Presentation for Sundance Conference General Re Capital Consultants September 7, 2000

1
Assessing Balance Sheet Protection Presented by
Joan Lamm-Tennant, PhD GeneralCologne Re Capital
ConsultantsCAS Seminar on Dynamic Financial
Analysis June 6 - 8, 2001 Boston
2
Topics

• What is Balance Sheet Risk?
• Why is Risk Assessment/Management Important?
• Evaluating the Effectiveness of Risk Management
  Strategies
• Capital Management Strategy
• Reinsurance Strategy
• Integrating Reinsurance Strategy with Asset
  Strategy
• Creating EVA by Managing Balance Sheet Risk
• Conclusion

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What is Balance Sheet Risk?

• Traditional measures of risk are not additive -
  asset risk plus liability risk does not equal
  enterprise risk

D
I
V
E
Traditional Analytics
Asset Risk
R
S
I
Enterprise Risk
F
I
C
A
Liability Risk
Traditional Analytics
T
I
O
N
Diversifiable Risk
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What is Balance Sheet Risk?

• Traditionally, risk has been thought of as
  volatility of ROE
• For an insurance enterprise, the probability of
  surplus loss (VaR) may be a more relevant risk
  measure - the likelihood of events
  causing concern.
• Expected Policyholder Deficit (T-VAR) measures
  the average loss beyond the VAR hurdle.

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Topics

• What is Balance Sheet Risk?
• Why is Risk Assessment/Management Important?
• Evaluating the Effectiveness of Risk Management
  Strategies
• Capital Management Strategy
• Reinsurance Strategy
• Integrating Reinsurance Strategy with Asset
  Strategy
• Creating EVA by Managing Balance Sheet Risk
• Conclusion

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Why is risk management important? Risk is costly
to the firm.

• Unhedged risk and therefore volatile earnings
  will
• increase taxes,
• cause agency (stakeholder) conflicts between
  corporate stakeholders (policyholders, managers,
  shareholders, regulators, etc.) which will result
  in dysfunctional investment decisions
• deprive firms of funds to sustain new investment
  plans - crowding out
• interfere with the design of effective
  compensation plans for managers
• Since risk (earnings volatility) is costly,
  management of risk will eliminate these costs and
  therefore create real economic value.

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Earnings volatility increases WACC and will
crowd out new investment.

• Why?
• Capital in an enterprise is derived form three
  prime sources - retained earnings, debt, and
  equity
• WACC is the weighted average cost of all three
  sources of capital
• External capital (equity) is more expensive than
  internal capital (retained earnings)
• When internal capital is consumed, new capital
  must come from external sources
• The risk-adjusted cost of the external capital
  will be derived from the earnings volatility -
  the higher the volatility the higher the cost

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Risk Raises WACC and Crowds Out New Investment.
Project Cost (In Millions) Rate of Return A
50 13.0 B 50
12.5 C 80 12.0 D
80 10.2
A 13
13
B 12.5
C 12
WACC
12
Percent
11
10
IOS
D 10.2
Optimal Capital Budget 180 million
0
50
100
150
200
250
Project Cost (In Millions) Rate of Return A
50 13.0 B 50
12.5 C 80 12.0 D
80 10.2
WACC
A 13
13
B 12.5
C 12
12
Percent
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Optimal Capital Budget 100 million
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IOS
D 10.2
0
50
100
150
200
250
Source Financial Management Theory and Practice
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Earnings volatility increases WACC and will
crowd out funds for new investment.

• What effect does this have on growth?
• In the second example, earning volatility was
  higher than in the first example, therefore
• the jump in the cost of capital due to going
  externally was greater, and
• the incremental charge for external capital was
  greater.
• In the second example, the capital budget is
  constrained to project A and B. Consequently due
  to earnings volatility, growth is reduced since
  Project C is not longer affordable.

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Why is risk management important?

• Managing risk allows firms to sustain profitable
  growth
• Capital adequacy is dependent on risk assessment
• Allocating capital based on risk to the various
  products is necessary to determine the capital
  charge when pricing business.
• EVA is created when the firm generates returns
  in excess of its cost of capital - marginal cost
  of capital is dependent on the firms risk
• A macro-assessment of risk is necessary to
  support micro-risk management strategies
• Asset Allocation Strategies Reinsurance Strategy
• Acquisition/Valuation Analysis New Product
  Assessment
• Agents in our business are concerned about risk
  - regulators, rating agencies, owners,
  policyholders, bondholders.

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Topics

• What is Balance Sheet Risk?
• Why is Risk Assessment/Management Important?
• Evaluating the Effectiveness of Risk Management
  Strategies
• Capital Management Strategy
• Reinsurance Strategy
• Integrating Reinsurance Strategy with Asset
  Strategy
• Creating EVA by Managing Balance Sheet Risk
• Conclusion

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• Capital Management Strategy

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Risk-Based Capital Allocation
Contribution of Risk by Income

• Based on the simulation of balance sheet and
  income statement data, identify where risk
  resides in the firm
• Based on the correlation and diversification
  characteristics of the key drivers of risk to
  the firm, and identify the contribution of
  various sectors to the risk of the firm

Category
Other
Underwriting
Asset Return
Reserves
Reserves
Other
Underwriting
Asset Returns
Risk Allocation by Product Group
Line Risk
Allocation Product 1 61.7 Product
2 8.6 Product 3 7.2 Product 4 5.5 All
Other 17.1 TOTAL 100
61.6
17.1
8.6
5.5
7.2
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Dynamic Capital Allocation
Once the required capital based on the risk of
the firm has been established, that capital may
be allocated using a marginal capital allocation
methodology

• This utilizes option pricing framework to
  allocate surplus so that the marginal default
  value is the same for all segments
• This allocates capital to a segment so that the
  marginal benefit to the firm for an additional
  unit of surplus is equal across segments
• Allocation is driven by uncertainty of losses,
  correlation with other segments losses and the
  correlation with return on assets

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Capital Allocations Techniques Need To Be
Understood By The Industry

• Regulatory - Risk Based Capital
• Capital Allocation Pricing Model
• Value-At-Risk
• Macro Marginal Allocation - Merton and Perold,
  1993
• Micro Marginal Allocation - Myers and Read,
  1999

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• Reinsurance Strategy

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Modeling Process - Reinsurance Strategy

• Based on the Frequency and Severity
  characteristics of each line of business
• Simulate individual claims for each line of
  business.
• These will serve as the basis for comparing
  different reinsurance structures.
• Based on the simulation of gross claims data,
  identify where the risk is derived from
  underwriting.

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Modeling Process - Reinsurance Strategy

• Based on the Allocation of Underwriting Risk
• Develop a set of reinsurance programs to
  evaluate.
• These will serve as the basis for comparing
  different reinsurance structures.
• For each set of simulated claims, compare the
  financial results under each reinsurance program
• Consider underwriting results, income, surplus
  and any other constraints and metrics.
• Each reinsurance program will be compared against
  the same set of simulated claims.

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Global (All Regions) - Period 1
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Reinsurance Strategic Options
Reinsurance Strategy Options
Buy Less Global Efficiency
Buy Smarter Regional Efficiency
Strategy 1
Strategy 2
Strategy 3
Strategy 4
Strategy 5
Strategy 6
Regional Design Program to Meet Regional
Results but Purchased from Center at Market Price
Evaluate with Dual DFA Decision Criteria and
Purchase Centrally if
Strategy Passes Both Criteria
Buy Cat and Treaty Globally - No
Regional Purchase
Buy No Voluntary Reinsurance at
Regional Level
Buy Only Cat Reinsurance Globally
Purchase Treaty at Local Level at Market
Price Based on Local Results
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Comparing Individual Reinsurance Proposals

• Individual programs can be directly compared
  against any metric, in this case, the nominal
  value of net underwriting profit.

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• Integrating Reinsurance Strategy with Asset
  Strategy

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Integrating Reinsurance Strategy with Asset
Strategy

• The Dilemmas
• How much catastrophe reinsurance to purchase?
• How to allocate the assets between equity and
  fixed income?
• The Choices
• Reinsurance None,2 million retention, 10
  million retention
• Assets Low return/risk (mostly fixed income),
  high return/risk (mostly equity)
• The Company
• 80 million in surplus
• Expected to write 80 million in premiums with
  150 million in assets

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Examining the Trade - Evaluation Process
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Examining the Trade

• Integration of reinsurance with the asset
  allocation choice extends the efficient frontier
  affording low risk alternatives not available
  otherwise
• A range of risk opportunities exist whereby
  integrating reinsurance with the asset choice
  allows for more efficient risk/return trade-offs
• A pecking order of risk choices is proposed
  for incremental increases in risk
• low retention, low risk asset allocation
• low retention, higher risk asset allocation
• high retention, low risk asset allocation
• high retention, high risk asset allocation

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Topics

• What is Balance Sheet Risk?
• Why is Risk Assessment/Management Important?
• Evaluating the Effectiveness of Risk Management
  Strategies
• Capital Management Strategy
• Reinsurance Strategy
• Integrating Reinsurance Strategy with Asset
  Strategy
• Creating EVA by Managing Balance Sheet Risk
• Conclusion

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Driving EVA

• Three important factors contribute to enterprise
  value

Enterprise Value (EV) (Float x Spread) - Cost
of Capital EV Funds (RAssets RUnderwriting)
- Equity (CCapital - RAssets)
Funds funds from underwriting premiums less
expenses, RAssets return on invested
assets, RUnderwriting annualized return on
underwriting premiums less
expenses less losses relative to
funds, Equity equity required due to loss
uncertainty CCapital cost of equity capital.
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Enterprise Value Drivers A Test of the
Proposition

• Sample included all publicly held
  property-casualty insurers in the US
• Time period included five years from 1994 to
  1998
• For each year we estimated the companys
  weighted average cost of capital
• For each year we estimated the companys
  economic value added
• We then asked the question - does EVA explain
  growth in market value?

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Cost of Capital
30
Economic Value Added
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Enterprise Value Drivers- A Test of the
Proposition

• Operational ROE is significant in explaining
  an insurance companys change in stock price.
• The higher the Operational ROE the greater the
  increase in firms in stock price or intrinsic
  value.
• While Operational ROE is significant in
  explaining the firms change in stock price,
  the explanatory power is improved when
  Operational ROE and Cost of Capital are
  considered together (effectively a proxy for
  EVA).

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Conclusion

• Why is Risk Assessment/Management Important?
• Needed to determine capital adequacy
• Allows for capital to be allocated to products
  and subsequently priced to create EVA
• Capital Efficiencies can be driven by
  second-order decisions
• Reinsurance Strategy
• Integrating Reinsurance Strategy with Asset
  Strategy

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Thank You
Joan Lamm-Tennant, PhD General Re Capital
Consulting jlammten_at_gcre.com 203 328-6818