1. Enterprise Risk Management A Presentation at Casualty Actuarial Society Ratemaking Seminar March 13, 2001 Las Vegas

2. Moderator Robert F. Wolf William M. Mercer Inc/MMC Enterprise Risk Panelists Robert Mackay MMC Enteprise Risk Barry Franklin Aon Risk Consultants Handouts Available to Download : www.casact.org

3. ….A decade ago The Actuary Consulted with the Risk Manager on Hazard Risks

4. ….Today The Risk Manager’s Role expanded beyond that of an insurance buyer,but rather to to optimize/consolidate the risk strategy under one integrated program. Rise of Chief Risk Officer

5. 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. How Does Risk Manifest Itself? Fortune 1000 Group Analysis 10% of the Fortune 1000 companies suffered a loss of over 25% of shareholder value within one month Doesn’t’ mean Hazard Risk isn’t important. It’s being handled.

6. What is ERM?

7. What is Enterprise Risk Management? Corporate Governance? “Never in all history have we harnessed such formidable technology. Every scientific advancement known to man has been incorporated into its design. The operational controls are sound and foolproof.” Crisis Management? Integrating Hazard and Financial Risks into a Single Contract? Establishing a Chief Risk Officer? E.J. Smith Captain, H.M.S. Titanic

8. What is Enterprise Risk Management? - EIU Survey “ERM assesses and manages all risks while looking for upsides in identifying risks.” “The goal of Enterprise Risk Management is to understand all of the risks on a quantitative and intuitive level and to manage them through a central risk area - to take advantage of the synergies of managing risk in one area.” “Enterprise Risk Management is about information and capital management.” “Good risk management is reflected in share price indirectly, but the market is not giving a premium for ERM yet, it’s still too new.” “The ultimate goal of Enterprise Risk Management is preservation of shareholder value.” “Managing risk enterprise wide means two things: bringing all the pieces of the enterprise together to add the exposures, and using the whole enterprise to manage risk - making sure at the corporate level that all the different oversight departments are working together.” “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.” Selected views of ERM by Senior Management: EIU survey of Senior Managers conducted in conjunction with MMC Enterprise Risk

9. So What is ERM All About?

10. ...But most of all, it’s about VALUE ERM Is About all These Things...

11. 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. How Does Risk Manifest Itself? Fortune 1000 Group Analysis 10% of the Fortune 1000 companies suffered a loss of over 25% of shareholder value within one month

12. Enterprise Risk Management - Why? - What? - How?

13. ERM Is Real But Why is It Timely? Current Silo-Approach Flawed Cross-company Risk Identification Integrated Risk Modeling Chief Risk Officers Emerging Need for Enterprise Risk Management New and Larger Risks Higher Market Value to Book Value ratios due to Intangible Assets New risks: demand shortfalls, competitive pressures, etc. New Risk Products Integrated Risk “Books” Growing Exponentially Insurance/Financial Convergence Increased Management Accountability New Regulations: Corporate Governance Shareholder Expectations for Transparency/ Management Process

14. MMC’s View of Enterprise Risk Management 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. Emerging Best Principles: 1. Risk management is a systematic, critical-risk focused activity 2. Risk is quantified to make informed business decisions 3. Risk management is an integral part of strategic planning and budgeting 4. Pricing, capital allocation, performance measures consider potential risk as well as returns 5. Risk is not automatically avoided, but weighed against opportunity to optimize risk versus return 6. Risk mitigation/financing focuses on events and volatilities that could compromise financial and strategic objectives

15. MMC Enterprise Risk Approach Goal: High-level critical risk assessment Understanding of integrated effects of risks In-depth design and implementation of solutions to mitigate / finance risks In-depth measurement and modelling of critical risks … of risk assessment, strategic planning, capital allocation, and performance measurement processes Corporate Process Solutions Market Solutions Integration Hazard Risk Analysis Financial Risk Analysis Operational Risk Analysis Strategic Risk Analysis Critical Risk Diagnostic Identification Analyses and Quantification Solution Development/Implementation Risk Management Process Redesign ERM Solution Implementation MMC Recommends Starting with an ERM Vision Workshop to focus an ongoing ERM Process Client Organization MMC Enterprise Risk Client Joint Team Approach MMC believes the client should be left wit the ability to independently conduct Enterprise Risk Management at the completion of the project. ERM Vision Setting

16. Organize A Risk Diagnostic Process to Focus on Critical Issues Division B or Geograph 2 Division C or Geography 3 Risk Maps Division A or Geography 1 Top 10 Critical Risks Top 10 Firm-Wide Risks Identifying Broad Risk Issues 1. Risk A 2. Risk B 3. Risk C 4. 5. 100. Risk XYZ 1. Risk A 2. Risk B 3. Risk C 4. 5. 100. Risk XYZ 1. Risk A 2. Risk B 3. Risk C 4. 5. 100. Risk XYZ 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Risk 1 Risk 2 Risk 3 Risk 4 Risk 5 Risk 6 Risk 7 Risk 8 Risk 9 Risk 10 1. 2. 3. 4. 5. 6.. 7. 8. 9. 10. 1. 2. 3. 4. 5. 6.. 7. 8. 9. 10. Revenue Or Net Income Source N A R R O W D O W N T O

17. Risk Solutions Integrated Risk Modeling Catastrophe Modeling Tort/Liability Modeling People Risk Modeling Risk Aggregation Analysis Employment related practices - process/coverage Employee turnover and productivity analysis External labor market assessment, simulations/ projections Customer loyalty and experience management High impact award analysis Structured Funding Structuring and placing funding related products where risk mgmt is an issue Financial Products Transfer of risk to third party Risk Aggregation Repackaging risk for financial products Operational Risk Risk management and mitigation services Securitization Sale/Leaseback arrangements Trade finance Asset Backed transactions Project finance/Emerging Market Finance Offshore/special purpose vehicles Derivatives, swaps, forwards, options (weather, credit, FX, interest rates, commodities) Non-tradable commodities New insurance policies - NetSecure for technology Multi-trigger products Difficult or non-standard risks (e.g., asbestos) Consolidation of placement information Benchmarking studies Risk tranching Indexes for financial products Creation of RMIS Creation of risk banks Intellectual property Supply chain/Just-in-Time Inventory analysis Business continuation planning - single supplier/ plants Crisis Management Fraud System Breakdowns Unauthorized Trading Value Driven Business Designs Brand vulnerability assessment Supply chain strategy analysis/supply source analysis Intellectual property valuation, licensing terms, choice analysis Profit Pattern Analysis People Risk Human capital strategies and tactical plans Strategic/Brand Risk Organization /operational strategies and plans Sample Tactics Risk Measurement & Modeling Purchased Materials Labor Hazard Financial Operations Top 10 Firm -Wide Risks Risk 1 Risk 2 Risk 3 Risk 4 Risk 5 Risk 6 Risk 7 Risk 8 Risk 9 Risk 10 Analyze and Resolve Critical Risk Issues

18. Enterprise Risk Management Modeling

19. From Operations –Impacts on Cash Flows used to fuel business. (e.g. Drain other things - R&D capital investments,...) From Investing From Financing ( e.g., Interest Rates) Cash Flow Balance Sheet Asset –Loss of book value/replacement value of “real” assets used to produce revenues Liabilities –Charges for losses/risk liabilities Shareholder Equity Revenues –Risks affecting volume,and price (e.g., interest rates, FX rates, inflation, recession) Operating Costs Fixed Variable –What is expected charge? –What is volatility around expected? Net Income –Can we better stabilise to enhance EPS projections/shareholder value Income Statement Relating A Risk Integration Model to Financial Performance

20. Consider Alternative Strategies/Programs A. To achieve a better “net” effect than current strategy and same volatility. B. To determine ways to improve “net” effect and reduce resulting volatility. From Operations –Impacts on Cash Flows used to fuel business. (e.g. Drain other things - R&D capital investments) From Investing From Financing –Interest Rates Cash Flow Balance Sheet Asset – Loss of book value/replacement value of “real” assets used to produce revenues Liabilities –Charges for losses/risk liabilities Shareholder Equity Revenues –Risks affecting volume,and price (e.g., interest rates, FX rates, inflation, recession) Operating Costs Fixed Variable –What is expected charge? –What is volatility around expected? Net Income –Can we better stabilise to enhance EPS projections/shareholder value Income Statement Potential Modelling Framework - Considering EPS Impacts Better/enhanced modeling of “expected” variable costs: Can we transfer at an efficient price? Can we mitigate/control/prevent to reduce charge? Better understanding of volatility and “worst case” outcomes considering portfolio effects: Does volatility matter? What is the size? Dynamics given risk Correlations Drastic Balance Sheet Impacts 1. Tornado 3. Mass Torts 4. Accounting Error We can also consider Cash Flow impacts of 1. Variable costs 2. Catastrophic Costs Raw, un-hedged, un-insured exposure Current set of strategies over layered on top of exposures What does this strategy do? What is “net” effect and the residual volatility? Models Can Examine 3 Scenarios

21. DATA PROCESS LEGEND Individual Models (HR) Individual Models (Pension) Individual Models (Hazard) Individual Models (Financial) Consolidation Model Common Factors Model Result Data Result Data Result Data Result Data Model Input Industry/ Company Overrides Policy Strategy Intervention Which risk should I manage the most? Which is the best program? The common factor model stochastically generates: Interest Rates GDP Foreign Exchange Hazard Events Commodity Prices In addition to the stochastic model input, other assumptions and parameters are specified The individual models calculate the results for each stochastic trial in the model input The results from each model are stored in a database. The consolidation tool collects results of individual models to produce an integrated distribution of results Structure of an Integrated Risk Model

22. Some Candidate Models - Random Walk & Mean Reverting

23. RW: lnS t - lnS t-1 = e t MR: lnS t - lnS t-1 =.10 [ln100 - lnS t-1 ] + e t Comparison of Price Paths Random Walk vs. Mean Reverting Process

24. Comparison of End-of-Year Price Distributions Random Walk vs. Mean Reverting Process

25. NameComm 1Comm 2Comm 3Comm 4 Combined Mean =131.81115.2510.72173.39431.17 Std Deviation =10.9410.041.536.0118.60 Coefficient of Variation =0.080.090.140.030.04 1% Perc =109.1393.787.67159.00390.73 5% Perc =114.7099.528.40164.10401.74 95% Perc =150.73132.4713.40183.29462.22 99% Perc =160.66141.0014.86189.58478.31 2000 Distribution of Annual Purchase Cost ($ MM) XYZ Cost Distributions This shows the commodity risk as a single portfolio consisting of 4 commodities taking into account risk reduction due to uncorrelated price movements in the 4 factors. The Budget Value noted is approximately $20million below the expected value of the simulated distribution. Values may deviate from budget due to: - Coverage in place, - Result of consensus price forecasts or budget negotiations. Distribution Of Annual Purchase Costs This table shows the stand-alone cost distributions of 4 commodities. While Commodity 4 has the potential for generating the greatest extreme cost in this group, in terms of variation about expected costs, Commodity 3 is, in one sense, “riskier” than Commodity 4 given its coefficient of variation (s.d./mean) of 14% compared to 3% for Commodity 4. XYZ Distribution of Annual Purchase Cost Combined 2000 0% 5% 10% 15% 20% 25% 360370380390400410420430440450460470480490500510520 Annual Cost ($ MM) Probability 5% Perc 95% Perc Mean Budget Value Cost Distributions - Example

26. Cost Distributions - Extreme Tail Risk

27. Summed Distribution - not a true probability distribution but a hypothetical one obtained by summing the percentiles across all commodities. Summing ignores diversification created by less than perfect correlation between commodities. Consider the impact of silo risk management and the cost of risk mitigation. Option premiums vary directly with the standard deviation of the underlying risk. If options were purchased on each commodity, then each premium would reflect individual commodity standard deviation and the sum of the premiums would reflect the Summed standard deviation of $33 million. Combined Distribution - represents the true risk of the diversified portfolio of commodities. Note the difference in standard deviation of $19 million compared to $33 million for the Summed Distribution. Marginal Distribution - shows the contribution of the diversified portfolio of commodities to the combined portfolio of the company. The commodity portfolio will contribute only $429 million of risk to the client’s combined portfolio at the 95th percentile versus the commodity portfolio’s own risk of $462 million at the same percentile. Deviation Distribution -- shows the distribution of deviations from budget. Examining Portfolio Effects - Combined, Summed and Marginal Cost Distributions

28. Diversification / covariance effect captured through integration of financial risks Reduces capital required to manage volatility Volatility Around Annual Expected Cost

29. Financing Risks Via Silo Management Over insurance/hedging of non-correlated and negatively correlated risks Under insurance/hedging of positively correlated risks Higher than understood exposure to event risk Missed opportunities to place risks in different markets Often leads to a sub-optimal enterprise result: Risk N 3 2 1... DECISION RETAIN PREMIUM + Enterprise Total Risk Retained Risk “unknown” Premium “unknown”

30. Silo Risk Management as a Portfolio of Interrelated Decisions Risk N 3 2 1... Enterprise Total Risk DECISION RETAIN PREMIUM + Retained Risk “known” Premium “known” Some risks should stay in silos Some risks should be split out from silos in which they currently reside Some risks should be combined in larger portfolios And, “Overlay” decisions may be necessary to produce the desired result.

31. Enterprise Risk Financing - Many Possibilities Fusing Risk Together Creating Risk Aggregation Centers Transforming Financial Risk to Insurance Risk Via A SPV Creating Multiple Triggers to Access Contingent Capital

32. Case Studies

33. Ratemaking? More of an account pricing issue than a technical insurance ratemaking issue. RISKOf the 18 considerations listed in the CAS SOP Regarding Property & Casualty Ratemaking, ERM really directly impacts only 1 - RISK ERM influences buyer behavior.

34. “Risk” per the Actuarial Statement of Principles Random variation from expected cost. –Reflected in cost of capital assumption. –Influences the underwriting profit provision. Systematic variation of estimated costs from expected costs. –Reflected in the contingency provision.

35. Risk from the CFO’s Perspective

36. General Risk Categories Hazard/Legal Risks Financial Risks Operational Risks Strategic Risks

37. Case Study - Imaginary Motors Based on composite and rescaled individual “Big 3” data, industry information, recent press releases and some pure “guestimates” Quantify risks individually and aggregate Measure “untreated” earnings impact Determine theoretical risk capital for selected level of earnings “protection”

38. Imaginary Motors -Assumptions Market Cap = $42.8 Billion Net Income = $5.45 Billion (ttm) EPS = $4.72 (ttm); Share Price = $38.12 Effective Tax Rate = 35% Protect against the “1 in 100 year event” Exposures can be transferred at pretax nominal cost (expenses offset PV factor)

39. Imaginary Motors Risks - I Hazard/Legal Risks –Property –Business Interruption –Cargo/Marine –Workers’ Compensation –Automobile Liability –General Liability –Product Liability –Employment Practices –Crime –Boiler & Machinery –Directors & Officers –Intellectual Property –Product Recall –Foreign Liability –E&O/Professional Liability

40. Imaginary Motors Risks - II Financial Risks –Credit –Residual Value –ERISA/Fiduciary –Foreign Exchange –Commodity Prices –Energy Prices –Interest Rates Operational Risks –Warranty –Product Recall –Contingent Business Interruption –Political –Intellectual Property –E-Commerce –Strike/Labor Relations

41. Imaginary Motors Risks - III Strategic Risks –Model Selection –Geographic Expansion –Brand Image –Product Pricing –R&D Investments –Acquisitions & Divestitures

42. Case Study - Hazard Risk

44. Case Study - Financial Risk

46. Case Study - Operational Risk

48. Case Study - Strategic Risk

50. Case Study - Composite Risk

52. Imaginary Motors - Implications To protect against earnings volatility at the “1 in 100 year” level on a pretax basis: –finance $11.2 B if risks treated individually; –finance $3.6 B if risks treated as a portfolio. Risk finance cost difference of $76 Million. –$0.04 in after-tax EPS. –Almost $400 M in market capitalization at current P/E multiple.

53. Imaginary Motors - Caveats Not all risks to Net Income are included. –WC, cargo, etc. due to lack of data; –general economic risks - interest rates, etc. “Portfolio Effect” potentially overstated –not all correlations reflected (warranty, recall and product liability, for example); –companies may look at some risks in portfolios (integrated insurance programs, combined aggregate excess programs, etc.).

54. The Benefits of ERM

55. Enterprise Risk Management Helps Organizations Quantification of risks on an integrated basis –Examines integrated effects, especially across operating and decision silos –Considers risks encountered by peers and by other industries Identification and prioritization of top critical risks –Better manages investments and capital structures –Focuses on business management, not crisis management Better Risk Information and Understanding Better Risk Management Improved risk management framework –Controls existing risks –Helps identify and manage changing risk profiles Better allocation of resources –Focuses risk management resources on the right risks Improved decision making –Improves cross-functional communication regarding risk –Considers risks in capital budgeting and strategic planning process more effectively –Allows cost/benefit analysis of alternative risk financing and mitigation strategies Improved Financial Performance Better avoidance and mitigation of threats to value Reduction of total volatility of cash flow and earnings –Ensures sufficient internal funds for strategic investments –Reduces likelihood of financial distress and thus the cost of financing –Minimizes surprises for shareholders and stakeholders Enhanced stakeholder confidence –Improves understanding of risks

56. Ten Major Take-Aways 1Be a catalyst. Challenge your management teams to think about risk issues impacting the organization. 2Wall Street is unforgiving when your firm misses its earnings - Be prepared by knowing how to respond to risks when and if they occur. 3Help your firm’s management consider and establish their risk tolerance for organization. 4The goal is to avoid a future catastrophic cash outflow by balancing short term cash investments in risk mitigation & financing. 5Be careful not to shy away from risks that cannot be quantified. They are still risks!

57. Ten Major Take-Aways 6Be leery of a “magic black box”. Determining total risk correlations may not be possible. 7ERM responses may well be (need to be) organizational and strategic responses. 8Don’t look to do this alone. Use other parts of your organization. 9As Plato said, “The first and best victory is to conquer self” –If you understand your company better, you have a better state of readiness 10 ERM should exercise senior managements’ minds and make them more agile in responding to risk surprises!