2001 Casualty Loss Reserve Seminar Fairmont Hotel New Orleans, La September 9-11, 2001 Robert F. Wolf FCAS, MAAA Principal William M. Mercer/MMC Enterprise Risk Consulting The Evolving Role in Enterprise Risk Management

Agenda n Introduction n ERM/Actuarial Evolution –Trends - What’s Going On? n ERM Platforms –Non-Insurance Company –Insurance Company n Wrap-up n Q&A Copies of Presentations Available at

What is ERM? n To me, Enterprise Risk Management is a process for identifying and prioritizing critical risks facing an organization, quantifying their impact on financial and strategic objectives, and implementing financial and organizational solutions to address them. n To others, it varies but the essence is the same –“ERM assesses and manages all risks while looking for upsides in identifying risks.” –“Enterprise Risk Management is about information and capital management.” –“The ultimate goal of Enterprise Risk Management is preservation of shareholder value.” –“The job of Enterprise Risk Management is figuring out where the edge of the cliff is, and making sure the risk takers know where it is.”

No Consensus on Best Risk Measure A =Variance Principal= Squared Dev from Mean B= VaR (Pr Ruin) Principle EPD Principal D TVaR Principal= C+D A B C

Evolution of Risk Management n As the quantification/approach to measuring/handling risk evolves, so too does our job description. n Risk Manager –From Insurance Buyer to Integrated/Consolidated Risk Strategy n Actuary –Traditional: Evaluate Hazard/Financial Risk –Evolution: DFA (Insurance Companies)/ ERM

Why the Evolution of ERM n New/Larger Risk –E-Commerce, Market/Book Values n New Risk Products –Merger of Insurance and Financial Institutions n Realization that Silo-Based Approaches are Flawed –Ignores inherent hedges and correlation n Increased Management Accountability –New Regulations requiring corporate governance

Why the Evolution of ERM n In short, because Society Demands it n Computer and Information Age –We couldn’t do what we are doing today if we needed to use slide-rules or abacus. n Focus Optimize Shareholder Value

Economist Intelligence Unit ERM Study

Risk Managers and Senior Executives Are Hearing More and More About Risk Management

Evolving Risk Manager n Evolving Risk Management Positions –Chief Risk Officer, ERM Councils, Global Director of Risk Management n Rise of, and Partnership with, Internal Audit –Corporate governance issues and perspectives n Rise of, and Partnership with, Treasury –Financial Management perspectives and insights n Rise of Board Audit Committees n Evolving Skill Base for Risk Managers

Why the Evolution of ERM n In short, because Society Demands it n Computer and Information Age –We couldn’t do what we are doing today if we needed to use slide-rules or abacus. n Focus Optimize Shareholder Value

Actuarial Evolution n ERM Evolution Actuarial Evolution n Traditional Roles –Evaluating Hazard/Financial Risk in a silo –Insurance Company n Determine what to charge in order to meet profits targets (Ratemaking) n What to set aside to meet future obligations of past events (Reserving) –Insurance Customers n What to budget in order to pay for self-insured obligations and premiums n What to set aside to meet future obligations of retained risk

Actuarial Evolution n Continuing Actuarial Evolution n Evolving Demands for Risk Integration –Insurance Company n Holistic Evaluation of Assets and Liabilities (Dynamic Financial Analysis (DFA)) –Optimum Capital Structure –Realization of Business Plan –Insurance Customers n Optimum Risk Financing –What risks to retain/insure - captives, retros, large deductibles –..but still only Hazard and Financial Risk

Optimum Integrated Hazard Risk Financing Corporate Considerations Cash Position Effective Tax Rate After-Tax Cost of Borrowing Credit Capacity Need for Admitted Carrier Paper Cost Predictability/Risk Appetite Market Assessment Risk Management Budget Loss Control Incentives Tools Loss Forecasting/Reserving Models Dynamic Financial Modeling Discounted Cash-Flow Models Risk/Cost Matrix Recommendations Optimum Retentions Optimum Funding Mechanisms Exogenous Contingent Events Economic Scenarios Interest Rates etc. Goal is to optimize shareholder value

Actuarial Evolution n ERM Evolution Actuarial Evolution –All sectors of Corporate America –Not merely Insurance Companies and their Customers –Includes Strategic and Operational Risks as well as Hazard and financial risks

Case Study Non-Insurance Corporation (See Presentation By Barry Franklin)

Case Study Framework ERM Insurance Company

P&C Goals - Not Just Survival n Three Considerations –Survival : How risky can you be n Prob {Cost of Runoff and New Business Costs > UEPR, Loss Reserves, Future Premiums, and Investment Income, Capital} UEPR, Loss Reserves, Future Premiums, and Investment Income, Capital} < a –Stability n Probability [(Loss Ratio + Expense Ratio) > Target Combined ratio] Target Combined ratio]<a –Optimizing Enterprise n CEOs and CFOs care more about stability v. survival.

ERM Insurance Company n 2.0 Billion of Premiums n $700 Million Surplus n Mulli-line Company - Primarily Personal Lines n 5 Regions n The Company Manages its silos well n 50% Premium Volume is rate sticky states n Asset Allocation: –80% Bonds –10% Equities –10% st-investments n 25% growth rate in recent years

Historical Reserve Margins Less Pressure on Rate Adequacy to Achieve Corporate Goals

Goal : Develop ERM Framework Addressing (Macro):   How much capital is Enough? – –Supporting Future Growth – –Excess Capital n n Should we give back to Shareholders? n n What if a beneficial acquisition arises? n n Should we increase our Shareholder dividend? – –Is debt financing appropriate? n n Is our investment strategy providing a good risk/reward n n How efficient is our reinsurance Structure? – –Cost/Benefit – –Catastrophe n n Should we be self insuring/insuring our operations risks?

Goal : Develop ERM Framework Addressing (Micro):   What region/state/product line/ target market should we grow/contract   What is my marginal capital at risk and corresponding return   What Combined Ratios do I need to achieve given market and economic conditions by product line to achieve macro goals:   ROE   MV/BV

How Much Capital do you Need? K+S K S Capital Truly Held includes Capital embedded in UEPR, Discount in Loss Reserves, Capital Tied up in NAIC RBC/ Best’s BCAR. Suggested Approach= Economic Capital is all that matters. The above reflects a timing constraint as to how much capital to hold if >Economic Capital. Must reflect this timing cost.

ERM Process MANAGEMENT & BOARD DECISIONS ECONOMIC CONDITIONS COMPETITION & INDUSTRY Investment Strategy Underwriting Strategy Operational Management Reinsurance Strategy Capital Structure Pro-forma Financials Operating Units Decisions Legal Entities ALM

Competition and External n Price Compensation & Elasticity of Demand n Jurisditional Risk n rate stickiness n tort laws n residual market n Best’s, RBC, etc.

Management Decisions n Business Plans –1 Year –5 Year n Board Directives –Asset and Investment Guidelines n Corporate Culture –Incentive Compensation

Economic Conditions n Inflation n Interest Rates n Currency Exchange n Equity Performance n Economic Conditions –Recessions n Combo of stochastic and scenario considerations

DFA Approach n Holistic View –Reinsurance Strategy –Investment Strategy –Underwriting Strategy (Macro) –Operational n Correlation –Forward Looking –5 Year Planning Horizon n DFA Platform –CFs, Income statements, ROEs, Balance Sheets

Reinsurance Strategy Considerations - Credit Risk

Investment Strategy

Interest rate shift Duration Line Reserves Assets Asset/ Liability Management If the asset duration exceeds the liability duration, then an upward shift in interest rates decrease equity. If the asset duration exceeds the liability duration, then an downward shift in interest rates increase equity. Change in Equity = Change is Assets - Change in Liability + - Duration Line Positive Duration Needs to Consider Cash Flows of New/Renewal Business

Interest rate shift Duration Line Assets Effects of Duration Mismatch ….so we May Need to consider inflation hedged securities or assets that tend to move with inflation such as stocks (long-term) and real estate And in many cases the LiabilityDuration is actually NEGATIVE + - Duration Line Reserves

CAS VFIC Research………. n Optimal Investment Strategy Does Not Imply Duration Matching –Analysis of Duration is only one part of the process n An upward sloping yield curve along with short duration loss reserves often imply that asset durations in excess of liability durations may increase net investment income and lower the probability of insolvency

Operational Risks Handled Similarly to Barry’s Approach to Corporate Client Also Includes Seasoning of Business - Renewals Get Better

Capital Financing Strategy n Capital Management –Macro- Is suffucient Capital Available? –Micro - Decision making Tool n What marginal capital and marginal returns can be realized at a product/target market/region/state basis? –Where to Grow/Contract?

Market Value Balance Sheet Definitions Assets Liabilities Capital Let K = Policyholder Supplied Funds (PHSF) Let S = Shareholder Supplied Funds (SHSF) K S K+S Returns R A = Return on Investments Using both policyholders and shareholder supplied $s R L = Cost of Debt (Borrowing PHSF) R C = Cost of Capital (Using SHSF) Returns R A on K+S funds S Costs at rate of R C K Costs at a rate of R L Balanced Levered Trust (K+S)R A = KR L + SR C SHSF Supply S (R C -R A ) = K(R A -R L ) PHSF Demand R L is the reserve discount rate, R L = R A - (S/K)(R C - R A ) R U = - K R L /Premium Insurance Company Earns Positive Economic Returns on Underwriting if R A > R L (R u > - (K/Premium) R A ) R C = (1 + K/S)R A + (Prem/S)R U Financial Markets Product Markets

Maximizing Shareholder Value Depends on Three Things…….. Market Value of Firm = S(ROE)/(1+R C )+ S(ROE)(1+G)/(1+R C ) 2 + S(ROE)(1+G) 2 /(1+R C ) 3 +…….. = S(ROE)/(R c -G) Book Value of Firm = S Market/Book Ratio = ROE/(R c -G) Earnings (ROE) Cost of Capital Long-Term Growth S = Statutory Surplus G= Long-Term Growth R c = Discount Cost of Capital

Allocation of Capital n Macro - How Much is Enough? How Much to Give Back to Shareholders n Micro- –What marginal capital and marginal returns can be realized at a product/target market/region/state basis? –Where to Grow/Contract –Choose target markets such that greatest return on marginal capital until each yield the same return –Allocate capital in proportion to marginal capital –See Glen Meyers “Cost of Financing Insurance” and “An Introduction to the Competitive Market Equilibrium Risk Load Formula”

In Meyer’s………….. Let P = Return and C = Capital. Then the insurer is better off by adding a line/policy if:  Marginal return on new business > return on existing business.

Overall Benefits- ERM Process n Optimum Capital Structure n What Operating Division is Enhancing/Destroying Enterprise Value n Realization Of Business Plans Enhanced –Micro Decision Making and Targets Consistent with Macro Decision Making n Dynamic Reforecasting of Business Plans and Incentive Plans - 5 Years

Wrap-up

Cost Overruns Accounting irregularities Manage- ment ineffective- ness Supply Chain Issues Competitive Pressure M&A Integration Problems Mis- aligned Products Customer Pricing Pressure Loss of Key Customer Supplier Problems R&D Delays Customer Demand Shortfall % of top 100 Regulatory Problems StrategicOperationalFinancialHazard Foreign Macro- Economic Issues Interest Rate Fluct- uation High Input Comm- odity Price Law- suits Natural Disasters Primary Cause of Stock Drop (# of Companies) Source: Compustat, Mercer Management Consulting analysis - Period Examined was June 1993 to May 1998 Note: There were also 5 stock drops for which the primary cause could not reliably be determined. These 5 stock drops are not depicted. Fortune 1000 Group Analysis 10% of the Fortune 1000 companies suffered a loss of over 25% of shareholder value within one month How Does Risk Manifest Itself?

Two Ways to Interpret Graph n Hazard and Financial Risk is Not Important n Hazard and Financial Risk has been and continues to be managed well –Testimonial for risk managers, actuaries, brokers, and financial analysts. –We need to continue the process n …The opportunity now is to work on the left side of the graph.

“….We don’t do things because they are easy. We do them because they are hard.” ….John F. Kennedy …….Significant Opportunities for Us.

Thank You

Q&A