry out the study. It covers the Research Design, Study Population, Sampling design, Sample size, Sources of data, Data collection instruments, Measurement of variables, Data analysis, Limitations to the study and how they were overcome. 3.1 Research Design The study was carried out using a quantitative cross-sectional survey design in which data relating to the study variables was gathered from the sample study population. The design was adopted because the researcher had interest in gathering data that represents what was going on about Private Tertiary Institutions at that time. 3.2 Study Population The study focused on 88 Private Tertiary Institutions in Uganda (NCHE, 2006). The study used a sample size of 51 institutions and these were determined using the average sample size for the three previous studies about higher education in Uganda by Kasozi & Musisi (2002), Keating (2001), & NCHE (2004). However, study respondents were staff members and students of these institutions. The population of staff members which comprised of faculty Deans and heads of departments in the 51 Institutions was 250

members and the population for students in these Institutions was 47,000 students (NCHE).

3.3 Sample Size The sample size was 380 for students and 153 for staff members determined using Krejcie and Morganâ&#x20AC;&#x2122;s table for determining the sample size. For a population of 4, 7000, the sample size is 380 and for the population of 250, the sample size is 153 (Krejcie & Morgan, 1970). See the Table 1 below; Table 1: Distribution of Sample size among respondents. Category Population

Staff 250 Students 47,000 Total 47,250 Source; Primary Data

Expected respondents (Sample size) 153 380 533

Actual respondents

% Response

114 287 401

75% 76% 75.23%

3.4 Sampling Design and Procedure At the level of the institution, the researcher selected 51 Private Tertiary Institutions. A list of these institutions was obtained from NCHE report (2006). Stratified random sampling was used basing on the study variables to get response from the staff members and students. The respondents for corporate culture, collaborative relationships, and organizational performance were staff members as the first stratum and the respondents for corporate reputation were students as the second stratum. The researcher went to the secretaries of the institutions, received a list of the staff members for the various Faculties and Departments and from this list, respondents were randomly selected. To get response from students, the researcher went to the registrar of the institutions, received a list of

continuing students and from this list, respondents were randomly selected. This was done when the institutions were open for the semester. The researcher aggregated these responses back to the organization (The Institution). To ensure a good response from the respondents, the researcher obtained an introductory letter from the Graduate Research Centre of Makerere University Business School and promised the respondents that the information was to be kept confidential. 3.5 Sources of Data Primary Data The main source of data used was primary. Data on Corporate reputation, Corporate culture, Collaborative relationships, and Performance of Private Tertiary Institutions in Uganda, was obtained from questionnaires filled by the selected sample of staff and students of these institutions. Secondary Data This was obtained from records of private tertiary institutions, journals and reports from the Ministry of Education and Sports, National Council for Higher Education, and Government of Uganda records. This data included; the number of Institutions, years of existence, academic staff, programmes offered, Student enrolment, location, and other characteristics of Private Tertiary Institutions in Uganda. 3.6 Data Collection Instruments The instruments used were; Questionnaires and personal observation of documents and records previously collected. Questionnaires were used to collect primary data. The questionnaires comprised of only close ended questions with a series of statements for

which the respondents were asked to indicate their degree of agreement or disagreement. The questionnaires were pre-tested for accuracy and completeness. The questionnaire was chosen as a data collection instrument because it could provide predetermined answers like what others studies have used. 3.7 Measurement of Variables. The study variables were measured using the approaches of the previous researchers as follows; 

Corporate culture was measured using the approach of Hofstede (2003).



Corporate reputation was measured using the approach of Cigdem (2006).



Collaborative relationships were measured using the approach of Kathy et al (2008).



Organizational performance was measured using the approach of Al-Turki (2003).

3.8 Reliability Test Reliability is the extent to which a measurement is free of variable error. Reliability is usually achieved when repeated measures of the same stable attributes in the same objects show limited variation. Table 2 below shows the alpha coefficients for the four study variables. Table 2: Alpha Coefficients of the Variables. Variable

Alpha coefficient (α)

Corporate culture

0.5702

Corporate reputation

0.8334

Collaborative relationships

0.9166

Organizational performance

0.7518

Source; Primary data Since the alpha coefficients in the table above exceed 0.5, the scales used to measure the four study variables are reliable (Nunnally, 1967).

3.9 Data Analysis Data was analysed using statistical package for social sciences (SPSS). The analysis involved Pearson correlation analysis, multiple regression analysis, T-test and analysis of variance (Anova). Anova tests and T-tests were used to determine the difference in perception about the variables in relation to various categories studied with in the demographic characteristics. Multiple regression analysis was used to establish the extent to which Independent variables and moderating variable predict the dependent variable. Pearson correlation analysis was used to determine the relationships between the study variables. The correlation coefficients reflected the extent and direction of the relationships. 3.10 Limitations to the Study The Researcher encountered the following constraints during the study; Access to some information. This was not easy since there seem to be limited literature about Private Tertiary Institutions in Uganda. Most literature is in news papers and there are very few researched papers. However, the Researcher managed to get assistance from NCHE library and media houses for some data. Non- response from some respondents. Some respondents simply had no interest in filling the questionnaires and therefore, didnâ&#x20AC;&#x2122;t return them. Some respondents returned half way filed questionnaires and therefore, couldnâ&#x20AC;&#x2122;t serve the purpose. However, the

researcher managed to follow up most of the questionnaires supplied by use of research assistants.

CHAPTER FOUR

DATA PRESENTATION AND ANALYSIS OF FINDINGS

4.0 Introduction This Chapter presents data, analysis, and interpretation of the findings. The findings are qualitative and quantitative and are obtained from mainly primary data and presented in tables and charts. The Relationship between the variables was ascertained by cross tabulations, correlation and regression analysis. The findings are interpreted in relation to the Research objectives and questions. 4.1 Sample Characteristics The characteristics of the sample involve those of the institutions and the respondents. 4.1.1 Characteristics of the Institutions These relate to; existence in years of the institution, level of qualification awarded, and ownership of the institution as shown below in Figures 2 to 4.

Figure 2; Existence in Years of the Institution

More than 10 Years 4 13%

10 Years and above 26 87%

Source; Primary Data From Figure 2 above, 87% of the Private Tertiary Institutions have operated for less than 10 years and only 13% have operated for 10 years and above. This implies that most Institutions have limited experience in the higher education sector. Figure 3; Level of Qualification Awarded

Degree Programs 30%

Diploma /Others Programs 70%

Source; Primary Data 33

From Figure 3 above, 70% of the Institutions offer Diploma and other programs, and only 30% offer degree programs. This implies that Private Tertiary Institutions in Uganda have not gotten the capacity to offer degree programs. Figure 4; Ownership of the Institutions

Religious Bodies, 5, 17%

Private Ownership, 25, 83%

Source; Primary Data From Figure 4 above, 83% of the Institutions are owned by private individuals, and only 17% are owned by religious bodies. This implies that the management of most Private Tertiary Institutions in Uganda is influenced by individual owners of these Institutions. 4.1.2 Gender by Category of Respondents. The results for gender by category of respondents in table 3 below indicated that the majority of the respondents in these institutions about 54% are male. In addition, the female comprised of approximately 46% of the sample. Furthermore, among the male respondents about 69% were students, and about 31% were staff members. On the other hand, among the female respondents, the majority approximately 75% were students. The results also indicated that there is no association between gender status and the category

of respondents (Sig. = .181). This implies that being a male or female is not a determining factor for being in the category of respondents. Table 3; Gender by Category of Respondents. Category of Respondent Student Male Gender

Total

Count

150

218

Row %

68.8

31.2

100.0

Column %

52.3

59.6

54.4

Count

137

183

74.9

25.1

100.0

Column %

47.7

40.4

45.6

Count

287

114

401

Row %

71.6

28.4

100.0

Female Row %

Total

Staff

Column % 2

X =1.793

df = 1 Sig. = .181

Source; Primary data 4.1.3 Age Group by Category of Respondents. The results in table 4 below indicate that the majority of the respondents approximately 50% had 25 years and below. The age group of 41 years and above had the least number of respondents with only 7% of the sample. In addition respondents with 25 years and below comprised of about 98% students and approximately 3% staff members. This implied that students played a big role in availing data to the researcher than staff members. The results also indicated that there is an association between the age group and the category of respondents (Sig. = .000 ). This implies that the age group is a determining factor for being in the category of respondents.

Table 4: Age Group by Category of Respondent.

Category of Respondent Student 20-25 yrs

194

199

Row %

97.5

2.5

100.0

Column %

67.6

4.4

49.6

Row %

72.3

27.7

100.0

Column %

20.9

20.2

20.7

32.1

67.9

100.0

Column %

5.9

31.6

13.2

Count

26.3

73.7

100.0

3.5

24.6

9.5

21.4

78.6

100.0

Column %

2.1

19.3

7.0

Count

287

114

401

Row %

71.6

28.4

100.0

Count Age Group 31-35 yrs

36-40 yrs

Row %

Row % Column % Count

41 yrs & Above Row %

Total

Count

Count 26-30 yrs

Staff

Column %

X2 =179.193

df = 4 Sig. = .000

Source; Primary data 4.1.4 Marital status by Children among Staff Members. The results in table 5 below for marital status by number of children indicated that the majority of the staff members about 67 % are married. In addition, the singles comprised of approximately 24% of the sample and the unmarried comprised of almost 10% of the sample. Furthermore, among the married respondents about 6% had no children at all, 72% had 1-5 children while some 21% had over 5 children. On the other hand, among the

unmarried, the majority almost 64% had 1-5 children. The results also indicated an association between oneâ&#x20AC;&#x2122;s marital status and the number of children the individual has (Sig. = .000). This implies that being married or single is a determining factor as to what number of children an individual will have. Table 5: Marital status by Children among staff members Children None 1-5 Over 5 20

Row %

74.1 22.2

3.7

100.%

Column %

71.4

8.8

5.6

23.7

6.6 72.4

21.1

100.0

17.9 80.9

88.9

66.7

27.3 63.6

9.1

100.0

10.7 10.3

5.6

9.6

114

24.6 59.6

15.8

100.0

Column % 100.0 100.0

100.0

Count Single

Count Marital Married Status

Row % Column %

Count Unmarried Row % Column %

Count Total

Total

Row %

X = 49.563 df = 4 Sig. = .000

Source; Primary data 4.1.5 Marital Status by having other Dependants among the Staff Members. The results for marital status by other dependants in table 6 below indicated that the majority of the staff members approximately 67% are married. In addition, the singles comprised of about 24% of the sample and the unmarried comprised of almost 10% of the sample. Furthermore, among the married respondents approximately 79% had other dependants, and 21% had no dependants. On the other hand, among the unmarried, the majority about 55% had had no dependants. The results also indicated that there is no 37

association between one’s marital status and having other dependants (Sig. = .034 ). This implies that being married or single is not a determining factor as to whether one should have other dependants or not. Table 6: Marital Status by having other Dependants among the Staff Members. Other Dependants Yes

Row %

63.0

37.0

100.0

Column %

20.7

31.3

23.7

Row %

78.9

21.1

100.0

Column %

73.2

50.0

66.7

45.5

54.5

100.0

Column %

6.1

18.8

9.6

Count

114

71.9

28.1

100.0

100.0 100.0

100.0

Count Marital Status Married

Count Unmarried Row %

Total

Count Single

Row % Column % 2

X =6.748 df = 2 Sig. = .034

Source; Primary data 4.1.6 Education Level by Related to any Leader of the Institution among the Staff Members. The results from table 7 below show that the majority of the staff members approximately 54% are graduates of the first degree. In addition, masters’ degree holders comprised of about 38% of the sample and about 2 % for A and O level graduates. Furthermore, among the first degree graduates, almost 85 % are related to the leaders of the institution and about 50% had no relationship with the leaders of the institution. On the other hand, among the masters’ degree holders, the majority approximately 96% had no relationship

with the leaders of the institution. This implied that master degree holders are recruited basing on competency unlike the counterparts with the first degree who are recruited basing on their relationship with the leaders of the institution. Table 7: Education Level by Related to any Leader of the Institution among the Staff Members. Relation to any leader of the Institution Yes

Count O-level

100.0

2.0

1.8

100.0

2.0

1.8

Row %

18.0

82.0

100.0

Column %

84.6

49.5

53.5

4.7

95.3

100.0

15.4

40.6

37.7

100.0

5.9

5.3

101

114

11.4

88.6

100.0

Row % Column % Count

A-level

Row % Column% Count

Education level First Degree

Count Masters Degree Row % Column % Count PhD

Row % Column % Count

Total

Row % Column %

X2 =5.881

Source; Primary data

df = 4 Sig. = .208

4.2 Pearson Correlation Analysis of the Variables. Pearson correlation analysis was used to establish the relationships between study variables as per objectives of the study. The correlation coefficients reflected the magnitude and direction of the relationships. Table 8: Correlation Coefficients between the variables. 1

Corporate culture

1.000

Corporate reputation

.467**

1.000

Collaborative relationships

.670**

.827**

1.000

Organizational performance

.594**

.581**

.673**

1.000

** Correlation is significant at 0.01 level (2tailed) * Correlation is significant at 0.05 level (2tailed) Source; Primary data 4.2.1The Relationship between Corporate Culture and Corporate reputation. Results in the Correlation Matrix above indicate that there was a significant positive Correlation between corporate culture and corporate reputation (r = 0.467**, p<0.01). This implies that an increase in corporate culture creates an increase in corporate reputation. 4.2.2 The Relationship between Corporate Reputation and Organizational Performance. Results in the correlation Matrix above reveal that there was a significant positive correlation between corporate reputation and organizational performance(r = 0.581**,

p<0.01). This means that an increase in corporate reputation creates an increase in organizational performance. 4.2.3 The Relationship Performance.

between

Corporate

Culture

and

Organizational

There was a significant positive correlation between corporate culture and organizational performance(r = 0.594**, p<0.01). This means that an increase in corporate culture creates an increase in organizational performance. 4.2.4 The Relationship between Corporate Reputation and Collaborative Relationships. Results in the Correlation Matrix above reveal that there was a significant positive correlation between corporate reputation and collaborative relationships (r = 0.827**, p<0.01). This means that an increase in corporate reputation creates an increase in collaborative relationships. 4.2.5 The Relationship between Collaborative Relationships and Organizational Performance. The above Correlation Matrix indicate that there was a significant positive correlation between collaborative relationships and organizational performance(r = 0.673**, p<0.01). This implies that an increase in collaborative relationships creates an increase in organizational performance. 4.3 Predicting Organizational Performance. To predict Organizational Performance, multiple regression analysis was used. Multiple regression analysis is a process by which several variables (Independent) are used to predict another variable (Dependent). This is often made once there is established

relationship among variables. A Multiple regression analysis was therefore adopted because the study involved several independent variables which were used to predict the values of the dependent variable. Thus, the values organizational performances were predicted on the basis of the values of corporate culture, corporate reputation, and collaborative relationships. The results of the analysis are presented in table 10 below; Table 9: Predicting Organizational Performance

R Square = .497 Adjusted R Square = .492 Unstandardized Coefficients Model

F= 93.229 P=.000 Standardized Coefficients Std. Error

Beta

Sig.

8.370

.000

Constant

.493

.178

Corporate

.155

.033

.271

4.754

.000

.85

.042

.086

2.009

.045

.344

.042

8.237

.000

culture Corporate reputation Collaborative

.477

relationships Dependent Variable; Organizational Performance Source; Primary data Table 9 above shows that corporate culture, corporate reputation and collaborative relationships are significant predictors of organizational performance. The overall regression model is significant at 5%. The three variables; corporate culture, corporate reputation and collaborative relationships can predict organizational performance with 49.2% certainty.

4.4 T-Test and Analysis of Variance (Other Findings). 4.4.1 Analysis of Variance (Anova) test for employee status. Anova test was used to deduce the level of significance among teaching and non-teaching staff in their perception of corporate culture, collaborative relationships and organizational performance as shown in the table below; Table10; ANOVA Test for employee status

Mean Corporate Culture Collaborative Relationships Organizational Performance

Std. Deviation

Std. Error

Sig.

Teaching Staff

3.365

0.329

0.047 9.670 .002

Non-Teaching Staff

3.567

0.353

0.044

Teaching Staff

3.283

0.868

0.124

Non-Teaching Staff

3.236

0.867

0.108 .080 .777

Teaching Staff

3.526

0.603

0.086

Non-Teaching Staff

3.547

0.570

0.071

Total

3.538

0.582

0.055 .037 .847

Source; Primary data Table 10 above shows that there is significant difference across teaching and nonteaching staff in their perception of corporate culture (sig. = 0.002).The perceptions of Non-Teaching staff are ranked higher (Mean = 3.567) than their Teaching counterparts (Mean = 3.365). There is no significant difference among teaching and nonteaching staff in their perception of Collaborative Relationships and Organizational Performance (i.e. significance level is greater than 0.01)

4.4.2 Analysis of Variance (Anova) Test for Employee Tenure. ANOVA test was used to deduce the level of significance across staff tenure in their perception of corporate culture, collaborative relationships and organizational performance as shown in the table below; Table11; ANOVA Test for employee tenure

Corporate Culture

Mean

Std. Deviation

1-5 yrs

3.459

0.364

0.039

6-10 yrs

3.541

0.308

0.067

11yrs & Above

3.563

0.411

0.155

1-5 yrs

3.303

0.849

0.092

3.211

0.918

0.200

11yrs & Above

2.821

0.886

0.335

1-5 yrs

3.610

0.539

0.058

6-10 yrs

3.396

0.605

0.132

11yrs & Above

3.078

0.807

0.305

Collaborative Relationships 6-10 yrs

Organizational Performance

Std. Error

Sig.

.647 .526

1.041 .356

3.620 .030

Source; Primary data Table 11 above shows that there is no significant difference across staff tenure in their perception of corporate culture, Collaborative Relationships and Organizational Performance (i.e. significance level is greater than 0.01) 4.4.3 ANOVA Test for Program by Corporate Reputation Variable among Students. ANOVA test was used to deduce the level of significance among day, evening and external students in their perception of the three dimensions of corporate reputation as shown in the table below;

Table12; ANOVA Test for program Mean Day Service Quality

0.595 0.073

External 3.523

0.537 0.170

3.393

Sig.

0.634 0.044 .157 .855

Evening 3.561 Day

Trust

3.512

Std. Std. Deviation Error

0.688 0.048 .893 .411

Evening 3.523

0.693 0.085

External 3.439

0.596 0.188

2.857 Day Social Responsibility Evening 2.798 Activities External 3.485

0.903 0.063 2.609 .075

3.100

0.845 0.059 3.882 .022

Day Communication

0.859 0.106 0.877 0.277

Evening 3.372

0.810 0.100

External 3.590

0.720 0.228

Source; Primary data Table 12 above shows that there is no significant difference among day, evening and external students in their perception of the three dimensions of corporate reputation (i.e. significance level is greater than 0.01). 4.4.4 ANOVA Test for Age Group by Corporate Reputation Variable among Students. ANOVA test was used to deduce the level of significance among students of various groups in their perception of the three dimensions of corporate reputation as shown in the table below.

Table13; ANOVA Test for Age groups.

Mean

Std. Std. Error Deviation

Sig.

20-25 yrs

3.530

0.665

0.048 .181 .948

26-30 yrs

3.504

0.530

0.068

31-35 yrs

3.502

0.556

0.135

36-40 yrs

3.451

0.471

0.149

41 yrs & Above 3.718

0.450

0.201

20-25 yrs

3.359

0.719

0.052 1.474 .210

26-30 yrs

3.546

0.609

0.079

31-35 yrs

3.593

0.526

0.128

36-40 yrs

3.513

0.659

0.208

41 yrs & Above 3.737

0.627

0.281

20-25 yrs

2.789

0.912

0.066 1.430 .224

26-30 yrs Social Responsibility 31-35 yrs Activities 36-40 yrs

2.954

0.911

0.118

3.143

0.720

0.175

3.030

0.667

0.211

41 yrs & Above 3.350

0.909

0.371

20-25 yrs

3.103

0.900

0.065 1.596 .176

26-30 yrs

3.326

0.747

0.097

31-35 yrs

3.391

0.582

0.141

36-40 yrs

3.149

0.582

0.184

41 yrs & Above 3.650

0.327

0.134

Service Quality

Trust

Communication

Source; Primary data Table 13 above shows that there is no significant difference among students of various groups in their perception of the three dimensions of corporate reputation (i.e. significance level is greater than 0.01).

4.4.5 T-Test for Gender by Corporate Reputation Variable. A T- test was used to deduce the level of significance between male and female students in their perception of the three dimensions of corporate reputation as shown in the table below. Table14; T-Test for Gender

Std. Gender Mean Deviation Service Quality Trust Social Responsibility Activities Communication

Std. Error Mean

3.498

0.623

0.051

Female 3.551

0.619

0.053

3.401

0.691

0.057

Female 3.450

0.683

0.059

2.853

0.861

0.071

Female 2.879

0.939

0.080

3.132

0.808

0.066

Female 3.233

0.877

0.076

Male Male Male Male

Sig.

.719

283 .473

.599

280 .549

.246

282 .806

.999

280 .319

Source; Primary data Table 14 above shows that there is no significant difference between male and female students in their perception of the three dimensions of corporate reputation (i.e. significance level is greater than 0.01).

CHAPTER FIVE SUMMARY, DISCUSSION, CONCLUSIONS AND RECOMMENDATIONS 5.0 Introduction This chapter presents a summary and discussion of the findings, conclusions and recommendations arising out of the research findings. It also suggests areas of further research. 5.1 Summary and Discussion of the Findings The study was conducted to establish the relationship between corporate culture, corporate reputation, collaborative relationships and performance of private tertiary institutions in Uganda. Below is a summary and discussion of the findings as per the study objectives; 5.1.1 The Relationship between Corporate Culture and Corporate Reputation. The researcher established that there was a significant positive correlation between corporate culture and corporate reputation. This confirms the research findings of Flatt & Kowalczyk (2006) who demonstrated that firms with stronger cultures tend to have a more favorable reputation. The weak cultural values of private tertiary institutions in Uganda have compromised their reputation. 5.1.2 The Relationship between Corporate Reputation and Organizational Performance. The researcher established that there was a significant positive correlation between corporate reputation and organizational performance. This is in line with the findings of Li-Ping, Shin-Hsiung, & Shin-Yi (2004) who established that corporate reputation is a critical factor for the success of private Universities and colleges. Due to the unfavorable

reputation of private tertiary institutions in Uganda, the quality of education offered by these institutions has been compromised. 5.1.3

The

Relationship

between

Corporate

Culture

and

Organizational

Performance. The researcher established that there was a significant positive correlation between corporate culture and organizational performance. This confirms the research findings of Flatt & Kowalczyk (2006) who established that a firmâ&#x20AC;&#x2122;s strong culture significantly influence its financial performance. The study findings to this effect are also in line with Balhazard, Cook & Potter (2006) which indicated that constructive corporate culture is positively associated with the output of quality products and services. A failure by private tertiary institutions in Uganda to breed constructive cultural values has led to the decline in their performance. 5.1.4 The Relationship between Corporate Reputation and Collaborative Relationships. The researcher established that there was a significant positive correlation between corporate reputation and collaborative relationships. This confirms the study findings of Dooley & Kirk (2007) who demonstrated that Institution-Industry collaborations are possible when a deserved reputation for research excellence is held. Due to the unfavorable reputation of private tertiary institutions in Uganda, collaborative relationships between these institutions and the industry are non existent.

5.1.5 The Relationship between Collaborative Relationships and Organizational Performance. The researcher established that there was a significant positive correlation between collaborative relationships and organizational performance. This is in line with Kathy et al (2008) findings which demonstrated that collaborative relationships enhance organizationâ&#x20AC;&#x2122;s education training mission by ensuring top quality training and fulfilling its training requirements for specific courses. 5.2 Conclusions. The following conclusions can be deducted from the findings and discussion; There was a significant positive relationship between corporate culture and corporate reputation. When there is an improvement in corporate culture, there is an increase in corporate reputation of private tertiary institutions. There was a significant positive relationship between corporate reputation and organizational performance. When there is an improvement in corporate reputation, there is an increase in the performance of private tertiary institutions. There was a significant positive relationship between corporate culture and organizational performance. When there is an improvement in corporate culture, there is an increase in the performance of private tertiary institutions. There was a significant positive relationship between corporate reputation and collaborative relationships. When there is an improvement in corporate reputation, there is an increase in the collaborative relationships by private tertiary institutions.

There was a significant positive relationship between collaborative relationships and organizational performance. An increase in collaborative relationships causes an increase in the performance of private tertiary institutions. The three variables; corporate culture, corporate reputation, and collaborative relationships are significant predictors of organizational performance. 5.3 RECOMMENDATIONS In light of the research findings, the following recommendations are made; 5.3.1 Relationship between Corporate Culture and Corporate Reputation. Following the findings that is a significant positive relationship between corporate culture and corporate reputation, the researcher recommends that Private Tertiary Institutions should improve on their corporate cultural practices so that there is increase in their reputation. It is advisable that the leaders of these Institutions encourage open communication with employees, equitable hiring, compensation and promotion of staff. In addition, customer care should be embraced to view customers especially students and parents as the most important elements for their operations and existence. This will increase their credibility among stakeholders and therefore, a growth in their reputation. 5.3.2 Relationship between Corporate Reputation and Organizational Performance. Following the findings that is a significant positive relationship between corporate reputation and organizational performance, the researcher recommends that Private Tertiary Institutions should improve on their corporate reputation so that there is increase in their performance. Given that all business in a democratic society exists by public permission and public approval, private tertiary institutions should build trust by encouraging open and honest communication, provide quality services especially to

students and their employees, engage in social responsibilities like subsidizing tuition charges to the underprivileged among other aspects in the bid to improve on their reputation. If this is adopted, these Institutions can attract the best students, attract and retain experienced and skilled staff, forge Collaborative relationships, as well as attracting research funding from local and international donors. These are important inputs for their performance. 5.3.3 Relationship between Corporate Culture and Organizational Performance. Following the findings that is a significant positive relationship between corporate culture and organizational performance, the researcher recommends that Private Tertiary Institutions should improve on their corporate culture so that there is increase in their performance. It advisable that these institutions shape and develop a corporate culture that is more conducive to employees and organizational setting. Standard performance, fair treatment of employees, team work, and, professionalism are some of the aspects of a desirable culture which can be adopted and if implemented can foster the success of these Institutions. 5.3.4 Relationship between Corporate Reputation and Collaborative Relationships. Following the findings that there is a significant positive relationship between corporate reputation and collaborative relationships, the researcher recommends that Private Tertiary Institutions should improve on their corporate reputation so that there is increase in their collaborative relationships. Having quality management, offering quality services, building trust especially through open and honest communication can be a basis for attracting potential partners in the industry and the academia at both local and international level.

5.3.5 Relationship between Collaborative Relationships and Organizational Performance. Following the findings that there is a significant positive relationship between collaborative relationships and organizational performance, the researcher recommends that Private Tertiary Institutions should improve on their collaborative relationships so that there is increase in their performance. It is advisable that these institutions identify the training and education needs of the industry, identify the benefits of cooperation, provide resources and learn more about the industry. 5.3.6 Relationship between Predictor Variables and Organizational Performance

Following the findings that corporate culture, corporate reputation, and collaborative relationships are significant predictors of organizational performance, the researcher recommends that Private Tertiary Institutions should improve on these variables so that there is an increase in their performance. 5.4 Suggested Areas for Further Research The researcher suggests the following areas for future research; i. Innovative Organizational culture and the performance of Higher Education in Uganda. ii. Corporate culture and customer satisfaction in Uganda public Universities. iii. Accountability, quality assurance mechanisms and the quality of Higher Education in Uganda. iv. The influence of Corporate culture on Organizational commitment and performance

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APPENDIX 1

QUESTIONNAIRE FOR STAFF MEMBERS MAKERERE UNIVERSITY BUSINESS SCHOOL QUESTIONNAIRE ON CORPORTAE CULTURE, CORPORATE REPUTATION, COLLABORATIVE RELATIONHIPS AND ORGANISATIONAL PERFORMANCE A CASE OF PRIVATE TERTIARY INSTITUTIONS IN UGANDA

TO BE ANSWERED BY STAFF MEMBERS OF SELECTED INSTITUTIONS

Introduction As part of my MSc. Accounting & Finance Programme, am carrying out a survey by use of a questionnaire to evaluate the relationship between corporate culture, corporate reputation, collaborative relationships and performance of private tertiary institutions in Uganda. You have been purposively selected as one of the respondents in the survey. Please kindly spare your valuable time and respond to the following questions as accurately and honestly as possible. Most questions require ticking the most appropriate options or filling in short answers. Your answers will not be disclosed to any one and thus no need to write your names on the questionnaire.

PART 1: BACKGROUND INFORMATION 1. Sex Male Female

2. How old are you? 60

20-25 years 26-30 years 31-35 years 36-40 years 41 years and above

3. Marital status? Single

Married?

Unmarried?

4. How many children do you have? Non

1-5

5. Do you have other dependants? Yes

More than 5

No.

6. Name of the Institution…………………………………………… 7. How many years have worked in this organization? 1-5 years

6-10years

11 and above years

8. Position held………………………………………………………

9. What is your Level of education? O’Level

1st Degree

A’ Level

Master’s Degree

PhD

10. Are you related to any leader of the institution? Yes

PART 2 ORGANIZATIONAL CULTURE We would like to know the level of perception you have with the following practices in your institution. Please indicate with a tick in the box the level of perception with each practice using these scales.

1= A very small extent 2= A small extent 3= A moderate extent 4 = A large extent 5 = A very large extent. Practices 1. Staff concentrates on the means of work and gives less concern for results. 2. Emphasis is put on details of work than output. 3. Quality prevails over quantity. 4. Individual needs of clients are addressed. 5. Staff is encouraged to avoid risks while doing work. 6. There are specialized and formalized work units. 7. The institution takes personal problems into account. 8. The institution takes responsibility for employee welfare. 9. Important decisions in this institution are made by committees. 10. Top management allows staff grievances to be published in news papers. 11. There is higher union membership among employees. 12. Top management team constitutes a smaller number of senior employees. 13. The institution considers Social and family background when hiring employees. 14. Most employees do not have appropriate formal education. 15. Staff has limited personal initiative for career development. 16. Organization structure shows less specialization of work units. 17. Managers spend a large share of their time on non official duties. 18. Employees are hired basing on their competency. 19. Employees take personal initiatives for their career development. 20. There is less union membership among employees. 21. Organization structure shows more specialization of work units. 22. Top managers spend most time on official duties in office. 23. People are open to new comers and outsiders. 24. Every body fits into the institution. 25. New employees need a short time to feel at home. 26. There is female participation in top management. 27. There is open communication climate. 28. People are secretive even among insiders. 29. Only special people fit into the institution. 30.New employees need some time to feel at home 31. There is formalization of all work systems in place. 32. Controversial issues about the institution are allowed to be published.

PART 3 COLLABORATIVE RELATIONSHIPS Please comment on the following statements in relation to your institutionâ&#x20AC;&#x2122;s Collaborative relationships with other institutions and the industry. Please indicate with a tick in the box

using these scales;

1= A very small extent 2= A small extent 3= A moderate extent 4 = A large extent 5 = A very large extent. Statements; Collaboration with other Institutions The institution; 1 collaborates with centers of international research excellence. 2. has alliances with local institutions for the purpose of conducting research. 3.collaborates with other institutions overseas for the purpose of conducting research. 4. conducts collaborative research with local academic institutions. 5. jointly fund research programs with local and international institutions. 6. collaborates with other institutions in teaching programs and student admissions. 7.collaborates with other institutions in areas of staff exchanges. 8. collaborates with other institutions in arrears of curriculum development. 9. collaborates with other institutions in arrears student exchange. 10. conducts joint academic seminars and conferences with other institutions. 11. conducts student internships with the industry to complete degree programs 12. conducts joint faculty meetings with other institutions on special topics. 13. has enhanced student learning through collaboration with other institutions. Collaboration with the industry The institution; 14. collaborates with the industry to fund joint research programs. 15. has collaborative research programs with commercial firms. 16. directly and effectively engages with industry partners. 17. engages with industry partners through allied Government funded research.

5 4 3 2 1

Statements;

18. has agreements with the industry to obtain basic research funds. 19. has solved society problems through collaboration with the industry. 20. formally arrange with the industry for placement of graduates into employment. 21. share information with the industry relating to the skills needed at work. 22. share information with the industry relating to teaching programs. 23. share information with the industry relating to placement of graduate trainees. 24. share information with the industry relating to industrial training programs. 25.share information with the industry regarding the availability of internships 26. share information with the employers about expectations from its graduates. Benefits Collaboration with the industry has; 27. helped Staff members to obtain industrial expertise. 28. helped the institution to develop knowledge needed in the market place. 29. has helped staff to get access to proprietary technology. 30. has increased the institutionâ&#x20AC;&#x2122;s research output. 31. has resulted into employment opportunities for the institution graduates. 32. met the training needs of adult learners. 33. has made the system of your institution more effective. 34. has led to more focus on practical learning by students. 35. added value to the institutionâ&#x20AC;&#x2122;s education.

PART 4 ORGANIZATIONAL PERFORMANCE We would like to know the level of perception you have with the following statements in relation to the performance of your institution. Please indicate with a tick in the box using these scales; SECTION A: Output Performance. 5 1= A very small extent 2= A small extent 3= A moderate extent 4 = A large extent 5 = A very large extent. Statements ; Quality of Graduates 1. Employers give a feed back that your graduates are able to perform the objectives set in your programs. 2. The institutionâ&#x20AC;&#x2122;s alumni believe that graduates perform the objectives set in the programs conducted. 3. Most of your graduates in the last three years have been employed. 4. The institution has maintained an average yearly score in professional exams. Quality of Research and Scholarship Staff of this institution has; 5. published articles in referred journals. 6. written papers in referred conferences. 7. won research grants and projects. 8. supervised a good number of graduate students per year. 9. published a good number of papers from master and PhD thesis in referred journals. Quality of Services to Community Staff of this institution has; 10conducted a good number of short courses for the benefit of the community per year. 11. participated in the short courses for the benefit of the community. 12. a good number of industrial- sponsored projects per year. 13. a good number of consultancy jobs per year. 14. been engaged in industrial consultancy every year.

SECTION B: Process Performance. 1= A very small extent 2= A small extent 3= A moderate extent 4 = A large 5 extent 5 = A very large extent. Statements; Teaching and learning process In this institution; 1. students evaluate staff members. 2. staff has won awards for excellence in teaching. 3. staff develops new course proposals every year. 4. staff develops new book proposals every year Research administration process In this institution; 5. it takes a short time to approve a research proposal. 6. it takes a short time to approve a conference application. 7. it takes a short time to process a promotion case. Administration process. In this institution; 8. a good number of yearly goals are achieved within the planning horizon. 9. a good number of higher administration requests for input are responded to by the deadline. 10. most staff members are satisfied by the administration process.

SECTION C: Input performance. 1= A very small extent 2= A small extent 3= A moderate extent 4 = A large 5 extent 5 = A very large extent. Statements; Faculty utilization In this institution; 1. staff-student ratio recommended by NCHE is adhered to. 2. Students spend a good number of hours in contact with the lectures. 3. each academic staff supervises a good number of graduate students per year. Course offering and laboratory utilization. 4. In this institution, planned course offerings are covered well. 5. In this institution, all planned laboratory hours are used by the students. Quality of incoming students. 6. The institution admits undergraduate students with at least two principle passes in A-level examinations. 7. The institution conducts admission tests post graduate studies. 8. Only students with scores above average in the admission tests are admitted. 9. Most students in this institution take three years to complete the first degree. 10. Only few students are expelled for failure to complete studies.

Quality of graduate students and research assistants. 11. The institution admits graduate students and research assistants with a good truck record of academic performance. 12. The institution has a minimum CGPA for graduate students and research assistants joining masters and PhD programs. 13. Graduate students complete their masters and PhD programs in time. Support staff capabilities. The institution has; 14. a good number of secretaries per section. 15. a good number of laboratory technicians per lab. 16. a good number of staff members satisfied by the support given by support staff.

APPENDIX 2 QUESTIONNAIRE FOR STUDENTS MAKERERE UNIVERSITY BUSINESS SCHOOL QUESTIONNAIRE ON CORPORTAE CULTURE, CORPORATE REPUTATION, COLLABORATIVE RELATIONHIPS AND ORGANISATIONAL PERFORMANCE A CASE OF PRIVATE TERTIARY INSTITUTIONS IN UGANDA

TO BE ANSWERED BY STUDENTS OF SELECTED INSTITUTIONS

Introduction As part of my MSc. Accounting & Finance Programme, am carrying out a survey by use of a questionnaire to evaluate the relationship between corporate culture, corporate reputation, collaborative relationships and performance of private tertiary institutions in Uganda. You have been randomly selected as one of the respondents in the survey. Please kindly spare your valuable time and respond to the following questions as accurately and honestly as possible. Most questions require ticking the most appropriate options or filling in short answers. Your answers will not be disclosed to any one and thus no need to write your names on the questionnaire.

PART 1: BACKGROUND INFORMATION 2. Sex/Gender Male Female 2. How old are you? 20-25 years 26-30 years 31-35 years 36-40 years 41 years and above

3. Name of the Institution…………………………………………… 4. Faculty……………………………………………………… 5. Course………………………………………………… 6. Year of Study………………………………………………………………. 7. Programme: (a) Day (b) Evening (c) External (Distance Learning)

PART 2: REPUTATION OF THE INSTITUTION We would like to know the extent to which you perceive the reputation of your institution in relation to; Service quality, Trust and Social responsibility activities. A. SERVICE QUALITY Please indicate with a tick in the box the extent to which you agree with the following statements by use of these scales. 1= A very small extent 2= A small extent 3= A moderate extent 4 = A large extent 5 = A very large extent Statements

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1. The location of your campus is good & convenient. 2. The campus is attractive. 3. The institution provides clean accommodation. 4. The institution offers excellent education at a reasonable cost. 5. The institution offers a wide range of programs. 6. The classes are clean, spacious and well equipped with furniture. 7. The classes are equipped with teaching materials. 8. The institution has up-to-date computer laboratory. 9. Your institution has a library with adequate reading materials. 10. The library is conveniently operated. 11. The library is well equipped with furniture. 12. The registration process is fast and doesn’t bother a lot. 13. The teaching staff is qualified and competent. 14. The Teaching staff is always available for classes. 15. The Teaching staff is approachable. 16. The teaching staff has positive attitude towards the students. 17. The teaching staff provides advice and guidelines to students regarding course planning. 18. The teaching staff is able to communicate well with the 69

students. 19. The teaching staff communicates well in the class room. 20. The teaching staff provides feed back about students’ progress. 21. The teaching staff is involved in research. 22. The teaching staff has good knowledge about the teaching area. 23. The teaching staff provides real world examples. 24. The institution assesses the exams very well and release results in time. 25. The institution provides good menu/food. 26. The institution provides social activities to students. 27. The institution provides recreational facilities to students. 28. The flow of information in your institution is quick and effective. 29. The institution offers adequate health services to students.

PART B: TRUST Please indicate with a tick in the box the extent to which you agree with the following statements by use of these scales. 1= A very small extent 2= A small extent 3= A moderate extent 4 = A large extent 5 = A very large extent Statements

1. The institution always meets your expectations. 2. The academic standards of your institution are very good. 3. The institution is reliable and dependable. 4. The institution offers high quality service. 5. The institution keeps its promises to the students. 6. The institution understands students’ needs. 7. The institution is proactive to dynamics of the environment. 8. You prefer the institution for its name. 9. You came to this institution on people’s recommendations. 10. You advise this institution to people around you. 11. There is no discrimination against students in this institution. 12. You prefer the institution for its administrative staff. 13. The institution has experienced and specialist lectures. 14. The lectures give satisfactory course content. 15.You often follow positive news about this institution in local media

PART C:

SOCIAL RESPONSIBILITY ACTIVITIES

Please indicate with a tick in the box the extent to which you agree with the following statements by use of these scales. 1= A very small extent 2= A small extent 3= A moderate extent 4 = A large extent 5 = A very large extent

5 Statements 1. Your institution makes charges easier to students who cannot afford. 2. The institution offers cost-sharing scheme to students with disabilities or with special needs. 3. The institution offers grace periods to students who delay in payment of tuition fees and other dues. 4. Your institution sponsors students who perform well academically. 5. The institution sponsors students with talents in co-curricular activities like foot ball. 6. At times you benefit from free institution services. 7. Your institution conducts free education workshops and seminars to benefit the society around it. 8. Your institution contributes positively to the social and cultural life of the country. 9. The institution sponsors social counseling programs to promote students morals. 10. In extraordinary situations your institution gives information to society immediately.

PART D: COMMUNICATION Please indicate with a tick in the box the extent to which you agree with the following statements by use of these scales. 1= A very small extent 2= A small extent 3= A moderate extent 4 = A large extent 5 = A very large extent 5 Statements 1. Administrators and lectures always communicate positively with students. 2. Your complaints and problems are instantly solved. 3. You can information easily from the institution by phone. 4. You can instantly reach the lecture you want to talk to. 5. Administrators make satisfactory explanations when solving your problems. 6. You don’t spend a lot time in offices for procedures. 7. You’re always served by contemporary brochures from the institution. 8. After paying your tuition fees, you have not experienced any charge which you have not been informed. 9. The institution has procedures in place to respond to any complaint in a timely manner. 10. You’re satisfied with the way the institution communicates with you.

Thanks for your co-operation

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rochette | Search Results | ERM Books

ERM Books Resources for Risk Management Education

Search Results for 'rochette' Did you find what you wanted ? January 25, 2010

SOA Advanced Finance/ERM Exam Posted by riskviews under Leave a Comment Asset/Liability Management of Financial Institutions: Maximising Shareholder Value Through Risk-Conscious Investing, Tilman, L.M., 2003, Euromoney Institutional Advisor Financial Statement Analysis: A Practitionerâ&#x20AC;&#x2122;s Guide, Fridson, M, Alvarez, F, Third Edition, 2002, John Wiley & Sons Investment Guarantees: Modeling and Risk Management for Equity-Linked Life Insurance, Hardy M., 2003, John Wiley & Sons Errata: http://www.stats.uwaterloo.ca/Faculty/erratum.pdf Life, Health and Annuity Reinsurance, Tiller, J.E., Tiller, D.F., Third Edition, 2005, ACTEX Risk Management, Crouhy, M., Galai, D., Mark, R., 2001, McGraw Hill http://ermbooks.wordpress.com/?s=rochette

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Strategic Risk Taking: A Framework for Risk Management, Damoradan,2007, Pearson/Wharton School Influenza Pandemics: Are We Ready for the Next One, by Max Rudolph, Risk Management section newsletter, July 2004 http://www.soa.org/library/newsletters/risk-management-newsletter/2004/july/rm-2004-iss02-rudolph.pdf Fixed Annuities in a Low Interest Rate Environment, Product Development newsletter, April 2003 http://www.soa.org/library/newsletters/product-development-news/2003/april/pdn0304.pdf Managing Variable Policyholder Behavior Risk, Product Development newsletter, March 2005 http://www.soa.org/library/newsletters/product-development-news/2005/march/pdn0503.pdf Death Benefit Focused UL, Product Development section newsletter, April 2003 http://www.soa.org/library/newsletters/productdevelopment-news/2003/april/pdn0304.pdf Whither the Variable Annuity, Product Development section newsletter, November 2003 http://www.soa.org/library/newsletters/product-development-news/2003/november/pdn0311.pdf Operational and Reputational Risks: Essential Components of ERM”, by M. Rochette, Risk Management, December 2006. http://www.soa.org/library/newsletters/risk-management-newsletter/2006/december/RMN0612.pdf Enterprise Risk Management Specialty Guide, SOA 2006 http://www.soa.org/library/professional-actuarial-specialty-guides/enterpriserisk-management/2005/august/spg0605erm.pdf Fair Value – Financial Economics Perspective by Babbel, Gold and Merrill, NAAJ, http://www.soa.org/library/journals/north-americanactuarial-journal/2002/january/naaj0201_2.pdf Fair Valuation of Insurance Liabilities: Principles and Methods” AAA Monograph, September 2002 http://www.actuary.org/pdf/finreport/fairval_sept02.pdf An Overview of Embedded Value, H. Mueller, Financial Reporter, Sept. 2003. http://www.soa.org/library/newsletters/financialreporter/2003/november/frn-2003-iss55-mueller.pdf Economic Capital for Life Insurance Companies, SOA Monograph, 2008 http://www.soa.org/files/pdf/research-ec-report.pdf Actuaries, Stochasticity and Risk Management: The Real Lessons of Long-term Capital Management”, B. Crompton, The Actuary, September 2007. http://ermbooks.wordpress.com/?s=rochette

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http://www.soa.org/library/newsletters/the-actuary-magazine/2007/august/act2007aug.aspx Risk Aggregation for Capital Requirements Using the Copula Technique”, Song Zhang, Risk Management Newsletter, March 2005, Issue #4 http://www.soa.org/library/newsletters/risk-management-newsletter/2005/march/rmn0503.pdf Liquidity Risk Measurement, CIA Educational Note http://www.actuaries.ca/members/publications/1996/9626e.pdf “Actuarial Aspects of SOX 404”, The Financial Reporter, Dec. 2004, http://www.soa.org/library/newsletters/financialreporter/2004/december/frn-2004-iss59-brownehay.pdf “Responsibilities of the Actuary for Communicating Sarbanes-Oxley Controls” The Financial Reporter, Dec. 2004, http://www.soa.org/library/newsletters/financial-reporter/2004/december/frn-2004-iss59-auvinen.pdf Risk Management: The Total Return Approach and Beyond, Ho, Risk Management Newsletter, November, 2004, Issue #3 http://www.soa.org/library/newsletters/risk-management-newsletter/2004/november/rmn0411.pdf Application of Coherent Risk Measures to Capital Requirements in Insurance”, Artzner, NAAJ, Vol 3, No 2 http://www.soa.org/library/journals/north-american-actuarial-journal/1999/april/naaj9904_1.pdf Plus Study Notes

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RE: Question on SOA publications/references - Yahoo! Courriel

RE: Question on SOA publications/references

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jeudi 18 août 2011 09 h 56

De: "Gina Rutgens" <grutgens@soa.org> À: "Michel Rochette" <m_rochette@yahoo.fr>

Good morning: Per your request, I have run the stats on the specified files. I have been experiencing some difficulty with our current analytics tool. What I have noticed is that stats from 2007 and 2008 may not be very accurate. You will see the stats below for your review. I would be happy to talk about any of them with you if you have any questions. Thank you, Gina Rutgens Title: Operational Risk in IT Projects URL: www.soa.org/library/newsletters/risk-management-newsletter/2005/july/rmn-2005-iss5rochette.pdf Post Date: 2005 2011 Downloads: NA 2010 Downloads: NA 2009 Downloads: NA 2008 Downloads: NA Title: Risk Dashboard: 2008-05-30 URL: www.soa.org/files/pdf/2008-qc-detoro-henderson-42.pdf Post Date: 2008 2011 Downloads: 465 2010 Downloads: 716 Title: Operational Risk URL: www.soa.org/library/newsletters/the-actuarymagazine/2005/february/ope2005february.aspx 2011 Page Views: 468 2010 Page Views: 581 2008 Page Views: 1,017 Title: Operational and Reputational Risk: Essentials Components of ERM URL: www.soa.org/library/newsletters/risk-managementnewsletter/2006/december/RMN0612.pdf Post Date: 2006 2011 Downloads: 1,724 2010 Downloads: 2,242 2009 Downloads: 2,335 2008 Downloads: 2,497 Title: October 2008 Issue of Risk Management Newsletter - Mandarin version URL: www.soa.org/library/newsletters/risk-management-newsletter/2008/october/rmn-2008mandarin.pdf Post Date: 2008 2011 Downloads: 574 2010 Downloads: 997 2009 Downloads: 1,100 Title: Reputational Risk URL: www.soa.org/files/pdf/lsprng07-001-rochette.pdf Post Date: 2007

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RE: Question on SOA publications/references - Yahoo! Courriel

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2011 Downloads: 3,785 2010 Downloads: 5,240 2009 Downloads: 3,282

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