Assessing Balance Sheet Protection Presented by Joan Lamm-Tennant, PhD

1. Assessing Balance Sheet Protection Presented by Joan Lamm-Tennant, PhD GeneralCologne Re Capital ConsultantsCAS Seminar on Dynamic Financial Analysis June 6 - 8, 2001 Boston

2. Topics • What is Balance Sheet Risk? • Why is Risk Assessment/Management Important? • Evaluating the Effectiveness of Risk Management Strategies • Capital Management Strategy • Reinsurance Strategy • Integrating Reinsurance Strategy with Asset Strategy • Creating EVA by Managing Balance Sheet Risk • Conclusion GeneralCologne Re Capital Consultants Proprietary & Confidential

3. C O R R E L A T I O N What is Balance Sheet Risk? • Traditional measures of risk are not additive - asset risk plus liability risk does not equal enterprise risk D I V E Traditional Analytics Asset Risk R S I Enterprise Risk F I C A Liability Risk Traditional Analytics T I O N DiversifiableRisk GeneralCologne Re Capital Consultants Proprietary & Confidential

4. 14.0% Mean 12.0% 4% probability of losing more than 10% of surplus 10.0% Probability 8.0% 6.0% 4.0% 2.0% 0.0% -35% -10% 0% +25% (Mean) +75% % Change in Surplus What is Balance Sheet Risk? • Traditionally, risk has been thought of as volatility of ROE • For an insurance enterprise, the probability of surplus loss (VaR) may be a more relevant risk measure - the likelihood of events causing concern. • Expected Policyholder Deficit (T-VAR) measures the average loss beyond the VAR hurdle. GeneralCologne Re Capital Consultants Proprietary & Confidential

5. Topics • What is Balance Sheet Risk? • Why is Risk Assessment/Management Important? • Evaluating the Effectiveness of Risk Management Strategies • Capital Management Strategy • Reinsurance Strategy • Integrating Reinsurance Strategy with Asset Strategy • Creating EVA by Managing Balance Sheet Risk • Conclusion GeneralCologne Re Capital Consultants Proprietary & Confidential

6. Why is risk management important? Risk is costly to the firm. • Unhedged risk and therefore volatile earnings will • increase taxes, • cause agency (stakeholder) conflicts between corporate stakeholders (policyholders, managers, shareholders, regulators, etc.) which will result in dysfunctional investment decisions • deprive firms of funds to sustain new investment plans - crowding out • interfere with the design of effective compensation plans for managers • Since risk (earnings volatility) is costly, management of risk will eliminate these costs and therefore create real economic value. GeneralCologne Re Capital Consultants Proprietary & Confidential

7. Earnings volatility increases WACC and will “crowd out” new investment. Why? • Capital in an enterprise is derived form three prime sources - retained earnings, debt, and equity • WACC is the weighted average cost of all three sources of capital • External capital (equity) is more expensive than internal capital (retained earnings) • When internal capital is consumed, new capital must come from external sources • The risk-adjusted cost of the external capital will be derived from the earnings volatility - the higher the volatility the higher the cost GeneralCologne Re Capital Consultants Proprietary & Confidential

8. Risk Raises WACC and “Crowds Out” New Investment. Project Cost (In Millions) Rate of Return A $50 13.0% B 50 12.5 C 80 12.0 D 80 10.2 A = 13% 13 B = 12.5% C = 12% WACC 12 Percent 11 10 IOS D = 10.2% Optimal Capital Budget = $180 million 0 50 100 150 200 250 Project Cost (In Millions) Rate of Return A $50 13.0% B 50 12.5 C 80 12.0 D 80 10.2 WACC A = 13% 13 B = 12.5% C = 12% 12 Percent 11 Optimal Capital Budget = $100 million 10 IOS D = 10.2% 0 50 100 150 200 250 Source: Financial Management Theory and Practice GeneralCologne Re Capital Consultants Proprietary & Confidential

9. Earnings volatility increases WACC and will “crowd out” funds for new investment. What effect does this have on growth? • In the second example, earning volatility was higher than in the first example, therefore • the jump in the cost of capital due to going externally was greater, and • the incremental charge for external capital was greater. • In the second example, the capital budget is constrained to project A and B. Consequently due to earnings volatility, growth is reduced since Project C is not longer affordable. GeneralCologne Re Capital Consultants Proprietary & Confidential

10. Managing risk allows firms to sustain profitable growth Capital adequacy is dependent on risk assessment Allocating capital based on risk to the various products is necessary to determine the capital charge when pricing business. EVA is created when the firm generates returns in excess of its cost of capital - marginal cost of capital is dependent on the firm’s risk A macro-assessment of risk is necessary to support micro-risk management strategies Asset Allocation Strategies Reinsurance Strategy Acquisition/Valuation Analysis New Product Assessment “Agents” in our business are concerned about risk - regulators, rating agencies, owners, policyholders, bondholders. Why is risk management important? GeneralCologne Re Capital Consultants Proprietary & Confidential

11. Topics • What is Balance Sheet Risk? • Why is Risk Assessment/Management Important? • Evaluating the Effectiveness of Risk Management Strategies • Capital Management Strategy • Reinsurance Strategy • Integrating Reinsurance Strategy with Asset Strategy • Creating EVA by Managing Balance Sheet Risk • Conclusion GeneralCologne Re Capital Consultants Proprietary & Confidential

12. Capital Management Strategy

13. Risk-Based Capital Allocation Contribution of Risk by Income • Based on the simulation of balance sheet and income statement data, identify where risk resides in the firm • Based on the correlation and diversification characteristics of the key drivers of risk to the firm, and identify the contribution of various sectors to the risk of the firm Category Other Underwriting Asset Return Reserves Reserves Other Underwriting Asset Returns Risk Allocation by Product Group Line % Risk Allocation Product 1 61.7% Product 2 8.6% Product 3 7.2% Product 4 5.5% All Other 17.1% TOTAL 100% 61.6% 17.1% 8.6% 5.5% 7.2% GeneralCologne Re Capital Consultants Proprietary & Confidential

14. Dynamic Capital Allocation Once the required capital based on the risk of the firm has been established, that capital may be allocated using a marginal capital allocation methodology • This utilizes option pricing framework to allocate surplus so that the marginal default value is the same for all segments • This allocates capital to a segment so that the marginal benefit to the firm for an additional unit of surplus is equal across segments • Allocation is driven by uncertainty of losses, correlation with other segments’ losses and the correlation with return on assets GeneralCologne Re Capital Consultants Proprietary & Confidential

15. Capital Allocations Techniques Need To Be Understood By The Industry • Regulatory - Risk Based Capital • Capital Allocation Pricing Model • Value-At-Risk • “Macro” Marginal Allocation - Merton and Perold, 1993 • “Micro” Marginal Allocation - Myers and Read, 1999 GeneralCologne Re Capital Consultants Proprietary & Confidential

16. Reinsurance Strategy

17. Modeling Process - Reinsurance Strategy • Based on the Frequency and Severity characteristics of each line of business • Simulate individual claims for each line of business. • These will serve as the basis for comparing different reinsurance structures. • Based on the simulation of gross claims data, identify where the risk is derived from underwriting. GeneralCologne Re Capital Consultants Proprietary & Confidential

18. Modeling Process - Reinsurance Strategy • Based on the Allocation of Underwriting Risk • Develop a set of reinsurance programs to evaluate. • These will serve as the basis for comparing different reinsurance structures. • For each set of simulated claims, compare the financial results under each reinsurance program • Consider underwriting results, income, surplus and any other constraints and metrics. • Each reinsurance program will be compared against the same set of simulated claims. GeneralCologne Re Capital Consultants Proprietary & Confidential

19. Global (All Regions) - Period 1 GeneralCologne Re Capital Consultants Proprietary & Confidential

20. Reinsurance Strategic Options Reinsurance Strategy Options Buy Less Global Efficiency Buy Smarter Regional Efficiency Strategy 1 Strategy 2 Strategy 3 Strategy 4 Strategy 5 Strategy 6 Regional Design Program to Meet Regional Results but Purchased from Center at Market Price Evaluate with Dual DFA Decision Criteria and Purchase Centrally if Strategy Passes Both Criteria Buy Cat and Treaty Globally - No Regional Purchase Buy No Voluntary Reinsurance at Regional Level Buy Only Cat Reinsurance Globally Purchase Treaty at Local Level at Market Price Based on Local Results GeneralCologne Re Capital Consultants Proprietary & Confidential

21. Percentiles of Nominal U/W Profit Different Reinsurance Programs 50,000 0 (50,000) (100,000) Nominal U/W Profit (150,000) 1st 5th (200,000) 25th (250,000) Median (300,000) Mean (350,000) 75th A B C D E F G H I J Gross 95th 99th Comparing Individual Reinsurance Proposals • Individual programs can be directly compared against any metric, in this case, the nominal value of net underwriting profit. GeneralCologne Re Capital Consultants Proprietary & Confidential

22. Integrating Reinsurance Strategy with Asset Strategy

23. Integrating Reinsurance Strategy with Asset Strategy • The Dilemmas • How much catastrophe reinsurance to purchase? • How to allocate the assets between equity and fixed income? • The Choices • Reinsurance: None,$2 million retention, $10 million retention • Assets: Low return/risk (mostly fixed income), high return/risk (mostly equity) • The Company • $80 million in surplus • Expected to write $80 million in premiums with $150 million in assets GeneralCologne Re Capital Consultants Proprietary & Confidential

24. Efficient Frontier No Reinsurance 12.0% Combined Frontier A-B - Risk Opportunities Made Available by Reinsurance B-C - Return Opportunities Otherwise Unavailable Without Reinsurance C B 10.0% 8.0% A Mean ROE 6.0% 4.0% 2.0% 0.0% 0.00% 0.50% 1.00% Average Excess Value Loss Examining the “Trade” - Evaluation Process GeneralCologne Re Capital Consultants Proprietary & Confidential

25. Examining the “Trade” • Integration of reinsurance with the asset allocation choice extends the efficient frontier affording low risk alternatives not available otherwise • A range of risk opportunities exist whereby integrating reinsurance with the asset choice allows for more efficient risk/return trade-offs • A “pecking order” of risk choices is proposed for incremental increases in risk • low retention, low risk asset allocation • low retention, higher risk asset allocation • high retention, low risk asset allocation • high retention, high risk asset allocation GeneralCologne Re Capital Consultants Proprietary & Confidential

26. Topics • What is Balance Sheet Risk? • Why is Risk Assessment/Management Important? • Evaluating the Effectiveness of Risk Management Strategies • Capital Management Strategy • Reinsurance Strategy • Integrating Reinsurance Strategy with Asset Strategy • Creating EVA by Managing Balance Sheet Risk • Conclusion GeneralCologne Re Capital Consultants Proprietary & Confidential

27. Spread Cost of Capital Float Driving EVA • Three important factors contribute to enterprise value Enterprise Value (EV) = (Float x Spread) - Cost of Capital EV =[Funds (RAssets + RUnderwriting)] - [Equity (CCapital - RAssets)] Funds = funds from underwriting = premiums less expenses, RAssets = return on invested assets, RUnderwriting = annualized return on underwriting = premiums less expenses less losses relative to funds, Equity = equity required due to loss uncertainty CCapital = cost of equity capital. GeneralCologne Re Capital Consultants Proprietary & Confidential

28. Enterprise Value Drivers: A Test of the Proposition • Sample included all publicly held property-casualty insurers in the US • Time period included five years from 1994 to 1998 • For each year we estimated the company’s weighted average cost of capital • For each year we estimated the company’s economic value added • We then asked the question - does EVA explain growth in market value? GeneralCologne Re Capital Consultants Proprietary & Confidential

29. Cost of Capital GeneralCologne Re Capital Consultants Proprietary & Confidential

30. Economic Value Added GeneralCologne Re Capital Consultants Proprietary & Confidential

31. Enterprise Value Drivers- A Test of the Proposition • Operational ROE is significant in explaining an insurance company’s change in stock price. • The higher the Operational ROEthe greater the increase in firm’s in stock price or intrinsic value. • While Operational ROE is significant in explaining the firm’s change in stock price, the explanatory power is improved when Operational ROE and Cost of Capital are considered together (effectively a proxy for EVA). GeneralCologne Re Capital Consultants Proprietary & Confidential

32. Conclusion Why is Risk Assessment/Management Important? • Needed to determine capital adequacy • Allows for capital to be allocated to products and subsequently “priced” to create EVA • Capital Efficiencies can be driven by “second-order” decisions • Reinsurance Strategy • Integrating Reinsurance Strategy with Asset Strategy GeneralCologne Re Capital Consultants Proprietary & Confidential

33. Thank You Joan Lamm-Tennant, PhD General Re Capital Consulting jlammten@gcre.com 203 328-6818