Enterprise Risk Management Challenges for Insurers

Donald Mango, FCAS, MAAADirector of Research and Development, GE ERC

My Role at GE ERC

GE ERC

> Worldwide provide of Reinsurance in P&C and Life and Health

– 2003 NWP ~US$9.8B

> Also major US primary insurance carrier

– 2003 NWP ~US$2.1B

> Subsidiary of General Electric– Unwavering parental

commitment to risk management

Director of R&D

> Risk and Pricing Models and Tools

– Methods, thought process, software tools

> Capacity Management– Techniques, risk modeling

> Intellectual Property and thought leadership

> Co-report to Chief Actuary and Chief Risk & Underwriting Officer

Four Major Issues

1. Control versus Coordination2. Point-of-Sale Risk Management3. Product Cost Forecasts4. Time Dimension

Four Major Issues

1. Control versus Coordination2. Point-of-Sale Risk Management3. Product Cost Forecasts4. Time Dimension

#1: Control versus Coordination

Control

> Checks and balances are part of sound corporate governance

> Inherent conflict of interest in the underwriting role (sales versus profit)

Coordination

> Too many controls lead to paralysis

> More eyes may lead to different but not necessarily better decisions

> Local market presence is undermined by excessive referrals

Mandate the decision processes> Key decision variable suite, information requirements, pricing

models, etc.

Distribute decision making authority> Acceptable concession to responsiveness, empowerment> Staff the positions appropriately, don’t legislate around

weaknesses

Audit with Authority> Trust but verify> No self-marked portfolios> Accountability for violations

#1: Control versus CoordinationProposal

Four Major Issues

1. Control versus Coordination2. Point-of-Sale Risk Management3. Product Cost Forecasts4. Time Dimension

#2: Point-of-Sale Risk Management

Much of the risk management activity is reactive and forensic> Record of executed

transactions

We end up with after-the-fact, lagging indicators

Portfolio information takes so long to compile that it often cannot inform real-time decisions

Not well matched to the inherent structural risks of insurers

> Commitment to make future payments

> Leveraged pool of contingent claims

> History of failed companies over-committing

Risk Budgets = linear, additive constraints that reflect product risk characteristics, portfolio situation

> Complexity must be distilled out key challenge facing the quants and actuaries

For each opportunity under consideration, give front-line people: the marginal benefit (return) and marginal budget usage, along with cumulative usage-to-date and departmental target

Competent people can “improve” a portfolio under these conditions

#2: Point-of-Sale Risk ManagementProposal

Four Major Issues

1. Control versus Coordination2. Point-of-Sale Risk Management3. Product Cost Forecasts4. Time Dimension

#3: Product Cost Forecasts

Accepted industry practice for loss ratio planning involves using one’s own history, modified for trends

These are somewhat incestuous, internally-based forecasts > Driving by looking in the

rear view mirror

Fails to anticipate or even react to changes

Economic Invisible Hands move money in and out of various financial products

Periodic product cost shocks, followed by gradual restoration of balance

May be enough pattern and predictability to eliminate a material portion of the systematic risk

Independent forecast models for product costs and price levels> Need to have cyclical components (e.g., mean

reversion)> Movements of the invisible hands> Factoring in major economic drivers

Would also be greatly facilitated by public domain synthetic indices, along with tradable options and futures on those indices

Would allow us to begin spreading systematic risk across a wide base

#3: Product Cost ForecastsProposal

Four Major Issues

1. Control versus Coordination2. Point-of-Sale Risk Management3. Product Cost Forecasts4. Time Dimension

Project evaluation models are still largely static

Our capital usage is dynamic and flowing

Capital commitment to an insurance entity is ongoing

Yet, paradoxically, the capital is not meant to be “used”

Capital allocation and ROE models do factor in one aspect of time – discounting

But what about the dynamics and flow?

Can we reflect the time dimension in our decision processes?

#4: Time Dimension

Capital Allocation may be the wrong asset usage analogue

> Allocation can mean either earmarking or transfer

> Typical models are based on a capital usage model of transfer to the segment, which then returns it over time

This may have theoretical appeal, by facilitating parallels to “project evaluation” from corporate finance

But it is unrealistic and unnecessary, and reinforces the static mindset

#4: Time DimensionCapital Usage

An alternative asset usage analogue is rental or occupation

“THE CAPITAL HOTEL™”

Underwriting of business occupies space (capacity) for a length of time

> Reserves require supporting capital

Occupation of that space excludes it from other uses

It should therefore pay an opportunity cost

#4: Time DimensionThe Capital Hotel

Simple change that clarifies the time dimension

Focus on capital as a shared resource simultaneously exposed to depletion by multiple segments

Puts the past squarely in the present

> Business that hangs around on the books uses up capacity

Focus moves to how long business occupies how much capacity (space)

> Charged for usage per unit of time

#4: Time DimensionThe Capital Hotel

Thank you for your attention