1 ERM - Post 9/11 Presented by: Susan Witcraft Guy Carpenter July 8, 2002

2 Overview ERM: Is it really used? For what is ERM valuable? Example

3 ERM: Is it Really Used? ERM is a process –Has been done in varying forms as long as companies have had to face risk –Has become more sophisticated in recent years as tools have evolved –Tools include DFA, RAROC, others

4 ERM: Is it Really Used? “Underestimating tail correlation coefficients in the DFA models will underestimate overall risk and the capital required to support the individual risks.... It is critical to understand the potential shortfalls in each analysis when using these tools to manage risk. The author believes failure to do this is one of the major reasons for rampant underpricing during the 1990s as management underestimated tail correlations (with the help of their consultants and mathematicians) and thus underestimated capital requirements in the quest for diversification. ” Bill Riker, Chapter 25, Correlation in Risk Management, page 529, bold and italics added.

5 ERM: Is it Really Used? Several major insurers using RAROC Lots of insurers have considered DFA Many insurers have played with it Only a few have implemented it –Even fewer have relied heavily on the full tool for decision making –Many have used “mini-DFA” to provide insight on decisions

6 For What is ERM Valuable? Asset allocation Reinsurance programs Capital adequacy Capital allocation Line of business mix Understanding income statement and balance sheet risks

7 Enhancing corporate communication Expanding actuaries’ horizons –Overall company management –Investments –Improved analysis tools For What is ERM Valuable?

8 Enhancing Corporate Communication Successful ERM implementation requires participation of all corporate departments. Topics of discussion are wide-ranging. Participants have varying levels of knowledge of these topics.

9 Expanding Actuaries’ Horizons: Overall Company Management Actuary –Oversees or implements model. –Understands issues important to all constituents. –Interprets results. –Participates in decision-making process.

10 Expanding Actuaries’ Horizons: Finance and Investments Enterprise risk management models include all corporate financial activities. Actuaries –Traditionally most familiar with underwriting issues. –Must become at least conversant with economic modeling, investment issues and finance to implement model and interpret results.

11 Expanding Actuaries’ Horizons: Analysis Tools ERM has required actuaries to refine and expand analysis techniques. Examples include modeling of: –Small, large and cat claims. –Development of booked reserves. –Payment pattern variability. –Links between losses and economic conditions. –Pricing process.

12 Improved Analysis Tools: Case Study Analysis tools can be used for other applications. Examples: –Reserve development and payment pattern variability for evaluating adverse development covers. –Separation of losses into small, large and cat for evaluating excess of loss or cat covers or for evaluating adequacy of rates for lines with facultative covers.

13 Case Study: Loss Portfolio Transfer Questions faced by company: –What is the economic cost of each loss portfolio transfer/adverse development cover proposal? –Does each proposal meet the auditors requirements for transfer of risk?

14 Background $200 million of loss and LAE reserves as of 12/31/01. Considering capital contribution or merger. Significant uncertainty surrounding reserve estimates. Want balance sheet protection.

15 Three Proposals 1. $75 million excess $175 million for $30 million. 2. $50 million excess $200 million for $15 million. 3. $250 million excess $0 for $190 million. All 3 include experience account with 7% interest credit guaranteed by ceding company and a reinsurers’ margin of $10 million {$15 million for (3)}.

16 Analysis Approach Simulate possible future payments by calendar year. Reflect differences in emergence patterns under varying historical reinsurance programs. Apply reinsurance terms to each scenario. Auditor defines risk transfer test. Calculate economic cost and risk transfer test.

17 Overall Approach Calendar Year Payments By Accident Year Calendar Year Payments By Accident Year Ending Reserve By Accident Year Ending Reserve By Accident Year Beginning Reserve By Accident Year

18 Payments x Inflation Claim Expected Inflation Claim Actual PaymentsActual  xReserveBeginning Component)RandomRatio(Payment 

19 Ending Reserve ComponentRandom ReserveinChange          ReserveEnding  Reserve Beginningx x                 InflationCost Claim Future Expected Prior Inflation Cost Claim Future Expected Current

20 Total Payments

21 Present Value of Payments

22 Evaluation of Proposals Proposal First Year Cost* Economic Cost Probability of Meeting Threshold $75 x $175$0$1.5 million34% $50 x $200$0$3 million30% $250 x $0$-10 million$4 million39% * Assumes no development.

23 ERM - Post 9/11 Presented by: Susan Witcraft Guy Carpenter July 8, 2002