1 Developing a Culture of Financial Discipline Issues and Challenges for Integration of Risk and Return Commentary and Audience Survey Russ BinghamCAS Spring Meeting Vice President Actuarial ResearchLake Buena Vista, FL Hartford Financial ServicesJune 17-20, 2007

2 Issues to Discuss and 10 Questions to Answer Financial Culture and Process My Company Has Developed a Culture of Financial Discipline? My Company Has Developed a Standardized Valuation Process and Has Implemented it Throughout the Organization? Modeling My Model Contains a Full Financial Structure? My Model Includes all Important Return Metrics? My Model Includes all Important Risk Metrics? Risk My Company Utilizes a Clearly Specified Definition of Risk as Part of Its Process of Financial Discipline? Risk and Return are Integrated at My Company? Economic Perspective Economic Accounting and Capital Concepts are Understood at My Company? My Company Has Developed an Independent, Internal Economic Capital View? I Believe that Statutory Accounting Should be Elminated? Three Major Challenges

3 1) My Company Has Developed a Culture of Financial Discipline? Financial discipline is a valuation process, supported by analytical methods and models, intended to provide timely and meaningful assessments of risk / return performance and trends associated with underwriting, investment and finance operations. Sound economic, risk-based analytics are used to support strategic and operational decision making throughout company. Requirements for Financial Discipline and ERM Success Financially astute senior leadership A committed senior management A technically sophisticated group (actuarial, accounting, finance) responsible for the development of fundamental core “benchmark” principles and their application Development and implementation of standardized companywide “benchmark” concepts and models An Understanding that goal is risk/return management 1) ___ Yes ___ No ___ Somewhat ___ Intend To

4 2) My Company Has Developed a Standardized Valuation Process and Has Implemented it Throughout the Organization? Standardized financial valuation throughout entire company  Ratemaking and product pricing  Planning  Performance monitoring  Incentive compensation  Capital attribution  Risk/return assessment  ERM Requires integration/utilization of actuarial, accounting and finance concepts Valuation must consider economic perspective (i.e. cash flow oriented, reflective of time value) and risk The same methodology (and preferably the same model) that is used for ratemaking should, if possible, also be used for planning, performance monitoring, financial analysis, incentive compensation, and ERM 2) ___ Yes ___ No ___ Somewhat ___ Intend To

5 3) My Model Contains a Full Financial Structure? Fully integrated Cash Flow, Balance Sheet and Income statements Policy / Accident period and Calendar period perspectives Economic and Conventional (Statutory, GAAP) accounting valuations 3) ___ Yes ___ No ___ Somewhat ___ Intend To Build

6 4) My Model Includes All Important Return Metrics? 5) My Model Includes All Important Risk Metrics? Incorporate all sources of return - Revenue and Expense, Policyholder and Shareholder Incorporate all sources of risk that can be “distributionalized” – Loss, Catastrophe Loss, Investment Yield, Cash Flow, etc. Provide all critical risk and return performance metrics – ROE, IRR, Total Risk-Adjusted Return, Economic Value Added, Benchmark Surplus, Embedded Value, Probability of Ruin, EPD, TVAR, RCR, etc. in addition to the more standard metrics (loss ratio, expense ratio, yield, etc.) Don’t confuse models with metrics – Ideally a single model should include as many risk and return metrics as are needed 4) ___ Yes ___ No___ Somewhat ___ Intend To 5) ___ Yes ___ No___ Somewhat ___ Intend To

7 6) My Company Utilizes a Clearly Specified Definition of Risk as Part of Its Process of Financial Discipline? 7) Risk and Return are Integrated at My Company? Risk Specification Risk sources versus Risk measurement  Catastrophes, financial markets, etc. are sources of risk  “Risk” resides in the potential for adverse financial outcomes, typically those which drain company capital. Risk metrics – generic steps for quantification  Specify variables of Interest  Develop outcome distributions  Specify adverse outcome criteria  Determine risk metric (frequency, severity, etc. of adverse outcomes)  Risk metric is a function of the range of possible adverse outcomes, driven by the level and volatilities of the outcomes for the variables of interest Risk / Return integration – a necessary step  Sharpe Ratio  Risk Coverage Ratio 6) ___ Yes ___ No ___ Somewhat ___ Intend To 7) ___ Yes ___ No ___ Somewhat ___ Intend To

8 Alternative Risk Metrics Policyholder oriented risk metrics (usually loss based)  Probability of ruin (POR)  Value at risk (VAR)  Tail Value at Risk (TVAR) - P&C  Conditional Tail Expectation (CTE) - Life  Expected policyholder deficit (EPD) Shareholder oriented risk metrics (based on total income or return)  Variability in total return (s R )  Value at risk (VAR)  Tail Value at Risk (TVAR) - P&C  Conditional Tail Expectation (CTE) - Life  Probability of Income Ruin (POIR)  Probability of surplus drawdown deficit (PSD)  Severity of surplus drawdown deficit (SSD)  Expected surplus drawdown deficit (ESD)  Earnings at Risk Risk / Return metrics  Sharpe Ratio  Risk Coverage Ratio (RCR) RBC and other Rating Agency measures - Only Sharpe ratio and RCR integrate risk and return, others are an expression of risk only - In one way or another all risk measures address the likelihood and/or the severity of an adverse outcome - Metrics differ in choice of variable used and in definition of adverse event (position in distribution)

9 Risk Coverage Ratio Risk / Return Metric – Total Return View

10 8) Economic Accounting and Capital Concepts are Understood at My Company? Internal versus External View  Economic versus Conventional (Stat, GAAP) Accounting  Policy / accident period versus Calendar period  Product level versus Aggregate company  Present value of expected future cash flows versus Reported historical results Risk Capital versus Rating Capital - An independent, internally derived view of risk capital will likely not agree with the externally derived rating agency capital view It is important to understand what “Economic” means (e.g. economic return, economic value, economic capital, etc.) – Generally “economic” means “market value”, and typically involves valuation based on cash flow, reflecting time value, and perhaps including an adjustment for risk 8) ___ Yes ___ No ___ Somewhat

11 9) My Company Has Developed an Independent, Internal Economic Capital View? External total company “constraints” must be met based on -  Calendar period (e.g. reported earnings), static where revised estimates can only be included in accounting period when revisions are made  Conventional accounting (Stat for rating agency and regulatory, GAAP for financial reporting)  Backward looking (reported historical financials)  Combined underwriting and investment results  Rating agency capital (e.g. S&P)  Reported results that are estimations, not “actual”, since they will subsequently be revised Internal line of business decisions (can, should, must?) be made based on financials that reflect the “purest” view of financial performance possible  Accident period oriented, not Calendar period, and revised to include latest estimates of ultimate values  Economically based accounting, not Conventional (statutory or GAAP)  Forward looking (includes future cash flow expectations)  P&C investment risk beyond low-risk cash flow matched strategy considered as separate investment activity, not part of underwriting  Risk-adjustment (and capital attribution) based on independent view of risk (using benchmark accident year, economic, cash flow, and low risk investment structure as noted above), not the rating agency view  Consistent with fair value accounting and economic capital principles  Actual results will eventually emerge with retrospective look-back 9) ___ Yes ___ No ___ Somewhat ___ Intend To

12 10) I Believe that Statutory Accounting Should be Elminated? Statutory accounting is for the benefit of others, and is not used at all for internal decision making by many (the majority of?) insurance companies Elimination of statutory accounting statements and reporting would provide significant expense savings GAAP financials and fair value financials together will provide sufficient information externally Fair value accounting will provide more complete information that better reflects the economics of the business  More accurately reflects the cost of liabilities, by considering future payment patterns  Considers time value of money  Reflects risk (volatility, uncertainty) of insurance 10) ___ Yes ___ No ___ Eventually

13 Three Major Challenges Determining Required Company Total Capital – “Sizing the Pot” Establishing Product level “Price for Risk” Relationship and Capital (or Cost of Capital) Attribution Methodology Controlling Required Capital Over Time (“Leverage for Return” RAROC or RORAC perspectives) which:  Applies capital (i.e., leverage) factors in order to determine required product level risk capital  Determines required risk capital sourcing from capital markets and product profits  Maintains risk over time by control of 1) the flow of risk capital and 2) the recognition and flow of profits based on the pattern of liabilities and risk resolution over time