Beyond Business Intelligence
Predictive Science for Today's Bottom Line
An enterprise risk model should provide a comprehensive set of reports that enable risk managers to see different aspects of a company’s risk. Risk reporting usually occurs at different levels within a company including the corporate level, subsidiary level, and business unit level. It is crucial that business units and subsidiaries use the same methods and follow the same guidelines to produce a standardized set of risk reports across the corporation.
The risk reporting capabilities possessed by ERM allow its users to analyze many different aspects of risk. ERM provides risk reports by risk category or business line; it can combine portfolios, individual companies, or company groups. This integrated approach to risk measurement enables rapid creation of new reports and customization of the existing reports upon request.
Banks and securities firms calculate risk at a short-term (3 to 10 trading days) horizon appropriate for trading operations. They traditionally report risk in terms of Value-at-Risk, but, often, a simplifying assumption of a normal distribution is made, and VaR is calculated in terms of standard deviation. For insurance companies, on the other hand, one year is a natural reporting horizon. Insurance operations, as a rule, are prone to rare but significant losses which manifest themselves in the highly non-normal, fat-tailed P&L distributions. Unlike the standard deviation, the properly calculated VaR-based metrics focus on the tail of the P&L distribution—on rare events that may threaten the very solvency of the company. These considerations are endorsed by regulatory authorities. The proposed Solvency II regulations require insurance companies to calculate VaR and similar risk measures on a longer-term basis of a one-year horizon. Solvency II specifically encourages the use of Tail VaR (TVaR, Expected Shortfall) (see [11], p. 105) defined as the expected amount of loss when the loss exceeds VaR. Tail VaR is conceptually close to measuring the risk in terms of the value of a hypothetical put option that would be required to completely hedge the losses over a certain threshold. This metrics possesses a number of desired qualities [27] and has become increasingly popular in risk management.
The standard ERM risk reports include Profit-and-Loss (P&L) distribution and such risk measures as:
VaR-based metrics measure the risk of rare events, such as catastrophes. If there happen to be just a few of scenarios with such events, these tail risk measures may not be estimated reliably. Seabury ERM improves the convergence of the VaR metrics with help of importance sampling and statistically robust L-estimation procedures [29], [30] (see Appendix D:for details of these techniques).
In addition to various risk measures, ERM calculates Economic Capital (EC) required to support the solvency at a given probability level. The EC is allocated to each business unit in proportion to their Incremental VaR, as supported by modern financial science. Finally, to facilitate performance measurement, Risk Adjusted Return on Capital (RAROC) is calculated for each business segment.