NABRICO

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ERM from a Small Insurance Company Perspective

NABRICO

Sept 30, 2011

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Agenda

Section 1 ERM Introduction

Section 2 Key Risks

Section 3 Streamlined Quantitative Process

Section 4 Other Influences

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Section 1: ERM Introduction

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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

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Enterprise Risk Management

“Bummer of a birthmark Hal”

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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?”

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Enterprise Risk Management Defined

Ensuring you are properly compensated for the risks you assume

Measure

MonitorManage

Risk

Return

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

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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

RiskAppetite

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Enterprise Risk Management Key Components

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

• controls, targets standards, limits, etc.

• risk selection & pricing

• risk transfer mechanisms

• capital allocation• risk / return tradeoffs• planning & budgeting• value-based

decisions

• risk monitoring• risk registers• risk learning• risk models

• risk tolerance & appetite

• resources & expertise• ownership and

responsibilityInformation Gathering

DecisionMaking

for better

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UnderwritingUnderwriting MarketMarketReserveReserve OperationalOperationalCreditCreditUnderwritingUnderwriting MarketMarketReserveReserve OperationalOperationalCredit

Key Risks

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

Market Credit

• Usually measured / modeledstochastically

• 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

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Section 2: Key Risks

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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

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Underwriting Risk Parameters:Coefficient Of Variation Of Gross Loss Ratio, 1992-2010

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Reserve Risk: The Silent Killer

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Accident Year

Net - LR Volatility

Last LR

First LRReserves impact current income • Prior accident years initial LRs too low

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

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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?

Proprietary & Confidential

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1961 1965 1969 1973 1978 1982 1986 1990 1994 1998 2002 2006 2010

Interest Rates - 3 Yr Treasuries

0

10

20

30

40

50

60

70

80

90

1990 1995 2001 2006 2011

Stock Market Volatility - VIX Index Prices

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Credit Risk - Crisis Lessons

Through December 2006, calibrating asset risk to historical data would have been driven by stressed scenarios of the LTCM bailout and 9/11.

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

Calibrating to historical data prior to 2007 is like basing earthquake risk estimates upon the volatility of daily paid earthquake losses

Monthly Change in Corporate Credit Spreads

-1

-0.5

0

0.5

1

1.5

2

De

c-9

1

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c-9

2

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9

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c-0

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9

AAA BBB

Monthly Change in Corporate Credit Spreads

-1

-0.5

0

0.5

1

1.5

2

De

c-9

1

De

c-9

2

De

c-9

3

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c-9

4

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5

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6

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AAA BBB

LTCM Crisis

9/11

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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

Section 3: Streamlined Quantitative Process

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ERM Goals

Quarterly Net Income

0

0.0005

0.001

2002Q1

Q2

Q3

Q4

2003Q1

Q2

Q3

Q4

2004Q1

Q2

Q3

Q4

2005Q1

Q2

Q3

Q4

2006Q1

Q2

Q3

Q4

2007Q1

Q2

Q3

Q4

2008Q1

Q2

Q3

Q4

2009Q1

Q2

Q3

Q4

2010Q1

Q2

Q3

Q4

2011Q1

Q2

-5

0

5

10

15

Mill

ions

Combined

-5

0

5

10

15 Single-State Writers

-4

-2

0

2

4 Multi-State Writers

Produce a reasonable return

Smooth income

Protect capitalOverall Goals

Reliable

Easy to maintain

Not a large investment

Small Company Requirements

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?

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ERM and the Risk Management Process

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

Data

Exposure Risk Management

Enterprise Risk Management

Economic Capital Modeling

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Economic Capital Model Governance

Cap

ital A

dequ

acy

Asset Risk

Non-Cat

Catastrophe

Market

Credit

Parameter Risk

UW Cycle

Duration

Volume

Key Risk Drivers

Peril

Concentration

Volatility

Correlation

Duration

Volume

Concentration

Credit Quality

Volume

Characteristics

Correlation and volatility are results of cat model driven by exposures and geography

Correlation and volatility input assumptions

Divergence between fundamental and market measures of volatility and correlation

Divergence between fundamental and market measures of volatility and correlation of spreads

Do we have

enough capital?

How much of the risk is insurance vs. asset risk related?

Views on nature of risk, time horizon to be used, data available for parameterization, and intended business

uses influences model structure

Underwriting Risk

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Pro Forma & Stress Testing Analysis (SRQ q56)

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)

UnderwritingStresses

Process: Push stress scenarios through Pro-Formas to determine impact

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)

ReservingStresses

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

MarketStresses

Drop each asset value 20%

Bonds | Agents Balances | Reinsurance Recoverables

Impacts B/S & Investment Income

CreditStresses

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Modified BCARLawyers Mutl Liab Ins Co of NC: Capital Views - BCAR

Capital ViewAM Best BCAR Modified BCAR

Baseline

10 Yr Return Time

25 Yr Return Time

75 Yr Return Time

100 Yr Return Time

250 Yr Return Time

500 Yr Return Time

1000 Yr Return Time

Asset Risk 8,430 9,904 13,178 17,196 17,907 20,878 22,796 24,279UW Risk 25,724 8,516 12,853 17,680 18,905 22,742 25,591 28,423Other Risk 2Required 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 7,220Required 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 41,432Adjusted 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)

$16.1 $19.7

$11.5

$2.0

($0.1)

($7.4)

($12.5)

($17.2)($20)

($15)

($10)

($5)

$0

$5

$10

$15

$20

$25

Baseline 10 Yr Return Time 25 Yr Return Time 75 Yr Return Time 100 Yr Return Time 250 Yr Return Time 500 Yr Return Time 1000 Yr Return Time

Excess Capital ($M)

BCAR Modified BCAR Calculation

Section 4: Other Influences

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Rating Agency ERM Review Approach

A.M. Best’s analytical framework for assessing ERM characteristics consists of three 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

S&P ERM assessments may consider five focal areas

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

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Distribution of ERM SRQ Responses (47 clients)

55a. CRO?

26%

2%

45%

15%

6%6%

Annually Semi-Annually QuarterlyOther Does not report Blank

Blank4%

No11%

Yes85%

55e. Board reportingRisk Culture Risk Monitoring

25.5%

6.4%

29.8%

6.4%

6.4%

0.0%

12.8%

12.8%

0% 10% 20% 30% 40%

Market

Credit

UW

Oper

Strategic

Liquidity

Not Specified

Blank

56b. Largest threat 6%

45%

23%

2%

11%

13%

Annually Quarterly MonthlyWeekly Other Blank

56f. Frequency of measuring risks

Yes30%

No66%

Blank4%

EC Models57a. ECM? 57b. If “No”, other tools

27.3%

39.4%

9.1%

24.2%

0% 10% 20% 30% 40% 50%

BCAR / RBC

Multiple

Other

Blank

Yes36%

No55%

Blank9%

58%

18%

6%

18%

Annually Semi-Annually Quarterly Other

58a. Impact analysis? Inflation

58b. How often?

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Regulatory Activity

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

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

Own Risk Solvency Assessment (ORSA)

Solvency II

NAICModernization Initiative

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

Regulatory activity is increasing the focus upon ERM initiatives

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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:

International Insurance Regulations

International Insurance Regulations

International Accounting Standards

International Accounting Standards

International BankingSupervision

International BankingSupervision

e.g., Canada, Swiss, UK

i.e., IFRS

i.e., Basel II / III

What’s everybody else doing? Five Focal Areas

Capital RequirementsCapital Requirements

Governance and Risk Management

Governance and Risk Management

Group SupervisionGroup Supervision

Accounting / Financial ReportingAccounting / Financial Reporting

ReinsuranceReinsurance

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Questions?

“Bummer of a birthmark Hal”