DFA and DFCA as ALM, ERM Tools

1. Britain Price Shawn CowlsSenior Vice President ConsultantSS&C Technologies, Inc. Tillinghast- Towers Perrin DFA and DFCA as ALM, ERM Tools

2. Agenda • 2003 Survey Results • Components of ERM • ERM Case Study (M&A)

3. ERM Challenges for the Industry – Results from 2003 Survey* • 53% of companies are still using static, single-point estimates for projections. • 33% of companies have an integrated model that handles both assets and liabilities. • 13% use a fixed yield to represent the expected portfolio return. • 38% of companies don't forecast results within an accounting framework. • Only 25% include tax effects. • 35% can drill into their assumptions and business logic. *Results from SS&C Technologies’ Planning & Forecasting Survey, published Friday, May 30, 2003 - Volume III, Issue X

4. ERM Industry Favorable Result from 2003 Survey* • Functional participation in planning is good, with 47% of companies having two to four functional areas involved in the process and 53% having over five areas represented. Finance and Accounting are best represented. *Results from SS&C Technologies’ Planning & Forecasting Survey, published Friday, May 30, 2003 - Volume III, Issue X

5. Model Requirements for Effective ERM • What you should have • Fully Integrated Model (Assets & Liabilities) • Risk Adjusted Assets • Sophisticated Economic Scenario Generation • Risk Adjusted Liabilities • True Decision Support Communication

6. Better insight into your “realistic” business operations Variability Interrelationships in business operations Value of Enterprise Risk Management • Underwriting • Investments • Accounting • Links your entire operations • Enhances your decision support • Graphical • Pro-forma financial statements • Data drill-down • Test alternative business strategies in advance • Investments, Reins., Capital Mgmt, M&A, Pricing, Tax,…

7. Risk Adjusted Assets... • Actual attributes for portfolio holdings should be accounted for in an ERM model (e.g., modeled proxies or CUSIP level of detail) • If proxies are used, then they should be defined with current portfolio attributes (e.g., duration, yield, coupon, term, etc.)

8. Economic Scenario Generation... • Assets should be valued using a sophisticated, multi-factor economic scenario generator Note Yield Curve Inversion

9. Scenario’s Effect on Assets

10. Risk Adjusted Liabilities... • Liabilities are “risk adjusted” when we imbed variability into our understanding of assumed values • Using probability distributions we account for various outcomes of key liability assumptions • Key assumptions to make dynamic: • Premiums • Losses • ALAE/UALE • Historic Held Loss Reserves • Speed of Loss Payout • Line Inflation (multiple of CPI)

11. ERM Incorporates the Compounding Effect of Business Uncertainty PPA Net Income After Tax Investment Income Auto Physical Damage (For all projection years) Underwriting Cash Flow

12. A Virtual Income Statement...

13. Generate economic scenarios Sample business variables Calculate liability cash-flows Calculate asset cash-flows and price investment portfolio Rebalance the asset portfolio Pay taxes, expenses and dividends Produce pro-forma financial statements in GAAP, STAT and Economic Valuation Make output available for graphical representation Repeat for thousands of iterations What does “simulation” mean?

14. Communicate Results with Graphics , NOT Statistics Stochastic Standard Deviation Log Normal Skewness Poisson Coefficient of Variation

15. Graphics Ease the Understanding of Risks Confidence Interval 95% MEAN

16. ERM: Case Study on M&A • Three models created: 1. Parent Company 2. Target Company 3. Merged Company • Models populated with 2002 statutory financials from AM Best data interface • Lines modeled: • Homeowners • Private Passenger Auto • Auto Physical Damage

17. Model Set-Up (cont.) Combined Private Passenger Auto Homeowners Auto Physical Damage Parent PPA Target PPA Parent APD Target APD Parent HO Target HO • No change in investment allocations • Major differences between modeled lines and companies: • Premiums-earning patterns • Commissions/expenses • Loss ratio and premium growth distributions created from 10 year historic results (AM Best Data)

18. Net Income Before Tax (2004)

19. RAROC (2004)

20. Combined Ratio (2004) Parent Target Merged

21. ROE (2004) Parent Target Merged

22. Net Leverage (2004) Parent Target Merged Fail Pass

23. Net Leverage Drill Down (2004) While capital efficient on an expected basis, simulation indicates that without corrective action the likelihood of failing this Best Ratio is 29% of the time. The acquisition improves this metric.

24. Absolute BCAR Projection A++ A+ A A-

25. Dynamic Financial Condition Analysis and Enterprise Risk Management Shawn Cowls, FSA, MAAA

26. Dynamic Financial Condition Analysis and Enterprise Risk Management • Enterprise Risk Management (ERM) • Dynamic Financial Condition Analysis (DFCA) • Bringing ERM and DFCA Together

27. Enterprise Risk Management (ERM) • Defining ERM • Critical Elements of ERM • Uses of ERM

28. Defining Enterprise Risk Management • Assessing and addressing risks, from all sources, that represent either material threats to business objectives or opportunities to exploit for competitive advantage • An effective ERM process will: • incorporate all material risks - financial and operational • evaluate all relevant strategies - financial and operational • consider all pertinent constraints • exploit natural hedges and portfolio effects among the risks, and financial and operational efficiencies among the strategies

29. Defining Enterprise Risk Management • Result • An optimal set of strategies that balances the need for capital and the need for return, growth, and consistency • In essence, an optimization of risk and value • Ultimately, ERM is a process composed of a number of different steps involving a range of insurance professionals

30. Critical Elements of Enterprise Risk Management • Assess risks • Identify risks and assess materiality • Classify and prioritize risks • Model risks • Articulate financial and operational strategies • Evaluate and refine financial and operational strategies • Monitor strategy performance and the risk environment

31. Uses of Enterprise Risk Management • An effective ERM process will help an insurer make sound decisions about which financial and operational strategies it should implement • What should our product mix be? • What channels should we distribute the products through, and to which markets? • What set of agency ratings should the company target? How do we most effectively achieve our target? • How much capital should we hold?

32. Uses of Enterprise Risk Management • An effective ERM process will help an insurer make sound decisions about which financial and operational strategies it should implement • How much and on what terms should we reinsure or hedge? • How should we invest our assets? • How much should we invest in technology? • How should resources be assigned to sales versus service and how should they be deployed across products and regions? • How much should we spend on recruiting, training, and retention?

33. Dynamic Financial Condition Analysis (DFCA) • Defining DFCA • Critical Elements of DFCA • Uses of DFCA

34. Defining Dynamic Financial Condition Analysis • Dynamic model of the interaction of: • Economic elements • Product features • Policyholder behavior • Company behavior • Over a number of expected and unexpected scenarios • Projection of financial results over a near horizon • Evaluation of a company’s fitness or condition • An analysis that synthesizes a company’s expected experience under various stresses

35. Critical Elements of Dynamic Financial Condition Analysis • A model that adequately represents a company’s business • Economic and environmental scenarios that test the financial condition • Interactivity between elements of the model and the economic and environmental scenarios • Communication of the condition and sensitivity of the company

36. Uses of Dynamic Financial Condition Analysis • Model financial strategies • Model the financial impact of various risks • Assess the value of various strategies in mitigating risks • Provide an analysis that communicates to management the company’s financial condition under specified strategies and scenarios

37. Bringing ERM and DFCA Together • Strategies • Models • Communication of Results

38. Bringing ERM and DFCA Together - Strategies • Making annual decisions with respect to • Distribution channel • Capital deployment • Investments • Technology

39. Bringing ERM and DFCA Together - Models • Environmental and Economic Scenarios • Expected environment • Unexpected environments • The interactive impact of these environments on: • Management behavior • Policyholder behavior • Policy cash flows • Portfolio manager behavior • Alternate strategies that may respond to various environments

40. Bringing ERM and DFCA Together - Communication of Results • Synthesis of the results organized by major risk factors • Highlights and summaries • Leave details in appendices • Fewer tables and more graphics! • What did we learn? • What risks can cause the greatest harm? • What impact do various risk mitigation strategies have on the results? • Which risks can occur together? Which are mutually exclusive? • How can insights be applied to business objectives?