Allocating Economic Capital to Drive Business Decisions An Application of Don Mango’s Shared Asset Approach April 11, 2014

Originally Don Mango’s Portion  Why is he not here? He made a scheduling blunder  double-booked with a family commitment Recognizing this is shorter than our usual session, and that his portion covers material in a published article, he felt his part should be edited down He wants you to see Tim and Terri!  Original paper – 2005 ASTIN Bulletin (reprinted in the 2006 CAS Forum): “Insurance Capital as a Shared Asset”  One example of presentation:  It is the foundational text for the Cost of Capital portion of the Institute of Actuaries (UK) syllabus 2

Shared Asset in Two Slides (#1)  Shared Assets Common pool resources that are shared Some are used consumptively and some non-consumptively  Consumptive (e.g., Reservoir, fisheries) Instantaneous with no return and no re-use Think DESTRUCTION  Non-consumptive (e.g., golf course, hotel) Time-based with return and subsequent re-use (with minimal maintenance) Think RENTAL 3

Shared Asset in Two Slides (#2)  In good times, an insurance portfolio only RENTS the capital “Reserves hold” If we knew secretly this was a riskless portfolio, this would still represent the “keep the lights on” minimum capital  However, when things go badly, the portfolio CONSUMES the capital “Reserve strengthening” or “catastrophe” Our capital model gives us the supporting information We need to define for ourselves just how “at-risk” this portion of the capital is, which lines are the culprits, and who should pay how much  This exercise we are calling “Defining our Risk Preferences” 4

Explicit Risk Preferences 5

Every Approach Has an IMPLICIT Risk Preference CARE!! Size of Loss Risk Aversion VaR Threshold VaR Don’t Care 6

Every Approach Has an IMPLICIT Risk Preference CARE Additional Care per $ of additional loss is constant Size of Loss Risk Aversion TVaR Don’t Care VaR Threshold 7

Every Approach Has an IMPLICIT Risk Preference Lost Earnings Ratings Watch Ratings Downgrades Heights of the different boxes represent the firm’s RISK PREFERENCE FUNCTION CARE CARE MORE CARE EVEN MORE “Zones of Impact” of Capital Size of Loss Risk Aversion Don’t Care 8

1. Being audited by the IRS 2. Catching a foul ball at baseball game 3. Being on a plane with a drunken pilot 1-in-1001-in-200Expected1-in-500 Articulating Risk Preferences

Using the Shared Asset Framework to allocate capital within a company 10

11 Allocating capital is an iterative process Risk Appetite Smart People Doing Math Results Risk Model Data Feedback Loop

12 Risk model data  Illustrative Company $10B Premium 4 States 2 lines (non-volatile & volatile) Risk Metrics Risk TypePremiumC/RExpected ProfitProb. of ProfitStd Dev Profit1/1001/2501/1,000 Line 1Non-volatile$7B96.0$0.3B94%$0.2B($0.2B) ($0.3B) Line 2Volatile$3B94.0$0.2B83%$0.6B($1.4B)($2.6B)($6.2B) Total Co$10B95.0$0.5B93%$0.6B($1.1B)($2.3B)($6.2B)

13 Risk appetite informs target capital  Risk appetite + Shared Asset Framework = target capital  Everyone’s appetite is different, let’s examine two choices Conservative: withstand 2x 1/250 years without losing “secure” rating Aggressive: withstand 2x 1/100 years without losing “secure” rating $2.2B Line 1 $1.1B $3.0B $4.1B Line 2 $2.2B Line 1 $1.1B $1.4B $2.5B Line 2 Aggressive Appetite Target Capital $0 $6B Conservative Appetite $3.3B $3.0B $6.3B Total Co $3.3B $1.4B $4.7B Total Co

14 Allocating to state  Guiding Principles: Fundamental before technical Keep it simple  Rental charge applied to states via uniform P/S ratio  Consumption charge will vary, but how? Could use same approach as assigning to line segments (fixed point) Or, could vary according to contribution to marginal portfolio risk (continuous) $3.0B $1.4B $4.1B $2.5B $1.1B Line 2 Target Capital $0 $6B Conservative Appetite Aggressive Appetite Uniform 2.7 P/S Contribution to Marginal Risk

15 Contribution to marginal risk  Definition of marginal risk? Total loss Worse then expected (excess of mean)

16 Allocation mechanics  Some outcomes are worse than others, differentiate consumption charge accordingly  Simple Risk Preference Losses that you earn your way out of (“earnable”) vs. those you don’t (“impairment”) Simple math is window average loss (co-x TVaR) “Impairment” Allocation Conservative Aggressive 10yr “Earnable” Payback“Impairment” 0% 100% 10% 90%

17 Results  Capital allocation translated into target combined ratio  These results are an important feedback loop Risk preferences are hard to articulate If you can’t accept these results, revisit your risk appetite 0% 100% 10% 90% $2.6B Target Capital $4.0B Target Capital MA

Driving business decisions with economic capital 18

19 Risk market in action  Target combined ratios are the “price” in our risk market  Prices send signals  How would you respond to these signals? Actual C/R Shrink??Grow?

20 The final frontier  Managing as a portfolio requires ability to make trades Profit Growth Return Volatility

Optimizing  Diversification has multiple benefits in optimizing portfolio Can make new risks look good Can make existing risks look better  Risk appetite and current portfolio define possibilities  Example: Remove FL Target Combined Ratio (Base) MAFLLAMNTotal Line 1100 Line Target Combined Ratio (Pro Forma) MAFLLAMNTotal X

Optimizing…Round 2  Example: Increase LA by 50% Target Combined Ratio (Base) MAFLLAMNTotal Line 1100 Line Target Combined Ratio (Pro Forma) MAFLLAMNTotal

23 Q&A