2001 Casualty Loss Reserve Seminar 2001 Casualty Loss Reserve Seminar Fairmont HotelFairmont Hotel

New Orleans, LaNew Orleans, LaSeptember 9-11, 2001September 9-11, 2001

Robert F. Wolf FCAS, MAAARobert F. Wolf FCAS, MAAAPrincipalPrincipal

William M. Mercer/MMC Enterprise Risk ConsultingWilliam M. Mercer/MMC Enterprise Risk Consulting

The Evolving Role in The Evolving Role in Enterprise Risk Enterprise Risk

ManagementManagement

AgendaAgenda

IntroductionIntroduction ERM/Actuarial ERM/Actuarial

EvolutionEvolution– Trends - What’s Going Trends - What’s Going

On?On? ERM PlatformsERM Platforms

– Non-Insurance CompanyNon-Insurance Company– Insurance CompanyInsurance Company

Wrap-upWrap-up Q&AQ&A

Copies of Presentations Available at www.casact.org

What is ERM?What is ERM? To me, Enterprise Risk Management is a process for To me, Enterprise Risk Management is a process for

identifying and prioritizing critical risks facing an organization, identifying and prioritizing critical risks facing an organization, quantifying their impact on financial and strategic objectives, quantifying their impact on financial and strategic objectives, and implementing financial and organizational solutions to and implementing financial and organizational solutions to address them.address them.

To others, it varies but the essence is the sameTo others, it varies but the essence is the same– ““ERM assesses and manages all risks while looking for upsides in ERM assesses and manages all risks while looking for upsides in

identifying risks.”identifying risks.”– ““Enterprise Risk Management is about information and capital Enterprise Risk Management is about information and capital

management.”management.”– ““The ultimate goal of Enterprise Risk Management is preservation The ultimate goal of Enterprise Risk Management is preservation

of shareholder value.”of shareholder value.”– ““The job of Enterprise Risk Management is figuring out where the 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 edge of the cliff is, and making sure the risk takers know where it is.”is.”

No Consensus on Best Risk No Consensus on Best Risk MeasureMeasure

800,000

900,000

1,000,000

1,100,000

1,200,000

1,300,000

1,400,000

1,500,000

0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% 100.0%

Percentile

Reserv

e A

mo

un

t

Nominal

PV

Reserve

Reserve+Capital

A =Variance Principal=

Squared Dev from Mean

B= VaR (Pr Ruin)

Principle

EPD Principal

DTVaR Principal=

C+D

A

B

C

Evolution of Risk Evolution of Risk ManagementManagement

As the quantification/approach to As the quantification/approach to measuring/handling risk evolves, so too measuring/handling risk evolves, so too does our job description.does our job description.

Risk ManagerRisk Manager– From Insurance Buyer to From Insurance Buyer to

Integrated/Consolidated Risk StrategyIntegrated/Consolidated Risk Strategy ActuaryActuary

– Traditional: Evaluate Hazard/Financial RiskTraditional: Evaluate Hazard/Financial Risk– Evolution: DFA (Insurance Companies)/ ERMEvolution: DFA (Insurance Companies)/ ERM

Why the Evolution of ERMWhy the Evolution of ERM New/Larger RiskNew/Larger Risk

– E-Commerce, Market/Book ValuesE-Commerce, Market/Book Values New Risk ProductsNew Risk Products

– Merger of Insurance and Financial InstitutionsMerger of Insurance and Financial Institutions Realization that Silo-Based Approaches are Realization that Silo-Based Approaches are

FlawedFlawed– Ignores inherent hedges and correlationIgnores inherent hedges and correlation

Increased Management AccountabilityIncreased Management Accountability– New Regulations requiring corporate New Regulations requiring corporate

governancegovernance

Why the Evolution of ERMWhy the Evolution of ERM

In short, because Society In short, because Society Demands itDemands it

Computer and Information AgeComputer and Information Age– We couldn’t do what we are doing We couldn’t do what we are doing

today if we needed to use slide-rules today if we needed to use slide-rules or abacus.or abacus.

Focus Optimize Shareholder Focus Optimize Shareholder ValueValue

Economist Intelligence Unit ERM Economist Intelligence Unit ERM StudyStudy

Use of financial metrics% of respondents

0% 10% 20% 30% 40% 50% 60% 70%

Cashflow volatility

Internal performance benchmarks

Expected claims exposure/costs

Industry benchmarks

Notional exposure amounts

Value at risk

Earnings at risk

EVA

RAROC

Companies using ERM Companies not using ERM

Do you believe that implementing ERM has the potential to improve your company's P/E ratio or

decrease your cost of capital?% responding, public companies

YES88%

NO12%

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

More About Risk ManagementMore About Risk Management

Evolving Risk ManagerEvolving Risk Manager Evolving Risk Management PositionsEvolving Risk Management Positions

– Chief Risk Officer, ERM Councils, Global Chief Risk Officer, ERM Councils, Global Director of Risk ManagementDirector of Risk Management

Rise of, and Partnership with, Internal AuditRise of, and Partnership with, Internal Audit– Corporate governance issues and perspectivesCorporate governance issues and perspectives

Rise of, and Partnership with, TreasuryRise of, and Partnership with, Treasury– Financial Management perspectives and Financial Management perspectives and

insightsinsights Rise of Board Audit CommitteesRise of Board Audit Committees Evolving Skill Base for Risk ManagersEvolving Skill Base for Risk Managers

Why the Evolution of ERMWhy the Evolution of ERM

In short, because Society In short, because Society Demands itDemands it

Computer and Information AgeComputer and Information Age– We couldn’t do what we are doing We couldn’t do what we are doing

today if we needed to use slide-rules today if we needed to use slide-rules or abacus.or abacus.

Focus Optimize Shareholder Focus Optimize Shareholder ValueValue

Actuarial EvolutionActuarial Evolution ERM Evolution Actuarial EvolutionERM Evolution Actuarial Evolution Traditional RolesTraditional Roles

– Evaluating Hazard/Financial Risk in a siloEvaluating Hazard/Financial Risk in a silo– Insurance CompanyInsurance Company

Determine what to charge in order to meet profits targets Determine what to charge in order to meet profits targets (Ratemaking)(Ratemaking)

What to set aside to meet future obligations of past events What to set aside to meet future obligations of past events (Reserving)(Reserving)

– Insurance CustomersInsurance Customers What to budget in order to pay for self-insured obligations What to budget in order to pay for self-insured obligations

and premiumsand premiums What to set aside to meet future obligations of retained riskWhat to set aside to meet future obligations of retained risk

Actuarial EvolutionActuarial Evolution

Continuing Actuarial EvolutionContinuing Actuarial Evolution Evolving Demands for Risk IntegrationEvolving Demands for Risk Integration

– Insurance CompanyInsurance Company Holistic Evaluation of Assets and Liabilities (Dynamic Holistic Evaluation of Assets and Liabilities (Dynamic

Financial Analysis (DFA))Financial Analysis (DFA))– Optimum Capital StructureOptimum Capital Structure– Realization of Business PlanRealization of Business Plan

– Insurance CustomersInsurance Customers Optimum Risk FinancingOptimum Risk Financing

– What risks to retain/insure - captives, retros, large deductiblesWhat risks to retain/insure - captives, retros, large deductibles– ..but still only Hazard and Financial Risk..but still only Hazard and Financial Risk

Optimum Integrated Hazard Optimum Integrated Hazard Risk FinancingRisk 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

ToolsLoss Forecasting/Reserving Models

Dynamic Financial ModelingDiscounted Cash-Flow Models

Risk/Cost Matrix

Recommendations

Optimum RetentionsOptimum Funding Mechanisms

Exogenous Contingent Events

Economic ScenariosInterest Rates

etc.

Goal is to optimize

shareholder value

Actuarial EvolutionActuarial Evolution

ERM Evolution Actuarial ERM Evolution Actuarial EvolutionEvolution– All sectors of Corporate AmericaAll sectors of Corporate America– Not merely Insurance Companies and Not merely Insurance Companies and

their Customerstheir Customers– Includes Strategic and Operational Includes Strategic and Operational

Risks as well as Hazard and financial Risks as well as Hazard and financial risksrisks

Case StudyCase Study

Non-Insurance CorporationNon-Insurance Corporation

(See Presentation By Barry (See Presentation By Barry Franklin)Franklin)

Case Study FrameworkCase Study Framework

ERM Insurance CompanyERM Insurance Company

P&C Goals - Not Just P&C Goals - Not Just SurvivalSurvival

Three ConsiderationsThree Considerations – Survival : How risky can you beSurvival : How risky can you be

Prob {Cost of Runoff and New Business Costs > UEPR, Prob {Cost of Runoff and New Business Costs > UEPR, Loss Reserves, Future Premiums, and Investment Loss Reserves, Future Premiums, and Investment Income, Capital} < aIncome, Capital} < a

– StabilityStability Probability [(Loss Ratio + Expense Ratio) > Target Probability [(Loss Ratio + Expense Ratio) > Target

Combined ratio]<aCombined ratio]<a

– Optimizing EnterpriseOptimizing Enterprise CEOs and CFOs care more about stability CEOs and CFOs care more about stability

v. survival.v. survival.

ERM Insurance CompanyERM Insurance Company

2.0 Billion of 2.0 Billion of PremiumsPremiums

$700 Million Surplus$700 Million Surplus Mulli-line Company - Mulli-line Company -

Primarily Personal Primarily Personal LinesLines

5 Regions5 Regions The Company The Company

Manages its silos Manages its silos wellwell

50% Premium 50% Premium Volume is rate Volume is rate sticky statessticky states

Asset Allocation:Asset Allocation:– 80% Bonds80% Bonds– 10% Equities10% Equities– 10% st-investments10% st-investments

25% growth rate in 25% growth rate in recent yearsrecent years

Historical Reserve MarginsHistorical Reserve Margins

Historical Loss Ratios

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

1990 1992 1994 1996 1998 2000 2002

Years

Rat

ios

Calendar Year Lossratios

Accident Year Lossratios

Reserve margin %

Less Pressure on Rate Adequacy to Achieve Corporate Goals

Goal : Develop ERM Goal : Develop ERM Framework Addressing Framework Addressing

(Macro):(Macro): How much capital is

Enough?– Supporting Future

Growth – Excess Capital

Should we give back to Shareholders?

What if a beneficial acquisition arises?

Should we increase our Shareholder dividend?

– Is debt financing appropriate?

Is our investment strategy providing a good risk/reward

How efficient is our reinsurance Structure?

– Cost/Benefit– Catastrophe

Should we be self insuring/insuring our operations risks?

Goal : Develop ERM Goal : Develop ERM Framework Addressing Framework Addressing

(Micro):(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:

ROEMV/BV

How Much Capital do you How Much Capital do you Need?Need?

K+S K

S

Capital Truly Held includesCapital 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 asto how much capital to hold if >EconomicCapital. Must reflect this timing cost.

ERM ProcessERM ProcessMANAGEMENT& BOARD DECISIONS

ECONOMIC CONDITIONS

COMPETITION &

INDUSTRY

Investment

Strategy

Underwriting

StrategyOperational

Management

Reinsurance

Strategy

Capital Structure

Pro-forma

FinancialsOperating Units

Decisions

Legal Entities

ALM

Competition and ExternalCompetition and External

Price Price Compensation & Compensation & Elasticity of Elasticity of DemandDemand

Jurisditional RiskJurisditional Risk rate stickinessrate stickiness tort lawstort laws residual marketresidual market

Best’s, RBC, etc.Best’s, RBC, etc.

ERM ProcessERM ProcessMANAGEMENT& BOARD DECISIONS

ECONOMICCONDITIONS

COMPETITION &

INDUSTRY

Investment

Strategy

Underwriting

StrategyOperational

Management

Reinsurance

Strategy

Capital Structure

Pro-forma

FinancialsOperating Units

Decisions

Legal Entities

ALM

Management DecisionsManagement Decisions

Business PlansBusiness Plans– 1 Year1 Year– 5 Year5 Year

Board DirectivesBoard Directives– Asset and Asset and

Investment Investment GuidelinesGuidelines

Corporate CultureCorporate Culture– Incentive Incentive

CompensationCompensation

ERM ProcessERM ProcessMANAGEMENT& BOARD DECISIONS

ECONOMICCONDITIONS

COMPETITION &

INDUSTRY

Investment

Strategy

Underwriting

StrategyOperational

Management

Reinsurance

Strategy

Capital Structure

Pro-forma

FinancialsOperating Units

Decisions

Legal Entities

ALM

Economic ConditionsEconomic Conditions

InflationInflation Interest RatesInterest Rates Currency ExchangeCurrency Exchange Equity PerformanceEquity Performance Economic ConditionsEconomic Conditions

– RecessionsRecessions Combo of stochastic Combo of stochastic

and scenario and scenario considerationsconsiderations

ERM ProcessERM ProcessMANAGEMENT& BOARD DECISIONS

ECONOMICCONDITIONS

COMPETITION &

INDUSTRY

Investment

Strategy

Underwriting

StrategyOperational

Management

Reinsurance

Strategy

Capital Structure

Pro-forma

FinancialsOperating Units

Decisions

Legal Entities

ALM

DFA ApproachDFA Approach Holistic ViewHolistic View

– Reinsurance StrategyReinsurance Strategy– Investment StrategyInvestment Strategy– Underwriting Strategy Underwriting Strategy

(Macro)(Macro)– OperationalOperational

CorrelationCorrelation– Forward LookingForward Looking– 5 Year Planning Horizon5 Year Planning Horizon

DFA PlatformDFA Platform– CFs, Income CFs, Income

statements, ROEs, statements, ROEs, Balance SheetsBalance Sheets

ERM ProcessERM ProcessMANAGEMENT& BOARD DECISIONS

ECONOMICCONDITIONS

COMPETITION &

INDUSTRY

Investment

Strategy

Underwriting

StrategyOperational

Management

Reinsurance

Strategy

Capital Structure

Pro-forma

FinancialsOperating Units

Decisions

Legal Entities

ALM

Reinsurance StrategyReinsurance Strategy

ERM ProcessERM ProcessMANAGEMENT& BOARD DECISIONS

ECONOMICCONDITIONS

COMPETITION &

INDUSTRY

Investment

Strategy

Underwriting

StrategyOperational

Management

Reinsurance

Strategy

Capital Structure

Pro-forma

FinancialsOperating Units

Decisions

Legal Entities

ALM

Reinsurance -EliminatingReinsurance -EliminatingInefficient OptionsInefficient Options

Any product above or to the rightof the efficient frontierefficient frontier providesless benefit than points on orbelow the efficient frontierefficient frontier.Inefficient options can be quicklyrecognized.By establishing an efficientefficientfrontierfrontier of options, one candiscover and create new or hybridsolutions that provide greaterbenefit

Gre

ater

) --

-Ben

efit

---(

Less

)

(Less) ---Cost---(Greater)

BareBare CurrentCurrent Option AOption A Option BOption B

EfficientEfficientFrontierFrontier

Considerations - Credit Risk

Investment StrategyInvestment Strategy

ERM ProcessERM ProcessMANAGEMENT& BOARD DECISIONS

ECONOMICCONDITIONS

COMPETITION &

INDUSTRY

Investment

Strategy

Underwriting

StrategyOperational

Management

Reinsurance

Strategy

Capital Structure

Pro-forma

FinancialsOperating Units

Decisions

Legal Entities

ALM

APPROACH TO ASSET/LIABILITYAPPROACH TO ASSET/LIABILITYRISK MANAGEMENTRISK MANAGEMENT

The “efficient frontier” is the set of possible strategies thatThe “efficient frontier” is the set of possible strategies thateither maximizes reward for a given level of risk or minimizeseither maximizes reward for a given level of risk or minimizesrisk for a given level of rewardrisk for a given level of reward

RiskR

ewar

d

Efficient Frontier

High

High

Low

Low

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……….CAS VFIC Research………. Optimal Investment Strategy Does Not Imply Duration Optimal Investment Strategy Does Not Imply Duration

MatchingMatching– Analysis of Duration is only one part of the processAnalysis of Duration is only one part of the process

An upward sloping yield curve along with short duration An upward sloping yield curve along with short duration loss reserves often imply that asset durations in excess loss reserves often imply that asset durations in excess of liability durations may increase net investment of liability durations may increase net investment income and lower the probability of insolvencyincome and lower the probability of insolvency

Operational RisksOperational Risks

ERM ProcessERM ProcessMANAGEMENT& BOARD DECISIONS

ECONOMICCONDITIONS

COMPETITION &

INDUSTRY

Investment

Strategy

Underwriting

StrategyOperational

Management

Reinsurance

Strategy

Capital Structure

Pro-forma

FinancialsOperating Units

Decisions

Legal Entities

ALM

Off-Balance Sheet RisksOff-Balance Sheet Risks

Employee MedicalEmployee MedicalPlansPlans

Self-insured WorkersSelf-insured WorkersCompensationCompensation

Credit RiskCredit Risk–– Asset PortfolioAsset Portfolio

–– ReinsuranceReinsurance

D&OD&O

E&OE&O

EPLEPL

BrandingBranding

Employee/OfficerEmployee/OfficerStock OptionsStock Options

IncentiveIncentiveCompensationCompensation

Handled Similarly to Barry’s Approach to Corporate Client

Also Includes Seasoning of Business - Renewals Get Better

Capital Financing StrategyCapital Financing Strategy

ERM ProcessERM ProcessMANAGEMENT& BOARD DECISIONS

ECONOMICCONDITIONS

COMPETITION &

INDUSTRY

Investment

Strategy

Underwriting

StrategyOperational

Management

Reinsurance

Strategy

Capital Structure

Pro-forma

FinancialsOperating Units

Decisions

Legal Entities

ALM

Capital ManagementCapital Management– Macro- Is suffucient Macro- Is suffucient

Capital Available?Capital Available?– Micro - Decision Micro - Decision

making Tool making Tool What marginal capital What marginal capital

and marginal returns and marginal returns can be realized at a can be realized at a product/target product/target market/region/state market/region/state basis?basis?

– Where to Where to Grow/Contract?Grow/Contract?

Market Value Balance SheetMarket Value Balance SheetDefinitions

Assets

Liabilities

Capital

Let K = Policyholder Supplied Funds (PHSF)Let S = Shareholder Supplied Funds (SHSF)

K

S

K+SReturnsRA = Return on Investments Using both policyholders and shareholder supplied $sRL = Cost of Debt (Borrowing PHSF)RC = Cost of Capital (Using SHSF) Returns RA

on K+S funds

S Costs

at rate of RC K Costs at a rate ofRL

Balanced Levered Trust

(K+S)RA = KRL + SRC

SHSF Supply

S (RC-RA) = K(RA-RL)

PHSF Demand RL is the reserve discount rate,

RL = RA - (S/K)(RC- RA)RU = - K RL/Premium

Insurance Company Earns Positive Economic Returns on Underwriting if RA > RL (Ru> - (K/Premium) RA )

RC = (1 + K/S)RA + (Prem/S)RU

Financial Markets

Product Markets

Maximizing Shareholder Value Depends Maximizing Shareholder Value Depends on Three Things……..on Three Things……..

Market Value of Firm = S(ROE)/(1+RC)+ S(ROE)(1+G)/(1+RC)2 + S(ROE)(1+G)2/(1+RC)3 +……..

= S(ROE)/(Rc-G)

Book Value of Firm = S

Market/Book Ratio = ROE/(Rc-G)

•Earnings (ROE)•Cost of Capital•Long-Term Growth

S = Statutory SurplusG= Long-Term GrowthRc = Discount Rate@ Cost of Capital

Allocation of CapitalAllocation of Capital Macro - How Much is Enough? How Much to Give Macro - How Much is Enough? How Much to Give

Back to ShareholdersBack to Shareholders Micro- Micro-

– What marginal capital and marginal returns can be What marginal capital and marginal returns can be realized at a product/target market/region/state basis?realized at a product/target market/region/state basis?

– Where to Grow/ContractWhere to Grow/Contract

– Choose target markets such that greatest return on Choose target markets such that greatest return on marginal capital until each yield the same returnmarginal capital until each yield the same return

– Allocate capital in proportion to marginal capitalAllocate capital in proportion to marginal capital– See Glen Meyers “Cost of Financing Insurance” and “An See Glen Meyers “Cost of Financing Insurance” and “An

Introduction to the Competitive Market Equilibrium Risk Introduction to the Competitive Market Equilibrium Risk Load Formula”Load Formula”

In Meyer’s…………..In Meyer’s…………..Let P = Return and C = Capital. Then the Let P = Return and C = Capital. Then the

insurer is better off by adding a line/policy if:insurer is better off by adding a line/policy if:

P P P

C C C

P C C P C P P C

P P

C C

Marginal return on new business > return on existing business.

Overall Benefits- ERM Overall Benefits- ERM ProcessProcess

Optimum Capital StructureOptimum Capital Structure What Operating Division is What Operating Division is

Enhancing/Destroying Enterprise ValueEnhancing/Destroying Enterprise Value Realization Of Business Plans EnhancedRealization Of Business Plans Enhanced

– Micro Decision Making and Targets Micro Decision Making and Targets Consistent with Macro Decision MakingConsistent with Macro Decision Making

Dynamic Reforecasting of Business Dynamic Reforecasting of Business Plans and Incentive Plans - 5 YearsPlans and Incentive Plans - 5 Years

Wrap-upWrap-up

24

12

76

4

21 1 1

11

7 76

32

10 0

0

5

10

15

20

25

Cost Overruns

Accounting irregularities

Manage-ment

ineffective-nessSupply Chain

Issues

Competitive Pressure

M&A Integration Problems

Mis-aligned

ProductsCustomer Pricing Pressure

Loss of Key

CustomerSupplier Problems

R&D Delays

Customer Demand Shortfall

% of top 100

Regulatory Problems

Strategic Operational Financial Hazard

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 1998Note: 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 Analysis10% of the Fortune 1000 companies suffered a loss of over 25% of shareholder value within one month

How Does Risk Manifest How Does Risk Manifest Itself?Itself?

Two Ways to Interpret Two Ways to Interpret GraphGraph

Hazard and Financial Risk is Not Hazard and Financial Risk is Not ImportantImportant

Hazard and Financial Risk has been and Hazard and Financial Risk has been and continues to be managed wellcontinues to be managed well– Testimonial for risk managers, actuaries, Testimonial for risk managers, actuaries,

brokers, and financial analysts.brokers, and financial analysts.– We need to continue the processWe need to continue the process

……The opportunity now is to work on The opportunity now is to work on the left side of the graph.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&AQ&A