1. Risk-Adjusted Capital Management
CAS/SOA ERM Symposium
July 30, 2003
Sim Segal, FSA, MAAA
Senior Manager
Deloitte & Touche

2. Agenda What is capital management?
The capital management process and its evolution
Practical application of capital management
Keys to success

3. Capital has two components
Capital is wealth . . .
. . . ”used” or ”available for use” . . .
. . . in the production of more wealth.
American Heritage Dictionary

4. Total Capital = Required + Available
Assets
Liabilities
Required capital
Used
Total capital
Available capital
Available for use

5. Capital management is managing both required and available capital
Required capital management
Maximize risk-based capital performance measure, within constraints
Available capital management
Maintain available capital at optimal level, balancing:
a) Future growth needs
b) Drag on returns
c) Capital flexibility

6. Capital management is managing both required and available capital
Required capital management
Focus of today’s
discussion
Maximize risk-based capital performance measure, within constraints
Available capital management
Maintain available capital at optimal level, balancing:
a) Future growth needs
b) Drag on returns
c) Capital flexibility

7. Agenda What is capital management?
The capital management process and its evolution
Practical application of capital management
Keys to success

8. The Capital management process has five steps
1. Define required capital
2. Allocate required capital
3. Select a capital measure to evaluate performance
4. Set a hurdle rate
5. Maximize capital measure, within constraints

9. Capital management has evolved in the insurance industry
1. Required Capital
2. Capital Allocation
3. Capital Measure
4. Hurdle Rate
Zero (ignored in pricing)
Company level
Internal Rate of Return (IRR)
Benchmark
Multiple of RBC (Statutory)
Segment level
Long-Term Weighted Average Cost of Capital (WACC)
Return on Investment (ROI)
Line of business or product line level
Multiple of RBC plus accounting adjustments (GAAP, but Stat-based)
Return on Equity (ROE)
WACC based on dynamic risk-free rate
Policy level
 Customer level
 Producer level
Return on Capital (ROC)
Value-at-Risk (VaR) (GAAP)
WACC based on dynamic risk-free rate and dynamic risk premium
Embedded Value (EV) or Fair Value (FV)

10. Agenda What is capital management?
The capital management process and its evolution
Practical application of capital management
Keys to success

11. Example: Public Multiline Financial, Inc.
Step 1: Define required capital

12. Required capital is risk-based . . . but what risk is being addressed?
Action by state insurance department
Economic ruin ? ?
Downgrade by rating agency ? ?
Loss of competitive standing ?

13. Required capital addresses multiple risks related to disparate constituencies
Benchmark Capital
To match the capital level of a key competitor
Economic Capital
To maintain a given probability of avoiding ruin
Total Required Capital
Rating Agency Capital
To maintain current debt or financial strength ratings
Regulatory Capital
To avoid regulatory action

14. Example: Public Multiline Financial, Inc.
Step 1: Define required capital
Required capital is Value-at-Risk (VaR), using a one-year time horizon and a 99.9% confidence level

15. Value-at-Risk (VaR) is based on a stochastic analysis of economic ruin
Illustrative
Confidence Level
95%
99%
99.9%
Probability
Loss Rate
Value-at-Risk Capital

16. Example: Public Multiline Financial, Inc.
Step 1: Define required capital
Step 2: Allocate capital

17. Allocating capital further down in the organization facilitates more decision-making
Segment
Segment
. . .
Segment
Strategic decisions, e.g.:
Growth
Market exit
Tactical decisions, e.g.:
Pricing
Mix of product portfolio
Transactional decisions, e.g.:
Retention efforts
Cross-selling
Producer compensation decisions
Product
Product
. . .
Product
Policy
Policy
Policy
. . .
Policy

18. Example: Public Multiline Financial, Inc.
Step 1: Define required capital
Step 2: Allocate capital
Capital is allocated down to the product level

19. Example: Public Multiline Financial, Inc.
Step 1: Define required capital
Step 2: Allocate capital
Step 3: Select a capital measure to evaluate performance

20. Each capital measure offers a unique focus
ROI emphasizes rate of return
ROE measures efficiency of usage of equity capital
ROC illustrates the ability to generate earnings per dollar of total capital
EV quantifies the dollar contribution to shareholder value

21. Case study: ROE-based compensation has disadvantages vs
Case study: ROE-based compensation has disadvantages vs. EV-based compensation
Hurdle rate = 15%
Situation
ROE-based* plan
EV-based plan
Value is created:
Management in a 20% ROE line of business decides to add a 16% ROE project
Penalized
Rewarded
Value is destroyed:
Management grows a 12% ROE business
* Compensation plan based on ROE and earnings

22. Example: Public Multiline Financial, Inc.
Step 1: Define required capital
Step 2: Allocate capital
Step 3: Select a capital measure to evaluate performance
Capital measure is Embedded Value (EV)

23. Embedded Value (EV) is a function of distributable earnings / surplus from inforce
Discounted value of distributable earnings from inforce business*
Value of inforce business
Embedded Value (EV)
Distributable surplus
Value of surplus
* Includes target surplus

24. Distributable earnings reflects changes in total surplus and target surplus
Adjusted statutory net income *
Target surplus released (consumed)
* Adjusted to replace investment income on surplus with investment income on target surplus

25. Example: Public Multiline Financial, Inc.
Step 1: Define required capital
Step 2: Allocate capital
Step 3: Select a capital measure to evaluate performance
Step 4: Set a hurdle rate

26. The hurdle rate is management’s estimate of its risk-return position on the efficient frontier?
Return ? Rm X X Rf m
Risk

27. Hurdle rate setting methods involve tradeoffs between simplicity, accuracy and stability
Stability of Measure
Benchmarking
Easiest
Poor
Long-term weighted average cost of capital (WACC)
Moderately complex
Moderate
Fair
WACC based on dynamic risk-free rates
High
Good
WACC based on dynamic risk-free rates and dynamic risk premium
Most complex
Highest
Best

28. Example: Public Multiline Financial, Inc.
Step 1: Define required capital
Step 2: Allocate capital
Step 3: Select a capital measure to evaluate performance
Step 4: Set a hurdle rate
Hurdle rate is WACC based on dynamic risk-free rates, with uniform hurdle rates throughout the enterprise

29. Example: Public Multiline Financial, Inc.
Step 1: Define required capital
Step 2: Allocate capital
Step 3: Select a capital measure to evaluate performance
Step 4: Set a hurdle rate
Step 5: Maximize capital measure, within constraints

30. Dynamic modeling clarifies potential impact of projects on embedded value (EV)

31. Required capital (200% RBC) Required capital (VaRC)
Constraint of maintaining the RBC ratio is more complex when using Value-at-Risk (VaR)
Statutory
GAAP
Available capital
0.1 B
Available capital
0.3 B
Required capital (200% RBC)
1.2 B
Required capital (VaRC)
1.0 B

32. Summary: practical applications of capital management
Strategic:
Manage stock analysts, e.g., reveal under-valued businesses
Strategic planning, e.g., project capital needs, quantify impact on capital ratios
Risk management, e.g., estimate probability of ruin and impact on stock price
Tactical:
Funding decisions, e.g., identify stock repurchase opportunities
Risk-return tradeoff decisions
Identifying highest value-added projects
Asset-liability management (ALM)
Provide incentive compensation aligned with increasing value

33. Agenda What is capital management?
The capital management process and its evolution
Practical application of capital management
Keys to success

34. Keys to success
Define required capital with deference to all key constituencies
Allocate capital as far down in the organization as possible
Select a capital measure that aligns with your goals
Align incentive compensation with the capital measure
Avoid fallacy of the “correct” hurdle rate
Manage constraints carefully while maximizing capital measure
Employ a disciplined process to setting or changing assumptions
Provide management with the tools to understand the impact of decisions on the capital measure

35. Risk-Adjusted Capital Management
Thank You!
CAS/SOA ERM Symposium
July 30, 2003
Sim Segal, FSA, MAAA
Senior Manager
Deloitte & Touche