Risk-Adjusted Capital Management CAS/SOA ERM Symposium July 30, 2003 Sim Segal, FSA, MAAA Senior Manager Deloitte & Touche

Agenda What is capital management? The capital management process and its evolution Practical application of capital management Keys to success

Capital has two components Capital is wealth . . . . . . ”used” or ”available for use” . . . . . . in the production of more wealth. American Heritage Dictionary

Total Capital = Required + Available Assets Liabilities Required capital Used Total capital Available capital Available for use

Capital management is managing both required and available capital Required capital management Maximize risk-based capital performance measure, within constraints Available capital management Maintain available capital at optimal level, balancing: a) Future growth needs b) Drag on returns c) Capital flexibility

Capital management is managing both required and available capital Required capital management Focus of today’s discussion Maximize risk-based capital performance measure, within constraints Available capital management Maintain available capital at optimal level, balancing: a) Future growth needs b) Drag on returns c) Capital flexibility

Agenda What is capital management? The capital management process and its evolution Practical application of capital management Keys to success

The Capital management process has five steps 1. Define required capital 2. Allocate required capital 3. Select a capital measure to evaluate performance 4. Set a hurdle rate 5. Maximize capital measure, within constraints

Capital management has evolved in the insurance industry 1. Required Capital 2. Capital Allocation 3. Capital Measure 4. Hurdle Rate Zero (ignored in pricing) Company level Internal Rate of Return (IRR) Benchmark Multiple of RBC (Statutory) Segment level Long-Term Weighted Average Cost of Capital (WACC) Return on Investment (ROI) Line of business or product line level Multiple of RBC plus accounting adjustments (GAAP, but Stat-based) Return on Equity (ROE) WACC based on dynamic risk-free rate Policy level  Customer level  Producer level Return on Capital (ROC) Value-at-Risk (VaR) (GAAP) WACC based on dynamic risk-free rate and dynamic risk premium Embedded Value (EV) or Fair Value (FV)

Agenda What is capital management? The capital management process and its evolution Practical application of capital management Keys to success

Example: Public Multiline Financial, Inc. Step 1: Define required capital

Required capital is risk-based . . . but what risk is being addressed? Action by state insurance department Economic ruin ? ? Downgrade by rating agency ? ? Loss of competitive standing ?

Required capital addresses multiple risks related to disparate constituencies Benchmark Capital To match the capital level of a key competitor Economic Capital To maintain a given probability of avoiding ruin Total Required Capital Rating Agency Capital To maintain current debt or financial strength ratings Regulatory Capital To avoid regulatory action

Example: Public Multiline Financial, Inc. Step 1: Define required capital Required capital is Value-at-Risk (VaR), using a one-year time horizon and a 99.9% confidence level

Value-at-Risk (VaR) is based on a stochastic analysis of economic ruin Illustrative Confidence Level 95% 99% 99.9% Probability Loss Rate Value-at-Risk Capital

Example: Public Multiline Financial, Inc. Step 1: Define required capital Step 2: Allocate capital

Allocating capital further down in the organization facilitates more decision-making Segment Segment . . . Segment Strategic decisions, e.g.: Growth Market exit Tactical decisions, e.g.: Pricing Mix of product portfolio Transactional decisions, e.g.: Retention efforts Cross-selling Producer compensation decisions Product Product . . . Product Policy Policy Policy . . . Policy

Example: Public Multiline Financial, Inc. Step 1: Define required capital Step 2: Allocate capital Capital is allocated down to the product level

Example: Public Multiline Financial, Inc. Step 1: Define required capital Step 2: Allocate capital Step 3: Select a capital measure to evaluate performance

Each capital measure offers a unique focus ROI emphasizes rate of return ROE measures efficiency of usage of equity capital ROC illustrates the ability to generate earnings per dollar of total capital EV quantifies the dollar contribution to shareholder value

Case study: ROE-based compensation has disadvantages vs Case study: ROE-based compensation has disadvantages vs. EV-based compensation Hurdle rate = 15% Situation ROE-based* plan EV-based plan Value is created: Management in a 20% ROE line of business decides to add a 16% ROE project Penalized Rewarded Value is destroyed: Management grows a 12% ROE business * Compensation plan based on ROE and earnings

Example: Public Multiline Financial, Inc. Step 1: Define required capital Step 2: Allocate capital Step 3: Select a capital measure to evaluate performance Capital measure is Embedded Value (EV)

Embedded Value (EV) is a function of distributable earnings / surplus from inforce Discounted value of distributable earnings from inforce business* Value of inforce business Embedded Value (EV) Distributable surplus Value of surplus * Includes target surplus

Distributable earnings reflects changes in total surplus and target surplus Adjusted statutory net income * Target surplus released (consumed) * Adjusted to replace investment income on surplus with investment income on target surplus

Example: Public Multiline Financial, Inc. Step 1: Define required capital Step 2: Allocate capital Step 3: Select a capital measure to evaluate performance Step 4: Set a hurdle rate

The hurdle rate is management’s estimate of its risk-return position on the efficient frontier ? Return ? Rm X X Rf m Risk

Hurdle rate setting methods involve tradeoffs between simplicity, accuracy and stability Stability of Measure Benchmarking Easiest Poor Long-term weighted average cost of capital (WACC) Moderately complex Moderate Fair WACC based on dynamic risk-free rates High Good WACC based on dynamic risk-free rates and dynamic risk premium Most complex Highest Best

Example: Public Multiline Financial, Inc. Step 1: Define required capital Step 2: Allocate capital Step 3: Select a capital measure to evaluate performance Step 4: Set a hurdle rate Hurdle rate is WACC based on dynamic risk-free rates, with uniform hurdle rates throughout the enterprise

Example: Public Multiline Financial, Inc. Step 1: Define required capital Step 2: Allocate capital Step 3: Select a capital measure to evaluate performance Step 4: Set a hurdle rate Step 5: Maximize capital measure, within constraints

Dynamic modeling clarifies potential impact of projects on embedded value (EV)

Required capital (200% RBC) Required capital (VaRC) Constraint of maintaining the RBC ratio is more complex when using Value-at-Risk (VaR) Statutory GAAP Available capital 0.1 B Available capital 0.3 B Required capital (200% RBC) 1.2 B Required capital (VaRC) 1.0 B

Summary: practical applications of capital management Strategic: Manage stock analysts, e.g., reveal under-valued businesses Strategic planning, e.g., project capital needs, quantify impact on capital ratios Risk management, e.g., estimate probability of ruin and impact on stock price Tactical: Funding decisions, e.g., identify stock repurchase opportunities Risk-return tradeoff decisions Identifying highest value-added projects Asset-liability management (ALM) Provide incentive compensation aligned with increasing value

Agenda What is capital management? The capital management process and its evolution Practical application of capital management Keys to success

Keys to success Define required capital with deference to all key constituencies Allocate capital as far down in the organization as possible Select a capital measure that aligns with your goals Align incentive compensation with the capital measure Avoid fallacy of the “correct” hurdle rate Manage constraints carefully while maximizing capital measure Employ a disciplined process to setting or changing assumptions Provide management with the tools to understand the impact of decisions on the capital measure

Risk-Adjusted Capital Management Thank You! CAS/SOA ERM Symposium July 30, 2003 Sim Segal, FSA, MAAA Senior Manager Deloitte & Touche