Enterprise Risk Management: Actuarial Perspective

1. Is [Enterprise] Risk Management for Actuaries? David Oakden OCCA Meeting Nov. 4, 2004 Based on a Presentation by Barry Franklin

2. The Actuary and ERM • ERM Definition • CAS Activities • SOA Activities • Examples

3. CAS ERM Definition • “The discipline by which an organization in any industry assesses, controls, exploits, finances and monitors risk from all sources for the purpose of increasing the organization’s short- and long-term value to its stakeholders” • Key elements: • Dual nature of risk • Value creation • CAS relevance beyond insurance industry

4. Risks to Capital Investment Risk Property Catastrophe Corporate Credit Risk Premium Growth Sovereign Risk Casualty Clash Enterprise Risk Reinsurance Recoverables Legislative / Regulatory Action Rating / Reputation Decline Operations Risks Risks to Earnings Risk factors in an organization

5. The CAS sees ERM in its Future CAS members will be recognized as leading experts in the evaluation of hazard risk and the integration of hazard risk with strategic, financial, and operational risk. Excerpt from CAS 2014 Centennial Goal

6. CAS Efforts to Date • CAS ERM Advisory Committee (2000/1) • ERM Definition and Framework • CAS Research & Education Priorities • CAS ERM Research Committee (2002-) • Research Priorities

7. CAS Advisory Committee on ERM: Goals • Define ERM; develop conceptual framework • Determine current/desired knowledge level • Identify research needs to close gaps • Identify education needs to close gaps • Recommend methods, priorities, timetable • Compile initial ERM bibliography • Recommend additional efforts of existing/new CAS committees

8. Risk Type Risk ManagementProcess Step • Strategic • Operational • Financial • Hazard • Establish context • Identify risks • Analyze/quantify risks • Integrate risks • Assess/prioritize risks • Treat/exploit risks • Monitor and review CAS ERM Conceptual Framework: Two Dimensions

9. CAS Recommendations -- Research • Highest priority topics • ERM overview • Value creation through ERM • Risk quantification (financial, operational, strategic) • Risk correlation & integration • Other priority topics • Risk tolerances, risk/reward metrics, portfolio optimization, monitoring, treatment, integrated products

10. CAS Recommendations -- Research (cont’d) • Form standing ERM Research Committee • Direct & monitor research per above • Expand, update, organize, maintain ERM bibliography • Work with other CAS committees to coordinate ERM research and provide content for education • Partner with other organizations • Develop internal and external communications, designate spokespersons

11. CAS Recommendations -- Education • Codified 2005 CAS ERM education needs • For each element of ERM framework • By degree of desired knowledge level • By type of education vehicle • Syllabus • Continuing Education • Developed detailed Learning Objectives for each element of ERM framework • Publish ERM bibliography • Accomplish through existing committees

12. ERM Research Committee -- Research Priorities • “ERM Overview” document • Financial risk quantification • Risk correlation/concentration/integration • Value creation through ERM • ERM bibliography • Coordination with other CAS committees • Coordination with other professions

13. SOA Efforts to Date • Established a Risk Management Task Force within the SOA Finance Practice Area in 2002 • to address the growing need for information on risk management • to make risk management a regular part of actuarial practice • to advance professional recognition and career opportunities for actuaries in the arena of risk management

14. Risk Management Task Force • Implementing Task Force Goals • promotion of actuarial expertise in areas of risk management, • promotion of opportunities for actuaries in the arena of risk management, • sponsorship of seminars on risk management, and • development of new risk management educational materials.

15. Task Force Subgroups • Credit risk management • Economic capital calculation and allocation • Enterprise risk management • Equity modeling • Extreme value models • Health risk management • Policyholder behavior in the tail • Pricing for risk • Risk-based capital covariance • Risk management metrics

16. Risk Management Section • The purposes of this Section are to further the education and research in the area of risk management and to establish leading risk management techniques. These efforts should be rigorous and based on sound principles such that resulting techniques are broadly transportable across disciplines and industries. These efforts should help to increase the profile of the actuarial profession as being leaders in the field of risk management. (emphasis added)

17. Other SOA Activities • Co-sponsorship of ERM Symposium • Course 8 offers an ERM extension • Joint effort with CAS on public relations effort to raise awareness of the actuary as chief risk officer • RFP for Internal Hedging Programs for Life Insurance Companies

18. Assessing Critical Risks Relative to Risk Tolerance ABC Critical Risk Analysis Potential EPS Impact of Average Loss Event Supply Chain Disruption $1.20 Manufacturing Disruption Changes in Regulation $1.00 $0.80 Product Launch Delay Location Concentration Avg Loss Event After-Tax EPS Impact $0.60 $0.03 per Share Intellectual Property $0.40 Third Party Liability Outsourced Manufacturing Environmental Contamination $0.20 $- O1 O2 O5 L1 L2 L3 L4 S1 S2 Critical Risk Area

19. Quantifying Critical Risks Operational Risk O1 Operational Risk O1 Potential Impact on After-Tax Cash Flow Potential Impact on After-Tax Cash Flow 100 4,000 (400) 3,000 (900) (1,400) 2,000 (1,900) LRP LRP Cash Flow ($Millions) (2,400) 1,000 Deviation from LRP ($M) Avg Event Avg Event (2,900) - 1 SD (3,400) 1 SD (3,900) (1,000) 2 SD 2 SD (4,400) (2,000) (4,900) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Plan Year Plan Year Operational Risk O1 Operational Risk O1 Potential Impact on NPV 2008 Market Cap Potential Impact on After-Tax EPS 37,877 8.00 40,000 6.00 33,126 35,000 31,564 4.00 30,000 27,605 25,251 2.00 25,000 Avg Event 22,084 LRP 18,938 - After-Tax EPS 20,000 1SD NPV Loss ($Millions) 16,563 Avg Event 19,548 12,626 (2.00) 15,000 2 SD 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 16,290 1 SD 11,042 13,032 (4.00) 10,000 2 SD 9,774 (6.00) 5,000 6,516 (8.00) - 10 15 20 25 30 Assumed P/E Ratio

20. Enterprise risk models translate risk into financial measures Operational Risk Models Projected Financials Risk Profile = Distribution of Future Financial Results Asset Behavior Models Economic Scenario Generator • Inflation • Interest Rates • Credit Costs • Currency Exchange • GDP Product Behavior Models Catastrophes & Random Claims • Company Strategy • Investments • Products • Capital/Structure • Reinsurance/Hedging • Operating Optimization

21. Ranked distribution of present values of future profits from each simulation $m + 0 Economic Capital – Selected risk tolerance level Cumulative probability Determining EC involves an analysis of the risk profile for a selected risk tolerance level EXAMPLE = “sufficient surplus capital to cover potential losses, at a given risk tolerance level, over a specified time horizon”

22. Evaluating Impact of Critical Risks on Debt Ratings • ABC’s debt ratings are based on a number of factors, the most prominent of which in the ratings analyses we have reviewed is Debt Service Coverage. • Based on our understanding of the rating agency analyses we reviewed, ABC’s rating would likely be lowered if the Debt Service Coverage Ratio drops below 125%. • Our simulation analysis suggests that the likelihood of the Debt Service Coverage Ratio dropping below 125%, as a result of the risk areas analyzed herein, is approximately 6.3%; that is to say ABC can be 93.7% confident that its rating will not be lowered due to contingencies associated with the risks analyzed. ABC Corporation 2002-2003 Reading the graph: The vertical axis represents the ABC’s 2002-2003 Debt Service Coverage Ratio. The horizontal axis represents the probability of the ratio being at or below the indicated level. For example, the point indicated by the arrow suggests that in 80% of simulated years, the ratio is projected to be 155% or less. Debt Coverage 165.0% 155.0% 145.0% 135.0% Model 125.0% Debt Coverage Ratio 115.0% Target 105.0% 95.0% 85.0% 75.0% 0% 20% 40% 60% 80% 100% Probability

23. Concluding Thoughts • ERM is a value creation tool • ERM is a unifying framework • ERM is an actuarial recruitment tool • ERM is an important part of the actuarial profession’s future