Property of Tillinghast - Towers Perrin Enterprise Risk Management Papers Presentation at CAS 2001 Seminar on Understanding the Enterprise Risk Management

Property of Tillinghast - Towers Perrin

Enterprise Risk Management Papers

Presentation at CAS 2001 Seminar on Understanding the Enterprise Risk Management Process

Jerry Miccolis, FCAS, MAAA, Tillinghast - Towers PerrinSamir Shah, FSA, MAAA, Tillinghast - Towers Perrin

April 2-3, 2001

2Property of Tillinghast - Towers Perrin

We will be addressing two ERM papers today

“Enterprise Risk Management: An Analytic Approach” by Jerry Miccolis and Samir Shah, Tillinghast - Towers Perrin Monograph, January 2000

“Creating Value through Enterprise Risk Management — A Practical Approach for the Insurance Industry” by Jerry Miccolis and Samir Shah, Tillinghast - Towers Perrin Monograph, April 2001

We will focus primarily on the second paper It represents our most current thinking It illustrates how to practically apply the concepts of the

first paper (within a specific industry) Applications to other industries should be clear

Property of Tillinghast - Towers Perrin

Creating Value through Enterprise Risk Management

A Practical Approach for the Insurance Industry

Value

Gro

wth

Retu

rn

Con

sis

ten

cy

Capital

This document is incomplete without the accompanying discussion; it is confidential and intended solely for the information and benefit of the immediate recipient thereof.

Jerry Miccolis, FCAS, MAAASamir Shah, FSA, MAAA


Here are some key findings from our recent ERM survey of insurance executives

Executives believe ERM is critical to helping them deal with their key business issues

They are not satisfied with current tools, techniques and processes to implement ERM — especially for dealing with operational risks

They want a more robust conceptual and methodological framework that: Encompasses all relevant risks — both financial and

operational Integrates both financial and operational strategies to

manage those risks


In our client work, insurers are increasingly asking important risk-related questions

How much capital do we need? And how do we convince the rating agencies?

How should our capital be deployed to business segments?

How can we maximize our return on capital, given our risk appetite?

How do we best invest our assets, given our liability mix?

Can we get a handle on our operational risks?

How can we optimize our distribution channel strategy?

How much, and on what terms, should we reinsure/hedge?

How do we encourage the right risk management behavior?

Are we prepared against our most critical down-side risks?

How can we minimize economic and accounting volatility?

We believe these questions need to be answered within the context of a comprehensive and coherent risk management framework...

We believe these questions need to be answered within the context of a comprehensive and coherent risk management framework...

The RiskValueInsights Framework

NYO 6Property of Tillinghast - Towers Perrin


Product andDistribution

Product mix Distribution

strategy Pricing Customer

service

Investments Asset/liability

management Liquidity Market risk

tolerance Tax profile

Organization Hiring/training HR policies Pay and

benefits Communication

Companies are managing a number of separate, but related, activities...

CapitalStructure Equity vs. debt Managing

excess capital Reinsurance Securitization


…with the overall objective of increasing enterprise value

Increasing returnIncreasing return

Improving consistencyImproving

consistency

Providing appropriate level, structure and allocation of capital

Providing appropriate level, structure and allocation of capital

Enhancing growthEnhancing growth

More on…using Embedded Value as the value measure

More on… the link between consistency and enterprise value

Increase valueIncrease value

by


The best way to effectively drive value is to understand the full risk environment in which you operate...

Financial

Asset

Liability

Risk

Operational

Event

Business

InternalEnvironment

Expansion/diversification

Culture

Distribution

Risk appetite

People

Processes

Technology

ExternalEnvironme

nt

Economic conditions

Social/legal trends

Political/regulatory climate

Natural catastrophes

Customer behavior

Competition

Investor expectations

Reputation/rating agency


…and the complete set of strategies available to you…

Risk

Financial

Asset

Liability

Operational

Event

Business

Operational Strategies

Hiring/training

Customer service

Market strategy

Distribution

M&A

Technology

Internal controls

Incentive programs

Financial Strategies

Capital structure

Investment strategy

Pricing

Product mix

Dynamic hedging

Reinsurance


…and to use this knowledge in a holistic risk management framework

Holisticallymanage

financial and operational

risks

Holisticallymanage

financial and operational

risks

Exploit natural hedges

and portfolio effects



Understand both

internal and

external environment

s

Investigate both

financial and

operational strategies

Increase return

Increase return

Improve consistenc

y

Improve consistenc

y

Establish capitalEstablish capital

Enhance growth

Enhance growth


The RiskValueInsights Process



A continual management process is needed to “operationalize” the framework

Develop Best

Strategies

Develop Best

Strategies

Implement

Strategies

Implement

Strategies

MonitorPerformance and

Environment


Environment

Operating Margin

0% 2% 4% 6% 8%

1999

Target

2000

8%

7%

6%

8%

7%6.80%

6.50% 6.60%

3.20%

2.50%

1.90%

3.10%

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

1997 1998 1999 2000 YTD

yields-new invmts portfolio yields GNP deflator

0

2

4

6

8

10

12

14

16

1997 1998 1999 2000 YTD

# catastrophes # bad faith lawsuits

Set theagenda

Establishbusiness

performancerequirements

Assess organization capabilities

Build the changestrategy

Align & deliver

Leadership

Measurement

Involvement

CommunicationChange

Enablers

Articulate

Strategies

Assess

Risks

Evaluate Strategies: Policyholde

rs’ Perspective

Evaluate Strategies: Owners’ Perspectiv

e

Refine Strategies


Develop

Developing best strategies involves a five-step exercise

Click on appropriate chevron above to see details of that step

Attribute capital to business segment

Attribute capital to business segment

Establish economic capital

requirement

Establish economic capital

requirement

Link to key performance

indicator(s) via financial model

Link to key performance

indicator(s) via financial model

Identify & overlay financial & operational strategies

Identify & overlay financial & operational strategies

KPI distributio

n

Articulate Strategie

s

Assess Risks

Evaluate Strategies:

Policyholders’ Perspective

Evaluate Strategies:

Owners’ Perspective

Refine Strategies

Decompose risk into root causesDecompose risk into root causes

Isolate impact of each strategy

Isolate impact of each strategy

Set objectives & constraints

Set objectives & constraints

Establish risk & value metrics

for growth, return &

consistency

Establish risk & value metrics

for growth, return &

consistency

Optimize strategies &

sensitivity-test

Optimize strategies &

sensitivity-test

Identify financial & operationa

l risk factors

Identify financial & operationa

l risk factors

Classify & prioritize

risk factors

Classify & prioritize

risk factors

Risk factor distribution

s


Successfully implementing certain strategies requires a change management process

Implement

Develop Change Capability

Energize and Engage for Broader

Impact

Mobilize First Wave and Secure Early Wins

Focus and Sequence Effort

Articulate the Ambition

Align & DeliverBuild the Change Strategy

Assess Organization Capabilities

Establish Business Performance Requirements

Set the Agenda

DeliverDesign

Leadership

Measurement

Involvement

CommunicationChange Enablers


Strategy performance and risk environment must be monitored to adjust strategies as necessary

MarketingMarketing

New business sold Retention of old

business Mix of business: new

and renewal Market share

New business sold Retention of old

business Mix of business: new

and renewal Market share

UnderwritingUnderwriting

Price achieved vs. target price

Exposure mix Quotes

accepted/declined Variance analysis

Price achieved vs. target price

Exposure mix Quotes

accepted/declined Variance analysis

ClaimsClaims

Frequency and severity of claims

Claims productivity

Frequency and severity of claims

Claims productivity

FinancialFinancial

Revenue Underwriting profit Investment profit Pre-tax operating income Net income Return on equity and total capital

Revenue Underwriting profit Investment profit Pre-tax operating income Net income Return on equity and total capital

InvestmentsInvestments

Cash flow Yield on new investments Yield on portfolio by class and

duration Convexity of assets Duration of assets Investment mix: new and

portfolio Credit default Total return

Cash flow Yield on new investments Yield on portfolio by class and

duration Convexity of assets Duration of assets Investment mix: new and

portfolio Credit default Total return

Human ResourcesHuman Resources

Agency composition (number, age, service)

Total employment by department Number and percentage

leaving the company Vacancy rates Average salary increase

vs. plan

Agency composition (number, age, service)

Total employment by department Number and percentage

leaving the company Vacancy rates Average salary increase

vs. plan

OtherOther

Audit compliance Inflation rates Interest rates GNP Exposure data (number of

cars, payroll, etc.) Competitor pricing

Audit compliance Inflation rates Interest rates GNP Exposure data (number of

cars, payroll, etc.) Competitor pricing

Monitor

Click here…to see these measures combined as a dashboard for performance management


Insurance and banking approaches to ERM are -- and should be -- different

Asset risk and liability risk

Liability characteristics: Certainty Liquidity Duration Demand payments

Risk metrics/models: VaR and ECOR/EPD Coherence

Operational risks Business risks and event risks Regulatory pressure Modeling approaches

Summary



The framework is holistic...

Holisticallymanageall risks

Holisticallymanageall risks

Financial Risk

Operational Risk





Investigate both financial

and operational strategiesCapital

structure

Investment strategy

Pricing

Product mix

Dynamic hedging

Reinsurance

Hiring/training

Customer service

Market strategy

Distribution

M&A

Technology

Internal controls

Incentive programs

Understand both internal and external

environmentsEconomic conditions

Social/legal trends

Political/regulatory climate

Natural catastrophes

Customer behavior

Competition

Investorexpectations

Expansion/diversification

Culture

Distribution

Risk appetite

People

Processes

Technology

Reputation/rating agency

Increase

return

Increase

return

Improve consisten

cy

Improve consisten

cy

Establish capitalEstablish capital

Enhance

growth

Enhance

growth



...The process is complete...

Develop Best

Strategies

Develop Best

Strategies

Implement

Strategies

Implement

Strategies


Environment


Environment

Operating Margin

0% 2% 4% 6% 8%

1999

Target

2000

8%

7%

6%

8%

7%6.80%

6.50% 6.60%

3.20%

2.50%

1.90%

3.10%

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

1997 1998 1999 2000 YTD

yields-new invmts portfolio yields GNP deflator

0

2

4

6

8

10

12

14

16

1997 1998 1999 2000 YTD

# catastrophes # bad faith lawsuits

Set theagenda

Establishbusiness

performancerequirements

Assess organization capabilities

Build the changestrategy

Align & deliver

Leadership

Measurement

Involvement

CommunicationChange

Enablers

Articulate

Strategies

Assess

Risks

Evaluate Strategies: Policyholde

rs’ Perspective

Evaluate Strategies: Owners’ Perspectiv

e

Refine Strategies


…And the approach can provide great value

Enables you to determine your appropriate capital level, redeploy unneeded capital and improve return on capital

Permits the proper attribution of capital to business segments and supports performance tracking of each segment

Helps you evaluate alternative capital structures that leverage returns

Provides a method for ensuring that enterprise owners receive proper compensation for risks assumed

Allows you to stabilize earnings and thereby increase enterprise value

Supports the development of an optimal risk financing strategy and program

Provides better information about your company, which increases negotiating leverage with: Reinsurers Rating agencies Capital markets Industry analysts M&A targets

Documents

Property of Tillinghast - Towers Perrin Enterprise Risk Management Papers Presentation at CAS 2001 Seminar on Understanding the Enterprise Risk Management