Key risk issues for insurers

1. Risk Management in Today’s
Uncertain Environment
Jason A. Jones
E-mail: jjones@JonesStrategyConsulting.com
Phone: (732) 476-6387
Bermuda, March 19 – 20, 2009

2. Overview
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Paradigm Shift from Risk to Uncertainty
The Risk Management Agenda for 2009
Re-assessing Investment Risk
Fixing Broken Risk Models
Managing to Higher Capital Requirements
Proactive Cycle Management
Focus on Counterparty Risk
About Jones Strategy Consulting
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

3. Paradigm Shift from Risk to Uncertainty
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A new approach to risk management is
needed to address uncertainty, not just risk
The financial crisis put uncertainty at the fore
What’s the difference?
Risk – randomness with known probability
Car accident frequency, odds of royal flush in poker
Uncertainty – randomness with unknown probability
Impact of global warming, outcome of financial crisis
Risk models can measure risk but not uncertainty,
so models are not enough
A new thinking is required
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

4. Paradigm Shift from Risk to Uncertainty
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Wrong thinking:
Everything can be assessed in a mathematical model
Human behavior and risk arbitrage don’t matter
Inter-relationships among risks are simple enough to
be quantified (e.g., correlations or copulas)
Better thinking:
Look for multiple ways of evaluating risk
Uncertainty is affected by human behavior
The past is not always a reliable indicator of the future
Complex systems can’t be modeled with “hard
science”
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

5. Paradigm Shift from Risk to Uncertainty
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It is, I think, particularly in periods of acknowledged
crisis that scientists have turned to philosophical
analysis as a device for unlocking the riddles of their
field. Scientists have not generally needed or wanted
to be philosophers.
- Thomas Kuhn
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

6. The Risk Management Agenda for 2009
6
Re-assessing Investment Risk
Fixing Broken Risk Models
Managing to Higher Capital Requirements
Proactive Cycle Management
Focus on Counterparty Risk
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

7. The Risk Management Agenda for 2009
Re-assessing Investment Risk
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Investment risk appeared artificially low due to:
Trend of rising financial leverage 1984–2007
Untested structured finance and derivative products hid risk
and leverage
Issues hurting investments today:
Systemic de-leveraging
Uncertain public policy response to financial crisis
Mortgage defaults keep rising
Investment risk is being re-assessed:
De-risking for liquidity and capital preservation
Focus on gross risk rather than net risk
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

8. The Risk Management Agenda for 2009
Fixing Broken Risk Models
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Many risk models are seriously flawed
Economic capital models are proving unstable
Catastrophe models substantially under-estimated
losses from hurricanes Ike (2008) and Katrina (2005)
Models don’t capture the whole picture (risks or
uncertainties that go unconsidered – lack of
imagination)
Rare events are hard to model due to unreliable data
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

9. The Risk Management Agenda for 2009
Fixing Broken Risk Models
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Loss of model credibility
AIG’s economic capital model indicated enough capital to
withstand 1-in-2000-year loss – 3 months before AIG’s
collapse!
On the folly of modeling 1-in-2000-year events (AKA
99.95% confidence level over 1-year horizon):
Putting this into historical perspective, it means withstanding World Wars
I and II, the Great Depression, the death of 30% to 60% of Europe’s
population during the Black Death in the 1340’s, the fall of the Roman
Empire, and countless other catastrophes and cataclysms in the past
two millennia. No company on earth could find a credible way to model
all of these risks, let alone manage capital requirements with such a
model.
- Quarterly Insurance Round-up: Third Quarter 2008, Jones Strategy
Consulting
So why are ING, Allianz and others modeling at “confidence
levels” of 99.95% or higher?
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

10. The Risk Management Agenda for 2009
Fixing Broken Risk Models
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What’s the solution?
Assess risk in multiple ways
No black box models
Use techniques to reduce model error
Remove from portfolio any risks which are: not understood,
unlimited or un-quantifiable
Use risk limits as safety nets
Model the whole loss distribution (good, bad and the ugly):
Good: 1-in-2 year scenario, expected loss
Bad: 1-in-20-year scenario, use reliable in-sample data
Ugly: Very rare scenarios that can’t be modeled
statistically – use scenario analysis, sensitivity analysis
Control and manage risk - don’t just measure it
Management judgment
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

11. The Risk Management Agenda for 2009
Managing to Higher Capital Requirements
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Insurers need more capital
Risk is elevated due to financial crisis and soft market
Investment losses took a big toll on capital
Top 10 P/C insurers lost 25% of their capital in 2008
Frozen capital markets – no more “just in time capital”
Actions to take
Retain capital – hold steady or cut dividends and share
buybacks
Favor de-risking and rate adequacy over market share
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

12. The Risk Management Agenda for 2009
Managing to Higher Capital Requirements
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Figures in $ millions
Shareholders’ Equity Shareholders’ Equity
Company 12/31/2008 12/31/2007 Change
Hartford Ins Group 9,268 19,204 -51.7%
American International Group, Inc 52,710 95,801 -45.0%
Allstate Ins Group 12,641 21,851 -42.1%
CNA Ins Cos 6,877 10,150 -32.2%
Liberty Mutual Ins Cos 10,160 12,366 -17.8%
W.R. Berkley Group 3,046 3,570 -14.7%
Progressive Ins Group 4,215 4,936 -14.6%
Berkshire Hathaway Ins 109,267 120,733 -9.5%
Chubb Group of Ins Cos 13,432 14,445 -7.0%
Travelers Ins Companies 25,319 26,616 -4.9%
Total 246,935 329,672 -25.1%
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

13. The Risk Management Agenda for 2009
Proactive Cycle Management
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The soft market continues
Global recession means lower insurance demand, downward
rate pressure and more competition
Forecast: Return of hard market (2010); Rate adequacy (2011)
Investments will not help
Expect investment losses and low investment income in 2009
Key actions to manage the cycle
Better metrics See my white paper,
Control terms and conditions Managing the
Be careful of new business Underwriting Cycle
Allocate capital
Build a foundation of accountability
Act quickly and aggressively
Watch for changes in loss cost inflation or deflation!
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

14. The Risk Management Agenda for 2009
Proactive Cycle Management
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Insurance rates keep declining
MarketScout:
P/C rates fell 8% in February 2009
Rate of decline is down from double digits
Declines across all classes
Cumulative rate decline exceeded 32% since February
2005!
Reinsurers are turning the corner
Guy Carpenter report on January 2009 renewals:
Prop/cat rates up 8% and casualty rates up 5%
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

15. The Risk Management Agenda for 2009
Focus on Counterparty Risk
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Counterparty risk is everywhere
Investments
Derivatives / hedges
Policyholders and agents
Reinsurers
Insurer responses:
Diversifying reinsurance programs
Focusing on gross exposures (not just net)
Re-evaluating policyholder behavior and agent balance
receivables
Reducing counterparty concentrations
Investment de-risking
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

16. The Risk Management Agenda for 2009
Focus on Counterparty Risk
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Use your own due diligence and judgment!
…regulators and investors should return to the tool they
used to assess credit risk before they began
delegating responsibility to the credit rating agencies.
That tool is called judgment.
- New York Times, March 16, 2009, page A23. Opinion piece
“Rated F for Failure” by Jerome S. Fons and Frank
Partnoy.
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

17. About Jones Strategy
Consulting
17
Reinsurance and
Insurance Risk,
Finance, and
Strategy:
Capital
ERM
Management
Counterparty Rating Agency
Credit Risk Relations
Risk Metrics Cycle
and Reporting Management
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

18. 18
402 Main Street, Suite 100-329
Metuchen, NJ 08840
www.JonesStrategyConsulting.com
Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009