Discussion of how to use shareholder value to drive risk management

1. RISK AND INVESTMENT
CONFERENCE
21-23 JUNE 2009
THE GRAND, BRIGHTON

2. The Shareholder Perspective:
Modelling & managing Risk to Franchise Value
or Using Enterprise Risk Management to Create and Manage Value
David Ingram, CERA, FRM, PRM
SVP, Willis Re
Risk and Investment Conference
June 23, 2009

3. AGENDA
I. Perspectives on Risk, ERM and Economic
Capital
II. Beyond ERM: Value Based Capital Management
III. VBCM vs. Dynamic Reinsurance Optimization
IV. VBCM vs. EC for ERM
V. Conclusion

4. What is RISK?
Can you tell someone how much
profits your firm made last year?
Can you also tell them how much risk
your firm took last year?
What odds would you give that your
firm will be open for business
tomorrow?
How about in 5 years?
That is RISK!

5. What is Risk Management?
In one long term study of the 100 largest
firms in the world,
Every 5 years, on the average, 10%
ceased to exist.
Risk Management means working to be
one of the 90 / 100 firms that survives.
Risk Management efforts need to stay
focused on that!

6. ERM Objectives

7. Risk Management Objectives
Link with
strategy Change Risk Management
High
Value
optimization
Strategic
integration
Loss Controlling
Medium Risk
measurement
Risk Steering
Risk
management
Loss
minimization Risk Trading
Low Compliance
Balance sheet Risk/return
Risk control Value creation
protection optimization
Adapted from Standard & Poor’s

8. Broad Characteristics of ERM
Loss Controlling
Limit exposures and therefore losses to risk tolerances
ERM adds Aggregate approach to risk tolerance
Risk Trading
Getting paid for risks taken
ERM adds Cost of Capital / consistent approach to risk margins
Risk Steering
Strategic choices to improve value
ERM adds risk vs. reward point of view
Change Risk Management
Managing the risks from new projects, products, territories, etc
ERM adds fitting the new into the existing risk profile & ERM program

9. ERM is like Seatbelts
They only work if you use them!

10. Economic Capital:
Focused on
Liquidation

11. Regulatory Focus
“The main purpose of the supervision of
insurance in general is to ensure that
insurers have the capacity to meet their
obligations to pay the present and future
claims of policyholders.”
IAIS 2000
So an ERM regime that focuses solely on
Solvency 2 Requirements is a program for
the benefit of the Policyholders!

12. Economic Capital
First Assumption:
The Firm went OUT OF BUSINESS at the
end of the prior period.
Economic Capital answers the question:
Under reasonably adverse conditions, how
much money is required to pay off existing
policyholder obligations?

13. Distortions?
Might that be a problem?
Making business decisions for a business that
did not go out of business (and does not plan to
go out of business) based upon a model that
assumes that they did go out of business?
But Everybody Does it that way – must be ok?

14. Economic Capital
Is not actually the answer to a question asked
by insurance company managers!
Their Question might be “How much Capital
should the firm hold?”
Almost all firms hold more than Economic
Capital – even those with ECM.
So it is clear that they are not using ECM for
determining level of capital to actually hold.

15. Beyond Economic
Capital:
Value Based
Capital
Management

16. Value Based Capital Mgt
VBCM makes value the central
focus of ERM
VBCM is based on an explicit model of
an insurer’s value
Value reflects the firm’s future, not just
its current balance sheet
Reinsurance and capital management
options are chosen for their value impact

17. The Components of Value
Liquidation versus franchise
value
Liquidation value = value of firm in
runoff
Adjusted book value
Reflects past decisions
Relatively fixed

18. The Components of Value
Franchise value = value of firm as
a going concern
Reflects anticipated future earnings
Discounted for time value
Adjusted for potential impairment
Can be enhanced by management
decisions

19. What is Risk?
Threat to the continuation of the firm.
What is Value?
Discounted future earnings
What are earnings if the firm fails?
Zero

20. What is Value?
Value = (1 – Risk) x Discounted Earnings
If you look at Value that way, then reducing Risk
increases Value!
Risk management involves comparing
The cost of reducing risk and
The increased value due to reduced Risk

21. Threats to franchise value
Adjustment for impairment is crucial
Impairment: (risk)
Diminution of ability to produce future
earnings
Temporary or permanent
Partial or complete
Typically has multiple sources
In VBCM, as in ERM, total risk matters

22. Threats to franchise value
Potential sources of impairment
Underwriting losses
Adverse loss reserve development
Stock market decline
Fixed income defaults
Reinsurer failure
These may in turn trigger rating agency
actions

23. The Objective of VBCM
Identify the capital and risk management
strategy that maximizes franchise value
Effect of Strategy on Franchise Value
70
Franchise Value
60
50
40
30
20
0 25 50 75 100 125 150 175 200
Surplus or Reinsurance Utilization

24. Key Features of VBCM
Value of firm = impairment-adjusted
present value of future earnings
Tradeoff between earnings & safety
Heavy emphasis on capital, ratings
Includes all major risks, not just U/W
Value as basis for choice

25. Using VBCM to Determine Optimal Level of
Capital Effect of Strategy on Franchise Value
70
Franchise Value
60
+37
50
+25
40
30
20
0 25 50 75 100 125 150 175 200
Surplus or Reinsurance Utilization
Note: Vertical axis is FV in excess of Surplus amount

26. Underlying Dynamic Example
Return Distributions
600
400
200
-
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
(200)
(400)
(600)
(800)

27. Value Determination
With zero Capital
Expected Return = 115
Probability of Impairment = 20%
Discount Rate = 5%
Value over 10 future years = 1150 – 500 – 180 = 470
Impairment Discount
VE Multiplier = 470 / 115 = 4.1

28. Adding Capital
Add $100 Capital
Capital Earns 2% after tax
So with discount of 5% Capital costs 3%
With $100 of capital, Expected Return is now 117
Probability of Impairment is now 11%
Value over 10 years is now = 1170 – 380 – 210 = 630
VE Multiplier is now = 630 / 117 = 5.4
Notice impact of Impairment decreases and impact of
discount increases.
That is the dynamic for VBCM

29. VBCM versus
Dynamic
Reinsurance
Optimization

30. VBCM Example – Reinsurance
Purchase
Gross Reins Alt 1 Reins Alt 2 Reins Alt 3 Reins Alt 4
Expected Reinsurance Premium - 202.4 175.4 30.1 39.9
Net Premium 501 298.6 325.7 470.9 461.1
Net Retained Losses 328 146.6 168.5 304.3 301.3
Expenses 150.3 150.3 150.3 150.3 150.3
Net Underwriting Result (A) 22.7 1.6 6.9 16.4 9.5
Net Income 100 78.9 84.2 93.7 86.8
Value At Risk (1 in 200 years) 65.4 27.1 21 56.9 28
Risk-Adjusted ROE Calculations
Total Economic Return on Capital 11.60% 2.00% 10.90% 9.60% 11.30%
VBCM Calculations
Probability of Impairment 1.00% 0.10% 0.10% 0.50% 0.10%
VE = Franchise Value Multiplier 24.8 32.2 32.2 28.4 32.2
Franchise Value 2,475.00 2,545.80 2,707.00 2,672.30 2,803.60
Benefit to Franchise Value 70.8 232 197.3 328.6

31. VBCM and ERM

32. VBCM vs. EC for ERM
Loss Controlling
Limit exposures and therefore losses to risk
tolerances
ERM adds Aggregate approach to risk tolerance
Set Aggregate Risk Tolerance to maximize
Value with VBCM
Manage with EC

33. VBCM vs. EC for ERM (continued)
Risk Trading
Getting paid for risks taken
ERM adds Cost of Capital / consistent approach to
risk margins
Using EC for Capital will cause problems!
Need to cover cost of the capital firm with
really hold

34. VBCM vs. EC for ERM (continued)
Risk Steering
Strategic choices to improve value
ERM adds risk vs. reward point of view
Managing to EC protects policyholders
Managing to Value for shareholders

35. VBCM vs. EC for ERM (continued)
Change Risk Management
Managing the risks from new projects, products,
territories, etc
ERM adds fitting the new into the existing risk profile
& ERM program
Very important to make sure that change does not impair
ability to meet policyholder expectations (EC) in the short
term
But should also make sure that change enhances value in
the long term

36. Conclusion

37. Conclusion: Why VBCM?
It provides a compelling criterion for
deciding how much capital a firm
needs to support its risk
Avoids vague criteria (risk tolerance) or
imitation of supposed peers

38. Conclusion: Why VBCM?
It enables decisions that benefit
shareholders or stakeholders and
can be explained, to them & others
Note that maximizing return on surplus
may not be the best criterion

39. Conclusion: Why VBCM?
It focuses on measuring and managing
the future (franchise value) rather
than the past
In contrast to reliance on statutory
accounting measures, which focus on
liquidation value

40. Managing the Invisible
At many firms, franchise value is
invisible
It is not measured or estimated
It is therefore not managed explicitly
VBCM makes franchise value visible &
attempts to explicitly identify actions that
will maximize it

41. Reference:
Managing the Invisible:
Measuring Risk, Managing Capital, Maximizing Value
Bill Panning
Willis Re, Inc.
March 2006
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=913682