1. Making better decisions… © Copyright 2003 Willis Limited all rights reserved. Using Enterprise Risk Management to Maximize Shareholder Value William H. Panning Executive Vice President Willis Re CAS/SOA Enterprise Risk Management Symposium, Washington, D.C., 2003

2. Making better decisions… 2 Agenda 1.Introduction: Enterprise Risk Management (ERM) as a discipline 2.The components of shareholder value 3.Risk, capital, and shareholder value 4.The importance of strategy to shareholder value 5.Conclusions: How ERM adds shareholder value 6.Appendix: Sources of further information My focus will be on Property-Casualty insurers I will avoid technical details (equations)

3. Making better decisions… 3 1. Enterprise Risk Management as a Discipline Enterprise Risk Management (ERM) is a way of thinking, measuring, and managing that enables managers to maximize the value of their firms to shareholders. ERM has three dimensions: Thinking  Conceptual and Cultural Measuring  Technological Managing  Behavioral What and how we think about ERM  what and how we measure What and how we measure  what and how we manage What and how we manage  the value of our organization Getting the conceptual framework right is crucial to the success of ERM

4. Making better decisions… 4 2. The components of shareholder value The shareholder value of a firm has two components: Adjusted current surplus: The value of its current surplus, adjusted for differences between economic and book value Franchise value: The expected value of future business profits, including business not yet written, adjusted for optionality and risk

5. Making better decisions… 5 2a. Adjusted Current Surplus Adjusted current surplus equals reported surplus... (+) reserve discount: the difference between nominal and discounted future loss payments (+) equity in the unearned premium reserve: the expected profit embedded in the unearned premium reserve (+ or -) the difference between the market and book value of invested assets (-) discount for credit risk of receivables and recoverables (-) adjusted for the risk of adverse loss development

6. Making better decisions… 6 2b. Franchise Value Franchise Value itself has two components, both adjusted for risk: Expected future profits from probable renewals of existing policies Expected future profits from new business not yet written Franchise value typically comprises 20% to 75% of a firm’s value. In contrast to adjusted current surplus, which reflects the profits from past decisions, Franchise Value is the only component of a firm’s value that can be actively managed

7. Making better decisions… 7 2c. ERM and Franchise Value For many firms, Franchise Value is a significant component of their market capitalization (number of shares x share price) Example: an auto insurer with assets of 12 billion, liabilities of 9 billion, and therefore surplus of 3 billion, but a market capitalization of 14 billion! In this case, franchise value comprises more than 3/4 of the firm’s market value Franchise value is real, and is reflected in the business rationale of directly marketed auto insurance ERM that ignores Franchise Value is seriously flawed

8. Making better decisions… 8 3. Risk, capital, and shareholder value Both components of shareholder value are subject to risk Adjusted current surplus is subject to Investment risk: changes in interest rates Credit risk: changes in credit spreads Liability risk: adverse loss reserve development In principle, these risks can be hedged Control asset-liability duration mismatch to limit investment risk Use diversification and credit default swaps to limit credit risk Use reinsurance or loss portfolio transfers to limit or avoid adverse reserve development

9. Making better decisions… 9 3a. Shareholder value at risk Franchise risk is subject to Interest rate risk: future premium and loss CFs are mismatched Industry pricing risk: future profits follow the underwriting cycle Solvency risk: capturing future profits requires sufficient capital In principle, these risks can also be hedged, at least partly: The interest rate risk of future profits can be controlled by appropriately adjusting the duration of the current asset portfolio Industry pricing risk can be partially controlled by managing the firm’s yearly growth rate Solvency risk can be controlled by altering underwriting and financial leverage and/or by purchasing reinsurance

10. Making better decisions… 10 3b. The need for improved measures of risk Current measures of risk are inappropriate for measuring the risk to shareholder value Value at Risk and Tail Value at Risk are cross-sectional measures: they measure the distribution of outcomes at a particular time in the future: the time horizon Cross-sectional measures of risk underestimate shareholder value at risk (“so far so good”) The expected future profits that comprise franchise value, and the risks that affect them, are longitudinal: they span the whole future. There is no “time horizon” for shareholder value.

11. Making better decisions… 11 3c. Implications of longitudinal measures of risk Longitudinal analysis of risk reveals important connections between adjusted current surplus and franchise value. Franchise value requires adequate current surplus: There may be regulatory restrictions on underwriting leverage Current investment may be necessary to capture future business Current surplus may be necessary to absorb unanticipated losses Impairments to current surplus – now or in the future – may limit the ability of a firm to fully capture its potential franchise value

12. Making better decisions… 12 3d. Tradeoffs between surplus and franchise value Increasing a firm’s surplus increases its ability to withstand unexpected losses and thus increases the probability that it will survive (remain solvent) in order to capture franchise profits This can be achieved by increasing the firm’s capital (surplus) or by purchasing reinsurance. Both are costly. The effect of increasing capital or purchasing reinsurance is curvilinear. Initially, these actions increase shareholder value, but the effect gradually decreases and eventually becomes negative. Having too much equity or too much reinsurance reduces the profitability of future business. There is an optimal risk/capital relationship that maximizes shareholder value. (Risk “appetite” is irrelevant.)

13. Making better decisions… 13 4. How strategy affects shareholder value The volume and profitability of future business depends upon business conditions and on management’s response to them. Different strategies for responding to changing business conditions have a substantial impact on the value of future business and on the shape of the firm’s distribution of returns

14. Making better decisions… 14 4a. The effect of strategy on risk and capital: an example Investment Strategy: Three portfolio managers all start out at the same time with portfolios of 50% stocks and 50% bonds, but follow different strategies: Buy-and-hold (B&H) Buy low & sell high (BL-SH) Momentum: buy as stocks rise, sell as they fall (MOM) The results are as follows: StrategyReturnStd Dev95%Loss 99%LossWC Loss MOM8.4% 14.0% 5.3%6.2% 7.1% B&H7.9% 10.2% 6.6% 11.8% 14.5% BL-SH7.4%7.9% 8.4% 18.7% 24.7% Note that Std Dev decreases going down, but other measures increase

15. Making better decisions… 15 4b. Results from a Buy and Hold Strategy

16. Making better decisions… 16 4c. Results from a Momentum Strategy

17. Making better decisions… 17 4d. Results from a Buy-Low-Sell-High Strategy

18. Making better decisions… 18 4e. Return Distributions from the three strategies

19. Making better decisions… 19 4f. The Importance of Strategy: Implications Strategy has a significant impact on the return distribution Risk measures like standard deviation can be misleading, since they fail to reflect differences in the shape of the return distribution. They fail to differentiate between upside and downside potential. Strategy has a significant impact on the amount of capital needed by the firm Strategy therefore affects both components of shareholder value For simplicity, this example focused on investment. But similar considerations apply to strategies for managing the firm’s growth options in underwriting

20. Making better decisions… 20 Conclusion: How ERM can add shareholder value ERM can help managers increase shareholder value by quantifying what is otherwise invisible to them Managers manage only what they can see and quantify Typically they see and quantify only accounting values: current surplus ERM can help managers add value in several ways: By quantifying franchise value, so that feedback is possible By measuring the risks to franchise value By helping managers recognize ways to increase franchise value By helping managers recognize ways to protect franchise value

21. Making better decisions… 21 ERM can assist managers in identifying the combination of risk and surplus that maximizes shareholder value This optimal combination has direct implications for underwriting and financial leverage and for business mix ERM can identify strategies that increase shareholder value by modifying the risk-return relationship Conclusion: How ERM can add value

22. Making better decisions… 22 Some sources of further information: William Panning, ALM for a Going Concern, in Edward Altman and and Irwin Vanderhoof, eds., Financial Dynamics of the Insurance Industry. Dow Jones-Irwin, 1994. William Panning, The Strategic Uses of Value at Risk: Long Term Capital Management for Property-Casualty Insurers, North American Actuarial Review, 3:2, April 1999. Harnessing the Elusive Risk Factor, Best’s Review, June 2001 The Virtues of Value at Risk, Best’s Review, September 2001 Rethinking Retention, Best’s Review, November 2001 Adding up the Skills, Best’s Review, September 2002 Changing the Answers, Best’s Review, January 2003 Managing the Invisible, Best’s Review, June 2003