ERM from a Small Insurance Company Perspective NABRICO Sept 30, 2011 Agenda Section 1 Section 2 Section 3 Section 4 ERM Introduction Key Risks Streamlined Quantitative Process Other Influences 1 1
Section 1: ERM Introduction Enterprise Risk Management Enterprise Risk Management means different things to different people Actuary: ERM = Calculate Economic Capital looks like DFA Accountant: ERM = SOX/COSO compliance looks like internal audit CEO\CFO: ERM = No earnings surprises looks like stable income CRO: ERM = Opportunity for a new role looks like Hal 3 2
Enterprise Risk Management Bummer of a birthmark Hal 4 ERM A Brief History of Time ERM began in banking Desire to understand risk in trading portfolios Banks include considerable transactional & operational risk ERM framework moves to Insurance ERM applied to insurance companies as evolution of Dynamic Financial Analysis Rating agencies pressure for more sophisticated risk quantification tools and more formal risk management processes Regulatory pressure in Europe through Solvency II Credit Crisis Occurs Banking ERM deficiencies revealed Rating agency credibility in dictating what good ERM looks like reduced Now What? How should we use models? How do we balance qualitative and quantitative aspects of risk management? 5 3
Enterprise Risk Management Defined Ensuring you are properly compensated for the risks you assume Measure Risk Manage Monitor Specify risk tolerance and manage within it Must understand risks individually to determine premium adequacy Must understand how risks aggregate to assure risk taking is aligned with risk capacity Complexity of task increases exponentially with size of organization 6 Capacity, Tolerance, Appetite and Limits Capacity Ultimate ability to assume and absorb risk Tolerance Undesirable risk that is tolerated Appetite Desirable risk, subject to the reward being adequate Risk Limits Silo-based criteria to help guide transactional risk-taking Risk Capacity Risk Tolerance Risk Appetite 7 4
Enterprise Risk Management Key Components Information Gathering risk tolerance & appetite resources & expertise ownership and responsibility risk monitoring risk registers risk learning risk models for better Decision Making capital allocation risk / return tradeoffs planning & budgeting value-based decisions controls, targets standards, limits, etc. risk selection & pricing risk transfer mechanisms ERM is a process that facilitates an efficient means to gather, organize, prioritize and validate information, such that management is positioned to make better decisions ERM is not software, a model, a project, a risk register, etc.; it embodies several quantitative and qualitative components that in balance supports value creation ERM is more about supporting strategy and exploiting opportunity and less about simply controlling risk Measure, monitor, and manage risk Assure firm is properly compensated for taking risks Complexity of task increases exponentially with the size of the firm 8 Key Risks Underwriting Reserve Market Credit Operational Pricing Risk Parameter Risk Loss Process Risk Cat Risk Product Design Risk 1 year Run-off Long-Tailed Lines Latent risks (A&E) Equity Interest Rate (GAAP) Currency Reinsurance Recoverables Bonds Default Downgrade migration Basel II banking defn: the risk of loss resulting from inadequate or failed internal processes, people, or systems, or from external events Usually measured / modeled stochastically Financial crisis has altered asset risk assumptions Correlation matrices augmented with scenario / stress testing Diversification impact varies greatly 25%-50% Limited advancement in this area Limited data 10-20% add on at the end Rating agencies want more with this 9 5
Section 2: Key Risks Underwriting Risk: Systemic Risk Asset Portfolio Risk Insurance Portfolio Risk Underwriting cycle, macroeconomic trends, legal changes etc. mean a certain level of systemic insurance risk always exists Insurers must estimate key elements when pricing to later find out the true level of the key elements 11 6
Underwriting Risk Parameters: Coefficient Of Variation Of Gross Loss Ratio, 1992-2010 12 Reserve Risk: The Silent Killer Net - LR Volatility Reserves impact current income Prior accident years initial LRs too low 100% 90% Last LR 80% First LR 70% 60% 50% 40% 30% 20% 10% 0% 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Accident Year Reserve risk: large solvency threat A.M. Best s 2011 Impairment Study: 54% of impairments from 1969 2010 can be attributed to reserve deficiencies & rapid growth Individual accident year development account for 4 of the 10 largest U.S. P&C industry events. Combined reserve development in 1998 2001 amounts to USD64 billion 55% more than Katrina 13 7
Market Risk Interesting Times Interest Rates extremely low where can they go? Any more levers to pull? Stock market volatility high Headlines: SHILLER Index: House Prices Probably Won t Hit Bottom For Years Ben White: Europe s Crisis Is Real, Ours Is Self-Inflicted Debt ceiling? Super committee? Interest Rates - 3 Yr Treasuries 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 1961 1965 1969 1973 1978 1982 1986 1990 1994 1998 2002 2006 2010 Stock Market Volatility - VIX Index Prices 90 80 70 60 50 40 30 20 10 0 1990 1995 2001 2006 2011 Proprietary & Confidential 14 Credit Risk - Crisis Lessons Monthly Change in Corporate Credit Spreads 2 AAA BBB Through December 2006, calibrating asset risk to historical data would have been driven by stressed scenarios of the LTCM bailout and 9/11. 1.5 1 0.5 0-0.5 October 2008 increase in spreads would have been an 11-18 sigma event on top of a September that was a 4-8 sigma change -1 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 LTCM Crisis 9/11 Calibrating to historical data prior to 2007 is like basing earthquake risk estimates upon the volatility of daily paid earthquake losses 15 8
Operational Risk Simple A Check list Things on list: Succession plan Data protected Systems backed up and redundancy in place D&O insurance Etc Proprietary & Confidential 16 Section 3: Streamlined Quantitative Process 9
ERM Goals Overall Goals Small Company Requirements Produce a reasonable return Smooth income Protect capital Reliable Easy to maintain Not a large investment Starting Point: Past Performance What has caused negative income for LPL carriers? Alternative: Level of stress that causes co to fail? What risks can drive this? Millions 15 10 5 0-5 15 10 5 0-5 4 2 0.001 0 0.0005-2 -4 0 2002Q1 Combined Single-State Writers Multi-State Writers 2003Q1 2004Q1 2005Q1 Quarterly Net Income 2006Q1 2007Q1 2008Q1 2009Q1 2010Q1 2011Q1 18 ERM and the Risk Management Process Economic Capital Modeling Enterprise Risk Management Exposure Risk Management Data Good data is the foundation of risk management Exposure risk management impossible without reliable reporting and data capture ERM impossible without good exposure risk management Risk aggregations Risk limits Cat model inputs ECM relies on good ERM foundation ECM worthless if risk controls not adequate to ensure models reflect current realities S&P will not review capital models from companies without a strong or excellent ERM rating 19 10
Economic Capital Model Governance Key Risk Drivers Characteristics Capital Adequacy Do we have enough capital? Underwriting Risk Asset Risk How much of the risk is insurance vs. asset risk related? Non-Cat Catastrophe Market Credit Parameter Risk UW Cycle Duration Volume Peril Concentration Volatility Correlation Duration Volume Concentration Credit Quality Volume Correlation and volatility input assumptions Correlation and volatility are results of cat model driven by exposures and geography Divergence between fundamental and market measures of volatility and correlation Divergence between fundamental and market measures of volatility and correlation of spreads Views on nature of risk, time horizon to be used, data available for parameterization, and intended business uses influences model structure 20 Pro Forma & Stress Testing Analysis (SRQ q56) Underwriting Stresses Reserving Stresses Exposures: Drop by 20% pushing premium base down Impacts I/S ER & LR Exposures: Lose key producer (SRQ q5 & 6) Claim Frequency & Severity: Increase 10%/20% Impacts I/S LR & B/S Rsvs Premium: Unable to get Rate Impacts I/S Prem & LR (SRQ q7 New/Renewal) Jump overall reserves up by 20% Impacts B/S Rsvs & I/S LR Ask consulting actuary or reinsurance broker to provide stresses or better a complete distribution of reserves Interest Rate Impact: Rsvs x Duration x Interest Rate Change (SRQ q1 & 58) Market Stresses Credit Stresses Interest Rates: Impact of a 1%, 2%, and 5% move up Impact = Bonds x Duration x Interest Rate Change (SRQ q1) Equities: Recent experience provides enough stress examples to use Impacts B/S & Investment Income Drop each asset value 20% Bonds Agents Balances Reinsurance Recoverables Impacts B/S & Investment Income Process: Push stress scenarios through Pro-Formas to determine impact 21 11
Modified BCAR Lawyers Mutl Liab Ins Co of NC: Capital Views - BCAR Capital View AM Best BCAR 10 Yr Time 25 Yr Time 75 Yr Time Modified BCAR 100 Yr Time 250 Yr Time 500 Yr Time 1000 Yr Time Baseline Asset Risk 8,430 9,904 13,178 17,196 17,907 20,878 22,796 24,279 UW Risk 25,724 8,516 12,853 17,680 18,905 22,742 25,591 28,423 Other Risk 2 Required Capital - Undiversified 34,156 18,421 26,031 34,876 36,811 43,619 48,387 52,702 Diversification & Profit Adjustments 14,341 1,328 2,678 4,214 4,543 5,714 6,516 7,220 Required Capital - Diversified & Profit Adjusted 19,815 17,093 23,353 30,662 32,268 37,905 41,871 45,482 Policy Holder Surplus 41,432 41,432 41,432 41,432 41,432 41,432 41,432 41,432 Adjusted Policy Holder Surplus 41,893 41,893 41,893 41,893 41,893 41,893 41,893 41,893 Excess Capital 16,134 19,673 11,534 2,033 (56) (7,384) (12,539) (17,234) Excess Capital ($M) $25 $20 $15 $10 $5 $0 ($5) ($10) ($15) ($20) BCAR Modified BCAR Calculation $19.7 $16.1 $11.5 Baseline 10 Yr Time 25 Yr Time $2.0 75 Yr Time 100 Yr Time 250 Yr Time 500 Yr Time 1000 Yr Time ($0.1) ($7.4) ($12.5) ($17.2) 22 Section 4: Other Influences 12
Rating Agency ERM Review Approach A.M. Best s analytical framework for assessing ERM characteristics consists of three focal areas: S&P ERM assessments may consider five focal areas Foundation of a Risk Management framework includes traditional practices and controls five key risk considerations: Credit Risk (e.g., counterparty credit risk) Market Risk (e.g., interest rate risk, investment risk, etc.) Underwriting Risk (e.g., pricing, reserves, etc.) Operational Risk (e.g., fraud, data security, etc.) Strategic Risk (e.g., adverse business decisions, etc.) Series of new questions in 2011 SRQ with a focus upon risk tolerance Key drivers for reaching strong or excellent ERM consist of clear evidence of: Robust risk culture and clearly articulated group risk appetite Strong or better controls for the firm s key risks An effective emerging risk management process Risk / reward optimization and strong strategic risk management 24 Distribution of ERM SRQ Responses (47 clients) Risk Culture 55a. CRO? Blank 4% No 11% Yes 85% 55e. Board reporting 15% 6% 6% 45% 26% 2% Annually Semi-Annually Quarterly Other Does not report Blank EC Models 57a. ECM? 57b. If No, other tools Risk Monitoring 56b. Largest threat Blank Not Specified Liquidity Strategic Oper UW Credit Market 0.0% 6.4% 6.4% 6.4% 12.8% 12.8% 25.5% 29.8% 0% 10% 20% 30% 40% Inflation 58a. Impact analysis? 56f. Frequency of measuring risks 6% 13% 11% 2% 45% 23% Annually Quarterly Monthly Weekly Other Blank 58b. How often? Blank 4% Blank 24.2% Blank 9% 18% No 66% Yes 30% Other Multiple BCAR / RBC 9.1% 27.3% 39.4% No 55% Yes 36% 6% 18% 58% 0% 10% 20% 30% 40% 50% Annually Semi-Annually Quarterly Other 25 13
Regulatory Activity Solvency II NAIC Modernization Initiative Harmonizing and improving insurance regulation across Europe Three pillars: risk quantification, risk management & governance, and disclosure Start date expected Jan 2013, with transitional period of up to 10yrs Significant regulatory uncertainty Focused upon Capital Requirements, Governance and Risk Management, Group Supervision, Accounting/Financial Reporting, and Reinsurance Update to RBC factors and formula, with likely inclusion of a catastrophe risk charge Reinsurance accreditation and collateral revisions Own Risk Solvency Assessment (ORSA) Companies will be required to have a documented risk management policy Quantitative measurement of risk exposure including stress condition evaluations Prospective solvency assessment demonstrating current risk tolerances and financial resources are sufficient to execute on its 3-5 year business plan in normal and stressed conditions Regulatory activity is increasing the focus upon ERM initiatives 26 NAIC s Solvency Modernization Initiative (SMI) Overview What is it? Per NAIC: Critical self-evaluation to update the US s insurance solvency regulation framework Will consider: What s everybody else doing? Five Focal Areas International Insurance Regulations International Accounting Standards International Banking Supervision e.g., Canada, Swiss, UK i.e., IFRS i.e., Basel II / III Capital Requirements Governance and Risk Management Group Supervision Accounting / Financial Reporting Reinsurance 27 14
Questions? Bummer of a birthmark Hal 28 15