Britain PriceBritain Price Shawn CowlsShawn CowlsSenior Vice PresidentSenior Vice President ConsultantConsultantSS&C Technologies, Inc.SS&C Technologies, Inc. Tillinghast-Tillinghast-

Towers Perrin Towers Perrin

DFA and DFCA as ALM, ERM ToolsDFA and DFCA as ALM, ERM Tools

AgendaAgenda

2003 Survey Results2003 Survey ResultsComponents of ERM Components of ERM ERM Case Study (M&A)ERM Case Study (M&A)

ERM Challenges for the Industry – ERM Challenges for the Industry – Results from 2003 Survey* Results from 2003 Survey*

53% of companies are still using static, single-point estimates for projections.

33% of companies have an integrated model that handles both assets and liabilities. 13% use a fixed yield to represent the expected

portfolio return.38% of companies don't forecast results within an

accounting framework. Only 25% include tax effects.

35% can drill into their assumptions and business logic.

*Results from SS&C Technologies’ Planning & Forecasting Survey, published Friday, May 30, 2003 - Volume III, Issue X

ERM Industry Favorable Result ERM Industry Favorable Result from 2003 Survey* from 2003 Survey*

Functional participation in planning is good, with 47% of companies having two to four functional areas involved in the process and 53% having over five areas represented. Finance and Accounting are best represented.

*Results from SS&C Technologies’ Planning & Forecasting Survey, published Friday, May 30, 2003 - Volume III, Issue X

Model Requirements for Effective Model Requirements for Effective ERMERM

What you should haveFully Integrated Model (Assets & Liabilities)Risk Adjusted Assets Sophisticated Economic Scenario GenerationRisk Adjusted LiabilitiesTrue Decision Support Communication

Value of Enterprise Risk ManagementValue of Enterprise Risk Management

Better insight into your “realistic” business operationsBetter insight into your “realistic” business operations VariabilityVariability Interrelationships in Interrelationships in

business operationsbusiness operations

UnderwritingUnderwriting InvestmentsInvestments AccountingAccounting

Links your entire operationsLinks your entire operations

Enhances your decision supportEnhances your decision support GraphicalGraphical Pro-forma financial Pro-forma financial

statementsstatements Data drill-downData drill-downTest alternative business strategies in advanceTest alternative business strategies in advance

Investments, Reins., Capital Investments, Reins., Capital Mgmt, M&A, Pricing, Tax,… Mgmt, M&A, Pricing, Tax,…

Risk Adjusted Assets...Risk Adjusted Assets... Actual attributes for portfolio holdings should be

accounted for in an ERM model (e.g., modeled proxies or CUSIP level of detail)

If proxies are used, then they should be defined with current portfolio attributes (e.g., duration, yield, coupon, term, etc.)

Economic Scenario Generation...Economic Scenario Generation...

Assets should be valued using a sophisticated, multi-factor economic scenario generator

Note Yield Curve Inversion

Scenario’s Effect on AssetsScenario’s Effect on Assets

Risk Adjusted Liabilities...Risk Adjusted Liabilities...

Liabilities are “risk adjusted” when we Liabilities are “risk adjusted” when we imbed variabilityimbed variability into our understanding of assumed valuesinto our understanding of assumed values

Using probability distributions we account for various Using probability distributions we account for various outcomes of key liability assumptionsoutcomes of key liability assumptions

Key assumptions to make dynamic:Key assumptions to make dynamic: PremiumsPremiums LossesLosses ALAE/UALEALAE/UALE Historic Held Loss ReservesHistoric Held Loss Reserves Speed of Loss PayoutSpeed of Loss Payout Line Inflation (multiple of CPI)Line Inflation (multiple of CPI)

PPA

Auto Physical Damage

Investment Income Net Income After Tax

(For all projection years)

ERM Incorporates the ERM Incorporates the Compounding Compounding EffectEffect of Business Uncertainty of Business Uncertainty

Underwriting Cash Flow

A Virtual Income Statement...A Virtual Income Statement...

Statutory Income Statement:

Net Earned Premium 100,000,000

Net losses incurred 75,000,000

Expenses 26,000,000

Net Underwriting Gain or (Loss) (1,000,000)

Net investment income earned 11,250,000

Net capital gains (losses) 3,750,000

Net Investment Gain or (Loss) 15,000,000

Net Income before Taxes 14,000,000

Federal income taxes incurred 2,520,000

Net Income after Taxes 11,480,000

Statutory Income Statement:

Net Earned Premium

Net losses incurred

Expenses

Net Underwriting Gain or (Loss)

Net investment income earned

Net capital gains (losses)

Net Investment Gain or (Loss)

Net Income before Taxes

Federal income taxes incurred

Net Income after Taxes

Generate economic scenariosGenerate economic scenarios Sample business variablesSample business variables Calculate liability cash-flowsCalculate liability cash-flows Calculate asset cash-flows and price investment Calculate asset cash-flows and price investment

portfolio portfolio Rebalance the asset portfolioRebalance the asset portfolio Pay taxes, expenses and dividendsPay taxes, expenses and dividends Produce pro-forma financial statements in GAAP, Produce pro-forma financial statements in GAAP,

STAT and Economic ValuationSTAT and Economic Valuation Make output available for graphical representation Make output available for graphical representation Repeat for thousands of iterationsRepeat for thousands of iterations

What does “simulation” mean?What does “simulation” mean?

Communicate Results with Communicate Results with Graphics , NOT StatisticsGraphics , NOT Statistics

Stochastic

Skewness

Standard Deviation

Log Normal

Coefficient of Variation

Poisson

Confidence Interval

MEAN

95%

Graphics Ease the Understanding Graphics Ease the Understanding of Risksof Risks

ERM: Case Study on M&A ERM: Case Study on M&A

Three models created:Three models created:1. Parent Company1. Parent Company

2. Target Company2. Target Company

3. Merged Company3. Merged Company

Models populated with 2002 statutory financials from AM Models populated with 2002 statutory financials from AM Best data interfaceBest data interface

Lines modeled:Lines modeled: HomeownersHomeowners Private Passenger AutoPrivate Passenger Auto Auto Physical DamageAuto Physical Damage

Model Set-Up (cont.)Model Set-Up (cont.)

No change in investment allocationsNo change in investment allocations Major differences between modeled lines and companies:Major differences between modeled lines and companies:

Premiums-earning patternsPremiums-earning patterns Commissions/expensesCommissions/expenses Loss ratio and premium growth distributions created from 10 year Loss ratio and premium growth distributions created from 10 year

historic results (AM Best Data)historic results (AM Best Data)

Combined

Homeowners Private PassengerAuto

Auto PhysicalDamage

ParentHO

TargetHO

ParentPPA

TargetPPA

ParentAPD

TargetAPD

Net Income Before Tax (2004)Net Income Before Tax (2004)

RAROC (2004)RAROC (2004)

Combined Ratio (2004)Combined Ratio (2004)

Parent Target Merged

ROE (2004)ROE (2004)

Parent Target Merged

Net Leverage (2004)Net Leverage (2004)

FailPass

Parent Target Merged

Net Leverage Drill Down (2004)Net Leverage Drill Down (2004)

While capital efficient on an expected basis, simulation indicates that without corrective action the likelihood of failing this Best Ratio is 29% of the time.

The acquisition improves this metric.

Absolute BCAR ProjectionAbsolute BCAR Projection

A++

A+

A

A-

2525

Dynamic Financial Condition Dynamic Financial Condition Analysis and Enterprise Risk Analysis and Enterprise Risk ManagementManagement

Shawn Cowls, FSA, MAAAShawn Cowls, FSA, MAAA

Dynamic Financial Condition Analysis Dynamic Financial Condition Analysis and Enterprise Risk Managementand Enterprise Risk Management

Enterprise Risk Management (ERM)Enterprise Risk Management (ERM)Dynamic Financial Condition Analysis Dynamic Financial Condition Analysis

(DFCA)(DFCA)Bringing ERM and DFCA TogetherBringing ERM and DFCA Together

Enterprise Risk Management (ERM)Enterprise Risk Management (ERM)

Defining ERMDefining ERMCritical Elements of ERMCritical Elements of ERMUses of ERMUses of ERM

Defining Enterprise Risk Defining Enterprise Risk ManagementManagement

Assessing and addressing risks, from all sources, Assessing and addressing risks, from all sources, that represent either material threats to business that represent either material threats to business objectives or opportunities to exploit for objectives or opportunities to exploit for competitive advantagecompetitive advantage

An effective ERM process will:An effective ERM process will: incorporate all material risks - financial and operationalincorporate all material risks - financial and operational evaluate all relevant strategies - financial and evaluate all relevant strategies - financial and

operationaloperational consider all pertinent constraintsconsider all pertinent constraints exploit natural hedges and portfolio effects among the exploit natural hedges and portfolio effects among the

risks, and financial and operational efficiencies among risks, and financial and operational efficiencies among the strategiesthe strategies

Defining Enterprise Risk Defining Enterprise Risk ManagementManagement

ResultResult An optimal set of strategies that balances the An optimal set of strategies that balances the

need for capital and the need for return, need for capital and the need for return, growth, and consistencygrowth, and consistency

In essence, an optimization of risk and valueIn essence, an optimization of risk and value

Ultimately, ERM is a process composed of Ultimately, ERM is a process composed of a number of different steps involving a a number of different steps involving a range of insurance professionalsrange of insurance professionals

Critical Elements of Enterprise Critical Elements of Enterprise Risk ManagementRisk Management

Assess risksAssess risks Identify risks and assess materialityIdentify risks and assess materiality Classify and prioritize risksClassify and prioritize risks Model risksModel risks

Articulate financial and operational Articulate financial and operational strategiesstrategies

Evaluate and refine financial and Evaluate and refine financial and operational strategiesoperational strategies

Monitor strategy performance and the risk Monitor strategy performance and the risk environmentenvironment

Uses of Enterprise Risk Uses of Enterprise Risk ManagementManagement

An effective ERM process will help an An effective ERM process will help an insurer make sound decisions about which insurer make sound decisions about which financial and operational strategies it financial and operational strategies it should implementshould implement What should our product mix be?What should our product mix be? What channels should we distribute the What channels should we distribute the

products through, and to which markets?products through, and to which markets? What set of agency ratings should the What set of agency ratings should the

company target? How do we most effectively company target? How do we most effectively achieve our target?achieve our target?

How much capital should we hold?How much capital should we hold?

Uses of Enterprise Risk Uses of Enterprise Risk ManagementManagement

An effective ERM process will help an insurer An effective ERM process will help an insurer make sound decisions about which financial and make sound decisions about which financial and operational strategies it should implementoperational strategies it should implement How much and on what terms should we reinsure or How much and on what terms should we reinsure or

hedge?hedge? How should we invest our assets?How should we invest our assets? How much should we invest in technology?How much should we invest in technology? How should resources be assigned to sales versus How should resources be assigned to sales versus

service and how should they be deployed across service and how should they be deployed across products and regions?products and regions?

How much should we spend on recruiting, training, and How much should we spend on recruiting, training, and retention?retention?

Dynamic Financial Condition Dynamic Financial Condition Analysis (DFCA)Analysis (DFCA)

Defining DFCADefining DFCACritical Elements of DFCACritical Elements of DFCAUses of DFCAUses of DFCA

Defining Dynamic Financial Defining Dynamic Financial Condition AnalysisCondition Analysis

DynamicDynamic model of the interaction of: model of the interaction of: Economic elementsEconomic elements Product featuresProduct features Policyholder behaviorPolicyholder behavior Company behaviorCompany behavior Over a number of expected and unexpected scenariosOver a number of expected and unexpected scenarios

Projection of Projection of financialfinancial results over a near horizon results over a near horizonEvaluation of a company’s fitness or Evaluation of a company’s fitness or conditionconditionAn An analysisanalysis that synthesizes a company’s that synthesizes a company’s

expected experience under various stressesexpected experience under various stresses

Critical Elements of Dynamic Critical Elements of Dynamic Financial Condition AnalysisFinancial Condition Analysis

A model that adequately represents a A model that adequately represents a company’s businesscompany’s business

Economic and environmental scenarios Economic and environmental scenarios that test the financial conditionthat test the financial condition

Interactivity between elements of the model Interactivity between elements of the model and the economic and environmental and the economic and environmental scenariosscenarios

Communication of the condition and Communication of the condition and sensitivity of the companysensitivity of the company

Uses of Dynamic Financial Uses of Dynamic Financial Condition AnalysisCondition Analysis

Model financial strategiesModel financial strategiesModel the financial impact of various risksModel the financial impact of various risksAssess the value of various strategies in Assess the value of various strategies in

mitigating risksmitigating risksProvide an analysis that communicates to Provide an analysis that communicates to

management the company’s financial management the company’s financial condition under specified strategies and condition under specified strategies and scenariosscenarios

Bringing ERM and DFCA TogetherBringing ERM and DFCA Together

StrategiesStrategiesModelsModelsCommunication of ResultsCommunication of Results

Bringing ERM and DFCA Together Bringing ERM and DFCA Together - Strategies- Strategies

Making annual decisions with respect toMaking annual decisions with respect to Distribution channelDistribution channel Capital deploymentCapital deployment InvestmentsInvestments TechnologyTechnology

Bringing ERM and DFCA Together Bringing ERM and DFCA Together - Models- Models

Environmental and Economic Scenarios Environmental and Economic Scenarios Expected environmentExpected environment Unexpected environmentsUnexpected environments

The interactive impact of these environments on:The interactive impact of these environments on: Management behaviorManagement behavior Policyholder behaviorPolicyholder behavior Policy cash flowsPolicy cash flows Portfolio manager behaviorPortfolio manager behavior

Alternate strategies that may respond to various Alternate strategies that may respond to various environmentsenvironments

Bringing ERM and DFCA Together Bringing ERM and DFCA Together - Communication of Results- Communication of Results

Synthesis of the results organized by major risk Synthesis of the results organized by major risk factorsfactors

Highlights and summariesHighlights and summaries Leave details in appendices Leave details in appendices Fewer tables and more graphics!Fewer tables and more graphics!

What did we learn?What did we learn? What risks can cause the greatest harm?What risks can cause the greatest harm? What impact do various risk mitigation strategies have What impact do various risk mitigation strategies have

on the results?on the results? Which risks can occur together? Which are mutually Which risks can occur together? Which are mutually

exclusive?exclusive? How can insights be applied to business objectives?How can insights be applied to business objectives?