The Evolving Role in Enterprise Risk Management

1. 2001 Casualty Loss Reserve Seminar Fairmont HotelNew Orleans, LaSeptember 9-11, 2001Robert F. Wolf FCAS, MAAAPrincipalWilliam M. Mercer/MMC Enterprise Risk Consulting The Evolving Role in Enterprise Risk Management

2. Agenda • Introduction • ERM/Actuarial Evolution • Trends - What’s Going On? • ERM Platforms • Non-Insurance Company • Insurance Company • Wrap-up • Q&A Copies of Presentations Available at www.casact.org

3. What is ERM? • To me, Enterprise Risk Management is a process for identifying and prioritizing critical risks facing an organization, quantifying their impact on financial and strategic objectives, and implementing financial and organizational solutions to address them. • To others, it varies but the essence is the same • “ERM assesses and manages all risks while looking for upsides in identifying risks.” • “Enterprise Risk Management is about information and capital management.” • “The ultimate goal of Enterprise Risk Management is preservation of shareholder value.” • “The job of Enterprise Risk Management is figuring out where the edge of the cliff is, and making sure the risk takers know where it is.”

4. No Consensus on Best Risk Measure C EPD Principal B D B= VaR (Pr Ruin) Principle A A =Variance Principal= Squared Dev from Mean TVaR Principal= C+D

5. Evolution of Risk Management • As the quantification/approach to measuring/handling risk evolves, so too does our job description. • Risk Manager • From Insurance Buyer to Integrated/Consolidated Risk Strategy • Actuary • Traditional: Evaluate Hazard/Financial Risk • Evolution: DFA (Insurance Companies)/ ERM

6. Why the Evolution of ERM • New/Larger Risk • E-Commerce, Market/Book Values • New Risk Products • Merger of Insurance and Financial Institutions • Realization that Silo-Based Approaches are Flawed • Ignores inherent hedges and correlation • Increased Management Accountability • New Regulations requiring corporate governance

7. Why the Evolution of ERM • In short, because Society Demands it • Computer and Information Age • We couldn’t do what we are doing today if we needed to use slide-rules or abacus. • Focus Optimize Shareholder Value

8. Economist Intelligence Unit ERM Study

9. Risk Managers and Senior Executives Are Hearing More and More About Risk Management

10. Evolving Risk Manager • Evolving Risk Management Positions • Chief Risk Officer, ERM Councils, Global Director of Risk Management • Rise of, and Partnership with, Internal Audit • Corporate governance issues and perspectives • Rise of, and Partnership with, Treasury • Financial Management perspectives and insights • Rise of Board Audit Committees • Evolving Skill Base for Risk Managers

11. Why the Evolution of ERM • In short, because Society Demands it • Computer and Information Age • We couldn’t do what we are doing today if we needed to use slide-rules or abacus. • Focus Optimize Shareholder Value

12. Actuarial Evolution • ERM Evolution Actuarial Evolution • Traditional Roles • Evaluating Hazard/Financial Risk in a silo • Insurance Company • Determine what to charge in order to meet profits targets (Ratemaking) • What to set aside to meet future obligations of past events (Reserving) • Insurance Customers • What to budget in order to pay for self-insured obligations and premiums • What to set aside to meet future obligations of retained risk

13. Actuarial Evolution • Continuing Actuarial Evolution • Evolving Demands for Risk Integration • Insurance Company • Holistic Evaluation of Assets and Liabilities (Dynamic Financial Analysis (DFA)) • Optimum Capital Structure • Realization of Business Plan • Insurance Customers • Optimum Risk Financing • What risks to retain/insure - captives, retros, large deductibles • ..but still only Hazard and Financial Risk

14. Optimum Integrated Hazard Risk Financing • Corporate Considerations • Cash Position • Effective Tax Rate • After-Tax Cost of Borrowing • Credit Capacity • Need for Admitted Carrier Paper • Cost Predictability/Risk Appetite • Market Assessment • Risk Management Budget • Loss Control Incentives Exogenous Contingent Events Economic Scenarios Interest Rates etc. Tools Loss Forecasting/Reserving Models Dynamic Financial Modeling Discounted Cash-Flow Models Risk/Cost Matrix Goal is to optimize shareholder value • Recommendations • Optimum Retentions • Optimum Funding Mechanisms

15. Actuarial Evolution • ERM Evolution Actuarial Evolution • All sectors of Corporate America • Not merely Insurance Companies and their Customers • Includes Strategic and Operational Risks as well as Hazard and financial risks

16. Case Study Non-Insurance Corporation (See Presentation By Barry Franklin)

17. Case Study Framework ERM Insurance Company

18. P&C Goals - Not Just Survival • Three Considerations • Survival : How risky can you be • Prob {Cost of Runoff and New Business Costs > UEPR, Loss Reserves, Future Premiums, and Investment Income, Capital} < a • Stability • Probability [(Loss Ratio + Expense Ratio) > Target Combined ratio]<a • Optimizing Enterprise • CEOs and CFOs care more about stability v. survival.

19. 2.0 Billion of Premiums $700 Million Surplus Mulli-line Company - Primarily Personal Lines 5 Regions The Company Manages its silos well 50% Premium Volume is rate sticky states Asset Allocation: 80% Bonds 10% Equities 10% st-investments 25% growth rate in recent years ERM Insurance Company

20. Historical Reserve Margins Less Pressure on Rate Adequacy to Achieve Corporate Goals

21. How much capital is Enough? Supporting Future Growth Excess Capital Should we give back to Shareholders? What if a beneficial acquisition arises? Should we increase our Shareholder dividend? Is debt financing appropriate? Is our investment strategy providing a good risk/reward How efficient is our reinsurance Structure? Cost/Benefit Catastrophe Should we be self insuring/insuring our operations risks? Goal : Develop ERM Framework Addressing (Macro):

22. Goal : Develop ERM Framework Addressing (Micro): • What region/state/product line/ target market should we grow/contract • What is my marginal capital at risk and corresponding return • What Combined Ratios do I need to achieve given market and economic conditions by product line to achieve macro goals: • ROE • MV/BV

23. How Much Capital do you Need? Capital Truly Held includes Capital embedded in UEPR, Discount in Loss Reserves, Capital Tied up in NAIC RBC/ Best’s BCAR. K+S K Suggested Approach= Economic Capital is all that matters. The above reflects a timing constraint as to how much capital to hold if >Economic Capital. Must reflect this timing cost. S

24. ERM Process ECONOMIC CONDITIONS MANAGEMENT & BOARD DECISIONS COMPETITION & INDUSTRY Reinsurance Strategy Investment Strategy Underwriting Strategy Operational Management ALM Capital Structure Pro-forma Financials Legal Entities Operating Units Decisions

25. Competition and External • Price Compensation & Elasticity of Demand • Jurisditional Risk • rate stickiness • tort laws • residual market • Best’s, RBC, etc.

26. Management Decisions • Business Plans • 1 Year • 5 Year • Board Directives • Asset and Investment Guidelines • Corporate Culture • Incentive Compensation

27. Economic Conditions • Inflation • Interest Rates • Currency Exchange • Equity Performance • Economic Conditions • Recessions • Combo of stochastic and scenario considerations

28. DFA Approach • Holistic View • Reinsurance Strategy • Investment Strategy • Underwriting Strategy (Macro) • Operational • Correlation • Forward Looking • 5 Year Planning Horizon • DFA Platform • CFs, Income statements, ROEs, Balance Sheets

29. Reinsurance Strategy Considerations - Credit Risk

30. Investment Strategy

31. Asset/ Liability Management Change in Equity = Change is Assets - Change in Liability If the asset duration exceeds the liability duration, then an upward shift in interest rates decrease equity. If the asset duration exceeds the liability duration, then an downward shift in interest rates increase equity. + Duration Line Duration Line Interest rate shift Reserves - Assets Positive Duration Needs to Consider Cash Flows of New/Renewal Business

32. Effects of Duration Mismatch And in many cases the LiabilityDuration is actually NEGATIVE ….so we May Need to consider inflation hedged securities or assets that tend to move with inflation such as stocks (long-term) and real estate + Duration Line Interest rate shift Reserves Duration Line - Assets

33. CAS VFIC Research………. • Optimal Investment Strategy Does Not Imply Duration Matching • Analysis of Duration is only one part of the process • An upward sloping yield curve along with short duration loss reserves often imply that asset durations in excess of liability durations may increase net investment income and lower the probability of insolvency

34. Operational Risks Handled Similarly to Barry’s Approach to Corporate Client Also Includes Seasoning of Business - Renewals Get Better

35. Capital Financing Strategy • Capital Management • Macro- Is suffucient Capital Available? • Micro - Decision making Tool • What marginal capital and marginal returns can be realized at a product/target market/region/state basis? • Where to Grow/Contract?

36. Market Value Balance Sheet Liabilities Definitions Assets Let K = Policyholder Supplied Funds (PHSF) Let S = Shareholder Supplied Funds (SHSF) K K+S Returns RA = Return on Investments Using both policyholders and shareholder supplied $s RL = Cost of Debt (Borrowing PHSF) RC = Cost of Capital (Using SHSF) Capital S Returns RA on K+S funds Balanced Levered Trust (K+S)RA = KRL + SRC S Costs at rate of RC K Costs at a rate of RL Financial Markets RL is the reserve discount rate, RL = RA - (S/K)(RC- RA) SHSF Supply PHSF Demand = S (RC-RA) K(RA-RL) RU = - K RL/Premium Insurance Company Earns Positive Economic Returns on Underwriting if RA > RL (Ru> - (K/Premium) RA ) Product Markets RC = (1 + K/S)RA + (Prem/S)RU

37. Maximizing Shareholder Value Depends on Three Things…….. • Earnings (ROE) • Cost of Capital • Long-Term Growth Market Value of Firm = S(ROE)/(1+RC)+ S(ROE)(1+G)/(1+RC)2 + S(ROE)(1+G)2/(1+RC)3 +…….. = S(ROE)/(Rc-G) Book Value of Firm = S Market/Book Ratio = ROE/(Rc-G) S = Statutory Surplus G= Long-Term Growth Rc = Discount Rate@ Cost of Capital

38. Allocation of Capital • Macro - How Much is Enough? How Much to Give Back to Shareholders • Micro- • What marginal capital and marginal returns can be realized at a product/target market/region/state basis? • Where to Grow/Contract • Choose target markets such that greatest return on marginal capital until each yield the same return • Allocate capital in proportion to marginal capital • See Glen Meyers “Cost of Financing Insurance” and “An Introduction to the Competitive Market Equilibrium Risk Load Formula”

39. In Meyer’s………….. Let P = Return and C = Capital. Then the insurer is better off by adding a line/policy if:  Marginal return on new business > return on existing business.

40. Overall Benefits- ERM Process • Optimum Capital Structure • What Operating Division is Enhancing/Destroying Enterprise Value • Realization Of Business Plans Enhanced • Micro Decision Making and Targets Consistent with Macro Decision Making • Dynamic Reforecasting of Business Plans and Incentive Plans - 5 Years

41. Wrap-up

42. Fortune 1000 Group Analysis10% of the Fortune 1000 companies suffered a loss of over 25% of shareholder value within one month % of top 100 Primary Cause of Stock Drop (# of Companies) Law-suits Natural Disasters Competitive Pressure Mis-aligned Products Loss of Key Customer R&D Delays Manage-ment ineffective- ness Foreign Macro-Economic Issues High Input Comm-odity Price Interest Rate Fluct-uation Cost Overruns Customer Demand Shortfall Customer Pricing Pressure Regulatory Problems Supplier Problems M&A Integration Problems Accounting irregularities Supply Chain Issues Strategic Operational Financial Hazard Source: Compustat, Mercer Management Consulting analysis - Period Examined was June 1993 to May 1998 Note: There were also 5 stock drops for which the primary cause could not reliably be determined. These 5 stock drops are not depicted. How Does Risk Manifest Itself?

43. Two Ways to Interpret Graph • Hazard and Financial Risk is Not Important • Hazard and Financial Risk has been and continues to be managed well • Testimonial for risk managers, actuaries, brokers, and financial analysts. • We need to continue the process • …The opportunity now is to work on the left side of the graph.

44. …….Significant Opportunities for Us. “….We don’t do things because they are easy. We do them because they are hard.” ….John F. Kennedy

45. Thank You

46. Q&A