A Case Study: ERM Implementation

at Erie Insurance

Gene Connell, Senior Vice President – ActuarialErie Insurance Group

Casualty Actuarial Society Spring Meeting – June 2007

Chief Actuary’s perspective on ERM

• Background: Who is Erie Insurance?– Regional

• Independent Agents

– Reciprocal• 3.8 million policies• $3.8 billion net written premium• $4.3 billion in surplus• $10.0 billion in invested assets

– 22nd largest P/C insurer in US

ERM is a hot topic

• MS Office– Doesn’t recognize ERM– Does recognize “hooey”

• Google: – “ERM” has 10,700,000 hits– “Hooey” has 483,000 hits

ERM is not well defined

• General Counsel – compliance

• Internal Audit – controls

• Actuaries – DFA

• Risk Managers – path to becoming king of the world

ERM Goal: Increase the Mean and Reduce the Standard Deviation

Corporate Earnings

ERM Goal: Increase the Mean and Reduce the Standard Deviation

Ret

urn

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

11.00%

3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00% 11.00% 12.00% 13.00%

Ave

rage

Ret

urn

Risk Level

Efficient Frontier Analysis

ERM Identifies/Measures Risk Events

Corporate Earnings

Adver

se L

oss

Devel

opm

ent

Lack

lust

er N

ew B

usin

ess

Inte

rest

Rat

e Hike

s

Agenc

y Def

ectio

n

Maj

or C

atas

troph

e

Frau

d/Sca

ndal

ERM Identifies Strategies to Control Risk

Adver

se L

oss

Devel

opm

ent

Lack

lust

er N

ew B

usin

ess

Inte

rest

Rat

e Hike

s

Agenc

y Def

ectio

n

Maj

or C

atas

troph

e

Frau

d/Sca

ndal

Absorb, reinsurance

Rate reduction, technology

Hedge, reallocate

Compensation, technology

Reinsurance, reduce exposure

Audit

Corporate Earnings

ERM Optimizes Risk Management

Adver

se L

oss

Devel

opm

ent

Lack

lust

er N

ew B

usin

ess

Inte

rest

Rat

e Hike

s

Agenc

y Def

ectio

n

Maj

or C

atas

troph

e

Frau

d/Sca

ndal

Absorb, reinsurance

Rate reduction, technology

Hedge, reallocate

Compensation, technology

Reinsurance, reduce exposure

Audit

Corporate Earnings

Brief History of ERM at ERIE

• I was asked by CEO to “do ERM”– Board inquiries– Magazines and consultants: “hot topic”

• Created a “risk universe”• Did high level risk inventory

– Senior management and Board involved• Easy part

ERIE Risk Universe

Strategic

Governance

Investment

Financial

Technology

Relationships

Measurement

Product Development

Pricing

Catastrophe

Litigation

Communications

Competitor

Customer Wants

Political

Innovation

Infrastructure

Info Relevance

Info Integrity

Info Access

Product Distribution

Partnering

Outsourcing

Customer ServiceHuman Resource

Change Readiness

Knowledge Capital

Alignment

Leadership

Legal

Regulatory

ComplianceFiduciary

Contractual Obligations

Corporate Governance

Conflicts of Interest

Privacy

Industry

Budget/Planning

Financial Markets

Capital Adequacy/Availability

Credit

Liquidity

Reporting

Taxation

Accounting Info

Employee/Third Party Fraud

Illegal Acts

Performance Gap

Customer Satisfaction

Regulatory

Policy/Procedure

Internal Controls

Management Fraud

Business Interruption

Terrorism

Regulatory Reporting

Version 3: April 7, 2007

Insurance

Operations

Comparison of Top Ten ListsManagement

– Technology Innovation– Infrastructure– Change Readiness– Product Distribution– Performance Gap– Product Development– Measurement– Partnering– Competitor– Budget & Planning

Board– Catastrophic Loss– Technology Innovation– Infrastructure– Change Readiness– Business Interruption– Competitor– Leadership– Pricing– Performance Gap– Product Distribution

Organizing for ERM at ERIE

• Have CEO, Board support • ERM Steering Committee

– Executives: COO, CFO, and General Counsel– Internal auditor and Chief IT officer

• ERM Working Group– Representatives from investments,

underwriting, risk management, accounting, actuarial, planning, internal audit, IT

• Consultant to help keep things moving

ERM Governance StructureBoard ofDirectors

Board ofDirectors

ExecutiveMgt. Team

ExecutiveMgt. Team

ERMSteering

Committee

ERMSteering

Committee

DivisionalERM Reps.

DivisionalERM Reps.

ERMWorkingGroup

ERMWorkingGroup

SeniorMgt. Team

SeniorMgt. Team

ERM Facilitation & Support ERM Responsibility

ERM Working Group Deliverables

• Governance Structure• Policy Statement• Framework• Education, Tools and Metrics• Periodic Reporting

– Board Audit and Strategy Committees– Ad hoc depending on Board’s concerns over

risk areas or ERM Committee’s need for direction

Actuarial’s role in ERM at ERIE

• Chair the ERM Steering Committee• Pricing uncertainty (range of indications)• Loss reserve uncertainty (range of estimates)• Dynamic Financial Analysis• Reinsurance Evaluation and Decision Support• Economic capital concepts• ERM process and reports

Dynamic Financial Analysis (DFA)

Historical and Projected Ranges of Combined Ratios

70%

80%

90%

100%

110%

120%

130%

140%

150%

Historical 2002 2003 2004 2005 2006 2007 2008

Reinsurance Alternatives

55%

65%

75%

85%

95%

105%

Direct (Noreinsurance)

Layer A Layer B Layer C

Ne

t L

os

s R

ati

o

1 in 10 Chance of Exceeding 1 in 100 Chance of Exceeding1 in 500 Chance of Exceeding 1 in 50 Chance of Exceeding1 in 1000 Chance of Exceeding

Capital Adequacy of P/C Operations

2006

Q4

2007

Q1

2007

Q2

2007

Q3

2007

Q4

2008

Q1

2008

Q2

2008

Q3

2008

Q4

2009

Q1

2009

Q2

2009

Q3

2009

Q4

Po

lic

yh

old

er

Su

rplu

s (

in m

illi

on

s)

A+/A++ Benchmark Capital Company Action Level Risk Capital (1-in-400, 3.0 Yr)

Risk capital at 2006Q4 is $X.X billion, given risk tolerance of 0.25% and 3.0 year time horizon. Statutory Capital held is $Y.Y billion. This results in discounted excess capital of $Z.Z million

Pol

icyh

olde

r S

urpl

us in

mill

ions

Capital Adequacy after Terrorism

2006

Q3

2006

Q4

2007

Q1

2007

Q2

2007

Q3

2007

Q4

2008

Q1

2008

Q2

2008

Q3

2008

Q4

2009

Q1

2009

Q2

2009

Q3

Po

lic

yh

old

er

Su

rplu

s (

in m

illi

on

s)

A+/A++ Benchmark Capital Company Action Level Risk Capital (1-in-400, 3.0 Yr)

Risk capital at 2006Q3 is $X.X billion, given risk tolerance of 0.25% and 3.0 year time horizon. Statutory Capital held is $Y.Y billion. This results in discounted excess capital of $Z.Z million

Pol

icyh

olde

r S

urpl

us in

mill

ions

Capital Adequacy w/o Home

2006Q4 2007Q1 2007Q2 2007Q3 2007Q4 2008Q1 2008Q2 2008Q3 2008Q4 2009Q1 2009Q2 2009Q3 2009Q4

Po

licy

ho

lde

r S

urp

lus

(in

mill

ion

s)

A+/A++ Benchmark Capital Company Action Level Risk Capital (1-in-400, 3.0 Yr)

Risk capital at 2006Q4 is $X.X billion, given risk tolerance of 0.25% and 3.0 year time horizon. Statutory Capital held is $Y.Y billion. This results in discounted excess capital of $Z.Z million

Pol

icyh

olde

r S

urpl

us in

mill

ions

3 Year Time Horizon ending 2009Q4Box Represents Range of 99.5% of DFA Paths - Net FIT

LO

B 1

Non

Ca

t

LO

B 2

Non

cat

LO

B 3

Non

Ca

t

LO

B 4

Non

Ca

t

LO

B 5

Non

Ca

t

LO

B 6

LO

B 7

LO

B 8

Non

Ca

t

Ca

ts N

oR

ein

s

Ca

t N

et R

ein

s

Inve

stm

ent

(no

nad

j)

Oth

er

3 Y

ea

r P

roje

cte

d C

ha

ng

e in

PH

S (

mill

ion

s)

Source of Variation in Policyholder Surplus

3 Y

ear

Pro

ject

ed C

hang

e in

PH

S

ERM Process and Reports

• Huge potential impact on company– Improve decision making by incorporating

financial discipline

• Risk identification and measurement• Response prioritization and measurement• Clearing house of risks and responses

– Reduce redundancy– Sleep at night list for CEO, Board

My Opinion on ERM

• At this time:– ERM is overblown– Expectations are too high– Those of us who have to deliver ERM

find that no one has done it well yet– Easy to spend $$$ and resources– Easy for it to be a bureaucratic drag

My Opinion on ERM

• BIG plus: Getting company to consider the potential downside as well as upside of any initiative– ERM is potential antibiotic for “PowerPoint

disease”

– This alone has enough potential to pay for ERM headaches

Actuaries are well-positioned to be effective ERM officers

• Quantitative skills• Financial knowledge• Understanding of stochastic methods • Familiar with translating business needs into

models

• Actuaries particularly well suited for insurance industry ERM positions

Watch Out For:

• Overlooking the many, critical non-actuarial aspects

• Resource drains– It takes skilled staff; it is not trivial

• Reactions of rest of company– Another bureaucratic headache– Silos unwilling to give up their autonomy

• Unrealistic expectations

ERM is Today’s Reality

• ERM is a wave sweeping through the industry

• A big wave – it will not pass on by

• Ride it, don’t fight it