N July 1998 Copyright © 1998 Oliver, Wyman & Company London New York Paris Frankfurt Madrid Toronto Singapore Confidential & Proprietary DYNAMIC FINANCIAL ANALYSIS SEMINAR

N CONFIDENTIALITY The financial services industry is extremely competitive. The confidentiality of companies’ plans and data is obviously critical. Oliver, Wyman & Company 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 Oliver, Wyman & Company’s 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 Oliver, Wyman & Company. Copyright © 1998 Oliver, Wyman & Company

N I.DFA DRIVES CAPITAL MANAGEMENT II.DFA UNCOVERS SKEWS IN RISK-ADJUSTED PROFITABILITY III.DFA SUPPORTS BUSINESS MODEL EVOLUTION IV.DFA CAN INTEGRATE MODELS DEVELOPED FOR BANKING INTRODUCTION

N O liver, W yman & C ompany – 3 – INTRODUCTION

N O liver, W yman & C ompany – 4 – BANKS AND INSURERS ARE BOTH BENEFITING FROM A CONVERGENCE OF THE ACTUARIAL AND FINANCIAL DISCIPLINES Knowledge Transfer Introduction... Actuarial View Financial View Improved Management of Financial Institutions Applied probability Reserving techniques Claims distributions Asset/liability modeling Cash flow modeling Time value of money Efficient markets theory CAPM No arbitrage conditions Cost of risk Capital management Risk-adjusted profitability to support –Corporate strategic decisions –Business Unit strategic and tactical decisions Balance sheet portfolio management Hedging/Reinsurance strategy

N O liver, W yman & C ompany – 5 – TODAY WE DISCUSS HOW DFA HAS SUPPORTED DECISIONS IN BOTH BANKING AND LIFE INSURANCE, AND DISCUSS ITS APPLICABILITY TO P&C INSURANCE Introduction... Applications (Decisions) Reports Methodologies Systems Data

N O liver, W yman & C ompany – 6 – I.DFA DRIVES CAPITAL MANAGEMENT

N O liver, W yman & C ompany – 7 – BANKS USE DFA TO QUANTIFY RISK IN TERMS OF ECONOMIC CAPITAL DFA Drives Capital Management...

N O liver, W yman & C ompany – 8 – ECONOMIC CAPITAL MEASURES THE CAPITAL REQUIRED TO ACHIEVE A TARGET SOLVENCY STANDARD DFA Drives Capital Management... Economic Capital for “AAA” solvency standard Solvency Standard AAAAAA.07%.03%.01%

N O liver, W yman & C ompany – 9 – Capital You Have COMPARING ECONOMIC CAPITAL TO AVAILABLE CAPITAL PROVIDES A VIEW OF CAPITAL ADEQUACY Solvency Standard 7 bp3 bp1 bp Corresponding S&P RatingAAAAAA Capital You Need DFA Drives Capital Management... Excess Capital

N O liver, W yman & C ompany – 10 – INDEED, THIS COMPARISON OF ACTUAL TO NEEDED CAPITAL HAS DRIVEN THE DRAMATIC INCREASE IN BANK SHARE BUYBACKS OVER THE PAST SEVERAL YEARS DFA Drives Capital Management... % Of total shares repurchased Year

N O liver, W yman & C ompany – 11 – THIS SERVES AS AN INPUT TO A DISCIPLINED CAPITAL MANAGEMENT PROCESS DFA Drives Capital Management... 1.Formulate capital investment plan to determine a business mix that maximizes the Bank’s long-term value to its shareholders based upon evaluation of the risk, return and growth characteristics of available opportunities 2.Determine target solvency standard given the mix of business activities implicit in the investment plan 3.Align capital structure to be consistent with #1 and #2 by taking appropriate actions (capital issuance, buyback, etc.) 4.Set risk limits and targets that reflect the investment plan and ensure compliance with the target rating 5.Set business unit RAROC and growth targets and the investment consequences of achieving (or not achieving) them 6.Measure performance by monitoring actual RAROC, capital usage, and growth against targets and limits

N O liver, W yman & C ompany – 12 – FOR P&C COMPANIES, THE FRAMEWORK IS THE SAME, BUT IS SOMEWHAT MORE COMPLEX BECAUSE OF MULTI-YEAR EXPOSURES... Economic Capital Time Expected Future Reported Losses Liability Economic Capital Time ECONOMIC CAPITAL FOR DRO LINE DFA Drives Capital Management...

N O liver, W yman & C ompany – 13 – … AND THE IMPACT OF REINSURANCE WITH XOL REINSURANCE DFA Drives Capital Management... Economic Capital NO REINSURANCE Probability Loss Probability Economic Capital Loss

N O liver, W yman & C ompany – 14 – II.DFA UNCOVERS SKEWS IN RISK- ADJUSTED PROFITABILITY

N O liver, W yman & C ompany – 15 – BUSINESS UNITECONOMIC CAPITAL RAROCHURDLEGROWTHINTRINSIC VALUE DFA Uncovers Profitability Skews... BANKS USE RISK-ADJUSTED RETURN ON CAPITAL  RAROC  TO MEASURE THE PRODUCTIVITY OF CAPITAL Personal Banking Corporate Banking What is the return on shareholders’ capital? What do shareholders require for risk? What is the business worth? Where is capital invested? Investment Banking Private Banking Total $2.3 BN $3.0 BN $1.5 BN $0.7 BN $7.5 BN 15% 35% 10% 15% 40% 21% 5% 7% 8% 6% $6.9 BN $12.2BN

N O liver, W yman & C ompany – 16 – RAROC= Net Income - Expected Loss Economic Capital RAROC “FEED-STARVE” RAROC Capital A B C D E F G H Hurdle Rate DFA Uncovers Profitability Skews... BANKS USE RAROC AS A GUIDE TO REDEPLOYING CAPITAL RESOURCES

N O liver, W yman & C ompany – 17 – DFA Uncovers Profitability Skews... LEADING FINANCIAL INSTITUTIONS ARE USING RAROC TO DRIVE KEY DECISIONS CEO Martin Taylor stated in Barclays’ annual report: “... we continue to refine our risk management techniques and focus on the return on economic capital, shifting capital away from areas of low or particularly unpredictable return and taking into account the contribution of each business to the Group’s overall volatility of earnings” Most commentators have stated that relatively poor risk-adjusted returns is the main rationale for Barclays selling BZW’s investment banking business Still more banks could learn from Barclays’ example –“The sorry fact is that those European banks that have chosen to stay in the game (of investment banking) are, almost without exception, either more tolerant of low returns than Barclays, or less sophisticated at measuring how low those returns are” (Financial Times, October 6, 1997)

N O liver, W yman & C ompany – 18 – SOME LIFE INSURERS ARE USING DFA TO DRIVE AN “ECONOMIC BALANCE SHEET” APPROACH... TRADITIONAL APPROACH“ECONOMIC BALANCE SHEET” APPROACH DFA Uncovers Profitability Skews... Intrinsic Value Value calculated by discounting shareholder cashflow

N O liver, W yman & C ompany – 19 – WHERE EACH CASHFLOW STREAM IS DISCOUNTED AT ITS APPROPRIATE RISK ADJUSTED DISCOUNT RATE Premiums + Investment Income – Claims/Reserves – Expenses Net Income P 1 P 2 P 3... I 1 I 2 I 3... C 1 C 2 C 3... E 1 E 2 E 3... DFA Uncovers Profitability Skews... Year PNINCNENPNINCNEN

N O liver, W yman & C ompany – 20 – THIS RISK-ADJUSTED VIEW REVEALED DRAMATIC VALUE CREATIONS SKEWS ACROSS PRODUCTS BEFORE RISK-ADJUSTMENTAFTER RISK-ADJUSTMENT PRODUCT VALUE MEASUREMENT DFA Uncovers Profitability Skews...

N O liver, W yman & C ompany – 21 – A TOP-DOWN ANALYSIS OF FOURTEEN TOP PROPERTY AND CASUALTY INSURERS REVEALS THAT ECONOMIC CAPITAL CAN DIFFER SUBSTANTIALLY FROM TRADITIONAL MEASURES OF CAPITAL ADEQUACY DFA Uncovers Profitability Skews... ECONOMIC VS. STATUTORY VIEWS OF CAPITAL ADEQUACY Premium-to-Economic Capital Premium-to-Surplus Economic Capital = Surplus

N O liver, W yman & C ompany – 22 – SKEWS IN RISK-ADJUSTED PROFITABILITY ACROSS BUSINESS UNITS WITHIN INDIVIDUAL COMPANIES SUGGEST IMPROVEMENTS FROM REDEPLOYING CAPITAL TO THE MOST ATTRACTIVE BUSINESSES DFA Uncovers Profitability Skews... RAROC ACROSS LOB FOR SELECTED COMPANIES PRELIMINARY High Mean Low High Mean Low

N O liver, W yman & C ompany – 23 – RAROC SKEWS ACROSS COMPANIES INDICATE OPPORTUNITIES TO IMPROVE BUSINESS UNIT RETURNS DFA Uncovers Profitability Skews... PRELIMINARY Targeted acquisition of attractive customers Redesigning products Altering reinsurance arrangements Targeted acquisition of attractive customers Redesigning products Altering reinsurance arrangements Potential Actions RAROC ACROSS COMPANIES High Mean Low High Mean Low General Liability - Claims Incurred General Liability - Claims Reported

N O liver, W yman & C ompany – 24 – III.DFA SUPPORTS BUSINESS MODEL EVOLUTION

N O liver, W yman & C ompany – 25 – IN BANKING, AN UNDERSTANDING OF THE RISK-ADJUSTED PRICING HAS INCREASED LIQUIDITY IN THE SECONDARY MARKETS, AND IS DRIVING AN EVOLUTION OF THE BUSINESS MODEL DFA Supports Business Model Evolution... Processing “Credit ALCO” Portfolio Investment Client Management Syndication Origination Credit Rating Loan Trading Product Structuring/ Securitization Borrowers Secondary Market

N O liver, W yman & C ompany – 26 – THIS MODEL IS LIKELY TO EVOLVE IN THE INSURANCE MARKET AS WELL, AS PRICING STANDARDS DEVELOP AND CAPITAL MARKETS BECOME MORE LIQUID Servicing & Processing Client Management Origination Underwriting Insureds Capital Markets Packaging & Distribution Reinsurance Retained Portfolio Warehouse Portfolio Sales & Trading DFA Supports Business Model Evolution...

N O liver, W yman & C ompany – 27 – IV.DFA CAN INTEGRATE MODELS DEVELOPED FOR BANKING

N O liver, W yman & C ompany – 28 – IN BANKING, CREDIT RISK IS MOST OFTEN CALCULATED ANALYTICALLY... DFA Can Integrate Banking Models...   

N O liver, W yman & C ompany – 29 – … AND MARKET RISK IS MOST OFTEN MEASURED USING PARAMETRIC VALUE-AT-RISK (VaR) DFA Can Integrate Banking Models... THESE RISKS ARE THEN AGGREGATED USING INTER-RISK CORRELATION ESTIMATES

N O liver, W yman & C ompany – 30 – LIKEWISE, DFA MODELS FOR P&C INSURERS CAN DRAW ON EXISTING MODELS FOR MEASURING CREDIT AND MARKET RISK EDF SEV Correlations EDF SEV Correlations Market Risk Covariance Matrix Process risk Correlations Process risk Correlations CAT Model Event Risk Inter-Risk Correlation Matrix Credit Risk/ Market Risk Calculator Liability Risk Calculator Operating Risk Calculator Standalone Credit Risk Capital Standalone Insurance Risk Capital Standalone Operating Risk Capital Standalone Market Risk Capital Credit Market Insurance Operating Total Economic Capital Contributory Capital Inter-Risk Diversification Factors Credit Risk Parameters Liability Risk Parameters Business Risk DFA Can Integrate Banking Models... These correlations are difficult to estimate Quantify and test separately