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2001 Casualty Loss Reserve Seminar Fairmont Hotel New Orleans, La September 9-11, 2001 Robert F. Wolf FCAS, MAAA Principal William M. Mercer/MMC Enterprise Risk Consulting. The Evolving Role in Enterprise Risk Management. Agenda. Introduction ERM/Actuarial Evolution Trends - What’s Going On?

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The Evolving Role in Enterprise Risk Management

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2001 Casualty Loss Reserve Seminar Fairmont HotelNew Orleans, LaSeptember 9-11, 2001Robert F. Wolf FCAS, MAAAPrincipalWilliam M. Mercer/MMC Enterprise Risk Consulting

The Evolving Role in Enterprise Risk Management


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Agenda

  • Introduction

  • ERM/Actuarial Evolution

    • Trends - What’s Going On?

  • ERM Platforms

    • Non-Insurance Company

    • Insurance Company

  • Wrap-up

  • Q&A

Copies of Presentations Available at www.casact.org


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What is ERM?

  • To me, 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.

  • To others, it varies but the essence is the same

    • “ERM assesses and manages all risks while looking for upsides in identifying risks.”

    • “Enterprise Risk Management is about information and capital management.”

    • “The ultimate goal of Enterprise Risk Management is preservation of shareholder value.”

    • “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.”


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No Consensus on Best Risk Measure

C

EPD Principal

B

D

B= VaR (Pr Ruin)

Principle

A

A =Variance Principal=

Squared Dev from Mean

TVaR Principal=

C+D


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Evolution of Risk Management

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

  • Risk Manager

    • From Insurance Buyer to Integrated/Consolidated Risk Strategy

  • Actuary

    • Traditional: Evaluate Hazard/Financial Risk

    • Evolution: DFA (Insurance Companies)/ ERM


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Why the Evolution of ERM

  • New/Larger Risk

    • E-Commerce, Market/Book Values

  • New Risk Products

    • Merger of Insurance and Financial Institutions

  • Realization that Silo-Based Approaches are Flawed

    • Ignores inherent hedges and correlation

  • Increased Management Accountability

    • New Regulations requiring corporate governance


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Why the Evolution of ERM

  • In short, because Society Demands it

  • Computer and Information Age

    • We couldn’t do what we are doing today if we needed to use slide-rules or abacus.

  • Focus Optimize Shareholder Value


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Economist Intelligence Unit ERM Study


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


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Evolving Risk Manager

  • Evolving Risk Management Positions

    • Chief Risk Officer, ERM Councils, Global Director of Risk Management

  • Rise of, and Partnership with, Internal Audit

    • Corporate governance issues and perspectives

  • Rise of, and Partnership with, Treasury

    • Financial Management perspectives and insights

  • Rise of Board Audit Committees

  • Evolving Skill Base for Risk Managers


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Why the Evolution of ERM

  • In short, because Society Demands it

  • Computer and Information Age

    • We couldn’t do what we are doing today if we needed to use slide-rules or abacus.

  • Focus Optimize Shareholder Value


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Actuarial Evolution

  • ERM Evolution Actuarial Evolution

  • Traditional Roles

    • Evaluating Hazard/Financial Risk in a silo

    • Insurance Company

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

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

    • Insurance Customers

      • What to budget in order to pay for self-insured obligations and premiums

      • What to set aside to meet future obligations of retained risk


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Actuarial Evolution

  • Continuing Actuarial Evolution

  • Evolving Demands for Risk Integration

    • Insurance Company

      • Holistic Evaluation of Assets and Liabilities (Dynamic Financial Analysis (DFA))

        • Optimum Capital Structure

        • Realization of Business Plan

    • Insurance Customers

      • Optimum Risk Financing

        • What risks to retain/insure - captives, retros, large deductibles

        • ..but still only Hazard and Financial Risk


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Optimum Integrated Hazard Risk 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

Exogenous Contingent Events

Economic Scenarios

Interest Rates

etc.

Tools

Loss Forecasting/Reserving Models

Dynamic Financial Modeling

Discounted Cash-Flow Models

Risk/Cost Matrix

Goal is to optimize shareholder value

  • Recommendations

    • Optimum Retentions

    • Optimum Funding Mechanisms


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Actuarial Evolution

  • ERM Evolution Actuarial Evolution

    • All sectors of Corporate America

    • Not merely Insurance Companies and their Customers

    • Includes Strategic and Operational Risks as well as Hazard and financial risks


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Case Study

Non-Insurance Corporation

(See Presentation By Barry Franklin)


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Case Study Framework

ERM Insurance Company


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P&C Goals - Not Just Survival

  • Three Considerations

    • Survival : How risky can you be

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

    • Stability

      • Probability [(Loss Ratio + Expense Ratio) > Target Combined ratio]<a

    • Optimizing Enterprise

  • CEOs and CFOs care more about stability v. survival.


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2.0 Billion of Premiums

$700 Million Surplus

Mulli-line Company - Primarily Personal Lines

5 Regions

The Company Manages its silos well

50% Premium Volume is rate sticky states

Asset Allocation:

80% Bonds

10% Equities

10% st-investments

25% growth rate in recent years

ERM Insurance Company


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Historical Reserve Margins

Less Pressure on Rate Adequacy to Achieve Corporate Goals


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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 Framework Addressing (Macro):


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Goal : Develop ERM Framework Addressing (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:

    • ROE

    • MV/BV


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How Much Capital do you Need?

Capital Truly Held includes

Capital embedded in UEPR,

Discount in Loss Reserves,

Capital Tied up in NAIC RBC/

Best’s BCAR.

K+S

K

Suggested Approach=

Economic Capital is all that matters.

The above reflects a timing constraint as

to how much capital to hold if >Economic

Capital. Must reflect this timing cost.

S


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ERM Process

ECONOMIC CONDITIONS

MANAGEMENT

& BOARD

DECISIONS

COMPETITION &

INDUSTRY

Reinsurance

Strategy

Investment

Strategy

Underwriting

Strategy

Operational

Management

ALM

Capital Structure

Pro-forma

Financials

Legal Entities

Operating Units

Decisions


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Competition and External

  • Price Compensation & Elasticity of Demand

  • Jurisditional Risk

    • rate stickiness

    • tort laws

    • residual market

  • Best’s, RBC, etc.


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    Management Decisions

    • Business Plans

      • 1 Year

      • 5 Year

    • Board Directives

      • Asset and Investment Guidelines

    • Corporate Culture

      • Incentive Compensation


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    Economic Conditions

    • Inflation

    • Interest Rates

    • Currency Exchange

    • Equity Performance

    • Economic Conditions

      • Recessions

    • Combo of stochastic and scenario considerations


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    DFA Approach

    • Holistic View

      • Reinsurance Strategy

      • Investment Strategy

      • Underwriting Strategy (Macro)

      • Operational

    • Correlation

      • Forward Looking

      • 5 Year Planning Horizon

        • DFA Platform

          • CFs, Income statements, ROEs, Balance Sheets


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    Reinsurance Strategy

    Considerations - Credit Risk


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    Investment Strategy


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    Asset/ Liability Management

    Change in Equity = Change is Assets - Change in Liability

    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.

    +

    Duration Line

    Duration Line

    Interest rate shift

    Reserves

    -

    Assets

    Positive Duration

    Needs to Consider Cash Flows of New/Renewal Business


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    Effects of Duration Mismatch

    And in many cases the LiabilityDuration is actually NEGATIVE

    ….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

    +

    Duration Line

    Interest rate shift

    Reserves

    Duration Line

    -

    Assets


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    CAS VFIC Research……….

    • Optimal Investment Strategy Does Not Imply Duration Matching

      • Analysis of Duration is only one part of the process

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


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    Operational Risks

    Handled Similarly to Barry’s Approach to Corporate Client

    Also Includes Seasoning of Business - Renewals Get Better


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    Capital Financing Strategy

    • Capital Management

      • Macro- Is suffucient Capital Available?

      • Micro - Decision making Tool

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

          • Where to Grow/Contract?


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    Market Value Balance Sheet

    Liabilities

    Definitions

    Assets

    Let K = Policyholder Supplied Funds (PHSF)

    Let S = Shareholder Supplied Funds (SHSF)

    K

    K+S

    Returns

    RA = Return on Investments Using both policyholders

    and shareholder supplied $s

    RL = Cost of Debt (Borrowing PHSF)

    RC = Cost of Capital (Using SHSF)

    Capital

    S

    Returns RA

    on K+S funds

    Balanced Levered Trust

    (K+S)RA = KRL + SRC

    S Costs

    at rate of RC

    K Costs at a rate of

    RL

    Financial Markets

    RL is the reserve discount rate,

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

    SHSF Supply

    PHSF Demand

    =

    S (RC-RA)

    K(RA-RL)

    RU = - K RL/Premium

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

    Product Markets

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


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    Maximizing Shareholder Value Depends on Three Things……..

    • Earnings (ROE)

    • Cost of Capital

    • Long-Term Growth

    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)

    S = Statutory Surplus

    G= Long-Term Growth

    Rc = Discount Rate@

    Cost of Capital


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    Allocation of Capital

    • Macro - How Much is Enough? How Much to Give Back to Shareholders

    • Micro-

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

        • Where to Grow/Contract

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

    • Allocate capital in proportion to marginal capital

    • See Glen Meyers “Cost of Financing Insurance” and “An Introduction to the Competitive Market Equilibrium Risk Load Formula”


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    In Meyer’s…………..

    Let P = Return and C = Capital. Then the insurer is better off by adding a line/policy if:

     Marginal return on new business >

    return on existing business.


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    Overall Benefits- ERM Process

    • Optimum Capital Structure

    • What Operating Division is Enhancing/Destroying Enterprise Value

    • Realization Of Business Plans Enhanced

      • Micro Decision Making and Targets Consistent with Macro Decision Making

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


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    Wrap-up


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

    % of top 100

    Primary Cause of Stock Drop (# of Companies)

    Law-suits

    Natural Disasters

    Competitive Pressure

    Mis-aligned Products

    Loss of Key Customer

    R&D Delays

    Manage-ment ineffective-

    ness

    Foreign Macro-Economic Issues

    High Input Comm-odity Price

    Interest Rate Fluct-uation

    Cost Overruns

    Customer Demand Shortfall

    Customer Pricing Pressure

    Regulatory Problems

    Supplier Problems

    M&A Integration Problems

    Accounting irregularities

    Supply Chain Issues

    Strategic

    Operational

    Financial

    Hazard

    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?


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    Two Ways to Interpret Graph

    • Hazard and Financial Risk is Not Important

    • Hazard and Financial Risk has been and continues to be managed well

      • Testimonial for risk managers, actuaries, brokers, and financial analysts.

      • We need to continue the process

    • …The opportunity now is to work on the left side of the graph.


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    …….Significant Opportunities for Us.

    “….We don’t do things because they are easy.

    We do them because they are hard.”

    ….John F. Kennedy


    Slide45 l.jpg

    Thank You


    Slide46 l.jpg

    Q&A


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