PROCEEDINGS May 15, 16, 17, 18, 2005 - Casualty Actuarial Society

PRESIDENTIAL ADDRESS 747use of these techniques and the resulting financial debacles theycaused have actually led to the need for ERM.Operating risks represent the failure of people, processes, orsystems. One recent example of operating risk is the announcement(The Wall Street Journal, November 9, 2005) by FreddieMac, the large mortgage finance company, that it discovered acomputer error that, since 2001, has been overvaluing accruedinterest on variable rate home equity loans. The effect of thiserror is estimated to be at least $220 million. The next day GeneralMotors announced that it had incorrectly booked creditsfrom suppliers in 2001 (WSJ, November 10, 2005). The overstatedearnings are estimated to be as high as $400 million, or50 percent of its reported profit during that year. To clarify thedistinction between hazard and operational risk, if an employeesteals from an employer, that is a hazard risk and can be coveredby typical insurance policies. However, if that employee inflatesearnings in order to “qualify” for a bonus, that is not consideredhazard risk and is not covered by insurance. This would beoperational risk.Strategic risk reflects the business decisions of an organizationor the impact of competition or regulation. An organizationthat adapts (or fails to adapt) to new markets, whose activitieslead to new forms of regulation that either help or hinder futureoperation, or whose business plan proves either successfulor unsuccessful–all are examples of strategic risk. Examples ofstrategic risk for insurance are the benefits produced for thosefirst to use credit scoring as a rating variable, and the marketshare losses of those companies that were slow to adopt thisapproach.ERM originally focused on loss prevention, controlling negativesurprises, and reducing downside risk. That was the initialreaction of both regulators and boards to the failures at BaringsBank, Enron, WorldCom, Arthur Andersen, and other corporations.ERM evolved into accepting risk, but measuring therisk associated with the expected returns from different business