The Role of the ENTERPRISE in Risk Management Richard Goldfarb, FCAS Ernst & Young Casualty Actuaries in Reinsurance Seminar New York, NY June 1-2, 2006

2 Discussion Outline  What is Enterprise Risk Management? Alternative Views of Enterprise Risk Management Alternative Balance Sheets –GAAP –Fair Value –Market Value  How an Enterprise Approach Can Impact Risk Management Strategies  Three Examples Interest Rate Risk Management Strategy Determining Optimal Capital Levels Risk-Based Capital Allocation

3 What is Enterprise Risk Management?  Traditional Risk Management Identification Measurement Monitoring Hedging and Risk Transfer  Enterprise Risk Management (ERM) How is this different from traditional risk management? What is the role of the enterprise?

4 Alternative Views of the Role of the Enterprise  View #1: Wider Perspective Applies risk management principles throughout the organization. It is “risk management” applied throughout the enterprise.  View #2: More Comprehensive Perspective Ensures that risk measurements reflect all sources of exposure to a given risk. It is “risk management” applied at an aggregate level within risk categories.  View #3: Portfolio Perspective Emphasizes the interactions of risks. It is “risk management” applied at an aggregate level across risk categories.  View #4: Total Firm Perspective Emphasizes the total value of the firm to the shareholders. It is “risk management” of the shareholders’ total interest in the enterprise as a going concern.

5 How Does a “ Going Concern ” Perspective Differ from the Others?  Traditional Perspectives Focus Only on the GAAP Balance Sheet Assets Liabilities Book Value of Equity  Going Concern Perspective Incorporates Franchise Value Total Firm Value = Book Value + Franchise Value –Reflects the value of the firm to its shareholders Franchise Value = Value of future business not yet written Includes renewals and “new” business  Three Balance Sheets US GAAP Fair Value Market Value

6 How Does a Going Concern Perspective Impact Risk Management?  Emphasizes Effect of Risk and Risk Reduction on the Shareholders What impact does the risk have on the value of the firm?  Measures, Manages and Hedges the Risks that Affect Shareholders  In some cases, the shareholder perspective can lead to decisions that are not even directionally the same as when only the balance sheet is taken into account.  Three Examples To Demonstrate This Point: Interest Rate Risk Management Identifying Optimal Capital Levels Risk-Based Allocation of Capital

7 Interest Rate Risk Management ( “ ALM ” ) – Background  Interest rate risk commonly measured using duration (and other related measures) Duration measures the sensitivity of the value of a series of cash flows to (small) changes in interest rates and is expressed relative to the value of the cash flows. Denoting the value of a bond as V, duration is calculated as:  Example: 5 year bond 6% annual coupon bond Principal of $1000 Continuously compounded interest rates are 4% Value = $1, Duration: Related to the “weighted average time to payment” (exact in the case of continuously compounded interest rates)  For small increase in yield, say.2%, duration indicates the change in value of the bond: Change in Value = - D * (Change in Yield) = -4.49*.2% = -0.89% Actual Change in Value = ( – )/ = -0.89%

8 Different Perspectives on ALM  Narrowest Perspective Considers only the bond portfolio Sets target duration of bond portfolio to D T. D T selected judgmentally  More Comprehensive Perspective Incorporates all invested assets with interest rate sensitivity – not just bonds. Aggregates interest rate risk measure, duration, across all assets  Wider Perspective Incorporates duration of liabilities. Naïve Rule of Thumb: Set D A = D L Ignores the dollar value of the assets and liability, assumes they are equal

9 Different Perspectives on ALM (Cont.)  Portfolio Perspective Emphasizes duration of surplus, D S, taking into account the value of the assets, A, and the value of the liabilities, L. Dollar Duration of Assets = Dollar Duration of Liabilities + Dollar Duration of Surplus A*D A = L*D L + (A-L)*D S D S = (A/S)*(D A - D L ) + D L Setting, D S = 0  D A = L/A* D L < D L Naïve Rule of Thumb: Asset duration must be lower than liability duration to immunize the surplus against changes in interest rates.  Enterprise Perspective See Next Slide

10 How the Enterprise View Affects Interest Rate Risk Management  Managing duration of surplus ignores the interest sensitivity of franchise value:  Market Value of Equity (MVE) = Fair Value Surplus (S) + Franchise Value (FV)  Dollar Duration of MV Equity = Dollar Duration of Surplus + Dollar Duration of FV $D MVE = $D S + $D FV Setting $D S = 0  $D MVE  0  Market Value of Equity will be sensitive to interest rates. Magnitude and sign depend on duration of franchise value, D FV D FV is very complex, but note that it will reflect the net effect of the following: –duration of future premiums –duration of future claims and expenses Market Value of Equity

11 Duration of Franchise Value  Consider Simple P&C Insurance Company Example Fixed Premiums Claims not interest sensitive Premiums collected before claims are paid, therefore duration of future premiums is less than duration of future claims As rates rise, value of future premiums falls by less than the value of the future claim payments and so the FV rises. This is negative duration! D Premium < D Claims  D FV < 0  Supposes the goal is to set Duration of MVE = 0 MVE “immunized” against changes in interest rates $D MVE = $D S + $D FV Therefore, with $D FV 0 Asset duration must be larger than the case where FV was ignored.

12 Duration of Franchise Value (continued)  More Interesting Case: Premiums = Present Value of Expected Claims (+ Risk Margin) Premiums are now interest sensitive D FV will depend on pricing strategy  Simple Model (Panning, Managing Interest Rate Risk: ALM, Franchise Value and Strategy) P = Written premium each year, collected at beginning of year E = Expenses, paid when premium is written = 25 L = Expected claims and expenses, paid at end of year = 75 y = risk free discount rate = 5% S = Company’s surplus, assumed constant each year = 50 k = firm’s target return on surplus –Pricing Policy: k = a + by –e.g. if b = 0, then k is constant; if b <> 0, then k varies with interest rates –Assume a = 15%, b = 0 cr = client retention (% of policies that renew each year) = 90% Ignoring risk premiums, P = [S*(k-y) + L]/(1+y) + E Franchise Value = Present value of all future premium, loss and expense cash flows

13 Duration of Franchise Value – Example Continued  Duration of Franchise Value  Notice that when premiums were not interest sensitive, D FV < 0 To immunize the market value, needed higher asset duration compared to “balance sheet” approach that ignored franchise value  With interest sensitive premiums, D FV > 0 To immunize the market value, now need lower asset duration compared to “balance sheet” approach that ignored franchise value  Interesting side note (see Panning paper for discussion) Lowering the asset portfolio duration may be costly Lowering it “enough” may not even be possible – or may need the use of complex derivative instruments with more perceived risk May be able to use pricing strategy (b <> 0) to manage this risk more effectively than altering asset portfolio composition.

14 Key Insight from Interest Rate Risk Management Example  Assuming that interest rate risk management is one of the firm’s priorities, the first step is to determine what to immunize: The Portfolio? The (GAAP, Stat or Fair Value) Surplus? The Value of the “Enterprise”?  One reasonable approach – focus on the enterprise and manage the interest rate risk that affects all components of this value. Ignoring franchise value, one could reasonably conclude that the “optimal” investment strategy is to have D A < D L. Including franchise value, but with fixed premiums and expected claims, optimal asset duration is higher In more general case, with interest sensitive premiums, duration decisions depend on much more complex factors such as the firm’s pricing strategy.  Other Examples Determining Optimal Capital Levels Risk-Based Capital Allocation

15 Determining Optimal Capital Levels  Current “Economic Capital” models consider only those assets and liabilities currently on the balance sheet (or perhaps, at most, one year of new business).  Naïve view – “Minimize capital so that return on capital can be maximized.”  But this ignores the franchise value, a significant portion of the market value of the firm’s equity. Franchise value depends on survival Survival is affected by “tail events” that make it impossible to pay all claims But survival is also affected by more routine events that destroy a large portion of the company’s surplus Optimal capital levels must be set so as to ensure survival, not just pay current claims!  Ignoring the franchise value makes it impossible to determine capital required to maximize shareholder value. See Panning (2006) Managing the Invisible: Measuring Risk, Managing Capital and Maximizing Value, CAS/SOA ERM Symposium Call for Papers for details.

16 Risk-Based Capital Allocation  Traditional Capital Allocation Measures “economic capital” based on tail measures of risk (VaR, CTE, etc.) Allocates capital to business units that most contribute to these “tail” events  Enterprise Approach Recognize that “routine” losses could materially impact surplus Capital allocation should reflect all scenarios where franchise value is impacted – not just tail scenarios Suggests that allocation should be based on risk measures at significantly lower percentiles  Potential Impact Some business units are not inherently volatile, but have tremendous uncertainty about the mean of the distribution Tail risk measures tend to heavily discount this uncertainty Risk measures at lower percentiles recognize that large and frequent deviations from the mean can lead to loss of surplus, loss of credit rating and significant loss in shareholder value

17 Summary  Enterprise Risk Management Should go beyond the balance sheet Focuses on the total firm value to its shareholders – the total enterprise, including Franchise Value Measures and manages the risk to the enterprise  Implications for Risk Management Strategy Can Be Significant  Three Examples: Interest Rate Risk Management Recognizing that the firm’s franchise value itself is sensitive to interest rate changes could lead to different choices in asset portfolio. Determining Optimal Capital Levels Recognizing that the firm’s franchise value depends on retaining a given rating suggests that more capital is needed than simply that which limits the risk of insolvency. Risk-Based Capital Allocation Recognizing that the firm’s franchise value can be destroyed by events that are not “in the tail” could shift attention to sources of risk that are less extreme, but still significant to the shareholders.

18 References  Panning, William H Managing the Invisible: Measuring Risk, Managing Capital, Maximizing Value. SOA/CAS 2006 ERM Symposium Call for Papers.  Panning, William H Managing Interest Rate Risk: ALM, Franchise Value and Strategy. Willis Re White Paper. Presented to the International Conference of Actuaries, May  Panning, William H Asset-Liability Management for a Going Concern. In Edward Altman and Irwin Vanderhoof, eds. Financial Dynamics of the Insurance Industry. Dow Jones-Irwin.