November 14, 2001 François Morin, FCAS, MAAA, CFA Capital Management 2001 CAS Annual Meeting - Atlanta, Georgia

2 Today’s agenda Objectives of the project Overview of approach taken Results and insights obtained

Objectives of the Project

4 The client established three broad objectives for the project Optimize the use of capital within and across the company Know how much capital is needed to support each business, and how changes in strategy alter needed capital Analyze performance on a consistent basis across all products, subsidiaries, countries Independent of accounting and regulatory regimes Improve the knowledge of the underlying risks and inform decisions as to the relationship between risk, capital and return

5 The client sought to “operationalize” a simple conceptual value framework Risk Profile of Business Segment Capital Required to Support Risk Value-Based Performance Assessment Required Returns on Capital Employed Actual Returns Consistently Measured

6 Working collaboratively with the client team, we were responsible for the key deliverables Initial assessment of existing tools and capabilities Development of conceptual framework Software Economic Scenario Generator -- Global CAP:Link P/C Financial Projection System -- TAS:P/C Life Financial Projection System -- already in place Results Aggregator/Calculator -- custom tool Training of staff Assistance to business units in model development and implementation Validation and analysis of results

Overview of approach taken

8 The client chose to implement a Dynamic Financial Analysis (DFA) approach Company Strategy Asset Mix Product Mix Capital Structure Reins/Hedging Economic Scenario Generator Projected Financials Risk Profile = Distribution of Future Financial Results Economic Capital Embedded Value Asset Behavior Model Product Behavior Model Optimization Inflation Interest Rates Credit Spreads Currency Exchange GDP

9 A common set of economic scenarios were used, so that model results could be combined Monthly time series variables for GDP, inflation, government bonds, credit spreads, equity returns For each of 13 countries, including currency exchange

10 For the Value Measurement Shareholder view Capital Asset Pricing Model (CAPM) approach Based on non-diversifiable risk Economic value = discounted value of free cash flows at the Risk Adjusted Return Reflects the riskiness of the business compared to an equity investment Shareholder view Capital Asset Pricing Model (CAPM) approach Based on non-diversifiable risk Economic value = discounted value of free cash flows at the Risk Adjusted Return Reflects the riskiness of the business compared to an equity investment For Capital at Risk Assessment Policyholder view Risk of ruin approach Based on adverse scenarios Economic Capital = amount of shareholder equity in excess of the Best Estimate Liability, required to assure payment in a high percentage of scenarios Policyholder view Risk of ruin approach Based on adverse scenarios Economic Capital = amount of shareholder equity in excess of the Best Estimate Liability, required to assure payment in a high percentage of scenarios The two sides of the framework: two measures of risk

11 The best estimate liability The Best Estimate Liability is an economic view of the reserves Discounted amount: allow for the financial profits on the assets backing reserves Includes both Loss Reserves and Unearned Premium Reserves Best Estimate Liability $ 2,625 M Statutory reserves $3,250 M Over reserves and discounting effect $ 625 M P&C Example The Best Estimate Liability (BEL) is the level of assets required to pay future policyholder benefits in a best estimate scenario The difference between statutory reserves and Best Estimate Liability is a source of funding available to meet economic capital requirements

12 Security factor The Security Factor is based on A constant annual Risk of Ruin of 0.1% which reflects Moody’s rating assessment for AA bonds The Risk Exposure Duration -- the length of time over which the business is exposed to adverse events multiplied by the amount of the exposure within the projection Other measures of security were also explored

13 Represents the level of assets, in addition to the BEL, required to pay future policyholder benefits at a chosen Security Factor The Economic Capital covers the volatility in:  The run-off of existing business  The future business (“pricing risk”) Sources of funding for the Economic Capital include:  The difference between the assets backing statutory reserves and the BEL  Shareholders’ equity above the statutory reserves Best Estimate Liability $4,000 M Over reserves and discounting effect Economic Capital $1,600M Pricing risk $700 M Run-off risk $900 M Statutory reserves $4,800 M P&C Example Economic capital

Results and insights obtained from the initial implementation

15 The initial implementation focused on key products and business segments Models were developed and implemented for 15 business units, operating in 8 countries 7 Life 8 P/C Typically, the models incorporated 90+% of the business in each unit Client staff in each unit were trained in the economic capital approach Each entity presented its results to a central management group; overall results presented to client board

16 Economic Reserves Margin in Reserves Market Value of Invested Assets Economic Capital Pricing risk Run-off risk Required Assets Receivables Statutory Reserves Shareholder Equity Financial Balance Sheet Excess S/H Assets Debt Actual Capital Debt Total Assets For any segment or grouping, it is possible to construct an economic balance sheet … Economic Components

17 By combining models, the client was able to enterprise measure diversification benefits Diversification effects are high between P&C businesses because the claims risks are largely uncorrelated Life businesses exhibit high diversification due to the varied nature of the different businesses The aggregation of Life and P&C creates little additional diversification because the dominant risk for the Group is the asset risk P/C Diversification effect Sum of P/C Segments Sum of Life Segments Aggregated P/C Business Aggregated Life Business Aggregated Total Life Diversification effect P/C -- Life Diversification effect Enterprise Diversification Benefit Economic Capital

18 Capital requirements comments Different types of business require markedly different levels of Economic Capital Differences in capital requirement for P/C businesses arise from three main causes Product type Catastrophe exposure Asset mix Life generally has low requirements because a proportion of reserves is policyholder deposits, which add little risk The actual capital held is 3.5X the Economic Capital A large proportion of the Economic Capital is covered by the over- reserve

19 The P/C business segments have disparate economic capital requirements Segment A Segment B Segment C Segment D Segment E Segment F Segment G Results depend on product mix, reinsurance program, and asset mix

20 Even within a product line, economic capital requirements vary Results are influenced by market conditions for the product, reinsurance, and asset mix Economic Capital Ratio to Premium -- Personal Insurance 0%50%100%150%200%250%300%350%400%450% Individual Health Private Motor A B C D E Household A B C D E

21 0% 10% 21% 24% 33% For the P/C businesses, the results indicated some inconsistencies in reinsurance purchasing Decisions regarding program retentions and limits were at the discretion of the business units, without a common framework for decision making

22 Economic Balance Sheet Value Economic Capital Excess unmodelled assets Best Estimate Liability Value of Unmodelled Excess Assets Value of modelled Excess Assets and Economic capital Value of renewals Excess modelled assets Using the economic capital, it is possible to measure the embedded value of the business

23 Value results at group level The framework is the same as Embedded Value, with two enhancements: Economic required capital (the capital that each business actually needs rather than that prescribed by the regulator) Level of risk in the business (calculation of a Risk Adjusted Return) This enhanced framework will allow us to: Measure value creation over time (increase in value) Calculate new business value Sharpen the product pricing metric Test whether different strategies create more value To fully use this framework, we will require at least two successive calculations of value at different points in time

24 Communication with regulators and rating agencies about capital management Implementation of Economic Capital now allows the client to change the flow of discussions with regulators and rating agencies In the past, discussions typically were a reaction to external agency’s assessment of capital adequacy — based on solvency tests or RBC formulas Client now has fact-based discussions, based on concrete risk analysis and objective standard The approach has been positively received by regulatory authorities; discussions with rating agencies are planned