CS-19 Risk Tools and Modeling - Risk Tolerances and Limits

1. CS-19 Risk Tools and Modeling - Risk Tolerances and Limits Russ Bingham Vice President and Director of Corporate Research Hartford Financial Services Enterprise Risk Management Symposium Washington, DC July 29-30, 2003

2. Outline • Modeling Basics • Financial Model Building Blocks • Models versus Metrics • Basic Risk Quantification Steps • Four Cornerstones of Risk / Return Relationship • Establishing Risk Tolerances and Limits • One Company’s Experience • Risk / Return Objectives • Risk / Return in Practice • Ten Commandments of Insurance Financial Modeling

3. “Building Blocks”: Valuation Fundamentals • Balance sheet, income and cash flow statements • Development “triangles” of marketing / policy / accident period into calendar period • Accounting valuation: conventional (statutory or GAAP) and economic (present value) • Risk / return decision framework which deals with separate underwriting, investment and financial leverage contributions

4. Models versus Metrics • A complete financial model should contain all relevant measures of return and risk • Several return metrics – ROE, IRR, net income, etc. • Several risk metrics – Probability of ruin, EPD, VAR, TVAR, TCE, Sharpe Ratio, PSD, RCR, etc. • All return metrics can be reconciled to each other and all risk metrics can be reconciled to each other

5. Basic Risk Quantification Steps 1. Select variable(s) of interest 2. Determine the statistical distribution of the variables(s) 3. Define and identify adverse outcomes 4. Determine the probability of an adverse outcome 5. Determine the severity of an adverse outcome 6. Calculate the risk metric (if it is not 4. or 5.)

6. Four Cornerstones of Risk / Return Relationship:Price, Risk, Leverage and Return • Selection of metrics to manage the tradeoff between risk and return • Consistency in return and risk metrics • Financial and operational applicability • Consistent treatment of Underwriting, Investment and Finance activities • Price for Risk, Leverage for Return • How is risk reflected in the price? • What is leverage / return “profile”?

7. Establishing Risk Tolerances and Limits • Identify risks that are of concern to management and calculate relevant risk metrics • Failure to achieve adequate returns - Probability / severity of below breakeven total return • Ratings downgrade - RBC tests • Insolvency - Probability of ruin, EPD, etc. • Considerations and conflicts that must be resolved • Internal versus external focus • Financial markets and rating agencies • Internal applications and risk management • Financial and Operational ties • Shareholder versus policyholder perspective • Accounting versus Economic basis • Time Dimension • Ultimate objective is to instill a company-wide financial discipline that maintains a dual focus on risk and return in alignment with management’s stated goals • Success requires a management commitment to such a process, including operational application of it, and supported by rigorous financial models and tools

8. One Company’s Experience:Risk / Return Objective • The objective is to maintain a discipline for dealing with the tradeoff between risk and return with the following attributes: • Consistent treatment of underwriting businesses and investments, both with respect to each other and over time • Ability to integrate underwriting, investment, and finance operations into an alignment with external rating agency views, particularly with respect to required capital and returns • Provide an independent assessment of capital needs and returns that properly considers the four fundamental dimensions of: (1) risk, (2) price, (3) leverage (capital needs) and (4) return • Lends itself to implementation in ratemaking, planning, and performance monitoring throughout the company

9. One Company’s Experience:Risk / Return in Practice • Risk AT THE HARTFORD is defined as the probability and severity of falling below breakeven return - Breakeven point is at ‘0’ operating return, equivalent to total return equal to low-risk yield • Risk is quantified by a model that reflects the volatility in: the amounts of premium, loss and expense; the timing of premium, loss and expense cash flows; and interest rates, including relevant correlations among them • Risk criteria applied uniformly in all lines of business • Required benchmark underwriting price (underwriting ratio) is determined in order to satisfy risk criteria - Investment can be dealt with in a similar manner, with required yield to be determined • Price discipline is maintained by keeping risk criteria at fixed level over time

10. One Company’s Experience:Risk / Return in Practice (cont’d) • On a benchmark basis, all underwriting businesses (as well as investment) fall on the Risk / Return tradeoff line - This is risk-adjusted return at uniform leverage - Businesses with higher volatility (i.e. uncertainty) are required to generate higher returns on this basis • Without affecting price or risk, business targets are expressed alternatively at a uniform return level using risk-adjusted leverage - These are the benchmark leverage ratios • The benchmark surplus generated in total provides an independent, risk-based estimate of capital needs, to judge versus RBC • The benchmark leverage split into individual components relating to premium, loss, and expense risk, does parallel the RBC factors somewhat, as does particularly the separation of underwriting and investment related risks

11. Ten Commandments of Insurance Financial Modeling 1. Thou shalt build only models that have an integrated set of balance sheet, income and cash flow statements 2. Thou shalt remain rooted in a policy period orientation and develop calendar period results from this base 3. Thou shalt reflect both conventional and economic accounting perspectives - guided by economics, constrained by conventions 4. Thou shalt recognize the separate contributions from each of underwriting, investment and finance activities 5. Thou shalt be guided by the risk / return relationship in all aspects 6. Thou shalt include all sources of company, policyholder and shareholder revenue and expense embodied in the insurance process 7. Thou shalt reflect all risk transfer activities 8. Thou shalt not separate risk from return 9. Thou shalt not omit any perspective or financial metric that adds understanding 10. Thou shalt allow differences in result only from clearly identified differences in assumption, and not from model omission