November 14, 2001

François Morin, FCAS, MAAA, CFA

Capital Management

2001 CAS Annual Meeting - Atlanta, Georgia

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Today’s agenda

Objectives of the project

Overview of approach taken

Results and insights obtained

Objectives of the Project

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The client established three broad objectives for the project

Optimize the use of capital within and across the company Know how much capital is needed to support each

business, and how changes in strategy alter needed capital

Analyze performance on a consistent basis across all products, subsidiaries, countries Independent of accounting and regulatory regimes

Improve the knowledge of the underlying risks and inform decisions as to the relationship between risk, capital and return

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The client sought to “operationalize” a simple conceptual value framework

Risk Profile of Business

Segment

Risk Profile of Business

Segment

Capital Required to Support Risk

Capital Required to Support Risk

Value-Based Performance Assessment

Value-Based Performance Assessment

Required Returns on

Capital Employed

Required Returns on

Capital Employed

Actual Returns

Consistently

Measured

Actual Returns

Consistently

Measured

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Working collaboratively with the client team, we were responsible for the key deliverables

Initial assessment of existing tools and capabilities

Development of conceptual framework

Software Economic Scenario Generator -- Global CAP:Link P/C Financial Projection System -- TAS:P/C Life Financial Projection System -- already in place Results Aggregator/Calculator -- custom tool

Training of staff

Assistance to business units in model development and implementation

Validation and analysis of results

Overview of approach taken

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The client chose to implement a Dynamic Financial Analysis (DFA) approach

Company Strategy

Asset Mix Product Mix Capital

Structure Reins/Hedging

Economic Scenario Generator

Projected FinancialsRisk Profile = Distribution of FutureFinancial Results

Economic Capital Embedded Value

Probability

Asset Behavior Model

Product Behavior Model

Optimization

Inflation Interest Rates Credit Spreads Currency

Exchange GDP

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A common set of economic scenarios were used, so that model results could be combined

Monthly time series variables for GDP, inflation, government bonds, credit spreads, equity returns

For each of 13 countries, including currency exchange

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

1 9 17 25 33 41 49 57 65 73 81 89 97 105 113 121

90 Day 10 Year CPI Inflation

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For the Value MeasurementFor the Value Measurement

Shareholder view

Capital Asset Pricing Model (CAPM) approach Based on non-diversifiable

risk

Economic value = discounted value of free cash flows at the Risk Adjusted Return Reflects the riskiness of the

business compared to an equity investment

Shareholder view

Capital Asset Pricing Model (CAPM) approach Based on non-diversifiable

risk

Economic value = discounted value of free cash flows at the Risk Adjusted Return Reflects the riskiness of the

business compared to an equity investment

For Capital at Risk Assessment

For Capital at Risk Assessment

Policyholder view

Risk of ruin approach Based on adverse scenarios

Economic Capital = amount of shareholder equity in excess of the Best Estimate Liability, required to assure payment in a high percentage of scenarios

Policyholder view

Risk of ruin approach Based on adverse scenarios

Economic Capital = amount of shareholder equity in excess of the Best Estimate Liability, required to assure payment in a high percentage of scenarios

The two sides of the framework: two measures of risk

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The best estimate liability

The Best Estimate Liability is an economic view of the reserves Discounted amount: allow

for the financial profits on the assets backing reserves

Includes both Loss Reserves and Unearned Premium Reserves

Best Estimate Liability

$ 2,625 M

Statutory reserves

$3,250 M

Over reservesand discountingeffect

$ 625 M

P&C Example

The Best Estimate Liability (BEL) is the level of assets required to pay future policyholder benefits in a best estimate scenario

The difference between statutory reserves and Best Estimate Liability is a source of funding available to meet economic capital requirements

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Security factor

The Security Factor is based on A constant annual Risk of Ruin of 0.1% which reflects

Moody’s rating assessment for AA bonds The Risk Exposure Duration -- the length of time over

which the business is exposed to adverse events multiplied by the amount of the exposure within the projection

Other measures of security were also explored

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Represents the level of assets, in addition to the BEL, required to pay future policyholder benefits at a chosen Security Factor The Economic Capital covers the volatility in:

The run-off of existing business The future business (“pricing risk”)

Sources of funding for the Economic Capitalinclude: The difference between the

assets backing statutory reserves and the BEL

Shareholders’ equityabove the statutoryreserves

Best Estimate Liability

$4,000 M

Over reserves

and discountingeffect

Economic Capital$1,600M

Pricing risk$700 M

Run-off risk$900 M

Statutory reserves

$4,800 M

P&C Example

Economic capital

Results and insights obtained from the initial implementation

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The initial implementation focused on key products and business segments

Models were developed and implemented for 15 business units, operating in 8 countries 7 Life 8 P/C

Typically, the models incorporated 90+% of the business in each unit

Client staff in each unit were trained in the economic capital approach

Each entity presented its results to a central management group; overall results presented to client board

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EconomicReserves

Marginin Reserves

MarketValue ofInvestedAssets

Economic Capital

Pricing risk

Run-off risk

Required Assets

Receivables

Statutory Reserves

Shareholder Equity

Financial Balance Sheet

ExcessS/H Assets

Debt

Debt

Actual Capital

Debt

Debt

TotalAssets

For any segment or grouping, it is possible to construct an economic balance sheet …

Economic Components

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By combining models, the client was able to enterprise measure diversification benefits

Diversification effects are high between P&C businesses because the claims risks are largely uncorrelated

Life businesses exhibit high diversification due to the varied nature of the different businesses

The aggregation of Life and P&C creates little additional diversification because the dominant risk for the Group is the asset risk

0

2

4

6

8

10

12

14

16

P/C Diversification effect

Sum of P/C

Segments

Sum ofLife

Segments

Aggregated P/C

Business

Aggregated Life

Business

Aggregated Total

Life Diversification effect

P/C -- Life Diversification effect

Enterprise Diversification BenefitEconomic Capital

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Capital requirements comments

Different types of business require markedly different levels of Economic Capital

Differences in capital requirement for P/C businesses arise from three main causes Product type Catastrophe exposure Asset mix

Life generally has low requirements because a proportion of reserves is policyholder deposits, which add little risk

The actual capital held is 3.5X the Economic Capital

A large proportion of the Economic Capital is covered by the over-reserve

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The P/C business segments have disparate economic capital requirements

Economic Capital Ratio to Premium

0% 20% 40% 60% 80% 100% 120% 140%

Belgium - Total

France - Total

Germany - Total

Ireland - Total

PPP - Total

UK - Total

ACS - Total

Economic Capital Ratio to Premium

0% 20% 40% 60% 80% 100% 120% 140%

Belgium - Total

France - Total

Germany - Total

Ireland - Total

PPP - Total

UK - Total

ACS - TotalSegment A

Segment B

Segment C

Segment D

Segment E

Segment F

Segment G

Results depend on product mix, reinsurance program, and asset mix

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Even within a product line, economic capital requirements vary

Results are influenced by market conditions for the product, reinsurance, and asset mix

Economic Capital Ratio to Premium -- Personal Insurance

0% 50% 100% 150% 200% 250% 300% 350% 400% 450%

Individual Health

Private Motor A

B

C

D

E

Household A

B

C

D

E

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Impact of Reinsurance on Economic Capital

Segment E

Segment D

Segment C

Segment B

Segment A

With Current Program

Without Cat Reins

0%

10%

21%

24%

33%

For the P/C businesses, the results indicated some inconsistencies in reinsurance purchasing

Decisions regarding program retentions and limits were at the discretion of the business units, without a common framework for decision making

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EconomicBalance Sheet

Value

EconomicCapital

Excessunmodelled assets

BestEstimateLiability

Value of Unmodelled Excess Assets

Value of modelled Excess Assets and Economic capital

Value of renewals

Excessmodelled assets

Using the economic capital, it is possible to measure the embedded value of the business

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Value results at group level

The framework is the same as Embedded Value, with two enhancements: Economic required capital (the capital that each

business actually needs rather than that prescribed by the regulator)

Level of risk in the business (calculation of a Risk Adjusted Return)

This enhanced framework will allow us to: Measure value creation over time (increase in value) Calculate new business value Sharpen the product pricing metric Test whether different strategies create more value

To fully use this framework, we will require at least two successive calculations of value at different points in time

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Communication with regulators and rating agencies about capital management

Implementation of Economic Capital now allows the client to change the flow of discussions with regulators and rating agencies In the past, discussions typically were a reaction to

external agency’s assessment of capital adequacy — based on solvency tests or RBC formulas

Client now has fact-based discussions, based on concrete risk analysis and objective standard

The approach has been positively received by regulatory authorities; discussions with rating agencies are planned