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Risk Appetite
- 1. Risk Appetite Webcast July14, 2009 © 2009 Towers Perrin
- 2. Biographies Linda Chase-Jenkins, Towers Perrin Linda 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, PartnerRe Eric 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 Perrin Joe 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. Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 2
- 3. Discussion topics Current practices and plans Definitions and best practices PartnerRe risk appetite Illustrative case study Q&A Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 3
- 4. Current practices andplans © 2009 Towers Perrin 4
- 5. Within 12 months,84% of respondents expect to have a documented risk appetite/tolerance statement Do you have a documented risk appetite/tolerance statement? No, and no plans to develop within next 12 months 16% 47% Yes No, but planned to be in place within 37% next 12 months In Place Planned Within 12 Months Not Planned Small 34% 44% 22% Medium and 57% 33% 10% Large Base: Total Respondents for Q.11 Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 5
- 6. Balance sheet solvencyis the principal focus of risk appetite/tolerance statements Which of the following measures of risk are used in your risk appetite/tolerance statement? Please select all that apply. Regulatory capital 55% Economic capital 54% Rating agency capital 33% GAAP or IFRS earnings volatility 28% Risk of loss of percentage 27% of GAAP or IFRS equity Risk of regulatory intervention 27% Risk of rating agency downgrade 22% Risk of percentage reduction in 20% GAAP or IFRS earnings vs. forecast Risk of loss of percentage of 20% embedded value or economic value Base: Those that have a documented risk appetite/tolerance statement n = 168 Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 6
- 7. Nearly 60% ofrespondents say their statements specifically forbid taking certain risks Does your risk appetite/tolerance statement specifically forbid the taking of certain risks? Please select all that apply. Yes — for risks where we do not have 44% sufficient understanding of the risks Yes — for risks where significant 35% damage to reputation may result Yes — for risks where we are unable to 21% satisfactorily model the risks Yes — for another reason 13% No 41% Base: Those that have a documented risk appetite/tolerance statement n = 168 Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 7
- 8. The majority ofcompanies have risk limits for their major risks, but only 23% have limits on operational risk 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. Market risk 64% Credit risk 65% Insurance risk 62% Operational risk 23% None of the above 13% Base: Total respondents n = 359 Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 8
- 9. Only 40% havedemonstrated consistency of their bottom-up risk limits with their risk appetite statements Have you demonstrated/modeled the consistency of your bottom-up risk limits with your top-down risk appetite/tolerance statement? 40% Yes 54% of North American respondents have demonstrated No 60% consistency with their risk appetite/tolerance statement vs. Europe 30% vs. Asia/Pacific 30% European companies have more comprehensive risk limits Base: Those that have a documented risk appetite/tolerance statement and have set limits to govern day-to-day risk taking n = 146 Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 9
- 10. Definitions and bestpractices © 2009 Towers Perrin 10
- 11. Risk appetite aimsto 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 Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 11
- 12. Definitions Risk appetite is… Total risk exposure organization will undertake to achieve its objectives Generally expressed in qualitative terms that reflect policyholder and shareholder considerations Set 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 Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 12
- 13. The risk appetitestatement provides guidance for a variety of key stakeholders 1. Policyholders, Bondholders…and Regulators, Rating Agencies Focus on strategies to prevent default Little or no interest in upside from risk taking or nature of risks 2. Shareholders and Analysts Focus on return on capital above the price of risk Don’t like surprises Interested in upside from risk taking; want thorough understanding of nature and distribution of risks 3. Management and Employees Need guidance regarding risk limits Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 13
- 14. Risk appetite isnot captured by any one measure due to the varied characteristics of underlying risk events Risk Appetite Key risk measures Other risk Profit Required Return on constraints volatility capital capital S/h focus P/h focus S/h focus Risk management processes, policies and procedures Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 14
- 15. Establishing risk appetiteand setting risk tolerances are integral to better risk-based decisions ERM Framework Organization Governance Accountability: Roles and Strategy Responsibilities Output Goals and objectives Risk Appetite Tools from Risk Process Appetite Corporate Risk Tolerance Process Identify Quantify Solve Execute Monitoring and Reporting Board reviews actual overall risk vs. established corporate risk tolerance Business units monitor aggregate risks against defined risk limits Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 15
- 16. Summary of riskappetite 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 Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 16
- 17. Risk Appetite Eric Gesick ChiefActuarial Officer July 14, 2009
- 18. Risk Appetite July 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
- 19. Risk Appetite July 14, 2009 19 Basis of Measurement – Economic Framework Quantitative aspect focuses on assumed risks Economic balance sheet drives our thinking GAAP and regulatory models provide additional constraints when reviewing capitalization Downside measure Impairment to economic balance sheet Not 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 risks Determine required capital range
- 20. Risk Appetite July 14, 2009 20 PartnerRe: Evolution of Stated Risk Appetite Focus on the three reinsurance “killers” or “shock losses” Catastrophe Loss trends/inflation (casualty) Equity market risk Define the metric Catastrophe = annual aggregate loss, all zones all perils Loss trends/inflation = prior year casualty loss ratio deterioration Equity market risk = stock market drop over one year period
- 21. Risk Appetite July 14, 2009 21 PartnerRe: Evolution of Stated Risk Appetite Return goals are easy to state, risk goals are more difficult Risk tolerance is informed by return goals Risk 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 event Remote = 1-in-75 year event Difficult to relate to a 1-in-100 or 1-in-250 due to model error and context
- 22. Risk Appetite July 14, 2009 22 PartnerRe: Evolution of Stated Risk Appetite There is no right answer Survey 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 sizes Hurricane Andrew and various aggregation assumptions Early 2000’s prior year casualty development and premium volumes Considerations Perception and credibility of Company: how would clients/shareholders view a loss from each specific risk Ability to recover and trade through a shock loss
- 23. Risk Appetite July 14, 2009 23 PartnerRe Risk Appetite 1-in-15 year event 1-in-75 year event Q1 2009 Q1 2009 Risk Modeled Risk Modeled Appetite 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 Where you are within your risk appetite is informed by the expected return outlook
- 24. Risk Appetite July 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 limits Casualty premium Market value of equities Limits Shock losses set by board Executive and business unit management define more specific limits by risk within underwriting authorities and guidelines
- 25. Risk Appetite July 14, 2009 25 PartnerRe Risk Limits Risk Metric Aggregate Limit % of Total Capital Max. aggregate exposure in any single zone $1.5 billion 31% on any single peril Actual Risk Dash Board: Current level of Catastrophe exposure $1.5 billion Limit $1.5 billion Risk Metric $billions Earned premium limit for casualty and other long-tail lines $3.8 for the 4 most recent underwriting periods Actual 4-year aggregate long-tail premiums earned 23% as % of all premiums earned in same period Risk Dashboard: Current level of 4-year aggregate long-tail earned premiums Actual $2.7 billion Limit $3.8 billion Based on exposure as at March 31, 2009
- 26. Risk Appetite July 14, 2009 26 Equity Investment Risk Limit Risk Metric Absolute Limit % Total Capital Maximum investment in equity and $2.4 billion 50% equity-like assets Current investments in equity and $0.8 billion 17% equity-like assets Risk Dashboard: Current level of equity and equity-like exposure Actual $0.8 billion Limit $2.4 billion Based on exposure as at at March 31, 2009
- 27. Risk Appetite July 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
- 28. Risk Appetite July 14, 2009 28 Desired Capital and Capital Management Desired Economic Capital Range Capital Capital Coverage At Risk Ratio Economic Capital 1-in-100 1-in-250 Return Period
- 29. Risk Appetite July 14, 2009 29 Risk Appetite: Conclusion Board engagement is required Credibility Stated risk appetite and proven ability to manage exposures to within the appetite Transparency 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 context Optimize risk/return within risk appetite and risk limits
- 30. Illustrative case study ©2009 Towers Perrin 30
- 31. There is animplied “contract” between the board and management on risk and return Board of Directors Management Sets/approves overall risk Develops business strategy, appetite and corporate risk sets financial targets (e.g., tolerance that align with growth, earnings, ROE) stakeholder expectations* Determines overall Approves capital plan “Risk (economic) capital needs and Contract” performs capital budgeting Ensures appropriate corporate risk governance Allocates capital Manages business to achieve results according to detailed business plans and agreed risk tolerances/ limits Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 31
- 32. More granular expectationscan be defined once the board and management agree on overall objectives Risk Appetite Board/CEO Risk Tolerance Statements C-Suite Risk Limit Risk Limit Risk Limit BU Leaders Risk Limit Risk Limit Risk Limit Etc. Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 32
- 33. 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 Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 33
- 34. 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 Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 34
- 35. Risk appetite wasdefined using a combination of qualitative and quantitative inputs Approach to Defining Client’s Risk Appetite/Risk Tolerance Qualitative Quantitative Inputs Client’s Mission, Vision, & Values Phase 1 Management and BOD Preliminary Risk Perspectives Appetite/Tolerance Industry/Client Historical Reference Points Client’s Risk Modeling and Sensitivity Testing Phase 2 Regulatory/Rating Revised Risk Agency Thresholds Appetite/Tolerance Board Review and Input Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 35
- 36. The initial phaseaimed 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 Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 36
- 37. For example, weasked each participant about their willingness to sustain various levels of surplus declines… Tolerance for Loss of Surplus Tolerable Annual Probability 1-in-2 50% Maximum 40% Management Average Outlier responses Board Average 1-in-3 Overall Average 30% 30% Minimum 1-in-X-Year Event 1-in-4 Equivalent 1-in-5 20% 18% Strong 14% Nearly all interviewees 11% stated that this should 1-in-10 10% Consensus 7% never happen. 7% 1-in-20 5% 3% 2% 2% 0% 0% 0% 10% Loss of Surplus 20% Loss of Surplus 50% Loss of Surplus Scenario Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 37
- 38. …and compared responsesto the historical experience for both the industry and client Comparison of Client's Tolerance for Surplus Losses to Historical Experience Probability 1-in-5 20% 16% 1-in-7 15% 1-in-X-Year Event Equivalent 11% 1-in-10 10% 8% 1-in-20 5% 5% 0% 0% 10% loss 20% loss 50% loss U.S. P/C Industry Client of surplus of surplus of surplus (1946 – 2008) (19XX – 2008) Client Interviewee Historical Benchmarks — Tolerance (Average) Frequency of Surplus Loss Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 38
- 39. Some questions wereaimed at comparing the perceived current and desired risk appetites Client’s Risk Appetite Number of Current Number of Desired Responses Responses 7 Management 7 Management 6 6 2 Board member Board member 5 2 5 4 4 1 3 3 2 3 1 5 2 4 2 3 1 2 1 2 2 1 1 1 1 1 0 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 (Low) Risk Appetite (High) (Low) Risk Appetite (High) Average Scores Current Desired Management 4.1 5.6 Board 3.1 4.8 Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 39
- 40. This interview/feedback approachlaid 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 Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 40
- 41. This interview/feedback approachalso 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 observed Preliminary risk appetite statement was refined Plan 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 established Risk limits are being established Risk modeling is being refined Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 41
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- 43. Q&A Linda Chase-Jenkins, Towers Perrin (212) 309-3897 Linda.chase-jenkins@towersperrin.com Eric Gesick, PartnerRe (441) 294-5291 Eric.gesick@partnerre.com Joe Lebens, Towers Perrin (860) 843-7056 Joe.lebens@towersperrin.com Proprietary and Confidential © 2009 Towers Perrin Not for use or disclosure outside Towers Perrin and its clients 43