1. Enterprise Risk Management Overview Ernst & Young LLP Enterprise Risk Management Overview Ernst & Young LLP

2. Enterprise Risk Management for Health Entities Slide 2 ERM: Basic Elements Global FocusGlobal Focus –Pricing risk –Operational Risk Suitability of accounting treatmentSuitability of accounting treatment –Reflecting real earnings –Matching revenue to risk Common framework comparing different types of risksCommon framework comparing different types of risks –Determining impact of different kinds of risk –“Extreme Risk” Global FocusGlobal Focus –Pricing risk –Operational Risk Suitability of accounting treatmentSuitability of accounting treatment –Reflecting real earnings –Matching revenue to risk Common framework comparing different types of risksCommon framework comparing different types of risks –Determining impact of different kinds of risk –“Extreme Risk”

3. Enterprise Risk Management for Health Entities Slide 3 How Relevant to Health Industry ? More Homogenous RiskMore Homogenous Risk –Less dramatic “extreme risk” –“Death of a thousand cuts” Little ALM ImpactLittle ALM Impact –Cash In – Cash Out –Short tail without much investment-supported pricing Extremely wide variety of unknownsExtremely wide variety of unknowns –Market, economy, regulation, providers, contractual, business –Common excuse for simple view is actually its extreme complexity More Homogenous RiskMore Homogenous Risk –Less dramatic “extreme risk” –“Death of a thousand cuts” Little ALM ImpactLittle ALM Impact –Cash In – Cash Out –Short tail without much investment-supported pricing Extremely wide variety of unknownsExtremely wide variety of unknowns –Market, economy, regulation, providers, contractual, business –Common excuse for simple view is actually its extreme complexity

4. Enterprise Risk Management for Health Entities Slide 4 How Relevant ? Example of Extreme P&C Risk Catastrophic Event Calls on Assets Cash Flow Impairment Cost of Capital Rises Possible Health Carrier Version Understate IBNP Miss Pricing & Earnings Earnings & Surplus Drop Cost of Capital Rises

5. Enterprise Risk Management for Health Entities Slide 5 How Relevant : Current Observations Recent Results – Favorable to Very FavorableRecent Results – Favorable to Very Favorable Challenges – Even in Favorable TimesChallenges – Even in Favorable Times –Observations by Regulators and/or Boards –Public – Profits coincident with Premium Increases –Using Capital Wisely? Anticipated Future ChallengesAnticipated Future Challenges –Responses to Affordability –Product/Network Development –Administrative Costs – Lower Premium Base How structured are carrier processes and abilities to measure and articulate the risks they face?How structured are carrier processes and abilities to measure and articulate the risks they face? Recent Results – Favorable to Very FavorableRecent Results – Favorable to Very Favorable Challenges – Even in Favorable TimesChallenges – Even in Favorable Times –Observations by Regulators and/or Boards –Public – Profits coincident with Premium Increases –Using Capital Wisely? Anticipated Future ChallengesAnticipated Future Challenges –Responses to Affordability –Product/Network Development –Administrative Costs – Lower Premium Base How structured are carrier processes and abilities to measure and articulate the risks they face?How structured are carrier processes and abilities to measure and articulate the risks they face?

6. Enterprise Risk Management for Health Entities Slide 6 Health Processes : Current Observations Traditional viewpoint – essentially pricing riskTraditional viewpoint – essentially pricing risk –Business risk, operations, business continuation not linked except by RBC –Soft linkage on items like acquisitions or new ventures Risks tend to be more homogenousRisks tend to be more homogenous –RBC-based measurement is becoming a common tool –Loosely quantified capital and vitality needs, short horizon timeframe Risk-Reward Trade-offsRisk-Reward Trade-offs –Product-specific targets - approximates pricing credibility –Steered by broad market consensus or anecdotal competitive limitation –Surplus contribution tends to be budget-based Budgeting and Projection ProcessBudgeting and Projection Process –Static or Deterministic – at best, some scenarios considered –Function of volume, trended costs, and bottom line –Target-driven cycle – adjust volume and price until “acceptable ” Traditional viewpoint – essentially pricing riskTraditional viewpoint – essentially pricing risk –Business risk, operations, business continuation not linked except by RBC –Soft linkage on items like acquisitions or new ventures Risks tend to be more homogenousRisks tend to be more homogenous –RBC-based measurement is becoming a common tool –Loosely quantified capital and vitality needs, short horizon timeframe Risk-Reward Trade-offsRisk-Reward Trade-offs –Product-specific targets - approximates pricing credibility –Steered by broad market consensus or anecdotal competitive limitation –Surplus contribution tends to be budget-based Budgeting and Projection ProcessBudgeting and Projection Process –Static or Deterministic – at best, some scenarios considered –Function of volume, trended costs, and bottom line –Target-driven cycle – adjust volume and price until “acceptable ”

7. Enterprise Risk Management for Health Entities Slide 7 Benchmarking: Surplus Levels

8. Enterprise Risk Management for Health Entities Slide 8 Benchmarking: Surplus Levels

9. Enterprise Risk Management for Health Entities Slide 9 Realized U/W Profits – Top 20 Carriers

10. Enterprise Risk Management for Health Entities Slide 10 Realized U/W Profits – BCBS Plans

11. Enterprise Risk Management for Health Entities Slide 11 Expanding the Dialogue - Pressures TargetsTargets –Data suggest some implied target – greater than RBC –Profit targets roughly linked to building surplus Capital MarketsCapital Markets –Cheap debt is buying some time as well –Europe / Banking has moved to Economic Capital –Life and P&C Carriers starting RAROC –Analyst and market considerations ProcessProcess –Above measures force more analytical linkages –Improving the credibility of the planning process –Need to recognize unique Health Industry requirements TargetsTargets –Data suggest some implied target – greater than RBC –Profit targets roughly linked to building surplus Capital MarketsCapital Markets –Cheap debt is buying some time as well –Europe / Banking has moved to Economic Capital –Life and P&C Carriers starting RAROC –Analyst and market considerations ProcessProcess –Above measures force more analytical linkages –Improving the credibility of the planning process –Need to recognize unique Health Industry requirements

12. Enterprise Risk Management for Health Entities Slide 12 Expanding the Dialogue SurplusSurplus –Broader recognition of risk / reward mix –Better quantification of viability and capital needs –Rationalization / Justification of surplus needs Health Profit TargetsHealth Profit Targets –Improved risk-reward equation by product –Required surplus contribution should be risk-based Budgeting and Projections ProcessBudgeting and Projections Process –Improving the linkage between capital needs and budget targets –Stochastic modeling – potentially RAPM / RAROC ReturnReturn –% of Premium still OK – may be converted from other measures –ROI target “denominator” --- RBC, Economic Capital SurplusSurplus –Broader recognition of risk / reward mix –Better quantification of viability and capital needs –Rationalization / Justification of surplus needs Health Profit TargetsHealth Profit Targets –Improved risk-reward equation by product –Required surplus contribution should be risk-based Budgeting and Projections ProcessBudgeting and Projections Process –Improving the linkage between capital needs and budget targets –Stochastic modeling – potentially RAPM / RAROC ReturnReturn –% of Premium still OK – may be converted from other measures –ROI target “denominator” --- RBC, Economic Capital

13. Capital and Surplus Management for Health Entities Surplus and Appropriate Returns Capital and Surplus Management for Health Entities Surplus and Appropriate Returns

14. Enterprise Risk Management for Health Entities Slide 14 Credit Risk Operational / Business Risk Underwriting Risk Market/Asset Liability Management Risk H1 Asset Devaluation Asset Concentration H2 Product Specific Risk Managed Care Credit Rate Guarantees H3 Reinsurance Capitation Receivables H4 Admin Risk Rapid Growth ASO H0 Interest in Affiliates Benchmarking: RBC Measurement

15. Enterprise Risk Management for Health Entities Slide 15 Using RBC to define Risk/Return Capital allocation was not among the RBC development goalsCapital allocation was not among the RBC development goals Positive AspectsPositive Aspects –Commonly accepted base –Ruin Theory with Monte Carlo simulations –Recognizes specific risk elements IssuesIssues –Broadly based factors = “average” –Some political compromise –Observations imply target is some multiple of RBC floor Capital allocation was not among the RBC development goalsCapital allocation was not among the RBC development goals Positive AspectsPositive Aspects –Commonly accepted base –Ruin Theory with Monte Carlo simulations –Recognizes specific risk elements IssuesIssues –Broadly based factors = “average” –Some political compromise –Observations imply target is some multiple of RBC floor

16. Enterprise Risk Management for Health Entities Slide 16 Alphabet Soup: Measures and Metrics Economic Value Added (EVA)Economic Value Added (EVA) –Rate of return versus cost of capital –Not a ratio, converted into % for planning –Often a multi-year projection of results Dynamic Financial Analysis (DFA)Dynamic Financial Analysis (DFA) –Stochastic modeling - P&C Carriers –Typically multi-year proposition with emphasis on asset impacts Return on Equity ( ROE or ROI )Return on Equity ( ROE or ROI ) –Question is --- what is the denominator ? –RBC can work – at least based on ruin theory –RBC is a broad measurement of risk by product Risk-Adjusted Return on Capital (RAROC / RAPM)Risk-Adjusted Return on Capital (RAROC / RAPM) –Economic Income / Economic Capital –Requires some form of modeling of risks assumed –Works well when comparing diverse lines of business Economic Value Added (EVA)Economic Value Added (EVA) –Rate of return versus cost of capital –Not a ratio, converted into % for planning –Often a multi-year projection of results Dynamic Financial Analysis (DFA)Dynamic Financial Analysis (DFA) –Stochastic modeling - P&C Carriers –Typically multi-year proposition with emphasis on asset impacts Return on Equity ( ROE or ROI )Return on Equity ( ROE or ROI ) –Question is --- what is the denominator ? –RBC can work – at least based on ruin theory –RBC is a broad measurement of risk by product Risk-Adjusted Return on Capital (RAROC / RAPM)Risk-Adjusted Return on Capital (RAROC / RAPM) –Economic Income / Economic Capital –Requires some form of modeling of risks assumed –Works well when comparing diverse lines of business

17. Enterprise Risk Management for Health Entities Slide 17 Using Economic Capital for Risk / Return Positive AspectsPositive Aspects –Specifically addresses business risks for the carrier –Comparing lines of business or new ventures –Can directly tie budgeting process to surplus needs –Possible emerging standard in other sectors IssuesIssues –Can require more sophisticated modeling –Judgment calls on some factors and distributions –Not yet commonly accepted approach Positive AspectsPositive Aspects –Specifically addresses business risks for the carrier –Comparing lines of business or new ventures –Can directly tie budgeting process to surplus needs –Possible emerging standard in other sectors IssuesIssues –Can require more sophisticated modeling –Judgment calls on some factors and distributions –Not yet commonly accepted approach

18. Enterprise Risk Management for Health Entities Slide 18 Medical trend volatility Lapse Mortality Morbidity Catastrophic Reserve volatility Multi-option choice Default risk Credit Risk Operational / Business Risk Litigation Disaster recovery Claim fraud Market conduct Claim rework costs New competitors New products Regulatory Tax law changes Capitation Issues Underwriting Risk Market/Asset Liability Management Risk Changes in interest rates Equities Volatility Fixed income Volatility Economic Capital or RAROC Measures

19. Enterprise Risk Management for Health Entities Slide 19 Measuring Economic Capital Expected level of loss Zero losses 0%100% Potential “unexpected” losses requiring capital for LOB A Loss rate Probability of loss Earnings Uniform risk (e.g., 99.75%) Potential “unexpected” losses requiring capital for LOB B 0%100% Earnings Loss rate LOB ALOB B Uniform risk (e.g., 99.75%)

20. Enterprise Risk Management for Health Entities Slide 20 Medical trend volatility Lapse Mortality Morbidity Catastrophic Reserve volatility Multi-option choice Underwriting Risk Economic Capital or RAROC Measures Factors modeled using stochastic outcomes

21. Enterprise Risk Management for Health Entities Slide 21 External Capital Expanding the Dialogue – Linkages BalanceSheet SurplusSolvencyInvestmentViability Benefits Expenses Taxes Premium Contribution to Surplus Investment Income Service Improvement

22. Enterprise Risk Management for Health Entities Slide 22 Premium Investment Income Benefits Capital Costs Admin Expenses Taxes Linking the Pieces SurplusRegulatoryInvestmentViability Budgeting Contribution to Surplus Capital Budget Capital Budget Strategic Plan Strategic Plan Capital Allocation Capital Allocation RBC “ + ” RAROCRAROC