1. Economic Capital Modeling A Key Part of the ERM Process Ronald T. Kuehn, FCAS, MAAA, CERA, CPCU, ARM, FCA Consulting Actuary, Huggins Actuarial Services, Inc.

2. 107 th MAMA Convention 2 Economic Capital is defined as – Sufficient surplus to cover adverse outcomes or to meet a business objective – With a given level of risk tolerance – Over a specified period of time Definition of Economic Capital

3. Definition of an Economic Capital Models (ECM) One primary tool to assess risk in an insurance organization Simulates the internal operations of the company relative to the external environment within which it is operating Indicates future levels and volatility of profitability, and Estimates appropriate amounts of capital to hold 107 th MAMA Convention 3

4. A Brief History of ECM 107 th MAMA Convention 4

5. A Brief History of ECM 107 th MAMA Convention 5

6. Model – Company or Product Risk Profiles – Risk Tolerance, Constraints & Strategies – Insurance Pricing & Business strategies – Performance Measurements – Capital Adequacy & Budgeting – Incentive Compensation Investment & Risk-Adjusted Rates of Return – Merger & Acquisition Pricing Details – Capital Allocation Among Business Units ECM Can …. 107 th MAMA Convention 6

7. Key Risks Being Measured by a Comprehensive Economic Capital Model 107 th MAMA Convention 7

8. ECM – Satisfy rating agency and regulatory criteria/inquiries – Aid in discussions with rating agencies and regulators – Capital adequacy measured against a company’s risk profile Benefits of an Economic Capital Model Compliance Related 107 th MAMA Convention 8

9. A.M. Best’s Supplemental Rating Questionnaire (no longer asks the ECM question as of year-end 2013) – Q 56: ECM – Risk Identification & Monitoring – Q 57: Frequency of Update to ECM and Measurement of Aggregate Risk – Q 58: Impact of Calendar Year Inflation on Reserves – Strong emphasis on Catastrophe Management (Updated as of January 14th, 2014) Preparation of the ORSA summary report Essential for Solvency II Compliance Benefits of an Economic Capital Model Compliance Related 107 th MAMA Convention 9

10. More to gain from ECM than compliance Improves risk awareness at all levels Enables better risk/reward decisions making Facilities linking strategy with planning Empowers firm to improve value for stakeholders Provides a competitive advantage including reduced cost of capital (University of Georgia Study 2013) Benefits of an Economic Capital Model Value Beyond Compliance 107 th MAMA Convention 10

11. A.M. Best 2010 ERM SRQ: Overall 28% of respondents use ECM to quantify aggregate risk Large (55%), Medium (33%), and Small (17%) 8% use ECM for management compensation NAIC moving with European regulator EIOPA ? – Solvency II will allow companies capital relief by use of internal ECM rather than standard model Insurance Companies & ECM 107 th MAMA Convention 11

12. Savvy Investors, media, and the financial community speak language of risk modeling (VaR, TVaR, PML, etc.) Demand more disclosure of metrics from ECMs. Developing ECM is costly as it requires: Acquiring actuarial and financial expertise Collecting of significant volume data Analyzing data to develop risk parameters Licensing or building ECM software platform Validating the model and organizing the management process for audit Insurance Companies & ECM 107 th MAMA Convention 12

13. RBC (Risk-Based Capital) Ratio – Implemented by the NAIC in the 1990’s – Formulaic estimate of necessary surplus and comparison to reported surplus – Used to authorize regulatory intervention into financially- distressed NAIC ORSA (Own Risk and Solvency Assessment) – Companies with at least $500 M WP – Group with at least $1B WP – Effective circa 2015 Existing Capital Adequacy Measures 107 th MAMA Convention 13

14. Rating Agency Measures: BCAR and others – Both formulaic and simulation-based – Used as significant input into assignment of financial strength ratings – Lack full transparency, as not all parameters are made public Insurance Companies & ECM 107 th MAMA Convention 14

15. Economic Capital Models (ECM’s) – Simulation based – Direct calculation of Economic Capital needed – Many other uses in addition to Economic Capital measure Insurance Companies & ECM 107 th MAMA Convention 15

16. Balance Sheet Inputs: Assets Cash Bonds Common Stock Other Asset Classes Liabilities Loss and Loss Adjust Reserves by Line / Subline Payment patterns for Existing Reserves Unearned Premium Reserve Other Liabilities Basic Inputs to an Economic Capital Model 107 th MAMA Convention 16

17. Direct Written Premium Claim Payout Pattern for Newly Generated Loss Underwriting Expenses Earnings Pattern Operational Risk – Lognormal Distribution Basic Inputs to an Economic Capital Model (Line of Business Inputs) 107 th MAMA Convention 17

18. Frequency and Severity Model – Frequency of Individual Claims with No Correlation – Claim Frequency Distribution - Examples Poisson – often selected Negative Binomial Binomial Basic Inputs to an Economic Capital Model (Cause of Loss) 107 th MAMA Convention 18

19. Frequency and Severity Model – Severity of Individual Claims with No Correlation – Claim Severity Distribution - Examples Lognormal – often selected Exponential Gamma Generalized Pareto Normal Uniform Weibull Basic Inputs to an Economic Capital Model (Cause of Loss) 107 th MAMA Convention 19

20. Basic Inputs to an Economic Capital Model (Cause of Loss) Aggregate Loss Model – Aggregate claims model can incorporate copulas (i.e., correlation between lines of business) Aggregate Loss Distribution Examples Lognormal Generalized Pareto Normal Uniform Weibull 107 th MAMA Convention 20

21. Basic Inputs to an Economic Capital Model (Cause of Loss) Selection of Copulas - adds correlation between lines of business Normal Copula – linear correlation coefficient Student’s T Copula – varies weight of coefficients in tail of distribution HRT Copula – more weight in right tail of distribution Partial Perfect Copula – mixes perfect correlation with uncorrelated 107 th MAMA Convention 21

22. Basic Inputs to an Economic Capital Model (Reinsurance Inputs) Reinsurance Contract Terms Per Risk Excess Corridors Ceded Premium Ceded Reinsurance Attachment Point Ceded Reinsurance Limit Specific Catastrophe Reinsurance Terms Reinsurance Catastrophe Modeling Results (i.e. AIR, EQECAT, RMS) 107 th MAMA Convention 22

23. Basic Inputs to an Economic Capital Model (Economic Scenarios) Leading edge economic models, providing full market risk and asset class coverage Estimates inflationary changes, wage & CPI Estimates of investment returns and default risk: US Treasury bonds US, United Kingdom, and Euro stock markets Emerging Markets stocks Blue Chip Stocks Corporate and Municipal bonds of varying quality Master Limited Partnerships Real Estate Investment Trusts (REITs) Mortgage Backed Securities 107 th MAMA Convention 23

24. Basic Outputs from an Economic Capital Model Outputs include but are not limited to: Over 180 customizable reports Cumulative Probability Density Functions Compare results from differing assumptions Include effect of catastrophe losses Calculates Value at Risk (VaR) & Tail Value at Risk (TVaR) Pro Forma Financial Statements Balance Sheet Income Statement Number of projected years is flexible 107 th MAMA Convention 24

25. Value at Risk (VAR) – Maximum loss at no more than one minus the confidence level Tail Value at Risk (TVaR) – Expected loss in worst X percentage of distribution; also called CTE Risk Adjusted Performance – Measure risk adjusted returns on some established capital amount Return on Equity – Simple accounting performance metric ECM - Key Risk Metrics Return on Equity = Net Income/Shareholder's Equity 107 th MAMA Convention 25

26. Happy Valley Insurance Company Case Study Line of Businesses: General Liability Workers’ Compensation Property Miscellaneous Write Businesses in 13 States on the East Coast 107 th MAMA Convention 26

27. As of 12/31/2014 LiabilitiesValues Net L&LAE Reserve$22.75 M Net UEPR$23.10 M Other Liabilities$4.72 M Total Liabilities$50.57 M Capital & Surplus$20.87 M Liabilities & Surplus$71.44 M Happy Valley Insurance Company Base Case - Liabilities & Surplus 107 th MAMA Convention 27

28. As of 12/31/2014 AssetsValues Bonds$43.40 M Stocks$1.25 M Cash$5.50 M Other Invested$0.30 M Total Invested$50.45 M Uncollected Premium$17.00 M Other Assets$4.00 M Total Assets$71.45 M Happy Valley Insurance Company Base Case - Assets by Class 107 th MAMA Convention 28

29. As of 12/31/2014 Lines of BusinessGross EPCeded EPNet EP General Liability$6.40 M$0.60 M$5.80 M Workers’ Compensation$3.70 M$1.00 M$2.70 M Property$35.90 M$11.00 M$24.90 M Total All Lines$46.00 M$12.60 M$33.40 M Happy Valley Insurance Company Base Case - Earned Premium 2015 107 th MAMA Convention 29

30. Reinsurance For All Years 2015 - 2019 Line of Business Base Case Retention General Liability$1.10 M Workers' Comp$0.50 M Property Per Risk$0.50 M Line of Business Catastrophe Layers Property Cat$ 4.00 M X/S $ 6.00 M $10.00 M X/S $10.00 M $20.00 M X/S $20.00 M $40.00 M X/S $40.00 M Happy Valley Insurance Company Base Case - Reinsurance Program 107 h MAMA Convention 30

31. Surplus at Various Confidence Intervals Probability2015 VaR2019 VaR 0.010% $(7.49) M$(27.03) M 0.079% $0 M$(14.46) M 0.491% $7.16 M$0 M 0.500% $7.21 M$0.09 M 50.000% $23.53 M$32.29 M 75.000% $24.57 M$36.60 M 99.000% $26.39 M$43.68 M 99.500% $26.62 M$44.49 M Mean $22.58 M$30.81 M Year - End 2014 Surplus$20.87 M *Results of 100,000 Monte Carlo Simulations Solvency II Standard Happy Valley Insurance Company Base Case ECM Results 107 th MAMA Convention 31

32. In the Base Case scenario, Happy Valley invests in: Government bonds, Blue chip stocks Cash Miscellaneous other assets In the Alternative Investment Scenario, Happy Valley increases its investment in: Blue chip stocks and Adds a substantial investment in master limited partnerships (MLP’s) Happy Valley Insurance Company Alternative Investment Scenario 107 th MAMA Convention 32

33. Investment Percentage AssetsYieldBase CaseAlternative Bonds2.50%60.70%45.00% Stocks0.00%1.70%3.50% MLP's6.00%0.00%14.00% Cash0.10%7.70% Other0.00%29.90%29.80% Total 100.00% Happy Valley Insurance Company Comparison of Investment Distribution 107 th MAMA Convention 33

34. Surplus at Various Confidence Intervals Probability2015 VaR2019 VaR 0.010% $(6.91) M$(27.15) M 0.080% $0 M$(13.01) M 0.340% $6.27 M$0 M 0.500% $7.45 M$2.41 M 50.000% $23.75 M$34.78 M 75.000% $25.10 M$39.69 M 99.000% $28.08 M$49.75 M 99.500% $28.56 M$51.15 M Mean $22.99 M$33.64 M Year - End 2014 Surplus$20.87 M *Results of 100,000 Monte Carlo Simulations Solvency II Standard Happy Valley Insurance Company Alternative Investment Scenario ECM Results Happy Valley Insurance Company Alternative Investments 107 th MAMA Convention 34

35. In the Base Case scenario, Happy Valley invests in: Government bonds Blue chip stocks Cash Miscellaneous other assets In the second alternative, Happy Valley uses excess surplus, to buy small, profitable personal auto insurer Costs $2.3 million over book value Assumes $5.0 million in net loss & loss adjustment reserves Assumes $3.5 million in unearned premium reserves Happy Valley Insurance Company Case Study - Buys Small Auto Insurer 107 th MAMA Convention 35

36. As of 12/31/2014 LiabilitiesValues Net L&LAE Reserve$27.75 M Net UEPR$26.60 M Other Liabilities$4.72 M Total Liabilities$59.07 M Capital & Surplus$18.53 M Liabilities & Surplus$77.61 M Happy Valley Insurance Company Buy Auto Insurer - Liabilities & Surplus 107 th MAMA Convention 36

37. As of 12/31/2014 AssetsValues Bonds$49.56 M Stocks$1.25 M Cash$5.50 M Other Invested$0.30 M Total Invested$56.61 M Uncollected Premium$17.00 M Other Assets$4.00 M Total Assets$77.61 M Happy Valley Insurance Company Buy Auto Insurer - Assets by Class 107 th MAMA Convention 37

38. As of 12/31/2014 Lines of BusinessGross EPCeded EPNet EP Personal Auto$7.20 M$2.00 M$5.20 M General Liability$6.40 M$0.60 M$5.80 M Workers’ Compensation$3.70 M$1.00 M$2.70 M Property$35.90 M$11.00 M$24.90 M Total All Lines$53.20 M$14.60 M$38.60 M Happy Valley Insurance Company Buy Auto Insurer - Earned Premium 2015 107 th MAMA Convention 38

39. Surplus at Various Confidence Intervals Probability2015 VaR2019 VaR 0.010% $(9.48) M$(27.17) M 0.100% $0 M$(10.75) M 0.480% $5.13 M$0 M 0.500% $5.22 M$0.15 M 50.000% $21.53 M$31.90 M 75.000% $22.60 M$36.22 M 99.000% $24.47 M$43.42 M 99.500% $24.71 M$44.19 M Mean $20.59 M$30.47 M Year - End 2014 Surplus$18.53 M *Results of 100,000 Monte Carlo Simulations Solvency II Standard Happy Valley Insurance Company Buy Auto Insurer - ECM Results 107 th MAMA Convention 39

40. In the third alternative scenario, Happy Valley reduces its reliance on reinsurance by: Doubling retention on General Liability Doubling retention on Property Per Risk Eliminating first Catastrophe layer Happy Valley Insurance Company Case Study – Alternative Reinsurance 107 th MAMA Convention 40 Graphic: RadientSkies/123RF.com

41. As of 12/31/2014 - Same as Base Case LiabilitiesValues Net L&LAE Reserve$22.75 M Net UEPR$23.10 M Other Liabilities$4.72 M Total Liabilities$50.57 M Capital & Surplus$20.87 M Liabilities & Surplus$71.44 M Happy Valley Insurance Company Alternative Reinsurance – Liabilities & Surplus 107 th MAMA Convention 41 Graphic: RadientSkies/123RF.com

42. As of 12/31/2014 – Same as Base Case AssetsValues Bonds$43.40 M Stocks$1.25 M Cash$5.50 M Other Invested$0.30 M Total Invested$50.45 M Uncollected Premium$17.00 M Other Assets$4.00 M Total Assets$71.45 M Happy Valley Insurance Company Alternative Reinsurance - Assets by Class 107 th MAMA Convention 42 Graphic: RadientSkies/123RF.com

43. Reinsurance For All Years 2015 - 2019 Line of Business Base Case Retention Alternative Retention General Liability$1.10 M$2.20 M Workers' Comp$0.50 M Property Per Risk$0.50 M$1.00 M Line of Business Catastrophe Original Layers Catastrophe Alternative Layers Property Cat$ 4.00 M X/S $ 6.00 M$10.00 M Retention $10.00 M X/S $10.00 M $20.00 M X/S $20.00 M $40.00 M X/S $40.00 M Happy Valley Insurance Company Comparison of Reinsurance Program 107 h MAMA Convention 43 Graphic: RadientSkies/123RF.com

44. Surplus at Various Confidence Intervals Probability2015 VaR2019 VaR 0.010% $(11.81) M$(31.88) M 0.166% $0 M$(9.60) M 0.500% $4.65 M$(1.04) M 0.588%$5.31 M$0 M 50.000% $24.48 M$37.19 M 75.000% $25.53 M$42.23 M 99.000% $27.35 M$50.48 M 99.500% $27.58 M$51.41 M Mean $23.32 M$35.43 M Year - End 2014 Surplus$20.87 M *Results of 100,000 Monte Carlo Simulations Solvency II Standard Happy Valley Insurance Company Alternative Reinsurance - ECM Results 107 th MAMA Convention 44 Graphic: RadientSkies/123RF.com

45. In the Base Case scenario, Happy Valley invests in: Government bonds Blue chip stocks Cash Miscellaneous other assets In the fourth alternative scenario, Happy Valley begins to pay its shareholders $1.8 million of dividends per year beginning in 2015 to reduce under-utilized surplus. Happy Valley Insurance Company Case Study – $1.8 M Dividend Per Year 107 th MAMA Convention 45 Graphic: CSA Images / B&W Engrave Ink Collection / Getty Images

46. As of 12/31/2014 - Same as Base Case LiabilitiesValues Net L&LAE Reserve$22.75 M Net UEPR$23.10 M Other Liabilities$4.72 M Total Liabilities$50.57 M Capital & Surplus$20.87 M Liabilities & Surplus$71.44 M Happy Valley Insurance Company $1.8 M Dividend Per Year – Liabilities & Surplus 107 th MAMA Convention 46 Graphic: CSA Images / B&W Engrave Ink Collection / Getty Images

47. As of 12/31/2014 – Same as Base Case AssetsValues Bonds$43.40 M Stocks$1.25 M Cash$5.50 M Other Invested$0.30 M Total Invested$50.45 M Uncollected Premium$17.00 M Other Assets$4.00 M Total Assets$71.45 M Happy Valley Insurance Company $1.8 M Dividend Per Year - Assets by Class 107 th MAMA Convention 47 Graphic: CSA Images / B&W Engrave Ink Collection / Getty Images

48. Reinsurance For All Years 2015 - 2019 Line of Business Base Case Retention General Liability$1.10 M Workers' Comp$0.50 M Property Per Risk$0.50 M Line of Business Catastrophe Original Layers Property Cat$ 4.00 M X/S $ 6.00 M $10.00 M X/S $10.00 M $20.00 M X/S $20.00 M $40.00 M X/S $40.00 M Happy Valley Insurance Company $1.8 M Dividend Per Year - Same as Base Case Reinsurance Program 107 h MAMA Convention 48 Graphic: CSA Images / B&W Engrave Ink Collection / Getty Images

49. Surplus at Various Confidence Intervals Probability2015 VaR2019 VaR 0.010% $(9.29) M$(38.10) M 0.100% $0 M$(22.44) M 0.500% $5.41 M$(10.74) M 2.480%$11.08 M$0 M 50.000% $21.73 M$23.06 M 75.000% $22.77 M$27.39 M 99.000% $24.59 M$34.45 M 99.500% $24.82 M$35.25 M Mean $20.78 M$21.44 M Year - End 2014 Surplus$20.87 M *Results of 100,000 Monte Carlo Simulations Solvency II Standard Happy Valley Insurance Company $1.8 M Dividend Per Year - ECM Results 107 th MAMA Convention 49 Graphic: CSA Images / B&W Engrave Ink Collection / Getty Images

50. Scenarios12345 Key Metrics Base Case Alternative Investment Buy Auto Insurer Alternative Reinsurance Pay $1.8 M Dividends 2015 BCAR 257.13% 262.53% 211.44% 255.82%234.02% 2019 BCAR 271.77% 287.90% 241.83% 283.02%199.51% 1 Yr Prob. of Ruin 0.08% 0.10% 0.17%0.10% 5 Yr Prob. of Ruin 0.49% 0.34% 0.48% 0.59%2.48% 12/31/2014 Surplus (M)$20.87 $18.53$20.87 12/31/2019 Surplus (M)$30.81$33.64$30.47$35.43$21.44 5 Yr Annual Adj. ROE 8.10% 10.02% 10.45% 11.16%7.84% Happy Valley Insurance Company Comparison of Key Metrics for Scenarios 107 th MAMA Convention 50

51. Initial Allocation of Year-End 2014 Surplus at 99% VaR LOB99% VaR Percent of Total Capital Allocation Casualty$4.221 M 13.69%$2.857 M Workers' Compensation$1.900 M 6.16%$1.286 M All Other$2.551 M 8.27%$1.727 M Property$22.165 M 71.88%$15.003 M Total$30.837 M 100.00%$20.873 M Happy Valley Insurance Company Initial Capital Allocation Using Net 99% VaR 107 th MAMA Convention 51

52. Initial Allocation of Year-End 2014 Surplus at 50% VaR LOB50% VaR Percent of Total Capital Allocation Casualty$2.335 M 12.83%$2.679 M Workers' Compensation$1.504 M 8.27%$1.726 M All Other$0.905 M 4.97%$1.038 M Property$13.452 M 73.93%$15.431 M Total$18.197 M 100.00%$20.873 M Happy Valley Insurance Company Initial Capital Allocation Using Net 50% VaR 107 th MAMA Convention 52

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54. Mr. Kuehn is professionally active; he served as the chairman of the Casualty Loss Reserve Seminar (CLRS). He has also served on the on the Casualty Practice Council of the American Academy of Actuaries, the CAS Examination Committee and Committee for Consultants’ Interests, and as past President, Education Chairman and Board Member of the Casualty Actuaries of the Mid-Atlantic Region (CAMAR). He currently serves on the Board of the Insurance Society of Philadelphia (ISOP), and he is a member of the ORSA subgroup of the ERM Committee of the Risk Management and Financial Reporting Council of the American Academy of Actuaries. His over forty three years in business have given him a thorough knowledge of the property- casualty business both from a company and consulting viewpoint. Ronald T. (Rusty) Kuehn, FCAS, MAAA, CERA, CPCU, ARM, FCA Mr. Kuehn is a consulting actuary with Huggins Actuarial Services, Inc. In his consulting practice he specializes in medical malpractice, private passenger automobile, workers’ compensation and commercial lines coverage working for insurance carriers, self- insured healthcare systems, self-insured corporations, brokers, municipal bond and mortgage insurance experience, and other types of clients. Contact Information: E-mail: rusty.kuehn@hugginsactuarial.com Cell Phone: 610-892-1823 www.hugginsactuarial.com 107 th MAMA Convention 54

55. Economic Capital Modeling A Key Part of the ERM Process Ronald T. Kuehn, FCAS, MAAA, CERA, CPCU, ARM, FCA Consulting Actuary, Huggins Actuarial Services, Inc.