ERM in the Rating Evaluation CAMAR Fall Meeting November 29, 2007 Thomas M. Mount, ACAS, MAAA Andrew Colannino, Vice President A.M.Best Company

What is Risk Management?

Risk management is a process which helps insurers identify, measure and manage the various types of risk within their operations.

What are the objectives of Risk Management?

Objectives of Risk Management To manage the organization’s exposure to potential earnings & capital volatility To manage the organization’s exposure to potential earnings & capital volatility To maximize the value of the firm to the organization’s various stakeholders To maximize the value of the firm to the organization’s various stakeholders Goal is to understand and manage risk, NOT to eliminate risk Goal is to understand and manage risk, NOT to eliminate risk

How does A. M. Best view Risk Management?

Risk Management Risk management is the common thread that links balance sheet strength, operating performance and business profile Risk management is the common thread that links balance sheet strength, operating performance and business profile Risk management fundamentals can be found in a company’s… Risk management fundamentals can be found in a company’s… Strategic decision making process Strategic decision making process Financial management and control practices Financial management and control practices Daily operating procedures Daily operating procedures

Traditional Risk Management vs. Enterprise Risk Management

Traditional Risk Management Fundamental policies and procedures of identifying, quantifying, and managing specific risks individually Fundamental policies and procedures of identifying, quantifying, and managing specific risks individually Categories of Risk Categories of Risk Credit Risk Credit Risk Market Risk Market Risk Underwriting Risk Underwriting Risk Operational Risk Operational Risk Strategic Risk Strategic Risk Little or no interaction/communication/alignment among risk managers Little or no interaction/communication/alignment among risk managers “Silo” approach “Silo” approach

Enterprise Risk Management ERM is the process through which insurers identify, quantify, and manage risk on an enterprise wide, holistic basis ERM is the process through which insurers identify, quantify, and manage risk on an enterprise wide, holistic basis The underlying premise of ERM is based on increasing value to shareholders and providing financial security to the organization The underlying premise of ERM is based on increasing value to shareholders and providing financial security to the organization

Will A. M. Best perform a separate rating analysis of Enterprise Risk Management?

ERM in the Rating Evaluation Not a separate component Not a separate component Impacts all three areas of the rating evaluation Impacts all three areas of the rating evaluation  Capitalization  Operating performance  Business profile Integrated into agenda Integrated into agenda Clearly the potential to weigh heavily on a rating Clearly the potential to weigh heavily on a rating

Does A. M. Best expect all companies to implement Enterprise Risk Management?

ERM in the Rating Evaluation Need for ERM will vary based on: Need for ERM will vary based on: Complexity of a company Complexity of a company type of products offered type of products offered Number of products offered Number of products offered Investments Investments Volatility of Earnings/potential significant capital loss (Risk profile) Volatility of Earnings/potential significant capital loss (Risk profile) Financial Flexibility Financial Flexibility Strength of its Traditional Risk management Strength of its Traditional Risk management

ERM in the Rating Evaluation However, implementing the concept of overall risk management, or even selected elements of ERM can help any company – regardless of size

ERM in the Rating Evaluation The development of principles-based solvency approaches, such as Solvency II in Europe, and the significant efforts of sophisticated insurer’s to raise the bar on the risk-management front, will ultimately become a competitive issue driving continued improvement and integration of ERM concepts for all insurers regardless of size

What is the impact of Enterprise Risk Management on ratings?

Impact of ERM on the Rating ERM will benefit company in one of two ways: ERM will benefit company in one of two ways: ERM will motivate the company to reduce risk ERM will motivate the company to reduce risk shift its business strategy from volatile lines to more stabile linesshift its business strategy from volatile lines to more stabile lines Aggregate reinsuranceAggregate reinsurance Less volatile investmentsLess volatile investments ERM will motivate the company to obtain higher returns for its existing risk ERM will motivate the company to obtain higher returns for its existing risk Charge higher ratesCharge higher rates

Impact of ERM - Example of Changing Business Strategy From Volatile to Stabile Lines TodayFuture Time BCAR 160 = Minimum for A+ Average Return Volatile Strategy A- Stabile Strategy will become A+ sooner

Impact of ERM - Example of Receiving Adequate Return for Risk TodayFuture Time BCAR 130 = Minimum for A- Inadeq Avg Return Ins Co w/Inadeq Return for Risk = B+ Ins Co w/Adeq Return will become A- sooner Adeq Avg Return

Risk Management and BCAR – Best’s Revised Approach LOWHIGH EARNINGS and CAPITAL VOLATILITY BCAR BCAR Guideline Weak Risk Management Strong Risk Management What’s New… AMB Requirements: Superior traditional risk management fundamentals Superior capital management and financial flexibility Strong ERM characteristics Strong Economic Capital modeling capabilities LOW relative earnings and capital volatility

Risk Management and BCAR – Best’s Revised Approach LOWHIGH EXPOSURE to EARNINGS and CAPITAL VOLATILTY BCAR BCAR Guideline Weak Risk Management Strong Risk Management What’s New… A.M. Best will consider allowing companies with STRONG risk management to maintain lower BCAR levels relative to the guideline for its rating

What is “Strong” Enterprise Risk Management?

Assessment of ERM Culture Culture Identification & Management of Risks Identification & Management of Risks Measurement of Risks Measurement of Risks

ERM - Culture Board & Senior Management establish risk profile risk tolerances risk management objectives/incentives Risk aware culture throughout organization All levels of management/employees Accountability CRO responsibilities Strategic decision making based on risk adjusted returns & other risk metrics Business strategy – plan and execution Capital allocation

ERM Identification & Management An objective framework which identifies, monitors, and manages emerging risks, risk accumulation, and correlations within and across the entire organization An objective framework which identifies, monitors, and manages emerging risks, risk accumulation, and correlations within and across the entire organization On going process On going process Exception reports Exception reports Reinsurance purchases based on risk tolerance Reinsurance purchases based on risk tolerance Contingency plans in place Contingency plans in place

ERM Measurement of Risk Risk/Return measures Risk/Return measures Correlation of Risks Correlation of Risks Impact of general economy Impact of general economy Impact of industry specific events / extreme events Impact of industry specific events / extreme events Catastrophe Models Catastrophe Models Economic Capital Models Economic Capital Models Data collection Data collection Quality of data Quality of data Data verification procedures Data verification procedures Access to the data Access to the data

ERM Measurement of Risk Economic Capital Models - Management must demonstrate how the model is used Economic Capital Models - Management must demonstrate how the model is used To make strategic decisions To make strategic decisions To allocate capital To allocate capital To understand volatility To understand volatility To understand risk correlations To understand risk correlations Quality of the model Quality of the model Sensitivity of the model Sensitivity of the model Internal Model is given consideration in the evaluation of required capital Internal Model is given consideration in the evaluation of required capital

Summary ERM is evaluated, but no separate rating is published ERM is evaluated, but no separate rating is published Importance of ERM will vary depending on the complexity/volatility/financial flexibility/traditional Risk Management of the company Importance of ERM will vary depending on the complexity/volatility/financial flexibility/traditional Risk Management of the company Credit for Companies implementing ERM will be recognized over time Credit for Companies implementing ERM will be recognized over time Credit given to strong internal company capital models that are used in ERM process Credit given to strong internal company capital models that are used in ERM process

Questions?