A Changing “World” of Risk Presented to American Risk and Insurance 7 August 2007 Joan Lamm-Tennant, PhD Global Chief Economist and Risk Strategist Guy Carpenter

1 Changing “World” of Risk  Drivers of Change  Seeing the Landscape –Focusing on the Totality of Risk –Linking Risk to Capital Management  Varying Strategies

2 Changing “World” of Risk Drivers of Change  Recent Shock to Capital –And awareness of new risks  Scrutiny of Corporate America –And new regulatory/rating agency hurdles –New code of behavior –New role of governance  Awakening the Capital Markets to Insurable Risk –Is it the last horizon? –Has pricing adjusted to whet the appetite of the titans? –Is it about diversification of risk?

3 Changing “World” of Risk Seeing the Landscape  Holistic or Enterprise Models of Risk –And products/strategies for managing enterprise risk  Linking Risk Management to Capital Management –Capital Adequacy –Capital Allocation –Capital Structure

4 Seeing the Landscape Enterprise Risk Models TIMELINESIMULATIONTIMELINESIMULATION TIMELINESIMULATIONTIMELINESIMULATION Enterprise Risk/Return Enterprise Risk/Return Economic Capital Economic Capital Operational Risk Event Tables Operational Risk Event Tables Aggregated Losses Aggregated Losses Asset Class Proxies Asset Class Proxies Duration/Maturity Credit Duration/Maturity Credit Catastrophe Event Tables Catastrophe Event Tables Aggregated Losses Aggregated Losses CORRELATEDCORRELATED CORRELATEDCORRELATED ECONOMICECONOMIC ECONOMICECONOMIC FACTORSsFACTORSs FACTORSsFACTORSs Correlated Loss Events Correlated Loss Events Frequency and Severity Distributions Frequency and Severity Distributions Reserve Adjustments Reserve Adjustments Severity Distributions Severity Distributions Reinsurance Default Reinsurance Default Credit Ratings Recoveries Credit Ratings Recoveries

5 Framing Reinsurance In “ERM” Vernacular

6 Framing Reinsurance In “Earnings” Vernacular XYZ’s Expected Net Income Net Income – All Lines

7 $200,000 Treaty $25,000,000 xs $10,000,000 Return / Risk Profile Economic Capital Released vs. Capital-at-Risk $6,500 $6,700 $6,900 $7,100 $7,300 $7,500 $7,700 $7,900 $8,100 $8,300 $8,500 ($6,400)($6,200)($6,000)($5,800)($5,600)($5,400)($5,200)($5,000)($4,800) Capital-at-Risk CaR (5%) (Risk) Economic Capital Released (Return) $300K Treaty $25,000,000 xs $10,000,000 $2M Cat $2.5M Cat $2M Cat $2.5M Cat $3M Cat $300,000 Treaty Aggregate $200,000 Treaty Aggregate $2M Cat $2.5M Cat $3M Cat $2.5M Cat $2M Cat $3M Cat Framing Reinsurance In “Capital” Vernacular

8 Seeing the Landscape Linking Risk Management to Capital Management Economic Capital Risk Tolerance Capital Adequacy ERM Models Risk Aggregation Asset VolatilityCatastrophe Models Reserve VolatilityFrequency / Severity Risk Modeling Reinsurance, Debt, Equity… Capital Structure Capital Allocation Pricing Risk-Adjusted Returns

9 Seeing the Landscape Linking ERM to Capital Management  Manage the Adequacy of Capital –How much capital does the firm require?  Too much capital will lower the ROEs … too little capital will increase the cost of capital and impose frictional costs of regulation  Maximize Return on Capital –Allocate capital to drive growth in lines yielding the highest return on risk-adjusted capital –RORAC, return on risk-adjusted capital –Often referred to as RAROC, risk-adjusted return on capital  Minimize the Cost of Capital –Achieve the optimal capital structure … balance the various sources of capital –Innovations in sources of capital  Surplus Notes, Catastrophe Bonds, Side Cars, ILWs, And more EVA: ROC – Cost of Capital

10 Changing “World” of Risk Varying Strategies  Reframing products –From Reinsurance to Contingent Capital  Repositioning expertise –From Broking to Capital Advisors with Transactional Excellence  Focus in on Economic Value Creation

11 Conclusion Change is Both Behavioral and Empirical

12 Re

13  2007 has already set a new record in terms of risk capital issued –19 transactions –$5.1 billion of risk capital placed  Nine first time sponsors  Balance of the year expected to be active with more deals involving Euro wind than in the first half of the year Catastrophe Bond Considerations Market Update

14 Catastrophe Bond Market – Primary Pricing Experience U.S. Wind Peril, May 2006 – Present, Exp. Loss < 3.0%