Ingram Brighton Sh Value

RISK AND INVESTMENT

CONFERENCE

21-23 JUNE 2009

THE GRAND, BRIGHTON

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

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

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!

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!

ERM Objectives

Risk Management Objectives

Link with

strategy

High

Low

Medium

Risk controlBalance sheet protection

Risk/return optimization

Value creation

Compliance

Loss

minimization

Risk

management

Risk

measurement

Strategic

integration

Value

optimization

Adapted from Standard & Poor’s

Loss Controlling

Risk Trading

Risk Steering

Change Risk Management

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

ERM is like Seatbelts

They only work if you use them!

Economic Capital:

Focused on

Liquidation

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!

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?

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?

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.

Beyond Economic

Capital:

Value Based

Capital

Management

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

The Components of Value

�Liquidation versus franchise value

�Liquidation value = value of firm in runoff

� Adjusted book value

� Reflects past decisions

� Relatively fixed

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

What is Risk?

� Threat to the continuation of the firm.

What is Value?� Discounted future earnings

What are earnings if the firm fails?� Zero

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

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

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

The Objective of VBCM

Effect of Strategy on Franchise Value

20

30

40

50

60

70

0 25 50 75 100 125 150 175 200

Surplus or Reinsurance Utilization

Franchise Value

Effect of Strategy on Franchise Value

20

30

40

50

60

70

0 25 50 75 100 125 150 175 200

Surplus or Reinsurance Utilization

Franchise Value

Identify the capital and risk management

strategy that maximizes franchise value

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

Using VBCM to Determine Optimal Level of Capital

Note: Vertical axis is FV in excess of Surplus amount

Effect of Strategy on Franchise Value

20

30

40

50

60

70

0 25 50 75 100 125 150 175 200

Surplus or Reinsurance Utilization

Franchise Value

Effect of Strategy on Franchise Value

20

30

40

50

60

70

0 25 50 75 100 125 150 175 200

Surplus or Reinsurance Utilization

Franchise Value

+25

+37

Underlying Dynamic ExampleReturn Distributions

(800)

(600)

(400)

(200)

-

200

400

600

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Value Determination� With zero Capital

� Expected Return = 115

� Probability of Impairment = 20%

� Discount Rate = 5%

� Value over 10 future years = 1150 – 500 – 180 = 470

� VE Multiplier = 470 / 115 = 4.1

Impairment Discount

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

VBCM versus

Dynamic

Reinsurance

Optimization

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

Total Economic Return on Capital 11.60% 2.00% 10.90% 9.60% 11.30%

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

Risk-Adjusted ROE Calculations

VBCM Calculations

VBCM and ERM

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

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

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

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

Conclusion

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

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

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

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

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