Risk Consultants - DFA Practice Enterprise Risk Management A Case Study CAS Seminar on Ratemaking...

Risk Consultants - DFA Practice

Enterprise Risk ManagementA Case Study

CAS Seminar on Ratemaking

March 11-13, 2001


Ratemaking?

• More of an account pricing issue than a technical insurance ratemaking issue.

• Of the 18 considerations listed in the CAS SOP Regarding Property & Casualty Ratemaking, ERM really directly impacts only 1 - RISKRISK

• ERM influences buyer behavior.


“Risk” per the Actuarial Statement of Principles

• Random variation from expected cost.– Reflected in cost of capital assumption.– Influences the underwriting profit provision.

• Systematic variation of estimated costs from expected costs.– Reflected in the contingency provision.


CoreBusiness

Strateg

ic

OperationalHazar

d

Financial

Capital

Cap

ital

Cap

ital

Capital

Risk from the CFO’s Perspective


General Risk Categories

• Hazard/Legal Risks

• Financial Risks

• Operational Risks

• Strategic Risks


Case Study - Imaginary Motors

• Based on composite and rescaled individual “Big 3” data, industry information, recent press releases and some pure “guestimates”

• Quantify risks individually and aggregate

• Measure “untreated” earnings impact

• Determine theoretical risk capital for selected level of earnings “protection”


Imaginary Motors -Assumptions

• Market Cap = $42.8 Billion

• Net Income = $5.45 Billion (ttm)

• EPS = $4.72 (ttm); Share Price = $38.12

• Effective Tax Rate = 35%

• Protect against the “1 in 100 year event”

• Exposures can be transferred at pretax nominal cost (expenses offset PV factor)


Imaginary Motors Risks - I

• Hazard/Legal Risks– Property

– Business Interruption

– Cargo/Marine

– Workers’ Compensation

– Automobile Liability

– General Liability

– Product Liability

– Employment Practices

– Crime

– Boiler & Machinery

– Directors & Officers

– Intellectual Property

– Product Recall

– Foreign Liability

– E&O/Professional Liability


Imaginary Motors Risks - II

• Financial Risks– Credit

– Residual Value

– ERISA/Fiduciary

– Foreign Exchange

– Commodity Prices

– Energy Prices

– Interest Rates

• Operational Risks– Warranty

– Product Recall

– Contingent Business Interruption

– Political

– Intellectual Property

– E-Commerce

– Strike/Labor Relations


Imaginary Motors Risks - III

• Strategic Risks– Model Selection

– Geographic Expansion

– Brand Image

– Product Pricing

– R&D Investments

– Acquisitions & Divestitures


Imaginary Motors Hazard Risk

0

1,000

2,000

3,000

4,000

5,000

6,000

100% 99%

90%

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70%

60%

50%

40%

30%

20%

10% 1% 0%

Probability of Exceedence

$Mil

lio

ns

Avg. NI

NI (Agg)

$Loss (Sum)

NI (Sum)

$Loss (Agg)

Avg. Loss

Case Study - Hazard Risk


Case Study - Hazard RiskRisk Area Min. Mean 100 Yr. 250 Yr. Max. St. Dev CV

Property Noncat -$ 8.54$ 28.19$ 32.20$ 53.23$ 6.08$ 0.71 Wind - 11.76 203.37 268.90 648.96 40.52 3.45 EQ - 15.35 520.95 903.91 2,570.03 108.63 7.08 Flood - 5.26 103.35 200.04 820.84 29.40 5.58 Automobile Liability 4.15 13.92 98.87 159.15 214.85 16.76 1.20 General Liability 3.90 11.49 38.97 50.50 284.32 8.15 0.71 Product Liability 349.87 572.73 1,232.59 1,284.46 3,301.76 157.74 0.28 Employment Practices 1.50 7.72 25.15 29.48 99.92 4.58 0.59 Crime - 0.06 0.52 4.41 58.29 1.02 16.23 Directors & Officers - 4.63 70.42 159.94 800.08 23.40 5.05 Foreign Liability 4.03 7.70 11.97 12.81 16.29 1.50 0.19 E&O/Professional - 0.02 0.10 0.37 28.22 0.52 32.76 Hazard Subtotal 363.45 659.18 2,334.46 3,106.15 8,896.79 398.30 0.60 Hazard Portfolio 395.83 659.18 1,454.98 1,784.28 3,840.32 201.88 0.31 Portfolio Effect 32.38 (0.00) (879.48) (1,321.88) (5,056.47) (196.42) (0.30)

Simulated Loss Amounts (in $Millions)


Imaginary Motors Financial Risk

-2,000

0

2,000

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6,000

8,00010

0% 99%

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$Mil

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Avg. Loss

Case Study - Financial Risk


Risk Area Min. Mean 100 Yr. 250 Yr. Max. St. Dev CVResidual Value 86.11$ 1,341.16$ 2,794.97$ 2,901.04$ 3,316.00$ 603.18$ 0.45 Credit (1,907.99) 513.89 1,880.30 2,049.65 2,653.43 619.73 1.21 ERISA/Fiduciary - 0.36 3.17 4.45 14.58 0.69 1.91 Financial Subtotal (1,821.88) 1,855.42 4,678.44 4,955.14 5,984.02 1,223.61 0.66 Financial Portfolio (883.83) 1,855.42 3,886.43 4,139.83 5,366.54 872.49 0.47 Portfolio Effect 938.05 (0.00) (792.01) (815.31) (617.48) (351.12) (0.19)


Case Study - Financial Risk


Imaginary Motors Operational Risk

-5,000

0

5,000

10,000

15,000

20,00010

0% 99%

90%

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70%

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50%

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$ M

illi

on

s

NI (Agg)

Avg. NI

$Loss (Sum)

NI (Sum)

$Loss (Agg)

Avg. Loss

Case Study - Operational Risk


Risk Area Min. Mean 100 Yr. 250 Yr. Max. St. Dev CVWarranty 3,157.93$ 3,596.38$ 3,864.48$ 3,902.22$ 4,030.41$ 115.40$ 0.03 Strike - 288.22 2,609.33 3,230.20 5,551.49 599.07 2.08 Product Recall 5.62 248.84 1,280.31 1,733.32 3,397.26 261.43 1.05 Political - 51.89 1,968.22 3,114.63 9,924.05 373.77 7.20 Intellectual Property - 21.26 115.56 170.67 803.63 26.75 1.26 Operational Subtotal 3,163.54 4,206.59 9,837.89 12,151.05 23,706.84 1,376.42 0.33 Operational Portfolio 3,264.95 4,206.59 6,984.44 7,768.32 13,976.52 761.10 0.18 Portfolio Effect 101.41 (0.00) (2,853.45) (4,382.73) (9,730.32) (615.32) (0.15)


Case Study - Operational Risk


Imaginary Motors Strategic Risk

-2,000

0

2,000

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6,000

8,00010

0% 99%

90%

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$Mil

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ss (

$Mil

lio

ns) Avg. NI

NI (Agg)

$Loss (Sum)

NI (Sum)

$Loss (Agg)

Avg. Loss

Case Study - Strategic Risk


Case Study - Strategic Risk

Risk Area Min. Mean 100 Yr. 250 Yr. Max. St. Dev CVPhase Out Division X 603.92$ 893.66$ 1,121.21$ 1,158.46$ 1,287.24$ 893.41$ 1.00 Invest in Division Y 909.54 1,340.50 1,681.84 1,737.39 1,945.73 1,340.36 1.00 Division Y Sales Increase (3,626.97) (2,432.76) (1,919.97) (1,858.99) (1,610.99) 893.41 0.37 Strategic Subtotal (2,113.51) (198.59) 883.07 1,036.86 1,621.98 466.70 2.35 Strategic Portfolio (1,563.68) (198.59) 449.75 516.08 780.88 293.49 1.48 Portfolio Effect 549.83 - (433.32) (520.78) (841.10) (173.20) (0.87)



Imaginary Motors Composite Risk

-10,000

-5,000

0

5,000

10,000

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20,000

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30,00010

0% 99%

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$Mil

lio

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Avg. NI

NI (Agg)

$Loss (Sum)

NI (Sum)

$Loss (Agg)

Avg. Loss

Case Study - Composite Risk


Risk Area Min. Mean 100 Yr. 250 Yr. Max. St. Dev CVHazard Subtotal 363.45 659.18 2,334.46 3,106.15 8,896.79 398.30 0.60 Financial Subtotal (1,821.88) 1,855.42 4,678.44 4,955.14 5,984.02 1,223.61 0.66 Operational Subtotal 3,163.54 4,206.59 9,837.89 12,151.05 23,706.84 1,376.42 0.33 Strategic Subtotal (2,113.51) (198.59) 883.07 1,036.86 1,621.98 466.70 2.35 All Risk Subtotal (408.39) 6,522.59 17,733.86 21,249.20 40,209.63 3,465.02 0.53 All Risk Portfolio 3,188.68 6,522.59 10,151.33 10,988.59 15,602.11 1,229.67 0.19 Portfolio Effect 3,597.07 - (7,582.53) (10,260.61) (24,607.52) (2,235.35) (0.34)


Case Study - Composite Risk


Imaginary Motors - Implications

• To protect against earnings volatility at the “1 in 100 year” level on a pretax basis:– finance $11.2 B if risks treated individually;– finance $3.6 B if risks treated as a portfolio.

• Risk finance cost difference of $76 Million.– $0.04 in after-tax EPS.– Almost $400 M in market capitalization at

current P/E multiple.


Imaginary Motors - Caveats

• Not all risks to Net Income are included.– WC, cargo, etc. due to lack of data;– general economic risks - interest rates, etc.

• “Portfolio Effect” potentially overstated– not all correlations reflected (warranty, recall and

product liability, for example);– companies may look at some risks in portfolios

(integrated insurance programs, combined aggregate excess programs, etc.).

Risk Consultants - DFA Practice Enterprise Risk Management A Case Study CAS Seminar on Ratemaking...

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