ERM in the Rating Evaluation

1. ERM in the Rating Evaluation CAMAR Fall Meeting November 29, 2007 Thomas M. Mount, ACAS, MAAA Andrew Colannino, Vice President A.M.Best Company

2. What is Risk Management?

3. Risk management is a process which helps insurers identify, measure and manage the various types of risk within their operations.

4. What are the objectives of Risk Management?

5. Objectives of Risk Management • To manage the organization’s exposure to potential earnings & capital volatility • To maximize the value of the firm to the organization’s various stakeholders • Goal is to understand and manage risk, NOT to eliminate risk

6. How does A. M. Best view Risk Management?

7. Risk Management • Risk management is the common thread that links balance sheet strength, operating performance and business profile • Risk management fundamentals can be found in a company’s… • Strategic decision making process • Financial management and control practices • Daily operating procedures

8. Traditional Risk Management vs. Enterprise Risk Management

9. Traditional Risk Management • Fundamental policies and procedures of identifying, quantifying, and managing specific risks individually • Categories of Risk • Credit Risk • Market Risk • Underwriting Risk • Operational Risk • Strategic Risk • Little or no interaction/communication/alignment among risk managers • “Silo” approach

10. Enterprise Risk Management • ERM is the process through which insurers identify, quantify, and manage risk on an enterprise wide, holistic basis • The underlying premise of ERM is based on increasing value to shareholders and providing financial security to the organization

11. Will A. M. Best perform a separate rating analysis of Enterprise Risk Management?

12. ERM in the Rating Evaluation • Not a separate component • Impacts all three areas of the rating evaluation • Capitalization • Operating performance • Business profile • Integrated into agenda • Clearly the potential to weigh heavily on a rating

13. Does A. M. Best expect all companies to implement Enterprise Risk Management?

14. ERM in the Rating Evaluation • Need for ERM will vary based on: • Complexity of a company • type of products offered • Number of products offered • Investments • Volatility of Earnings/potential significant capital loss (Risk profile) • Financial Flexibility • Strength of its Traditional Risk management

15. ERM in the Rating Evaluation However, implementing the concept of overall risk management, or even selected elements of ERM can help any company – regardless of size

16. ERMin the Rating Evaluation The development of principles-based solvency approaches, such as Solvency II in Europe, and the significant efforts of sophisticated insurer’s to raise the bar on the risk-management front, will ultimately become a competitive issue driving continued improvement and integration of ERM concepts for all insurers regardless of size

17. What is the impact of Enterprise Risk Management on ratings?

18. Impact of ERM on the Rating • ERM will benefit company in one of two ways: • ERM will motivate the company to reduce risk • shift its business strategy from volatile lines to more stabile lines • Aggregate reinsurance • Less volatile investments • ERM will motivate the company to obtain higher returns for its existing risk • Charge higher rates

19. Impact of ERM - Example of Changing Business StrategyFrom Volatile to Stabile Lines Volatile Strategy A- Stabile Strategy will become A+ sooner Average Return BCAR 160 = Minimum for A+ Today Future Time

20. Impact of ERM - Example of Receiving Adequate Return for Risk Ins Co w/Adeq Return will become A- sooner Ins Co w/Inadeq Return for Risk = B+ Adeq Avg Return BCAR Inadeq Avg Return 130 = Minimum for A- Today Future Time

21. Risk Management and BCAR – Best’s Revised Approach AMB Requirements: Superior traditional risk management fundamentals Superior capital management and financial flexibility Strong ERM characteristics Strong Economic Capital modeling capabilities LOW relative earnings and capital volatility Weak Risk Management Strong Risk Management BCAR What’s New… BCAR Guideline LOW HIGH EARNINGS and CAPITAL VOLATILITY

22. Risk Management and BCAR – Best’s Revised Approach Weak Risk Management What’s New… A.M. Best will consider allowing companies with STRONG risk management to maintain lower BCAR levels relative to the guideline for its rating Strong Risk Management BCAR BCAR Guideline LOW HIGH EXPOSURE to EARNINGS and CAPITAL VOLATILTY

23. What is “Strong” Enterprise Risk Management?

24. Assessment of ERM • Culture • Identification & Management of Risks • Measurement of Risks

25. ERM - Culture • Board & Senior Management establish • risk profile • risk tolerances • risk management objectives/incentives • Risk aware culture throughout organization • All levels of management/employees • Accountability • CRO responsibilities • Strategic decision making based on risk adjusted returns & other risk metrics • Business strategy – plan and execution • Capital allocation

26. ERM Identification & Management • An objective framework which identifies, monitors, and manages emerging risks, risk accumulation, and correlations within and across the entire organization • On going process • Exception reports • Reinsurance purchases based on risk tolerance • Contingency plans in place

27. ERMMeasurement of Risk • Risk/Return measures • Correlation of Risks • Impact of general economy • Impact of industry specific events / extreme events • Catastrophe Models • Economic Capital Models • Data collection • Quality of data • Data verification procedures • Access to the data

28. ERMMeasurement of Risk • Economic Capital Models - Management must demonstrate how the model is used • To make strategic decisions • To allocate capital • To understand volatility • To understand risk correlations • Quality of the model • Sensitivity of the model • Internal Model is given consideration in the evaluation of required capital

29. Summary • ERM is evaluated, but no separate rating is published • Importance of ERM will vary depending on the complexity/volatility/financial flexibility/traditional Risk Management of the company • Credit for Companies implementing ERM will be recognized over time • Credit given to strong internal company capital models that are used in ERM process

30. Questions?