L Risk Based Capital: Convergence of Banking and Insurance Risk Management Thomas C. Wilson, Managing Director, Head Finance and Risk Practice Ramy Tadros, Senior Job Manager, Insurance Practice Use this cover page for internal presentations C O N F I D E N T I A L The Actuarial Profession Finance and Investment Conference 2003 Edinburgh, June 22-23

L CONFIDENTIALITY Our clients’ industries are extremely competitive. The confidentiality of companies’ plans and data is obviously critical. Mercer Oliver Wyman will protect the confidentiality of all such client information. Similarly, management consulting is a competitive business. We view our approaches and insights as proprietary and therefore look to our clients to protect Mercer Oliver Wyman interests in our presentations, methodologies and analytical techniques. Under no circumstances should this material be shared with any third party without the written consent of Mercer Oliver Wyman. Copyright © 2003 Mercer Oliver Wyman Notes: This confidentiality page should be included in every client presentation

2 L Notes: Copyright © 2003 Mercer Oliver Wyman Mercer Oliver Wyman Strategic management consulting focused on financial services 650 individuals, 500+ professionals Offices in New York, London, Frankfurt, Zurich, Toronto, etc. Created by merger with Mercer Management Consulting FIG Retail Banking Corporate & Commercial Banking Capital Markets & Asset Management Insurance Corporate Strategy Finance & Risk Insurance Actuaries

3 L Notes: Copyright © 2003 Mercer Oliver Wyman Contents 1.Risk Capital Measurement Practices 2.Risk Management Practices 3.Risk Capital and Value Management Notes: This page is both a Contents and Section page (never use it without the black bar). Move the black bar down to highlight the appropriate section and make the highlighted section text white Arial Black

4 L Notes: Copyright © 2003 Mercer Oliver Wyman Risk Capital Definition Risk Capital Credit Risk Market Risk Operational Risk Business Risk Insurance Risk Life P&C Non- CAT P&C CAT Counter- party Risk Transfer Risk Trading Risk ALM Risk “Definition”: Ex ante assessment of... Maximum possible loss Within a confinable interval Over a defined time horizon Aggregation

5 L Notes: Copyright © 2003 Mercer Oliver Wyman Bulleted text always starts at the same point on the page. If necessary, make the text size smaller if there’s too much on a page. Do not change the paragraph spacing unless absolutely necessary. Implementation and Use of Economic Capital Aegon Allianz Aviva AXA Fortis ING Generali Lloyd’s of London Munich Re Prudential Royal & Sun Alliance Swiss Life Swiss Re Winterthur Zurich Insurers Covered % Respondents 0% 10% 20% 30% 40% 50% 60% Not at allIn Development Piloted Once Used Operationally Used as Major Tool Source: Mercer, Oliver, Wyman Survey Current Use of Economic Capital...

6 L Notes: Copyright © 2003 Mercer Oliver Wyman Capital Benchmark – Group Level (Including Insurance) Banc Sabadell Barclays BSCH CIBC Credit Suisse Group Den Danske Deutsche Bank Dresdner Bank Fortis Nordea Rabobank Royal Bank of Canada San Paolo IMI Standard Chartered Toronto Dominion UBS Unicredito Westpac Banking Groups Covered Source: Mercer, Oliver, Wyman Survey

7 L Notes: Copyright © 2003 Mercer Oliver Wyman Capital Benchmark - Insurance Operations Only % Financial Market Risk <10% Insurance Risk<5% Credit Risk % Operational & Business Risk Source: Mercer, Oliver, Wyman Survey

8 L Notes: Copyright © 2003 Mercer Oliver Wyman Evolving Regulatory Standards Support Use of Economic Capital: EU Solvency II Proposals PROPOSED INSURANCE SOLVENCY PRINCIPLES 1. Minimum capital requirements 2. Supervisory review of internal capital adequacy 3. Market discipline Two levels of capital – Minimum safety level – Target level  “Standardised Approach”  “Internal Model Approach” Group solvency requirement taking account of additional risks at group level. Other prudential rules (assets and liabilities) Insurers must assess, and supervisors review, solvency relative to their risk profile and hold sufficient capital for their risks Quality of required internal risk and capital measures/controls should be proportional to size and riskiness of insurer Regulators will intervene at an early stage if capital levels deteriorate Improved disclosure of – Capital structure (including ‘realistic free assets’) – Risk measurement and management practices – Risk profile – Capital adequacy Potentially, market-based charging of insurers for their “risk of failure”

9 L Notes: Copyright © 2003 Mercer Oliver Wyman Management Practices Support Use of Economic Capital Bulleted text always starts at the same point on the page. If necessary, make the text size smaller if there’s too much on a page. Do not change the paragraph spacing unless absolutely necessary. Corporate Level Transaction or ‘tactical’ level Impact on Corporate Strategy – Business portfolio composition – Relative growth Impact on financial & capital management – Group capitalization – Capital attribution and capacity allocation – Reinsurance optimization Asset/liability management Improved risk profile transparency – Board-level reporting – External reporting, e.g. rating agency, etc. Improved product pricing and customer relationship management discipline Improved limit structures and control mechanisms Improve risk capacity allocation

10 L Notes: Copyright © 2003 Mercer Oliver Wyman Best Practice: Dynamic, Multi-year Framework Bulleted text always starts at the same point on the page. If necessary, make the text size smaller if there’s too much on a page. Do not change the paragraph spacing unless absolutely necessary. Asset Shares Capital Assets Cash-flow projection over the next 25 years Accounting Perspective Economic Perspective Stochastic cash-flow projections: – Equity returns – Bond returns  Credit risk  Interest rate risk – Dynamic policyholder behaviour Management actions: – Bonus declarations – Asset mix – Dividend and capital policies

11 L Notes: Copyright © 2003 Mercer Oliver Wyman Risk Capital Measurement Issues General parameter definition – Definition, e.g. max loss, shortfall risk, survival probability, etc. – Confidence interval – Time horizon, e.g. one year, multi-year Risk coverage, especially – Operational risk – ‘Business risk’, etc. Measurement approach, e.g. – Accounting vs. mark-to-market – Run-off versus on-going business Stochastic model parameterization – Financial markets, e.g. ‘arbitrate free’ vs economic, asset return models for equity markets, interest rates, credit spreads/defaults – Modeling customer behavior – Modeling own behavior, e.g. asset mix, crediting/bonus rate policies, new business, etc. Aggregation techniques Attribution techniques, e.g. proportional, marginal, covariance, etc.

12 L Notes: Copyright © 2003 Mercer Oliver Wyman AAA Calibration BBB Calibration Years Dynamic Profile of Required Shareholder Support Expected Required Capital Injection A Calibration 25-Year Probability of Requiring Shareholder Support = X % Cumulative Probability of Requiring Shareholder Support Internal Models Allow for a Dynamic View of Capital Requirements... Cumulative Probability of Default (Asset Share Basis)

13 L Notes: Copyright © 2003 Mercer Oliver Wyman Probability of Fund Insolvency Over the Run-Off Period Bonus DeclarationPolicyholder lapse behaviourAsset switching Probability of Default... and Test the Impact of Management’s Discretion Around Bonus Declaration and Asset Switching Rules

14 L Notes: Copyright © 2003 Mercer Oliver Wyman Impact of Investment Returns on Projects Shareholder Transfers 10th Percentile 30th Percentile 70th Percentile 90th Percentile Mean Annual Shareholder Cashflows Investment Returns From a Shareholder Perspective, the Tools Can Provide the Basis for The Quantification of Fair Value Distribution of PV of Shareholder Transfers PV of Shareholder Transfers Mean of Distribution (Adjusted Embedded Value) Time

15 L Notes: Copyright © 2003 Mercer Oliver Wyman Contents 1.Risk Capital Measurement Practices 2.Risk Management Practices 3.Risk Capital and Value Management Notes: This page is both a Contents and Section page (never use it without the black bar). Move the black bar down to highlight the appropriate section and make the highlighted section text white Arial Black

16 L Notes: Copyright © 2003 Mercer Oliver Wyman Risk Management Framework - Five Components Committees 2) STRUCTURE/ORGANIZATION Line, staff and committee structure Policies & procedures; roles &responsibilities; limits & authorities, performance metrics, incentives 4) INFORMATION & REPORTS Standardized reports to support control & decision making Underlying reporting processes, information and systems 5) MEASUREMENT METHODS Detailed methods and approaches Risk, capital and economic performance 1) RISK STRATEGY/PHILOSOPHY Supporting strategic decisions: Is risk profile consistent with optimum EVA-based business strategy? Is risk profile consistent with economic and financial solvency standards? Are assets optimally invested relative to liabilities? Fiduciary responsibilities: Is risk profile well understood and within limits? Are risks appropriately structured, priced and underwritten? STRATEGY IMPLEMENTATION 3) MANAGEMENT PROCESSES

17 L Notes: Copyright © 2003 Mercer Oliver Wyman Example Risk Management Organization: European Reinsurer Supervisory Board Group Executive Committee Business Unit CEO Business Segment CEO Group CFO BU CFO Board Committees, e.g. Finance Committee Audit Committee Corporate Committees, Executive Committee Capital & Capacity Comm Finance Committee Product Mgmt Comm Underwriting Comm SAA Committee TAA Committee Corporate Networks, e.g. Risk Management Finance Network SAA Staff STRATEGIC FOCUS TACTICAL FOCUS Group CEO LE Board BU/LE Committees, e.g. Reserving Committee Audit Committee BU CRO Board Comm Finance Audit Group CRO Group CIO What risk organization? -Group, business unit risk structure? -Line, staff, committee, network? -Composition & staffing? -Responsibilities, authorities, performance metrics, incentives?

18 L Notes: Copyright © 2003 Mercer Oliver Wyman Example Corporate Calendar - Standing Agendas : Standing Agenda

19 L Notes: Copyright © 2003 Mercer Oliver Wyman Example Reporting Framework - Group SAA Report A4 vertical pages enhanced, excluding appendix Annual, enhanced form, for Board Finance Committee Ad-hoc, if required by market/insurance developments or significant change in liability profile Report designed to support specific decisions within well defined decision processes

20 L Notes: Copyright © 2003 Mercer Oliver Wyman Contents 1.Risk Capital Measurement Practices 2.Risk Management Practices 3.Risk Capital and Value Management Notes: This page is both a Contents and Section page (never use it without the black bar). Move the black bar down to highlight the appropriate section and make the highlighted section text white Arial Black

21 L Notes: Copyright © 2003 Mercer Oliver Wyman Management Practices Support Use of Economic Capital Impact on corporate strategy – Business portfolio composition – Relative growth Impact on financial/capital management – Overall corporate capitalization – Improved capital attribution – Improved capacity allocation Improved risk profile transparency/Board reporting Bulleted text always starts at the same point on the page. If necessary, make the text size smaller if there’s too much on a page. Do not change the paragraph spacing unless absolutely necessary. Improved product pricing and customer relationship discipline Improved limit structures/control mechanisms Improved risk capacity allocation LevelValue Drivers/Issues Group Holding Company Wholesale Investment Banking Asset Management Private Banking Domestic Commercial and Retail Insurance Corporate Banking Trading Investment Banking Asset Management Private Banking CommercialConsumer P&C Insurance Life Insurance High Impact Low Impact Corporate Level “Strategic” “Financial” Business Level “Operational” ‘Product’ Level “Tactical” Driving business behavior consistent with transaction economics

22 L Notes: Copyright © 2003 Mercer Oliver Wyman Integration Into Strategic Decisions Which three measures are most used by your institution for strategic planning and decision making? Source: CFO/CRO Survey 2002, Banks only How satisfied are you with regards to the following aspects of your performance measurement framework?

23 L Notes: Copyright © 2003 Mercer Oliver Wyman Integration Into Strategic Decisions What prevents economic capital from being as important as it could? Which areas of performance measurement could be most improved?

24 L Notes: Copyright © 2003 Mercer Oliver Wyman Common Issues in Driving a Value-Creation Culture Strategic and Financial Management – Strategic priorities typically not articulated in manner which is actionable and measurable – Performance metrics  Not measured accurately  Not aligned to value creation, too detailed and/or too high-level, not understood, and/or not accepted – Critical financial management processes not optimized to focus management on tough decisions and concrete actions, or not providing proper and timely information for effective decision making  Strategy development processes  Planning & budgeting processes  LOB performance tracking and review processes  Capital allocation and risk assessment processes – Structural alignment between responsibility, authority and performance metrics Organizational Alignment – Incentives and performance management aligning financial rewards and value creating results and behaviors – Communication and education of how the organization creates value and how it cascades down to individuals/teams Cultural Change – Readiness and willingness to change – Commitment to change from senior leaders through front-line employees

25 L Notes: Copyright © 2003 Mercer Oliver Wyman Different Performance Total Shareholder Return S&P US Index Time to double: >7 yrs Time to quadruple: 5 yrs

26 L Notes: Copyright © 2003 Mercer Oliver Wyman Value Driven at a High Level by M/B Multiple, RoE * Assumes 33% dividend rate M/B=1.0; RoE=12%* M/B=1.5; RoE=12%* M/B=1.5; RoE=15%* Time to Double Shareholder Value Model

27 L Notes: Copyright © 2003 Mercer Oliver Wyman This is where we would put any important information specific to this particular document or page, i.e. special colors or formats Understanding M/B Multiple for Insurance Companies Actual M/B Predicted M/B EMPIRICAL EVIDENCEINTRINSIC VALUE THEORY * Steady state residual income model Cost of Capital Growth Perception Gap Excess Returns ACTUAL VS. PREDICTED M/B SELECTED FINANCIAL INSTITUTIONS MBMB ROE - CoC CoC - g 1 ++=

28 L Notes: Copyright © 2003 Mercer Oliver Wyman Issues Between Internal & External Metrics Perception Gap MBMB RoE - CoC CoC - g 1 ++=

29 L Notes: Copyright © 2003 Mercer Oliver Wyman Focus on Financial Management Key requirements Linking shareholder value directly to business unit drivers Multi-period framework to capture growth Economic perspective as opposed to accounting but reconcilable to financial statements Key requirements Recognition of external environment and macro trends Clear link between plan and strategy for achieving plan Value contract/balanced score card focused on value and tailored to individual business External Value Metrics Internal Intrinsic Value Metrics Balance Sheet and Income Statement Drivers Business-Level Value Drivers Analysis of strategic position -Market growth/margin context and trends -Strategic position analysis Detailed business unit plans -Projected finances linked to intrinsic value - Concrete KPI objectives to support plans -Balance sheet/capital plans -Headcount targets Tailored Value Contract/ Balanced scorecard M/B, P/E impact Valuation of parts Economic adjusted financial statements # customers, avg balance, etc. CLEARLY ARTICUALTED STRATEGY & TARGETS TOP-DOWN PERFORMANCE METRICS STRATEGIC PLAN

30 L Notes: Copyright © 2003 Mercer Oliver Wyman This is where we would put any important information specific to this particular document or page, i.e. special colors or formats Focus on Financial Management MANAGEMENT PROCESSES DECISION ORGANIZATION INCENTIVES BASED ON ECONOMIC METRICS Key requirements Corporate level organizational alignment – Management structure  Executive committee, OC, OCEO  Strategic Business Unit definition and leadership – Management committees Business unit alignment: Decision making and responsibilities, e.g. distribution/ production Corporate SBUs Functional Management Units Focused initiatives Focused initiatives Corporate Strategy & Targets Group & BU Strategic Plans Macro view of growth, sector attractiveness Micro view of value of existing business, products, customers Group & BU 3 Year Operational Strategic Plans Revenue Costs Capital Value Year 1 Year 2 Year 3 Budget - 10,000 ( Bonus RM Portfolio Value Creation Key requirements Formal processes leading to ‘linked chain’ – Strategy development – Planning processes – Performance evaluation processes – Management and resource allocation processes Informal processes – Advisor, Partner, Controller Key requirements Leveraged/meaningful incentives Linked to value creation and limited number of key value drivers Compensation horizon consistent with value creation horizon Client Example: RM Bonuses vs. RM Portfolio Value Creation Committees