Risk Appetite

© 2009 Towers Perrin

Risk Appetite Webcast

July 14, 2009

© 2009 Towers Perrin 2Proprietary and Confidential

Not for use or disclosure outside Towers Perrin and its clients

Biographies

Linda Chase-Jenkins, Towers PerrinLinda Chase-Jenkins is a Principal of Towers Perrin based in the firm’s New York office. Ms. Chase-Jenkins also co-leads the firm’s global enterprise risk management insurance practice. Her areas of expertise include risk and capital management, strategy development and business planning for a wide range of insurance and financial services companies.

Eric Gesick, PartnerReEric Gesick is the Chief Actuarial Officer for PartnerRe and is based in the firm’s Bermuda office. Mr. Gesick has oversight responsibility for PartnerRe’s actuarial function, including the organization’s reserving process for group coverage. Additionally, he is responsible for PartnerRe’s capital modeling, capital allocation and return measurement.

Joe Lebens, Towers PerrinJoe Lebens is a Principal of Towers Perrin based in the firm’s Hartford office. Mr. Lebens also leads the firm’s enterprise risk management sales team within Towers Perrin’s North America property & casualty insurance practice. His areas of expertise include capital management through the use of dynamic financial modeling.



Discussion topics

Current practices and plans

Definitions and best practices

PartnerRe risk appetite

Illustrative case study

Q&A

Current practices and plans

© 2009 Towers Perrin 4



16%

37%

47%

Within 12 months, 84% of respondents expect to have a documented risk appetite/tolerance statement

Base: Total Respondents for Q.11

In Place Planned Within 12 Months Not PlannedSmall 34% 44% 22%Medium and Large

57% 33% 10%

No, but planned to be in place within

next 12 months

Yes

No, and no plans to develop within next 12 months

Do you have a documented risk appetite/tolerance statement?



Balance sheet solvency is the principal focus of risk appetite/tolerance statements

20%

20%

22%

27%

27%

28%

33%

54%

55%

Base: Those that have a documented risk appetite/tolerance statement n = 168

Regulatory capital

Economic capital

Rating agency capital

GAAP or IFRS earnings volatility

Risk of loss of percentage of GAAP or IFRS equity

Risk of regulatory intervention

Risk of rating agency downgrade

Risk of percentage reduction in GAAP or IFRS earnings vs. forecast

Risk of loss of percentage of embedded value or economic value

Which of the following measures of risk are used in your risk appetite/tolerance statement? Please select all that apply.



Nearly 60% of respondents say their statements specifically forbid taking certain risks

41%

13%

21%

35%

44%

Base: Those that have a documented risk appetite/tolerance statement n = 168

Yes — for risks where we do not have sufficient understanding of the risks

Yes — for risks where significant damage to reputation may result

Yes — for risks where we are unable to satisfactorily model the risks

Yes — for another reason

No

Does your risk appetite/tolerance statement specifically forbid thetaking of certain risks? Please select all that apply.



The majority of companies have risk limits for their major risks, but only 23% have limits on operational risk

13%

62%

64%

65%

23%

None of the above

Operational risk

Insurance risk

Credit risk

Market risk

Base: Total respondents n = 359

For which of the following types of risk have you set limits to govern day-to-day risk taking within the business? Please select all that apply.



Only 40% have demonstrated consistency of their bottom-up risk limits with their risk appetite statements

Base: Those that have a documented risk appetite/tolerance statement and have set limits to govern day-to-day risk taking n = 146

60%

40% Yes

No

54% of North American respondents have demonstrated consistency with their risk appetite/tolerance statement vs. Europe 30% vs. Asia/Pacific 30%

European companies have more comprehensive risk limits

Have you demonstrated/modeled the consistency of yourbottom-up risk limits with your top-down risk appetite/tolerance statement?

Definitions and best practices




Risk appetite aims to provide a framework for managing risk in the business

Risk appetite is defined formally by the board to provide guidance/principles to management

Risk appetite does not seek to address the detail of policies, procedures, etc.

Provides a means of communicating the board’s views/expectations on risk



Definitions

Risk appetite is…Total risk exposure organization will undertake to achieve its objectivesGenerally expressed in qualitative terms that reflect policyholder and shareholder considerationsSet and endorsed by the board through discussions with management

Corporate risk tolerance is…Amount of risk an organization is willing to accept in aggregate(or occasionally within a specific business unit or risk category)Expressed in quantitative terms that can be monitored

Risk limits are…The more granular tolerance levels expressed for specific products, business lines or risk categories used to monitor the organization’s risk exposure



The risk appetite statement provides guidance for a variety of key stakeholders

1. Policyholders, Bondholders…and Regulators, Rating Agencies

Focus on strategies to prevent defaultLittle or no interest in upside from risk takingor nature of risks

2. Shareholders and AnalystsFocus on return on capital above the price of riskDon’t like surprisesInterested in upside from risk taking; want thorough understanding of nature and distribution of risks

3. Management and EmployeesNeed guidance regarding risk limits



Risk appetite is not captured by any one measure due to the varied characteristics of underlying risk events

Risk Appetite

Key risk measures

Other risk constraintsRequired

capital

P/h focus

Return on capital

S/h focus

Profit volatility

S/h focus

Risk management processes, policies and procedures



Establishing risk appetite and setting risk tolerances are integral to better risk-based decisions

Output from Risk

Appetite Process

ERM Framework

Goals and objectivesRisk AppetiteCorporate Risk Tolerance

Strategy

Board reviews actual overall risk vs. established corporate risk tolerance Business units monitor aggregate risks against defined risk limits

Monitoring and Reporting

GovernanceAccountability: Roles and Responsibilities

Organization

IdentifyQuantifySolveExecute

ProcessTools



Summary of risk appetite best practices

Risk appetite articulated explicitly and calibrated to company’s targeted financial performance indicators

Management engages board in discussion about risk appetite (qualitative) and corporate risk tolerances (quantitative)

Risk profiles for business units and enterprise consider stress events to ensure company can withstand unexpected events

Risk limits for individual business activities established like overall risk appetite —quantitative, bottom-up aggregation

Compliance with corporate risk tolerances and risk limits is monitored and reported

July 14, 2009

Risk AppetiteEric Gesick

Chief Actuarial Officer

Risk AppetiteJuly 14, 2009 18

Importance of a Stated Risk Appetite

Clients, shareholders, employees and regulators need to know how much risk you are willing to take, not just how much you actually take

Key to governance: Set of principles and policies that guide behavior for all risks

Limit, accumulation and exposure management

Necessary to determine required capital

Alignment of risk and return objectives


Basis of Measurement – Economic Framework

Quantitative aspect focuses on assumed risks

Economic balance sheet drives our thinkingGAAP and regulatory models provide additional constraints when reviewing capitalization

Downside measureImpairment to economic balance sheetNot earnings volatility

Risk attitudes can be described by associating probabilities of loss with tolerance of economic capital loss

Once a maximum risk tolerance is determined, we can translate into a guideline for actions on specific risksDetermine required capital range


PartnerRe: Evolution of Stated Risk Appetite

Focus on the three reinsurance “killers” or “shock losses”CatastropheLoss trends/inflation (casualty)Equity market risk

Define the metricCatastrophe = annual aggregate loss, all zones all perilsLoss trends/inflation = prior year casualty loss ratio deteriorationEquity market risk = stock market drop over one year period



Return goals are easy to state, risk goals are more difficultRisk tolerance is informed by return goalsRisk appetite and return goals need to be aligned

We asked the board the following: How much economic capital are you willing to lose for each shock loss?

Focus on unlikely and remote events for specific risks Unlikely = 1-in-15 year eventRemote = 1-in-75 year eventDifficult to relate to a 1-in-100 or 1-in-250 due to model error and context



There is no right answerSurvey of Board in role of representatives of shareholder interests

Need a context: scenario testing from prior known events or “what if” scenarios

Repeat of the 1929 – 1933 bear market and equity portfolio sizesHurricane Andrew and various aggregation assumptionsEarly 2000’s prior year casualty development and premium volumes

ConsiderationsPerception and credibility of Company: how would clients/shareholders view a loss from each specific riskAbility to recover and trade through a shock loss


PartnerRe Risk Appetite

Where you are within your risk appetite is informed by the expected return outlook

1-in-15 year event 1-in-75 year eventQ1 2009 Q1 2009

Risk Modeled Risk ModeledAppetite Loss Appetite Loss

Catastrophe (incl. ILS) 12% 7% 24% 20%

Casualty 12% 9% 18% 12%

Equity and Equity Like 15% 4% 18% 6%

Stated as a percent of Economic Capital


PartnerRe: Extension of Risk Appetite to Risk Limits

Consistent with and derived from risk appetite

Non-modeled metrics that are observable, can be directly measured, and are easily actionable

Aggregation of limitsCasualty premiumMarket value of equities

LimitsShock losses set by boardExecutive and business unit management define more specific limits by risk within underwriting authorities and guidelines


PartnerRe Risk LimitsRisk Metric Aggregate Limit % of Total Capital

Max. aggregate exposure in any single zone on any single peril

$1.5 billion 31%

Based on exposure as at March 31, 2009

Risk Dash Board: Current level of Catastrophe exposureLimit $1.5 billion

Actual $1.5 billion

Risk Metric $billions

Earned premium limit for casualty and other long-tail lines for the 4 most recent underwriting periods

$3.8

Actual 4-year aggregate long-tail premiums earned as % of all premiums earned in same period

23%

Limit $3.8 billion

Risk Dashboard: Current level of 4-year aggregate long-tail earned premiumsActual

$2.7 billion


Equity Investment Risk Limit

Risk Dashboard: Current level of equity and equity-like exposure

Limit $2.4 billion

Based on exposure as at at March 31, 2009

Actual $0.8 billion

Risk Metric Absolute Limit % Total Capital

Maximum investment in equity and equity-like assets

$2.4 billion 50%

Current investments in equity and equity-like assets

$0.8 billion 17%


PartnerRe: Desired Capital Range

Modeled loss for all risks in extreme tail

Additional consideration based on judgment regarding known but non-modeled loss

Scenario testing and “what if’s” to put in context

The Question: How much of your capital are you willing to lose if multiple tail events occur in one year?

Diversification becomes an important element to consider and is a key risk management tool


Desired Capital and Capital Management

CapitalAt Risk

1-in-100 1-in-250

Return Period

DesiredEconomic

CapitalRange

CapitalCoverageRatio

Econ

omic

Cap

ital


Risk Appetite: Conclusion

Board engagement is required

CredibilityStated risk appetite and proven ability to manage exposures to within the appetiteTransparency and communication are important so clients and shareholders can make their own assessments

Qualitative and Quantitative Assessment

Without a risk appetite, it is difficult to put a return goal into contextOptimize risk/return within risk appetite and risk limits

Illustrative case study




There is an implied “contract” between the board and management on risk and return

Sets/approves overall risk appetite and corporate risk tolerance that align with stakeholder expectations*

Approves capital plan

Ensures appropriate corporate risk governance

Board of Directors ManagementDevelops business strategy, sets financial targets (e.g., growth, earnings, ROE)

Determines overall (economic) capital needs and performs capital budgeting

Allocates capital

Manages business to achieve results according to detailed business plans and agreed risk tolerances/ limits

“Risk Contract”



More granular expectations can be defined once the board and management agree on overall objectives

Board/CEO

Risk Appetite

Risk Tolerance Statements

C-Suite Risk Limit Risk Limit Risk Limit

BU Leaders Risk Limit Risk Limit Risk Limit

Etc.



Client background

Board composed of individuals from varied backgrounds and different industries

Lacked common definition or understanding of “risk”

No common perspective on amount of risk company was currently accepting

No common perspective on amount of risk company should be willing to accept

No risk appetite or risk tolerance statements in place



Client objectives

Establish a common foundation/understanding and vocabulary for discussions of risk between the board and senior management (and the entire organization)

Develop preliminary risk appetite and risk tolerance statements

Informed by relevant industry and client information and benchmarks

Create an approach to validating and refining the preliminary risk appetite/tolerance statements



Risk appetite was defined using a combination of qualitative and quantitative inputs

Approach to Defining Client’s Risk Appetite/Risk Tolerance

InputsQuantitativeQualitative

Preliminary Risk Appetite/Tolerance

Phase 1

Phase 2

Revised Risk Appetite/Tolerance

Client’s Mission, Vision, & Values

Management and BOD Perspectives

Industry/Client Historical Reference

Points

Client’s Risk Modeling and Sensitivity Testing

Regulatory/Rating Agency Thresholds

Board Review and Input



The initial phase aimed at establishing a common understanding and risk vocabulary

Board and management perspectives on risk were captured through confidential individual interviews

The objective was to determine how much uniformity there is in the perspectives of board members and senior management

We asked a common set of questions to each participant

Results were compiled and presented to the board and management

Individual responses remained anonymous



For example, we asked each participant about their willingness to sustain various levels of surplus declines…

Tolerance for Loss of SurplusTolerable Annual

Probability

Scenario

1-in-X-Year Event

Equivalent

1-in-10

1-in-5

1-in-3

1-in-2

1-in-20

1-in-4

Outlier responses

Nearly all interviewees stated that this should never happen.

StrongConsensus

30%

18%

7%

14%

5%3%

7%

11%

0%

10%

20%

30%

40%

50%

2% 2%0% 0%10% Loss of Surplus 20% Loss of Surplus 50% Loss of Surplus

MaximumManagement AverageBoard AverageOverall AverageMinimum



…and compared responses to the historical experience for both the industry and client

Probability

1-in-X-Year Event

Equivalent

1-in-20

1-in-10

1-in-7

1-in-5

Comparison of Client's Tolerance for Surplus Losses to Historical Experience

Client Interviewee Tolerance (Average)

Historical Benchmarks — Frequency of Surplus Loss

11%

16%

0%

8%

5%

0%

5%

10%

15%

20%

10% loss of surplus

20% loss of surplus

50% loss of surplus

U.S. P/C Industry(1946 – 2008)

Client(19XX – 2008)



Some questions were aimed at comparing the perceived current and desired risk appetites

Client’s Risk Appetite

(Low) (High)

Number of Responses

Current

Current DesiredManagement 4.1 5.6Board 3.1 4.8

Risk Appetite

2

1 1

43

12

2

1

01234567

1 2 3 4 5 6 7 8 9 10

ManagementBoard member

Average Scores

(Low) (High)

Number of Responses

Desired

Risk Appetite

1

2

3

112

5

2

01234567

1 2 3 4 5 6 7 8 9 10

ManagementBoard member



This interview/feedback approach laid the foundation for developing a risk appetite statement

Consistent vocabulary created among all board and management participants

Process helped drive a more consistent appetite for risk between and among the board and management

More realistic expectations

Interview process created non-threatening environment to facilitate learning and understanding

Preliminary risk appetite statement was drafted



This interview/feedback approach also elevated the level of discussion and decision making about risk

In subsequent phases of the project:Economic capital modeling was completed— Results were compared with the preliminary risk

tolerances; some incompatibility was observedPreliminary risk appetite statement was refinedPlan was developed to bring company into line with its newly agreed upon and stated risk appetite and risk tolerances

Additional work is under way:Risk monitoring and reporting process are being establishedRisk limits are being establishedRisk modeling is being refined



Q&A

Linda Chase-Jenkins, Towers Perrin(212) [email protected]

Eric Gesick, PartnerRe(441) [email protected]

Joe Lebens, Towers Perrin(860) [email protected]

Risk Appetite

Economy & Finance

Transcript of Risk Appetite