Enterprise Risk Management: Impact on Standard & Poor’s Credit Ratings

Enterprise Risk Management:Impact on Standard & Poor’s Credit Ratings Raam Ratnam – Standard & Poor’s

An S&P Definition of ERM A comprehensive, forward-looking, active, iterative, permanent discipline to … imagine, identify, understand, then mitigate, remove, or learn to live with … anything that can impair a company’s ability to repay debt in full and on time.

Why are Rating Agencies Interested in ERM? • A Deeper Understanding of Management • More Forward-Looking Ratings • Clearer External Communications • Better Differentiation

A Subtle Change in Language… and Behavior Earnings… “Return on Invested Capital” “Return per Unit of Risk” Forecasting… “Single/Limited Scenarios” “Unlimited Scenarios” Strategy… “Making Smart Bets” “Selecting Strategies along the Efficient Frontier”

Where Has ERM Been Applied in the Ratings Process? • Financial Institutions • Insurance • Traders (Power, Agriculture, Commodities) • Other Sectors

Before Formal ERM Evaluation Lower Higher ERM Quality Lower Higher Risk Tolerance Credit Rating: Low Low High

With Formal ERM Evaluation Lower Higher ERM Quality Lower Higher Risk Tolerance Credit Rating: Low High

With Formal ERM Evaluation Upgrades Lower Higher ERM Quality Rating Pressure Lower Higher Risk Tolerance Credit Rating: Low Low High

Sector Specific Application ERM is not the same in each sector – • The Universal ERM Framework is not a straight-jacket blindly applied to each company • S&P carefully explores each sector and develops an ERM platform that makes sense for that sector • Flexibility allows for company differences in application of ERM

General Framework

Strategic Risk Management Risk Mgt Culture & Governance Universal ERM Structure Risk B Control Processes Risk A Control Processes Risk C Control Processes Emerging Risks Mgmt

Strategic Risk Management Risk Mgt Culture & Governance Universal ERM Structure Risk A Control Processes Risk B Control Processes Risk C Control Processes Emerging Risks Mgmt

Strategic Risk Management Risk Mgt Culture & Governance Universal ERM Structure Risk B Control Processes Risk A Control Processes Risk C Control Processes Emerging Risks Mgmt

Application of ERM in the Insurance Sector

Insurance Risk management is at the heart of the insurance business Objective: Enhance ratings process by increasing our analytical focus on insurers’ risk management practices • Previously, only qualitative credit given to risk management practices and models • Ultimately, may give some quantitative recognition to risk models, but only where models are robust and underlying risk management framework is sound

ERM & Ratings • ERM Quality Evaluation is based on the risks of the company • Importance of ERM in the company rating is based on:- Capacity to absorb losses- Complexity of risks • A insurer with tight capital and complex risks- ERM is very important • A insurer with excess capital and ordinary risks- ERM is not as important

ERM Quality Classifications

Economic Capital Review (2007 Plan) For Insurers with Strong or Excellent ERM • Standard & Poor’s will develop robust processes for evaluating insurers' internal economic capital models • To be performed only for companies with effective ERM • Evaluations of economic capital will be used in conjunction with existing static, risk-based measures • Dynamic approach will enhance our existing and prospective view of capital adequacy Standard & Poor’s can incorporate benefits of uncorrelated risks (diversification)

Insurance ERM Summary 1. ERM is a new organizing concept– A collection of issues we have always covered 2. ERM applies to all insurers globally ERM evaluation is tailored to the risks of each insurer ERM recognizes all the risk management of the insurer– Even if the company does not do “ERM”!!! 5. ERM is reflected in insurer ratings– Importance of ERM will vary among companies – just as every other factor does 6. ERM is a new section in the ratings report 7. ERM is not a new Capital Model– ERM is not primarily concerned with looking at an insurer’s Economic Capital Model Risk & Capital Risk Control Emerging RM

Insurance Credit Ratings – 15 years ago “Prudential tolerates more aggressive balance sheet risk than some peers.” “Prudential has detailed methodology to compare the risk/reward tradeoffs for various investment opportunities …15% of the general account is invested in higher risk assets.” “[mortgage] concentrations exist in California (23%), New York (10%) and New Jersey (7%)…” S&P Credit Research Report, Feb. 15, 1992 Prudential Insurance Co. of America Financial Strength Rating: AAA

Insurance Credit Ratings – Today “…reflects Prudential's strong risk-management culture, integrated approach to risk monitoring, and excellent credit risk management capabilities. The otherwise strong ERM is somewhat mitigated by the lack of an overall quantitative view of risk from which an adequate strategic risk management process can be formed.” S&P Credit Research Report, Jan. 12, 2007 Prudential Insurance Co. of America Financial Strength Rating: AA-

Overall ERM Evaluation (Dec. ’06, 241 Insurers)

Trading Risk Management Analysis:the Electric Power Sector

Trading Risk Management – Three Part Analysis • Capital adequacy Measures discrete risks of market, credit and operational risks • Liquidity Measures exposure to collateral calls under stress scenarios • Risk management practices – ‘PIM’ Evaluation of a company’s ability to identify and monitor significant risks, limit losses and operate within well-communicated risk tolerances  New!

PIM • Policies • Risk Culture and Structure • Infrastructure • Processes and Technology • Methodology • Measurement and Reporting Emerging Risks Mgmt Risk B Control Process Risk A Control Process

PIM Assessment Test Phase • Initiated in April 2006; Completed in May 2007 • Goal: mapping risk management infrastructure to what S&P concludes are best practices • Applied to ten companies initially • Utility and energy merchants • Pure trading • Large and small

Companies Selected • Black Hills Corp. (BBB- / Stable Outlook) • Constellation Energy Group Inc. (BBB+ / Negative Outlook) • Dynegy Inc. (B / Stable Outlook) • Edison Mission Energy (BB- / Stable Outlook) • Exelon Corp. (BBB+ / CreditWatch Negative) • Mirant Corp. (B+ / Stable Outlook) • NRG Energy Inc. (B+ / Stable Outlook) • Reliant Energy Inc. (B / Positive Outlook) • Sempra Energy (BBB+ / Stable Outlook) • TXU Corp. (BB / CreditWatch Negative)

PIM Assessment Results Summary • Interesting • Large variation in risk management infrastructures • Risk appetite does not necessarily match risk management structures and modeling resources • Most policies and key system components only in place for a short time for most companies • Expected • Dominance of senior management in risk identification and control is sometimes a key concern • Asset-based trading is less robust that pure trading • Internal reporting is robust but external reporting is poor across the board

Next Steps in ERM Analysis for S&P

Where we are with ERM Analysis Non-Financial Sectors Merchant Power, Trading Sectors FinancialSectors Assess Value of ERM Analysis Evaluate Risk Control Processes Evaluate Enterprise-Wide ERM Update PIM Methodology from Lessons Learned Extend to 2nd group of Power Cos and other Traders Incorporate into Analytic Reports Scoring All Firms on ERM Impact on Some Ratings and Dozens of Rating Outlooks Deep Dive ERM Analysis and Advanced Capital Modeling Publish Draft Methodology; Expose for Comment Conduct Open Forum Discussions Discuss During Regularly Scheduled Review Meetings

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Enterprise Risk Management: Impact on Standard & Poor’s Credit Ratings