Filename Copyright © 2002 ERisk CAS Ratemaking Seminar 2002 Peter Nakada Global Head of Consulting, ERisk March 2002

Filename 1 Remember why we’re here Direct Expense and Overhead Excess Profit Total Premium and Fees Risk Load  Reflects relative cost due to variability in claim frequency and severity  Incorporates portfolio concentrations How do you charge for risk in a leveraged financial institution? Target ROE ROE > Target Expected Loss  Present value of liabilities –or–  Nominal value of liabilities and include impact of investment income

Filename 2 Framing the debate  How do we define risk? –VaR, TVaR –EPD –Economic Capital (Shortfall Probability)  How do we charge for risk? –RAROC –EVA, CAPM, Economic Profit –SVA –Traditional standard deviation, variance- based Framework  RAROC –Value-based –Single-period –Analytical  DFA –Accounting-based –Multi-period –Simulation Technique WHAT HOW

Filename 3 Capital Accumulation Capital Management Late ’80s Losses LDC lending Portfolio insurance Junk bonds Real estate lending Interest rate spike Focus on earnings growth, cost efficiency Qualitative risk measures Seat-of-the-pants pricing Strong pricing cycles Focus on return on equity Quantitative risk measures, capital linked to risk Risk-based pricing hurdles Dampened pricing cycles Pre 1990Post 1990 Lessons learned from banking

Filename 4 Banks used Economic Capital to drive strategic decisions... CEO SHAREHOLDER PERSPECTIVE RATING AGNECY PERSPECTIVE Economic Capital RAROC Risk vs. Reward Financial Strength Risk vs. Capital Expected Return Economic Capital Structure

Filename 5... and drove this discipline into the businesses via RAROC-based pricing tools Calculate based on risk Loan Pricing Tool Exposure Expected Loss Expense Allocation Economic Capital bp $ $ $ RAROC $ % VALUE ADDED Calculated Commitment Maturity Commitment Fee Drawn Spread Avg. Utilization Fees & Other Income %  $  yrs $ bp Rating Sub-Portfolio Calculate Break- Even

Filename 6 RAROC techniques are different from traditional DFA techniques...  Philosophy: Make it useful –Build bridges to data –Quick results and revise often –Spend effort in proportion to risk  Economic value-based model  Single period, analytical approach –Easy to incorporate management experience  Capital attribution approach widely accepted in banking  Philosophy: Make it accurate –Analysis paralysis –Spaceship building –Everything’s a nail  Accounting-based accrual model  Multi-period, simulation approach –Overall effect of micro-level dependencies obfuscated  Various capital attribution approaches P&C RAROC Dynamic Financial Analysis... and provide important advantages, driven by a decade of evolution in banking

Filename 7 RAROC uses Economic Capital as the common measure of risk across all risk types Enterprise-wide Risk Comprehensive coverage of risk types All risks measured on a consistent basis Time horizon harmonized across analysis Confidence interval linked to financial strength Forward-looking, not historical volatility Additive across activities (business, product, customer) Non-Cat Risk Operating Risk Asset Risk CAT Risk Probability Economic Capital Probability linked to solvency standard

Filename 8 1 Use the right model for each risk – don’t shortchange asset risk Capital Required by the US P&C Industry by Risk Type Asset Risk Non-Cat Liability Risk Property Catastrophe Risk Operating Risk *Source: P&C RAROC: A Catalyst for Improved Capital Management in the Property and Casualty Insurance Industry, Nakada, et al., The Journal of Risk Finance, Fall 1999.

Filename 9 2 Value-based models allow you to define a single distribution for each risk type Probability Change in value over one period Economic Capital Expected Loss Solvency standard: how strong do you want your firm to be?

Filename 10 Aggregate Distribution Total Risk 3 Modular, analytical models are faster and more transparent Market Risk Credit Risk A/LM Risk Operating Risk Inter-risk correlations Value AGGREGATOR CAT Risk Non-CAT Risk

Filename 11 4 It is easier to calculate risk contributions from an analytical model Policy Risk Risk Contribution ……… n Risk contributions Simulation Analytical 10,000 iterations, 100 policies “F9” in Excel A few matrix multiplications 10,000 iterations x 100 policies 1,000,000 iterations Calculation of Contributions (hours) (minutes or seconds) Policy Risk Risk Contribution ……… n Risk contributions

Filename 12 5 Correlation and other assumptions should be explicit – and tested Confidence Intervals around Economic Capital Estimates -30%-20%-10%0%10%20%30% TOTAL Credit Risk Operating Risk Analogs Cat Risk Non-Cat Risk Interest Rate Volatility Market Index Volatility Risk Correlation Percent Change in Economic Capital Available Capital Model/Parameter Tested Confidence - Confidence +