ERM: a Corporate Model Approach SOA Conference Chicago Thomas S. Y. Ho April

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

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

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

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?

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

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

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

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

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

Bankruptcy Condition on the Lattice

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

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

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

Summary Principal Financial Institution Inforce business Inforce+franchise Risk Management ALMERM Management toolsTotal return approach DFA Valuation Concept of embedded value Capitalization valuation Risk financeRe-insuranceCorp insurance

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

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