Assessing Balance Sheet Protection Presented by Joan Lamm-Tennant, PhD GeneralCologne Re Capital Consultants CAS Seminar on Dynamic Financial Analysis June 6 - 8, 2001 Boston

2 GeneralCologne Re Capital Consultants Proprietary & Confidential Topics What is Balance Sheet Risk? Why is Risk Assessment/Management Important? Evaluating the Effectiveness of Risk Management Strategies –Capital Management Strategy –Reinsurance Strategy –Integrating Reinsurance Strategy with Asset Strategy Creating EVA by Managing Balance Sheet Risk Conclusion

3 GeneralCologne Re Capital Consultants Proprietary & Confidential C O R R E L A T I O N D I V E R S I F I C A T I O N Asset Risk Traditional Analytics Liability Risk Traditional Analytics Enterprise Risk Diversifiable Risk What is Balance Sheet Risk? Traditional measures of risk are not additive - asset risk plus liability risk does not equal enterprise risk

4 GeneralCologne Re Capital Consultants Proprietary & Confidential Traditionally, risk has been thought of as volatility of ROE For an insurance enterprise, the probability of surplus loss (VaR) may be a more relevant risk measure - the likelihood of events causing concern. Expected Policyholder Deficit (T-VAR) measures the average loss beyond the VAR hurdle. What is Balance Sheet Risk?

5 GeneralCologne Re Capital Consultants Proprietary & Confidential Topics What is Balance Sheet Risk? Why is Risk Assessment/Management Important? Evaluating the Effectiveness of Risk Management Strategies –Capital Management Strategy –Reinsurance Strategy –Integrating Reinsurance Strategy with Asset Strategy Creating EVA by Managing Balance Sheet Risk Conclusion

6 GeneralCologne Re Capital Consultants Proprietary & Confidential Why is risk management important? Risk is costly to the firm. Unhedged risk and therefore volatile earnings will –increase taxes, –cause agency (stakeholder) conflicts between corporate stakeholders (policyholders, managers, shareholders, regulators, etc.) which will result in dysfunctional investment decisions –deprive firms of funds to sustain new investment plans - crowding out –interfere with the design of effective compensation plans for managers Since risk (earnings volatility) is costly, management of risk will eliminate these costs and therefore create real economic value.

7 GeneralCologne Re Capital Consultants Proprietary & Confidential Earnings volatility increases WACC and will “crowd out” new investment. Why? Capital in an enterprise is derived form three prime sources - retained earnings, debt, and equity WACC is the weighted average cost of all three sources of capital External capital (equity) is more expensive than internal capital (retained earnings) When internal capital is consumed, new capital must come from external sources The risk-adjusted cost of the external capital will be derived from the earnings volatility - the higher the volatility the higher the cost

8 GeneralCologne Re Capital Consultants Proprietary & Confidential Risk Raises WACC and “Crowds Out” New Investment. Source: Financial Management Theory and Practice A = 13% C = 12% B = 12.5% Percent WACC D = 10.2% Optimal Capital Budget = $100 million IOS ProjectCost (In Millions)Rate of Return A $ % B C D A = 13% C = 12% B = 12.5% Percent WACC D = 10.2% Optimal Capital Budget = $180 million IOS ProjectCost (In Millions)Rate of Return A $ % B C D

9 GeneralCologne Re Capital Consultants Proprietary & Confidential Earnings volatility increases WACC and will “crowd out” funds for new investment. What effect does this have on growth? In the second example, earning volatility was higher than in the first example, therefore –the jump in the cost of capital due to going externally was greater, and –the incremental charge for external capital was greater. In the second example, the capital budget is constrained to project A and B. Consequently due to earnings volatility, growth is reduced since Project C is not longer affordable.

10 GeneralCologne Re Capital Consultants Proprietary & Confidential Managing risk allows firms to sustain profitable growth Capital adequacy is dependent on risk assessment Allocating capital based on risk to the various products is necessary to determine the capital charge when pricing business. EVA is created when the firm generates returns in excess of its cost of capital - marginal cost of capital is dependent on the firm’s risk A macro-assessment of risk is necessary to support micro-risk management strategies –Asset Allocation StrategiesReinsurance Strategy –Acquisition/Valuation AnalysisNew Product Assessment “Agents” in our business are concerned about risk - regulators, rating agencies, owners, policyholders, bondholders. Why is risk management important?

11 GeneralCologne Re Capital Consultants Proprietary & Confidential Topics What is Balance Sheet Risk? Why is Risk Assessment/Management Important? Evaluating the Effectiveness of Risk Management Strategies –Capital Management Strategy –Reinsurance Strategy –Integrating Reinsurance Strategy with Asset Strategy Creating EVA by Managing Balance Sheet Risk Conclusion

Capital Management Strategy

13 GeneralCologne Re Capital Consultants Proprietary & Confidential Contribution of Risk by Income Category Other Underwriting Asset Returns Reserves Asset Return Reserves Other Underwriting Based on the simulation of balance sheet and income statement data, identify where risk resides in the firm Based on the correlation and diversification characteristics of the key drivers of risk to the firm, and identify the contribution of various sectors to the risk of the firm Line % Risk Allocation Product 161.7% Product 28.6% Product 37.2% Product 45.5% All Other17.1% TOTAL100% 61.6% 8.6% 7.2% 5.5% 17.1% Risk Allocation by Product Group Risk-Based Capital Allocation

14 GeneralCologne Re Capital Consultants Proprietary & Confidential Dynamic Capital Allocation This utilizes option pricing framework to allocate surplus so that the marginal default value is the same for all segments This allocates capital to a segment so that the marginal benefit to the firm for an additional unit of surplus is equal across segments Allocation is driven by uncertainty of losses, correlation with other segments’ losses and the correlation with return on assets Once the required capital based on the risk of the firm has been established, that capital may be allocated using a marginal capital allocation methodology

15 GeneralCologne Re Capital Consultants Proprietary & Confidential Capital Allocations Techniques Need To Be Understood By The Industry Regulatory - Risk Based Capital Capital Allocation Pricing Model Value-At-Risk “Macro” Marginal Allocation - Merton and Perold, 1993 “Micro” Marginal Allocation - Myers and Read, 1999

Reinsurance Strategy

17 GeneralCologne Re Capital Consultants Proprietary & Confidential Based on the Frequency and Severity characteristics of each line of business Simulate individual claims for each line of business. These will serve as the basis for comparing different reinsurance structures. Based on the simulation of gross claims data, identify where the risk is derived from underwriting. Modeling Process - Reinsurance Strategy

18 GeneralCologne Re Capital Consultants Proprietary & Confidential Based on the Allocation of Underwriting Risk Develop a set of reinsurance programs to evaluate. These will serve as the basis for comparing different reinsurance structures. For each set of simulated claims, compare the financial results under each reinsurance program Consider underwriting results, income, surplus and any other constraints and metrics. Each reinsurance program will be compared against the same set of simulated claims. Modeling Process - Reinsurance Strategy

19 GeneralCologne Re Capital Consultants Proprietary & Confidential Global (All Regions) - Period 1

20 GeneralCologne Re Capital Consultants Proprietary & Confidential Reinsurance Strategic Options Reinsurance Strategy Options Buy Less Global Efficiency Buy Smarter Regional Efficiency Buy No Voluntary Reinsurance at Regional Level Buy Only Cat Reinsurance Globally Buy Cat and Treaty Globally - No Regional Purchase Strategy 1Strategy 2Strategy 3Strategy 4Strategy 5Strategy 6 Regional Design Program to Meet Regional Results but Purchased from Center at Market Price Evaluate with Dual DFA Decision Criteria and Purchase Centrally if Strategy Passes Both Criteria Purchase Treaty at Local Level at Market Price Based on Local Results

21 GeneralCologne Re Capital Consultants Proprietary & Confidential Individual programs can be directly compared against any metric, in this case, the nominal value of net underwriting profit. Percentiles of Nominal U/W Profit Different Reinsurance Programs (350,000) (300,000) (250,000) (200,000) (150,000) (100,000) (50,000) 0 50,000 A BCDEFGHIJGross Nominal U/W Profit 1st 5th 25th Median Mean 75th 95th 99th Comparing Individual Reinsurance Proposals

Integrating Reinsurance Strategy with Asset Strategy

23 GeneralCologne Re Capital Consultants Proprietary & Confidential The Dilemmas How much catastrophe reinsurance to purchase? How to allocate the assets between equity and fixed income? The Choices Reinsurance: None,$2 million retention, $10 million retention Assets: Low return/risk (mostly fixed income), high return/risk (mostly equity) The Company $80 million in surplus Expected to write $80 million in premiums with $150 million in assets Integrating Reinsurance Strategy with Asset Strategy

24 GeneralCologne Re Capital Consultants Proprietary & Confidential Efficient Frontier 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 0.00%0.50%1.00% Average Excess Value Loss Mean ROE No Reinsurance Combined Frontier A B C A-B - Risk Opportunities Made Available by Reinsurance B-C - Return Opportunities Otherwise Unavailable Without Reinsurance Examining the “Trade” - Evaluation Process

25 GeneralCologne Re Capital Consultants Proprietary & Confidential Integration of reinsurance with the asset allocation choice extends the efficient frontier affording low risk alternatives not available otherwise A range of risk opportunities exist whereby integrating reinsurance with the asset choice allows for more efficient risk/return trade-offs A “pecking order” of risk choices is proposed for incremental increases in risk low retention, low risk asset allocation low retention, higher risk asset allocation high retention, low risk asset allocation high retention, high risk asset allocation Examining the “Trade”

26 GeneralCologne Re Capital Consultants Proprietary & Confidential Topics What is Balance Sheet Risk? Why is Risk Assessment/Management Important? Evaluating the Effectiveness of Risk Management Strategies –Capital Management Strategy –Reinsurance Strategy –Integrating Reinsurance Strategy with Asset Strategy Creating EVA by Managing Balance Sheet Risk Conclusion

27 GeneralCologne Re Capital Consultants Proprietary & Confidential Three important factors contribute to enterprise value Float Cost of Capital Spread Enterprise Value (EV) = (Float x Spread) - Cost of Capital EV =[Funds (R Assets + R Underwriting )] - [Equity (C Capital - R Assets )] Funds = funds from underwriting = premiums less expenses, R Assets = return on invested assets, R Underwriting = annualized return on underwriting = premiums less expenses less losses relative to funds, Equity = equity required due to loss uncertainty C Capital = cost of equity capital. Funds = funds from underwriting = premiums less expenses, R Assets = return on invested assets, R Underwriting = annualized return on underwriting = premiums less expenses less losses relative to funds, Equity = equity required due to loss uncertainty C Capital = cost of equity capital. Driving EVA

28 GeneralCologne Re Capital Consultants Proprietary & Confidential Sample included all publicly held property-casualty insurers in the US Time period included five years from 1994 to 1998 For each year we estimated the company’s weighted average cost of capital For each year we estimated the company’s economic value added We then asked the question - does EVA explain growth in market value? Enterprise Value Drivers: A Test of the Proposition

29 GeneralCologne Re Capital Consultants Proprietary & Confidential Cost of Capital

30 GeneralCologne Re Capital Consultants Proprietary & Confidential Economic Value Added

31 GeneralCologne Re Capital Consultants Proprietary & Confidential Operational ROE is significant in explaining an insurance company’s change in stock price. The higher the Operational ROE the greater the increase in firm’s in stock price or intrinsic value. While Operational ROE is significant in explaining the firm’s change in stock price, the explanatory power is improved when Operational ROE and Cost of Capital are considered together (effectively a proxy for EVA). Enterprise Value Drivers- A Test of the Proposition

32 GeneralCologne Re Capital Consultants Proprietary & Confidential Conclusion Why is Risk Assessment/Management Important? Needed to determine capital adequacy Allows for capital to be allocated to products and subsequently “priced” to create EVA Capital Efficiencies can be driven by “second-order” decisions Reinsurance Strategy Integrating Reinsurance Strategy with Asset Strategy

Thank You Joan Lamm-Tennant, PhD General Re Capital Consulting