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This presentation focuses on the principles and practicalities of establishing a working risk appetite statement supported by risk limits and tolerances.
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© 2009 Towers Perrin
Risk Appetite Webcast
July 14, 2009
© 2009 Towers Perrin 2Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
Biographies
Linda Chase-Jenkins, Towers PerrinLinda Chase-Jenkins is a Principal of Towers Perrin based in the firm’s New York office. Ms. Chase-Jenkins also co-leads the firm’s global enterprise risk management insurance practice. Her areas of expertise include risk and capital management, strategy development and business planning for a wide range of insurance and financial services companies.
Eric Gesick, PartnerReEric Gesick is the Chief Actuarial Officer for PartnerRe and is based in the firm’s Bermuda office. Mr. Gesick has oversight responsibility for PartnerRe’s actuarial function, including the organization’s reserving process for group coverage. Additionally, he is responsible for PartnerRe’s capital modeling, capital allocation and return measurement.
Joe Lebens, Towers PerrinJoe Lebens is a Principal of Towers Perrin based in the firm’s Hartford office. Mr. Lebens also leads the firm’s enterprise risk management sales team within Towers Perrin’s North America property & casualty insurance practice. His areas of expertise include capital management through the use of dynamic financial modeling.
© 2009 Towers Perrin 3Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
Discussion topics
Current practices and plans
Definitions and best practices
PartnerRe risk appetite
Illustrative case study
Q&A
Current practices and plans
© 2009 Towers Perrin 4
© 2009 Towers Perrin 5Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
16%
37%
47%
Within 12 months, 84% of respondents expect to have a documented risk appetite/tolerance statement
Base: Total Respondents for Q.11
In Place Planned Within 12 Months Not PlannedSmall 34% 44% 22%Medium and Large
57% 33% 10%
No, but planned to be in place within
next 12 months
Yes
No, and no plans to develop within next 12 months
Do you have a documented risk appetite/tolerance statement?
© 2009 Towers Perrin 6Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
Balance sheet solvency is the principal focus of risk appetite/tolerance statements
20%
20%
22%
27%
27%
28%
33%
54%
55%
Base: Those that have a documented risk appetite/tolerance statement n = 168
Regulatory capital
Economic capital
Rating agency capital
GAAP or IFRS earnings volatility
Risk of loss of percentage of GAAP or IFRS equity
Risk of regulatory intervention
Risk of rating agency downgrade
Risk of percentage reduction in GAAP or IFRS earnings vs. forecast
Risk of loss of percentage of embedded value or economic value
Which of the following measures of risk are used in your risk appetite/tolerance statement? Please select all that apply.
© 2009 Towers Perrin 7Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
Nearly 60% of respondents say their statements specifically forbid taking certain risks
41%
13%
21%
35%
44%
Base: Those that have a documented risk appetite/tolerance statement n = 168
Yes — for risks where we do not have sufficient understanding of the risks
Yes — for risks where significant damage to reputation may result
Yes — for risks where we are unable to satisfactorily model the risks
Yes — for another reason
No
Does your risk appetite/tolerance statement specifically forbid thetaking of certain risks? Please select all that apply.
© 2009 Towers Perrin 8Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
The majority of companies have risk limits for their major risks, but only 23% have limits on operational risk
13%
62%
64%
65%
23%
None of the above
Operational risk
Insurance risk
Credit risk
Market risk
Base: Total respondents n = 359
For which of the following types of risk have you set limits to govern day-to-day risk taking within the business? Please select all that apply.
© 2009 Towers Perrin 9Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
Only 40% have demonstrated consistency of their bottom-up risk limits with their risk appetite statements
Base: Those that have a documented risk appetite/tolerance statement and have set limits to govern day-to-day risk taking n = 146
60%
40% Yes
No
54% of North American respondents have demonstrated consistency with their risk appetite/tolerance statement vs. Europe 30% vs. Asia/Pacific 30%
European companies have more comprehensive risk limits
Have you demonstrated/modeled the consistency of yourbottom-up risk limits with your top-down risk appetite/tolerance statement?
Definitions and best practices
© 2009 Towers Perrin 10
© 2009 Towers Perrin 11Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
Risk appetite aims to provide a framework for managing risk in the business
Risk appetite is defined formally by the board to provide guidance/principles to management
Risk appetite does not seek to address the detail of policies, procedures, etc.
Provides a means of communicating the board’s views/expectations on risk
© 2009 Towers Perrin 12Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
Definitions
Risk appetite is…Total risk exposure organization will undertake to achieve its objectivesGenerally expressed in qualitative terms that reflect policyholder and shareholder considerationsSet and endorsed by the board through discussions with management
Corporate risk tolerance is…Amount of risk an organization is willing to accept in aggregate(or occasionally within a specific business unit or risk category)Expressed in quantitative terms that can be monitored
Risk limits are…The more granular tolerance levels expressed for specific products, business lines or risk categories used to monitor the organization’s risk exposure
© 2009 Towers Perrin 13Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
The risk appetite statement provides guidance for a variety of key stakeholders
1. Policyholders, Bondholders…and Regulators, Rating Agencies
Focus on strategies to prevent defaultLittle or no interest in upside from risk takingor nature of risks
2. Shareholders and AnalystsFocus on return on capital above the price of riskDon’t like surprisesInterested in upside from risk taking; want thorough understanding of nature and distribution of risks
3. Management and EmployeesNeed guidance regarding risk limits
© 2009 Towers Perrin 14Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
Risk appetite is not captured by any one measure due to the varied characteristics of underlying risk events
Risk Appetite
Key risk measures
Other risk constraintsRequired
capital
P/h focus
Return on capital
S/h focus
Profit volatility
S/h focus
Risk management processes, policies and procedures
© 2009 Towers Perrin 15Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
Establishing risk appetite and setting risk tolerances are integral to better risk-based decisions
Output from Risk
Appetite Process
ERM Framework
Goals and objectivesRisk AppetiteCorporate Risk Tolerance
Strategy
Board reviews actual overall risk vs. established corporate risk tolerance Business units monitor aggregate risks against defined risk limits
Monitoring and Reporting
GovernanceAccountability: Roles and Responsibilities
Organization
IdentifyQuantifySolveExecute
ProcessTools
© 2009 Towers Perrin 16Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
Summary of risk appetite best practices
Risk appetite articulated explicitly and calibrated to company’s targeted financial performance indicators
Management engages board in discussion about risk appetite (qualitative) and corporate risk tolerances (quantitative)
Risk profiles for business units and enterprise consider stress events to ensure company can withstand unexpected events
Risk limits for individual business activities established like overall risk appetite —quantitative, bottom-up aggregation
Compliance with corporate risk tolerances and risk limits is monitored and reported
July 14, 2009
Risk AppetiteEric Gesick
Chief Actuarial Officer
Risk AppetiteJuly 14, 2009 18
Importance of a Stated Risk Appetite
Clients, shareholders, employees and regulators need to know how much risk you are willing to take, not just how much you actually take
Key to governance: Set of principles and policies that guide behavior for all risks
Limit, accumulation and exposure management
Necessary to determine required capital
Alignment of risk and return objectives
Risk AppetiteJuly 14, 2009 19
Basis of Measurement – Economic Framework
Quantitative aspect focuses on assumed risks
Economic balance sheet drives our thinkingGAAP and regulatory models provide additional constraints when reviewing capitalization
Downside measureImpairment to economic balance sheetNot earnings volatility
Risk attitudes can be described by associating probabilities of loss with tolerance of economic capital loss
Once a maximum risk tolerance is determined, we can translate into a guideline for actions on specific risksDetermine required capital range
Risk AppetiteJuly 14, 2009 20
PartnerRe: Evolution of Stated Risk Appetite
Focus on the three reinsurance “killers” or “shock losses”CatastropheLoss trends/inflation (casualty)Equity market risk
Define the metricCatastrophe = annual aggregate loss, all zones all perilsLoss trends/inflation = prior year casualty loss ratio deteriorationEquity market risk = stock market drop over one year period
Risk AppetiteJuly 14, 2009 21
PartnerRe: Evolution of Stated Risk Appetite
Return goals are easy to state, risk goals are more difficultRisk tolerance is informed by return goalsRisk appetite and return goals need to be aligned
We asked the board the following: How much economic capital are you willing to lose for each shock loss?
Focus on unlikely and remote events for specific risks Unlikely = 1-in-15 year eventRemote = 1-in-75 year eventDifficult to relate to a 1-in-100 or 1-in-250 due to model error and context
Risk AppetiteJuly 14, 2009 22
PartnerRe: Evolution of Stated Risk Appetite
There is no right answerSurvey of Board in role of representatives of shareholder interests
Need a context: scenario testing from prior known events or “what if” scenarios
Repeat of the 1929 – 1933 bear market and equity portfolio sizesHurricane Andrew and various aggregation assumptionsEarly 2000’s prior year casualty development and premium volumes
ConsiderationsPerception and credibility of Company: how would clients/shareholders view a loss from each specific riskAbility to recover and trade through a shock loss
Risk AppetiteJuly 14, 2009 23
PartnerRe Risk Appetite
Where you are within your risk appetite is informed by the expected return outlook
1-in-15 year event 1-in-75 year eventQ1 2009 Q1 2009
Risk Modeled Risk ModeledAppetite Loss Appetite Loss
Catastrophe (incl. ILS) 12% 7% 24% 20%
Casualty 12% 9% 18% 12%
Equity and Equity Like 15% 4% 18% 6%
Stated as a percent of Economic Capital
Risk AppetiteJuly 14, 2009 24
PartnerRe: Extension of Risk Appetite to Risk Limits
Consistent with and derived from risk appetite
Non-modeled metrics that are observable, can be directly measured, and are easily actionable
Aggregation of limitsCasualty premiumMarket value of equities
LimitsShock losses set by boardExecutive and business unit management define more specific limits by risk within underwriting authorities and guidelines
Risk AppetiteJuly 14, 2009 25
PartnerRe Risk LimitsRisk Metric Aggregate Limit % of Total Capital
Max. aggregate exposure in any single zone on any single peril
$1.5 billion 31%
Based on exposure as at March 31, 2009
Risk Dash Board: Current level of Catastrophe exposureLimit $1.5 billion
Actual $1.5 billion
Risk Metric $billions
Earned premium limit for casualty and other long-tail lines for the 4 most recent underwriting periods
$3.8
Actual 4-year aggregate long-tail premiums earned as % of all premiums earned in same period
23%
Limit $3.8 billion
Risk Dashboard: Current level of 4-year aggregate long-tail earned premiumsActual
$2.7 billion
Risk AppetiteJuly 14, 2009 26
Equity Investment Risk Limit
Risk Dashboard: Current level of equity and equity-like exposure
Limit $2.4 billion
Based on exposure as at at March 31, 2009
Actual $0.8 billion
Risk Metric Absolute Limit % Total Capital
Maximum investment in equity and equity-like assets
$2.4 billion 50%
Current investments in equity and equity-like assets
$0.8 billion 17%
Risk AppetiteJuly 14, 2009 27
PartnerRe: Desired Capital Range
Modeled loss for all risks in extreme tail
Additional consideration based on judgment regarding known but non-modeled loss
Scenario testing and “what if’s” to put in context
The Question: How much of your capital are you willing to lose if multiple tail events occur in one year?
Diversification becomes an important element to consider and is a key risk management tool
Risk AppetiteJuly 14, 2009 28
Desired Capital and Capital Management
CapitalAt Risk
1-in-100 1-in-250
Return Period
DesiredEconomic
CapitalRange
CapitalCoverageRatio
Econ
omic
Cap
ital
Risk AppetiteJuly 14, 2009 29
Risk Appetite: Conclusion
Board engagement is required
CredibilityStated risk appetite and proven ability to manage exposures to within the appetiteTransparency and communication are important so clients and shareholders can make their own assessments
Qualitative and Quantitative Assessment
Without a risk appetite, it is difficult to put a return goal into contextOptimize risk/return within risk appetite and risk limits
Illustrative case study
© 2009 Towers Perrin 30
© 2009 Towers Perrin 31Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
There is an implied “contract” between the board and management on risk and return
Sets/approves overall risk appetite and corporate risk tolerance that align with stakeholder expectations*
Approves capital plan
Ensures appropriate corporate risk governance
Board of Directors ManagementDevelops business strategy, sets financial targets (e.g., growth, earnings, ROE)
Determines overall (economic) capital needs and performs capital budgeting
Allocates capital
Manages business to achieve results according to detailed business plans and agreed risk tolerances/ limits
“Risk Contract”
© 2009 Towers Perrin 32Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
More granular expectations can be defined once the board and management agree on overall objectives
Board/CEO
Risk Appetite
Risk Tolerance Statements
C-Suite Risk Limit Risk Limit Risk Limit
BU Leaders Risk Limit Risk Limit Risk Limit
Etc.
© 2009 Towers Perrin 33Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
Client background
Board composed of individuals from varied backgrounds and different industries
Lacked common definition or understanding of “risk”
No common perspective on amount of risk company was currently accepting
No common perspective on amount of risk company should be willing to accept
No risk appetite or risk tolerance statements in place
© 2009 Towers Perrin 34Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
Client objectives
Establish a common foundation/understanding and vocabulary for discussions of risk between the board and senior management (and the entire organization)
Develop preliminary risk appetite and risk tolerance statements
Informed by relevant industry and client information and benchmarks
Create an approach to validating and refining the preliminary risk appetite/tolerance statements
© 2009 Towers Perrin 35Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
Risk appetite was defined using a combination of qualitative and quantitative inputs
Approach to Defining Client’s Risk Appetite/Risk Tolerance
InputsQuantitativeQualitative
Preliminary Risk Appetite/Tolerance
Phase 1
Phase 2
Revised Risk Appetite/Tolerance
Client’s Mission, Vision, & Values
Management and BOD Perspectives
Industry/Client Historical Reference
Points
Client’s Risk Modeling and Sensitivity Testing
Regulatory/Rating Agency Thresholds
Board Review and Input
© 2009 Towers Perrin 36Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
The initial phase aimed at establishing a common understanding and risk vocabulary
Board and management perspectives on risk were captured through confidential individual interviews
The objective was to determine how much uniformity there is in the perspectives of board members and senior management
We asked a common set of questions to each participant
Results were compiled and presented to the board and management
Individual responses remained anonymous
© 2009 Towers Perrin 37Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
For example, we asked each participant about their willingness to sustain various levels of surplus declines…
Tolerance for Loss of SurplusTolerable Annual
Probability
Scenario
1-in-X-Year Event
Equivalent
1-in-10
1-in-5
1-in-3
1-in-2
1-in-20
1-in-4
Outlier responses
Nearly all interviewees stated that this should never happen.
StrongConsensus
30%
18%
7%
14%
5%3%
7%
11%
0%
10%
20%
30%
40%
50%
2% 2%0% 0%10% Loss of Surplus 20% Loss of Surplus 50% Loss of Surplus
MaximumManagement AverageBoard AverageOverall AverageMinimum
© 2009 Towers Perrin 38Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
…and compared responses to the historical experience for both the industry and client
Probability
1-in-X-Year Event
Equivalent
1-in-20
1-in-10
1-in-7
1-in-5
Comparison of Client's Tolerance for Surplus Losses to Historical Experience
Client Interviewee Tolerance (Average)
Historical Benchmarks — Frequency of Surplus Loss
11%
16%
0%
8%
5%
0%
5%
10%
15%
20%
10% loss of surplus
20% loss of surplus
50% loss of surplus
U.S. P/C Industry(1946 – 2008)
Client(19XX – 2008)
© 2009 Towers Perrin 39Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
Some questions were aimed at comparing the perceived current and desired risk appetites
Client’s Risk Appetite
(Low) (High)
Number of Responses
Current
Current DesiredManagement 4.1 5.6Board 3.1 4.8
Risk Appetite
2
1 1
43
12
2
1
01234567
1 2 3 4 5 6 7 8 9 10
ManagementBoard member
Average Scores
(Low) (High)
Number of Responses
Desired
Risk Appetite
1
2
3
112
5
2
01234567
1 2 3 4 5 6 7 8 9 10
ManagementBoard member
© 2009 Towers Perrin 40Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
This interview/feedback approach laid the foundation for developing a risk appetite statement
Consistent vocabulary created among all board and management participants
Process helped drive a more consistent appetite for risk between and among the board and management
More realistic expectations
Interview process created non-threatening environment to facilitate learning and understanding
Preliminary risk appetite statement was drafted
© 2009 Towers Perrin 41Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
This interview/feedback approach also elevated the level of discussion and decision making about risk
In subsequent phases of the project:Economic capital modeling was completed— Results were compared with the preliminary risk
tolerances; some incompatibility was observedPreliminary risk appetite statement was refinedPlan was developed to bring company into line with its newly agreed upon and stated risk appetite and risk tolerances
Additional work is under way:Risk monitoring and reporting process are being establishedRisk limits are being establishedRisk modeling is being refined
Q&A
© 2009 Towers Perrin 43Proprietary and Confidential
Not for use or disclosure outside Towers Perrin and its clients
Q&A
Linda Chase-Jenkins, Towers Perrin(212) [email protected]
Eric Gesick, PartnerRe(441) [email protected]
Joe Lebens, Towers Perrin(860) [email protected]