Enterprise Risk Management: Risk, Capital, and Value Bill Panning, EVP, Willis Re

1. Enterprise Risk Management: Risk, Capital, and Value Bill Panning, EVP, Willis Re

2. The Argument in Brief • For Enterprise Risk Management (ERM) to be a practical discipline, it must address three crucial questions: • How much risk are we taking as a firm? • How much capital (surplus + reinsurance) should we have, given our risk? • Are there practical and effective ways to enhance the value of our firm by changing our risk-capital balance? • As typically presented and practiced, ERM addresses only the first of these three questions. It therefore lacks relevance to a firm’s strategic decisions and its value to stakeholders.

3. The Argument in Brief (continued) • At Willis Re we have developed a value-based approach to capital management and reinsurance that specifically focuses on practical strategic decision making. • Our value-based approach specifically explains what is typically assumed but rarely described: how “better” information about risk can be used to make “better” strategic decisions that make the firm more valuable. • ERM will survive only if it becomes a practical way to deliver measurable value to those who implement it.

4. Part I How much risk are we taking as a firm?

5. So where are the numbers? Advice from my first boss: • An insurance company gets paid for assuming risk from clients • The key to success is making sure that the price is adequate • Successful insurers are the ones that maintain the right balance between risk and return, between the risk that they assume and the return that they obtain from doing so. My question to my first boss: • I’ve seen numerous reports, spreadsheets, meetings, etc. that analyze our profits • Where are the reports, spreadsheets, meetings, etc. that analyze our risks?

6. What happens when we don’t have numbers (risk measures) • We focus far more on return than on risk • We don’t really measure risk we can’t compare different risks • And we can’t compare the same risk over time • Therefore we can’t really manage risk, since we lack feedback • Lack of measurement also means that we become very susceptible to potentially distorted perceptions of risk • We also become complacent, and readily attribute high profits (from low losses) to skill rather than luck

7. The key event in the evolution of ERM • 1989: Dennis Weatherstone, CEO of J. P. Morgan, asks for a report, to be delivered to him daily at 4:15 pm, that answers the following question: How much could we lose if tomorrow turns out to be a relatively bad day? • Why 4:15? Because if the number was larger than he was comfortable with, there was still time to do something about it

8. Why this is a great question How much could we lose if tomorrow turns out to be a relatively bad day? • It is short and clear. Everyone can understand it. • It provides an alternative to standard deviation as a risk measure • It defines risk as the potential for loss • It focuses on a specific time horizon • It focuses on the firm as a whole (the “enterprise”) and not on numerous individual trading desks • other reports did indeed focus on trading desks (where is our risk?) • Its objective was managing risk, not just measuring it (4:15)

9. What is a relatively bad day? • Analogy to weather: how cold could it get on a relatively cold day? • We could answer by specifying a percentile: “95% of the time (days) the temperature stays above zero” • Value at Risk (VaR): “95% of the time our losses will be less than $125 million” • $125 million is therefore the 95% VaR

10. Benefits of having a measure of risk – VaR or otherwise • We can track risk over time • We can compare different risks to one another • We can determine a reward to risk ratio for different risks • Value of measuring risk in dollars, as in VaR • We can use the number to inform strategic decisions • Mix of business • Investment versus underwriting • Reinsurance decisions

11. Some limitations of Value at Risk It is not clear how to pick a percentile (or several) • Pick more than one (we are trying to manage a distribution, not just one point on a distribution) • Pick the number, then determine the percentile • Example, instead of reporting the 95th percentile loss (95% VaR), determine the magnitude of the loss that would bring about some key event (e.g., a one-notch downgrade) and report the probability of that happening. Then track that number. • This translates VaR into something meaningful to managers

12. Some limitations of Value at Risk, continued A technical problem: “coherence” and subadditivity • The basic problem: VaR measures can sometimes indicate that the combination of two portfolios is more risky than either one taken separately. This should not happen. However, • It’s not at all clear that this is a big problem in practice. The examples that illustrate this problem are highly contrived. • Comprehensibility and relevance are offsetting benefits • There is no reason to rely on a single risk measure.

13. What risk measurement does NOT tell us How do we use risk measures to make good strategic decisions? • Example: how did Weatherstone determine when his firm was taking too much risk? Are we using risk measures that are the most appropriate ones, given our objectives? • Example: VaR focuses on losses that occur in a specific period. But it ignores additional consequences in later periods. • For a going concern, there is no “horizon,” since the firm’s whole future matters, as we will see.

14. Part II How much capital should we have, given our risk?

15. How do firms answer this question in practice? • Peer comparison: maintain financial ratios similar to peers • Ratings: maintain ratios needed to sustain a target rating • Risk tolerance: adopt guidelines that reflect chosen risk limits

16. Some limitations of current practices • Peers: what are appropriate peer comparisons? • What companies? • What ratios? • Implicit assumption that other firms have gotten it right? • Ratings: what is the best rating to have? • Do rating agencies have it right? • Risk tolerance: what is it? Who decides? • Does that person or group have it right? • And what do we mean by “right”?

17. How much capital should we have, given our risk? Willis Re’s approach: manage risk and capital (surplus + reinsurance) so as to maximize the value of the firm We call our approach “Value-based Capital Management”TM One of its components is “Value-based Reinsurance”TM What’s crucial: we make these practical realities, not just slogans

18. To achieve this objective we need to measure value • We begin by creating a valuation model with observable parameters that are understandable and measurable (unlike “risk appetite”) • This model specifies how value is to be measured • It incorporates measures of risk and measures of return • It is explicit and transparent (unlike “risk tolerance”)

19. The components of firm value: (1) Liquidation value • The value of the firm has two components: the first is liquidation value: the net present value (NPV) achieved by placing the firm in runoff • This is the market value of assets, less the present (discounted) value of liabilities, that exist on the firm’s current balance sheet • These include future cash flows from business now on the books • It is the result of decisions made in the past • Apart from claims handling, liquidation value cannot be managed • Ironically, this is typically the focus of management reporting

20. The components of firm value: (2) Franchise value • The second component is franchise value, which is the impairment-risk-adjusted present value of expected earnings or cash flows from future business not yet written • Practically speaking, modeling earnings is more transparent to senior management than modeling cash flows • Like cash flows, future earnings must be discounted for time value • For firms with high growth rates, future earnings must also be adjusted to reflect decreasing sustainability of high growth • There are important judgments here; managerial input is crucial

21. The components of firm value: (2) Franchise value (cont.) • Future earnings must also be adjusted to reflect the possibility of impairment: the likelihood that they may not occur, or may be reduced, by events that occur between now and then • Impairment is a reduction in the ability of a firm to produce future earnings. It does not necessarily imply default, but does imply that the flow of net income is reduced or stopped. • There are important examples of impairment in which firms remain solvent but are unable to recapitalize or obtain ratings that enable them to continue writing business. Their earnings capacity is crippled. • Adverse ratings changes are one type of impairment; they reduce the ability of a firm to produce a given level of earnings • Here again, managerial input is crucial

22. More about franchise value • In contrast to liquidation value, franchise value presents the value obtained by operating the firm in the future, as a going concern • Franchise value is therefore the only portion of the firm’s value that can truly be managed • There are important tradeoffs between net income and franchise value (and therefore stakeholder value) that should be incorporated in a valuation model • Publicly traded firms with significant franchise value have a market-to-book ratio that significantly exceeds 1.0 • For most firms, franchise value is invisible, since it is not included in managerial reports or accounting statements

23. How ratings and regulation affect franchise value • The EU, UK, and USA all face a common emerging environment: rating agencies (US) and regulatory rules (Solvency II) impose specific criteria for evaluating an insurer’s capital adequacy. • Low scores on these measures make it more difficult for an insurer to maintain revenues and profits, since potential clients will see impairment of some sort – mild or severe – as likely • Additional surplus or reinsurance is costly, but lowers the risk of a significant fall in an insurer’s capital adequacy measure

24. Value-based Capital ManagementTM • Value-based Capital ManagementTM necessarily focuses on both components of a firm’s total value: liquidation value and franchise value • But the emphasis is necessarily on franchise value, since liquidation value is fixed

25. Value-based Capital ManagementTM: how it works • Suppose a firm has very little capital relative to its risk exposure • Suppose also that it is being appropriately paid for taking risk • If its capital is low relative to its risk, then impairment is probable • Its expected earnings stream is high, but likely to be short or quickly reduced • Let’s agree that additional surplus and reinsurance are costly • Even so, increasing its surplus or increasing its reinsurance may increase the value of a firm, by reducing impairment probabilities • However, beyond some critical point, adding surplus or reinsurance actually lowers the value of the firm, by making it over-capitalized or over-reinsured.

26. Critical implications of Value-based Capital ManagementTM • There is an optimal relationship between a firm’s risk exposure and its capitalization, between risk and capital, consisting of its surplus plus reinsurance • Getting this relationship right maximizes the value of a firm to its stakeholders • Critical implication: decisions about surplus and reinsurance should focus on the franchise value that is at risk, and not just on the current-year earnings that might be lost (VaR). • VaR looks at potential losses within a specified limited horizon • Near-term earnings at risk are often dwarfed by the consequent potential loss of subsequent earnings • Value-based Capital ManagementTM focuses on the franchise value of a going concern, which has a potentially infinite horizon

27. The value of adding capital

28. Why “Value-added”? • The horizontal axis in the preceding graph is the absolute amount of capital added to a hypothetical firm with real parameters, starting from a base of zero surplus. • The vertical axis is value added: the increase in the value of the firm, less the capital added to the firm. • Why value-added rather than value? Because adding capital to a firm always increases its value, even if most of that capital is wasted. • Example: if investing an additional $100 increases the value of the firm by, say, $50, that is still a net increase in value. But value added is negative. • The appropriate objective is to invest additional funds in the firm when doing so adds value in excess of the investment; if adding $100 increases firm value by $150, then value-added is $50.

29. Part III Are there practical and effective ways to enhance the value of our firm by changing our risk-capital balance?

30. Some specific applications of our approach Identifying actions that can increase value: • Increasing or decreasing surplus or reinsurance, as described • Altering the firm’s mix of business • Shifting reinsurance among lines of business • Changing attachments and/or limits on reinsurance • Changing the structure of the firm’s reinsurance program • Evaluating loss portfolio transfers • Changing the firm’s asset mix • Purchasing equity or credit hedges • Hedging interest rate or FX exposure

31. An illustrative application of our approach • A new client, which provided liability insurance to medical institutions, and had grown substantially over 30 years • Early on it purchased per risk reinsurance that attached at $1 million and went up to the firm’s $20m limit of liability • As it grew, it increased its attachment to the current $3m • Our Value-based Capital ManagementTM model revealed that the client’s reinsurance strategy was suboptimal • It protected the firm from extremely severe losses • But as the firm grew and had more claims, severity risk became more diversified; its current risk was principally from frequency. • So we recommended raising its attachment, and using the savings to purchase an aggregate stop loss that protected the firm from excessive loss frequency. • The result: an increase in the value of the firm.

32. Key Issues • Modeling a complex firm is nontrivial • On the other hand, almost every decision made at a firm relies on some model of its value, whether implicit or explicit • It is better to have an explicit and testable model of a firm’s value than to have an implicit model that is unexamined • The model just outlined has been implemented at several of the top ten firms in the US

33. Conclusion: POV is worth 80 IQ points • Alan Kay, a computer science pioneer, got it right: adopting the right point of view helps us to make more intelligent decisions • Think about multiplying 12 x 12 in our current number system as contrasted to doing so in Roman numerals • Value-based Capital ManagementTM is a point of view that has the same effect on the way you think about your business

34. For questions, comments, discussion, contact me at Bill.Panning@willis.com Cell: 502-387-5411