Property of Tillinghast - Towers Perrin Enterprise Risk Management Papers Presentation at CAS 2001 Seminar on Understanding the Enterprise Risk Management Process Jerry Miccolis, FCAS, MAAA, Tillinghast - Towers Perrin Samir Shah, FSA, MAAA, Tillinghast - Towers Perrin April 2-3, 2001

Property of Tillinghast - Towers Perrin 1 We will be addressing two ERM papers today “Enterprise Risk Management: An Analytic Approach” by Jerry Miccolis and Samir Shah, Tillinghast - Towers Perrin Monograph, January 2000 “Creating Value through Enterprise Risk Management — A Practical Approach for the Insurance Industry” by Jerry Miccolis and Samir Shah, Tillinghast - Towers Perrin Monograph, April 2001 We will focus primarily on the second paper It represents our most current thinking It illustrates how to practically apply the concepts of the first paper (within a specific industry) Applications to other industries should be clear

Property of Tillinghast - Towers Perrin Creating Value through Enterprise Risk Management A Practical Approach for the Insurance Industry Value Growth Return Consistenc y Capital This document is incomplete without the accompanying discussion; it is confidential and intended solely for the information and benefit of the immediate recipient thereof. Jerry Miccolis, FCAS, MAAA Samir Shah, FSA, MAAA

Property of Tillinghast - Towers Perrin 3 Here are some key findings from our recent ERM survey of insurance executives Executives believe ERM is critical to helping them deal with their key business issues They are not satisfied with current tools, techniques and processes to implement ERM — especially for dealing with operational risks They want a more robust conceptual and methodological framework that: Encompasses all relevant risks — both financial and operational Integrates both financial and operational strategies to manage those risks

Property of Tillinghast - Towers Perrin 4 In our client work, insurers are increasingly asking important risk-related questions How much capital do we need? And how do we convince the rating agencies? How should our capital be deployed to business segments? How can we maximize our return on capital, given our risk appetite? How do we best invest our assets, given our liability mix? Can we get a handle on our operational risks? How can we optimize our distribution channel strategy? How much, and on what terms, should we reinsure/hedge? How do we encourage the right risk management behavior? Are we prepared against our most critical down-side risks? How can we minimize economic and accounting volatility? We believe these questions need to be answered within the context of a comprehensive and coherent risk management framework...

The RiskValueInsights  Framework NYO 5 Property of Tillinghast - Towers Perrin

6 Product and Distribution Product mix Distribution strategy Pricing Customer service Investments Asset/liability management Liquidity Market risk tolerance Tax profile Organization Hiring/training HR policies Pay and benefits Communication Companies are managing a number of separate, but related, activities... Capital Structure Equity vs. debt Managing excess capital Reinsurance Securitization

Property of Tillinghast - Towers Perrin 7 …with the overall objective of increasing enterprise value Increasing return Improving consistency Providing appropriate level, structure and allocation of capital Providing appropriate level, structure and allocation of capital Enhancing growth More on… using Embedded Value as the value measure More on… the link between consistency and enterprise value Increase value by

Property of Tillinghast - Towers Perrin 8 The best way to effectively drive value is to understand the full risk environment in which you operate... Financial Asset Liability Risk Operational Event Business Internal Environment Expansion/diversification Culture Distribution Risk appetite People Processes Technology External Environment Economic conditions Social/legal trends Political/regulatory climate Natural catastrophes Customer behavior Competition Investor expectations Reputation/rating agency

Property of Tillinghast - Towers Perrin 9 …and the complete set of strategies available to you… Risk Financial Asset Liability Operational Event Business Operational Strategies Hiring/training Customer service Market strategy Distribution M&A Technology Internal controls Incentive programs Financial Strategies Capital structure Investment strategy Pricing Product mix Dynamic hedging Reinsurance

Property of Tillinghast - Towers Perrin 10 …and to use this knowledge in a holistic risk management framework Holistically manage financial and operational risks Holistically manage financial and operational risks Exploit natural hedges and portfolio effects Exploit natural hedges and portfolio effects Understand both internal and external environments Investigate both financial and operational strategies Increase return Improve consistency Establish capital Enhance growth Increase value

The RiskValueInsights  Process NYO 11 Property of Tillinghast - Towers Perrin

12 A continual management process is needed to “operationalize” the framework Develop Best Strategies Implement Strategies Monitor Performance and Environment Set the agenda Establish business performance requirements Assess organization capabilities Build the change strategy Align & deliver Leadership Measurement Involvement Communication Change Enabler s Articulate Strategies Assess Risks Evaluate Strategies: Policyholders ’ Perspective Evaluate Strategies: Owners’ Perspective Refine Strategies

Property of Tillinghast - Towers Perrin 13 Develop Developing best strategies involves a five-step exercise Click on appropriate chevron above to see details of that step Attribute capital to business segment Establish economic capital requirement Link to key performance indicator(s) via financial model Identify & overlay financial & operational strategies KPI distribution Articulate Strategies Assess Risks Evaluate Strategies: Policyholders’ Perspective Evaluate Strategies: Owners’ Perspective Refine Strategies Decompose risk into root causes Isolate impact of each strategy Set objectives & constraints Establish risk & value metrics for growth, return & consistency Optimize strategies & sensitivity-test Identify financial & operational risk factors Classify & prioritize risk factors Risk factor distributions

Property of Tillinghast - Towers Perrin 14 Successfully implementing certain strategies requires a change management process Implement Develop Change Capability Energize and Engage for Broader Impact Mobilize First Wave and Secure Early Wins Focus and Sequence Effort Articulate the Ambition Align & Deliver Build the Change Strategy Assess Organization Capabilities Establish Business Performance Requirements Set the Agenda Deliver Design Leadership Measurement Involvement Communication Change Enablers

Property of Tillinghast - Towers Perrin 15 Strategy performance and risk environment must be monitored to adjust strategies as necessary Marketing New business sold Retention of old business Mix of business: new and renewal Market share New business sold Retention of old business Mix of business: new and renewal Market share Underwriting Price achieved vs. target price Exposure mix Quotes accepted/declined Variance analysis Price achieved vs. target price Exposure mix Quotes accepted/declined Variance analysis Claims Frequency and severity of claims Claims productivity Frequency and severity of claims Claims productivity Financial Revenue Underwriting profit Investment profit Pre-tax operating income Net income Return on equity and total capital Revenue Underwriting profit Investment profit Pre-tax operating income Net income Return on equity and total capital Investments Cash flow Yield on new investments Yield on portfolio by class and duration Convexity of assets Duration of assets Investment mix: new and portfolio Credit default Total return Cash flow Yield on new investments Yield on portfolio by class and duration Convexity of assets Duration of assets Investment mix: new and portfolio Credit default Total return Human Resources Agency composition (number, age, service) Total employment by department Number and percentage leaving the company Vacancy rates Average salary increase vs. plan Agency composition (number, age, service) Total employment by department Number and percentage leaving the company Vacancy rates Average salary increase vs. plan Other Audit compliance Inflation rates Interest rates GNP Exposure data (number of cars, payroll, etc.) Competitor pricing Audit compliance Inflation rates Interest rates GNP Exposure data (number of cars, payroll, etc.) Competitor pricing Monitor Click here… to see these measures combined as a dashboard for performance management

Property of Tillinghast - Towers Perrin 16 Insurance and banking approaches to ERM are -- and should be -- different Asset risk and liability risk Liability characteristics: Certainty Liquidity Duration Demand payments Risk metrics/models: VaR and ECOR/EPD Coherence Operational risks Business risks and event risks Regulatory pressure Modeling approaches

Summary NYO 17 Property of Tillinghast - Towers Perrin

18 The framework is holistic... Holistically manage all risks Holistically manage all risks Financial Risk Operational Risk Exploit natural hedges and portfolio effects Exploit natural hedges and portfolio effects Investigate both financial and operational strategies Capital structure Investment strategy Pricing Product mix Dynamic hedging Reinsurance Hiring/training Customer service Market strategy Distribution M&A Technology Internal controls Incentive programs Understand both internal and external environments Economic conditions Social/legal trends Political/ regulatory climate Natural catastrophes Customer behavior Competition Investor expectations Expansion/ diversification Culture Distribution Risk appetite People Processes Technology Reputation/ rating agency Increase return Improve consistenc y Establish capital Enhance growth Increase value

Property of Tillinghast - Towers Perrin 19...The process is complete... Develop Best Strategies Implement Strategies Monitor Performance and Environment Set the agenda Establish business performance requirements Assess organization capabilities Build the change strategy Align & deliver Leadership Measurement Involvement Communication Change Enabler s Articulate Strategies Assess Risks Evaluate Strategies: Policyholders ’ Perspective Evaluate Strategies: Owners’ Perspective Refine Strategies

Property of Tillinghast - Towers Perrin 20 …And the approach can provide great value Enables you to determine your appropriate capital level, redeploy unneeded capital and improve return on capital Permits the proper attribution of capital to business segments and supports performance tracking of each segment Helps you evaluate alternative capital structures that leverage returns Provides a method for ensuring that enterprise owners receive proper compensation for risks assumed Allows you to stabilize earnings and thereby increase enterprise value Supports the development of an optimal risk financing strategy and program Provides better information about your company, which increases negotiating leverage with: Reinsurers Rating agencies Capital markets Industry analysts M&A targets