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Discussion of how to use shareholder value to drive risk management
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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