Enterprise Risk Management An Introduction to Best’s Enterprise Risk Model (Developed Jointly with Seabury Insurance Capital, LLC) Michael L. Albanese Group Vice President April 2, 2001

Enterprise Risk Management & The New World of Risks  Where are we today?  Best’s view of industry capitalization  Current evaluation process  Where are we going?  The performance imperative  New models for new times?  A holistic view of risk?  Enterprise risks  Role of capital adequacy in the rating process  Performance matters

Best’s Capital Study: Key Findings As of year end 1999: Over 75% of Best’s Domestic-Rated Groups Maintain “Extra” Capital above their Current Rating Requirements of Approximately $88B Decapitalization of “Extra” Capital Modestly Boosts Anemic ROEs from 6.5% to 7.3% Roughly 50% of the Groups Maintain “Excess” Capital above Best’s “A++” Standards The Top 10 Groups Command 44% of Industry Writings, but Exhibit Little “Extra” Capital (excl. State Farm / Berkshire) Relative to their Ratings

Size Segmentation Large (PHS > 250M) Medium ( ) Small ( ) Very Small ( < 10) % PHS % % Unit $ $88.2 X/S PHS vs Current Rating % NPW

Best’s Capital Study: Key Findings As of year end 1999: Only 50% of Companies Rated as “Excellent” or “Superior” Generate Returns on Surplus that Exceed their Cost of Capital Except for a Minority of Sophisticated Groups, Much of the Industry Lacks Effective Capital Management, Including a Basic Understanding of: Enterprise Risk Management Cost of Capital Risk Adjusted Performance Measurement Value-Creation

Responding to Market Dynamics— Financial Management  Today “excess” capital likely much lower -- market correction, loss reserve deficiencies  Capital allocation vs. capital accumulation  How much is enough?  The optimal capital structure?  Performance measurement  Historical measures  Forward/risk-adjusted view  Value added (Returns > risk-adjusted cost of capital)  Decision basis?

The Performance Imperative  Equal playing field  Performance defines viability  Top line  Bottom line  Value-added products, services, relationships  Performance drives financial strength  Rating considerations  Adequacy, quality, stability  Growing differential among companies

Where are we today? The Current View...  Relative financial strength  Best’s Capital Adequacy Ratio (BCAR)  Regulatory requirements  Risk-Based Capital (RBC)  Future needs  Growth, strategy, competitive positioning  Financial flexibility  Operating results, holding company  Sensitivity analysis

BCAR Structure Non-Life B1 - Fixed Income B2 - Equity Securities B3 - Interest Rate Capital B4 - Credit Capital B5 - Reserve Capital B6 - NPW Capital B7 - Business Risk Capital NRC=  B1 2 +B2 2 +B3 2 +(.5xB4) 2 +(.5xB4+B5) 2 +B6 2 + B7 Capital Adequacy — Rating Methodologies

Catastrophe Risks — Non-Life  Direct charge to surplus  Higher of:  100 year hurricane (Net PML)  250 year earthquake (Net PML)  Include reinstatement costs  Tax-affected

Where are we going?  Future capital needs...  Relative financial strength  Risk-adjusted capital remains important  Emerging risks  Dynamic analysis  VAR framework  DFA?

Enterprise Risk Model — A VAR Framework?  Non-insurance and market related risks  Insurance risk component critically important  Based on mainstream risk management practices  Market metrics vs. regulatory requirements  More dynamic approach  Provides view of all risks, not just insurance  Currently, the financial services standard  Natural extensions -- RAROC, DFA

Static Ratio Analysis Risk Based Capital Value At Risk Cash Flow Testing Financial Dynamic Financial Analysis Accuracy Complexity Reg. 126 Capital Adequacy Techniques

The estimation of potential loss arising from a change in underlying risk variables (e.g., asset risk, insurance risk, interest rate risk, market risk, foreign exchange risk) over a defined holding period, for a given level of statistical confidence. Defining VAR...

Enterprise Risk Model... Company-Specific Input Statement SRQ Others ERM Calculation Inputs Capital Markets Data Insurance Risk Database Company-Specific ER VaR & Risk Cap. - LOB1 VaR & Risk Cap. - LOB2 VaR & Risk Cap. - LOBxx Total VaR & Risk Cap. Enterprise risk ratio = Economic Capital* VaR *Capital Adjusted for Reserves, Cat Exposures, Capital Gain, etc. Credit I.R. Insur. Market Exchan. Credit I.R. Insur. Market Exchan. GCM Calculation Engine

Enterprise Risk-- Insurance Risk Module (Non-Life)  Premium related risks  Loss ratio analysis  Correlation matrix  Direct writers  Reinsurers  Reserve related risks  Loss reserve development (AY)  Correlation matrix  Direct writers  Reinsurers  Catastrophe related risks  Non-normal distributions  Consistent with BCAR  100 yr hurricane (PML)  250 yr earthquake (PML)  Reinstatements  Tax-affected  Surplus

Company Loss Ratio: Home Owners … Var. Peer 1 Peer 2 Peer 3. Peer % 72% 88%... 80% 10% 85% 68% 82%... 78% 20% 90% 85% 92%... 94% 8% % 82% 78%... 80% 6% Industry Average 16% Loss Ratio: Priv. Pass. Auto Liab … Var. 78% 76% 80%... 83% 4% 74% 72% 74%... 77% 2% 66% 74% 78%... 83% 12% % 64% 72%... 80% 10% 8% Correlation Premium Related Risks -- Non-Life

Company Reserve: Home Owners … Var. Accid. Yr. 90 Accid. Yr. 91 Accid. Yr. 92. Acc. Yr $10 $18 $15... $10 15% $21 $25... $22 10% $12... $13 5%..... $12 0% Peer 1 Avg Peer 2 Avg. Industry Avg 20% 30%. 27% Company Avg 13% Reserve: Priv. Pass. Auto Liab … Var. $80 $78 $85... $80 25% $68 $55... $62 20% $54... $52 5%..... $52 0% 23% 18% 32%. 27% Correl ation Reserve Related Risks -- Non-Life

Why Does Value Matter?  Long-term obligations  Provides flexibility  Promotes financial strength  Vitality vs. survival  Separates the “advantaged” from the “disadvantaged”

Performance Measurement — Rating Considerations  Where are profits being generated?  What drives them?  How adequate are they?  How sustainable/volatile are they?  What serves as the basis of strategic and financial decisions?  How are profits and capital measured and managed?