Risk Consultants - DFA Practice Enterprise Risk Management A Case Study CAS Seminar on Ratemaking March 11-13, 2001

Risk Consultants - DFA Practice Ratemaking? More of an account pricing issue than a technical insurance ratemaking issue. RISKOf the 18 considerations listed in the CAS SOP Regarding Property & Casualty Ratemaking, ERM really directly impacts only 1 - RISK ERM influences buyer behavior.

Risk Consultants - DFA Practice “Risk” per the Actuarial Statement of Principles Random variation from expected cost. –Reflected in cost of capital assumption. –Influences the underwriting profit provision. Systematic variation of estimated costs from expected costs. –Reflected in the contingency provision.

Risk Consultants - DFA Practice Risk from the CFO’s Perspective

Risk Consultants - DFA Practice General Risk Categories Hazard/Legal Risks Financial Risks Operational Risks Strategic Risks

Risk Consultants - DFA Practice Case Study - Imaginary Motors Based on composite and rescaled individual “Big 3” data, industry information, recent press releases and some pure “guestimates” Quantify risks individually and aggregate Measure “untreated” earnings impact Determine theoretical risk capital for selected level of earnings “protection”

Risk Consultants - DFA Practice Imaginary Motors -Assumptions Market Cap = $42.8 Billion Net Income = $5.45 Billion (ttm) EPS = $4.72 (ttm); Share Price = $38.12 Effective Tax Rate = 35% Protect against the “1 in 100 year event” Exposures can be transferred at pretax nominal cost (expenses offset PV factor)

Risk Consultants - DFA Practice Imaginary Motors Risks - I Hazard/Legal Risks –Property –Business Interruption –Cargo/Marine –Workers’ Compensation –Automobile Liability –General Liability –Product Liability –Employment Practices –Crime –Boiler & Machinery –Directors & Officers –Intellectual Property –Product Recall –Foreign Liability –E&O/Professional Liability

Risk Consultants - DFA Practice Imaginary Motors Risks - II Financial Risks –Credit –Residual Value –ERISA/Fiduciary –Foreign Exchange –Commodity Prices –Energy Prices –Interest Rates Operational Risks –Warranty –Product Recall –Contingent Business Interruption –Political –Intellectual Property –E-Commerce –Strike/Labor Relations

Risk Consultants - DFA Practice Imaginary Motors Risks - III Strategic Risks –Model Selection –Geographic Expansion –Brand Image –Product Pricing –R&D Investments –Acquisitions & Divestitures

Risk Consultants - DFA Practice Case Study - Hazard Risk

Risk Consultants - DFA Practice Case Study - Hazard Risk

Risk Consultants - DFA Practice Case Study - Financial Risk

Risk Consultants - DFA Practice Case Study - Financial Risk

Risk Consultants - DFA Practice Case Study - Operational Risk

Risk Consultants - DFA Practice Case Study - Operational Risk

Risk Consultants - DFA Practice Case Study - Strategic Risk

Risk Consultants - DFA Practice Case Study - Strategic Risk

Risk Consultants - DFA Practice Case Study - Composite Risk

Risk Consultants - DFA Practice Case Study - Composite Risk

Risk Consultants - DFA Practice Imaginary Motors - Implications To protect against earnings volatility at the “1 in 100 year” level on a pretax basis: –finance $11.2 B if risks treated individually; –finance $3.6 B if risks treated as a portfolio. Risk finance cost difference of $76 Million. –$0.04 in after-tax EPS. –Almost $400 M in market capitalization at current P/E multiple.

Risk Consultants - DFA Practice Imaginary Motors - Caveats Not all risks to Net Income are included. –WC, cargo, etc. due to lack of data; –general economic risks - interest rates, etc. “Portfolio Effect” potentially overstated –not all correlations reflected (warranty, recall and product liability, for example); –companies may look at some risks in portfolios (integrated insurance programs, combined aggregate excess programs, etc.).