ERM: a Corporate Model Approach SOA Conference Chicago

1. ERM: a Corporate Model ApproachSOA Conference Chicago Thomas S. Y. Ho April 26 2004 tom.ho@thomasho.com

2. Outline • Defining ERM for Principal Financial Institutions • Total return approach & DFA • Embedded value & Firm Valuation • Liabilities/re-insurance & capital structure • Conclusion: extending “fair value” concepts to all the claims on the revenues of the firm

3. Principal Financial Institutions • Merton’s definition of principal financial institutions • Managing the balance sheet • Subject to market risks and business risks • Sales volume related to the balance sheet items • Inforce business versus new sales • Asset/liability Management & ERM

4. Total Return Approach • Extending from cashflow testing • Fair value of assets • Transfer pricing curve • Option adjusted spreads • Implied volatilities • Fair value of liabilities • Required option adjusted spread • Implied volatilities from the capital markets • Managing the “equity” or the “surplus” • The total return approach deals with inforce business

5. Dynamic Financial Analysis (DFA) • Project future sales • Analyze the simulated financial statements • Stochastic sampling • Formulate business strategies • No consistent framework in valuation • How to increase shareholders’ value? • How to capture the impact of long dated products?

6. Firm Valuation • Importance of firm valuation in corporate finance, and investments • Traditional method of discounting the free cashflows • The approach ignores the optionality of the free cashflows • Research using real options ignores the flow of funds of the firm’s operations, from revenues to net income. • Comparing with the Embedded Value approach

7. A Corporate Model Approach • Specify the business model of the firm • Use the “primitive firm” as the “underlying security” in valuing the business risks. • The firm is modeled as a contingent claim on the primitive firm. • Relate the financial statements to the firm value, and to the values of the claims on the firm. • In sum: model the cashflows from revenues to net incomes, and show how the firm makes money

8. Strategic Value of a Firm • Real options embedded in the firm • Top down approach • Bottom up approach

9. Revenue Risk Process • GRI is the gross return on investment • The process is a martingle • Based on capital assets

10. Primitive Firm Value • CA capital asset • m gross profit margin • Cost of capital for the business risk • Expected perpetual revenue is the present revenue

11. Bankruptcy Condition on the Lattice

12. Importance of the Valuation • Determination of the appropriate discount rate • Determine the appropriate value of the claims on the firm’s cashflows or the assets • Consistent with maximizing the shareholders’ value

13. Surplus Management and Capital Structure Management • Surplus (“equity”) is managed to support the obligations to the liability for the inforce business • Capital structure management uses debt to provide the optimal returns to the shareholders adjusting for the risks • Complex debt structure and product mix in the capital structure

14. Risk Finance • Re-insurance as products of a principal financial institution • Re-insurance as a risk management tool for the products • Corporate insurance extends to concept of risk finance from the balance sheet to the capital structure of a firm • Corporate insurance as a product and as a risk management tool

15. Summary

16. Conclusions • Must redefine enterprise risk management for insurers • Integrate valuation to cashflow testing and DFA • Valuation leads to optimal capital structure • Corporate insurance, debt structure, product mix are the moving parts to maximize the shareholders (or stakeholders) value

17. References • “The Oxford Guide to Financial Modeling”Oxford University Press 2004 • “Risk Management of an Insurer” 2004 • “Valuing High Yield Bonds: a Business Modeling Approach” Journal of Investment Management 2004