ERM: Modeling for Capacity What’s - IASA 2015/Sessions/ARF/ARF-2… · IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW ERM: Modeling for Capacity – What’s Your Appetite?

IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

ERM: Modeling for Capacity – What’s Your Appetite?

ARF Program Track, Session #608

Agenda

Section 1 Considerations for evaluating risk capacity, tolerances,

and appetite

Section 2 Rating Agency Influences

Section 3 ERM in the Real World

ERM: US P&C Insurer Survival 1987-present

Source: AM Best US P&C Group Net Written Premium ranking 1987, 2014-01-13 (9 mos)

'87 Company '13 Disposition '87 Company '13 Disposition '87 Company '13 Disposition

1 State Farm 1 34 America exited 67 Orion Capital bought by Royal

2 Allstate 3 35 Employers Re bought by GE, Swiss Re 68 Teledyne spun off into Unitrin

3 Aetna sold P/C to Travelers 36 Zurich 17 69 NJ Manufacturers 47

4 AIG 6 Federal bailout 37 Motors =GMAC 70 Westfield 46

5 Liberty Mutual 4 38 Progressive 7 71 Utica National 78

6 Nationwide 8 39 Commercial Union bought by White Mountain 72 John Hancock no longer writing P&C

7 Hartford 11 40 California State Auto Assn 73 Foremost bought by Farmers

8 Farmers 9 bought by Zurich 41 Sentry 42 74 State Auto Mutual 48

9 Travelers 5 42 Associated Insurance bought by Travelers 75 Country Companies 37

10 CIGNA sold to ACE 43 Auto Owners 15 76 Selective 41

11 CNA 13 sold pers/l (ALL); reins (WTM) 44 Erie Ins. Exch. 16 77 Clarendon bought by Hannover Re

12 Continental bought by CNA 45 PMA under supervision 78 American Mutual Liab

13 USF&G bought by St Paul 46 Interins Exch Auto Club S. CA 31 = Auto Club Enterprises Ins Group 79 Shelter Ins 51

14 Crum & Forster bought by Fairfax 47 Auto Club of MI 80 Mercury General 34

15 Fireman's Fund bought by Allianz 48 Berkshire Hathaway 2 81 Skandia America In runoff

16 Chubb 12 49 Southern Farm Bureau 56 82 Employers Mutual Casualty = EMC

17 Kemper in run off 50 Cincinnati Financial 23 83 Zenith National

18 St. Paul bought by Travelers 51 Munich Re 18 84 California Casualty

19 Royal in run off mgmt buyout 52 Employers of TX 85 Alfa 60

20 USAA 10 53 Swiss Re 35 86 ALLIED bought by Nationwide

21 General Re bought by Berkshire Hathaway 54 Metroplitan 28 now Met P&C 87 Argonaut

22 Lincoln National sold P/C to Am States/Safeco 55 Old Republic 36 88 Arkwright merged with FM Global

23 Home bought by Zurich 56 Federated Mutual 57 89 Fremont Calif WC, Unicover

24 Prudential bought by Liberty Mutual 57 Ford Motor sold? 90 Allendale merged with FM Global

25 American General bought by AIG 58 Colonial Penn run off / no longer in P&C 91 Medical Liab Mut (NY)

26 American Financial 30 = Great American 59 Nationale-Nederlanden no longer writing 92 Penn National

27 Transamerica spun off to TIG (Fairfax) 60 Amica Mutual 44 93 Central Benefits Mutual exited P/C

28 Reliance insolvent 61 Atlantic Mutual Balboa partnership 94 Hartford Steam Boiler bought by AIG

29 Safeco bought by Liberty Mutual 62 Winterthur bought by CSFB, XL 95 Commercial Credit

30 GEICO bought by Berkshire Hathaway 63 20th Century rescued by AIG 96 Grange Mutual 59

31 American Family 14 64 Amerisure Companies 90 97 SAIF Oregon state fund

32 General Accident no longer in US P/C 65 Harleysville Sold to Nationwide 98 American Bankers bought by Assurant

33 Ohio Casualty bought by Liberty Mutual 66 W. R. Berkely 20 99 Motorists Mutual 89

100 Indiana Farm Bureau


ERM – What is the Objective?

Ensuring you are properly compensated for the risks you assume

Measure

Monitor Manage

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


Risk Capacity

Risk Tolerance

Risk Appetite

Capacity: Absolute risk bearing capacity; loss in excess of capacity results in insolvency

ERM Framework Capacity, Tolerance, Appetite, Limits

Tolerance: Amount company is willing to venture in the normal course of business

Appetite: Process used by companies to evaluate risk vs. return tradeoff; type of risks accepted

Risk Limits: Set of silo-based sub-limits such as maximum credit risk per principle, net line size, catastrophe risk limits

Risk Tolerance/Risk Appetite Statement Examples

“The Company manages its exposure to key risks such that the modeled economic loss at

a 1 in 15 year and a 1 in 75 year return period are less than the economic capital

the Company is willing to expose to the key risks at those return periods... The Company’s risk limits

are stated as explicit numerical expressions, such as total aggregate limits in a

catastrophe zone, earned premium for casualty business, and the market value of equity and equity-like securities.” (Modeled economic loss appetite by risk type: Cat risk at a 1 in 75yr $960M max, Casualty at a 1 in 15yr $480M max, Equity at a 1 in 75yr $720M max)

Quantitative

Definition

“The risk appetite is set in relation to a variety of risk measures including economic capital and earnings at

risk, as well as regulatory capital requirements. To ensure exposures to particular risks are appropriate and that the Company remains well-diversified across risk categories, we manage specific risk exposures against enterprise-wide limits established for each of these specific risks.”

Qualitative

Definition

Simple

Definition “Grow as fast as possible at a 96 Combined Ratio”

44%

12%

8%

8%

7%

7%

7%

3%

3%

Def. Reserves / Inadequate Pricing

Rapid Growth

Miscellaneous

Affiliate Problems

Cat Losses

Alleged Fraud

Investment Issues

Change in Business

Reins. Failure

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

Primary Causes of U.S. P/C Impairments (1968 – 2013)

A.M. Best Impairment Study – Non-Life Focus on Most Material Risk Sources

Source: A. M. Best Impairment Study 2014

* A. M. Best defines impairment as any type of restrictive regulatory action


Spectrum of Approaches to Risk Tolerance

Qualitative Quantitative

Catastrophe Risk

Lat/Long level

exposure data

available

Model-centric

quantitative approach

Likelihood and

severity both

quantified

Portfolio level

tolerance linked to

front line underwriting

decisions

Market/Credit Risk

CUSIP level exposure

information available

Scenario based

quantitative approach

Severity impact of

interest rate changes

or stock price drop

quantified

Portfolio level

tolerance linked to

asset allocation limits

Credit quality and

concentration limits

Operational Risk

Limited exposure

data

Rarely quantified or

articulated as a limit

Limited monitoring of

specific exposures

Examples:

– Regulatory Risk

– Financial Controls

– HR/Employee

Turnover

Reserve Risk

Limited exposure

benchmark data

Rate and reserve

adequacy monitored

Variability not

commonly quantified

Rarely articulated in

“limit” formulation

Usually increases

along with growth


Catastrophe Risk Tolerance Study Overview

Composition

96 Different Reinsurers/Insurers

Global Reinsurers/Insurers

Year Percent Reporting

2013 85%

2012 89%

2011 89%

2010 83%

2009 86%

2008 81%

2007 77%

15%

18%

4%

20%

44%

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

Not Disclosed

Secondary Sources

Investor / AnalystPresentations

Annual Reports

10K Reports

Distribution of Data Sources

68% of the data came from Primary Sources (10K,

Annual Reports, or Investor Presentations)


Catastrophe Risk Tolerance Disclosure Distribution

61%

34%

5%

Net PML

Reinsurance Structure

Other

0% 10% 20% 30% 40% 50% 60% 70%


45%

27%

20%

8%

Specific Peril - Regional

All Perils - All Regions

Specific Peril - All Regions

All Perils - Regional

0% 20% 40% 60%

All Regions vs Regional Aggregate vs Occurrence

Occurrence

70%

Aggregate

30%

Risk Metrics PML Disclosures


Catastrophe Risk Tolerance Disclosure Analysis Sample Composite PML Target Ranges Post Tax Detail: 2013

4%

17% 14%

19%

0%

5%

10%

15%

20%

25%

30%

Mean High

1:100 After Tax Net PML as a Percent of Equity

6%

28%

16%

25%

0%

5%

10%

15%

20%

25%

30%

Mean High

1:250 After Tax Net PML as a Percent of Equity

Reinsurers generally operate at a higher catastrophe risk exposure

relative to equity

Post-event share price decline best predicted by reported Katrina losses

alone, rather than Katrina, Rita and Wilma losses combined

Reinsurers/Insurers losing less than 10% of shareholder value had Katrina

losses in the following ranges, which are consistent with recent PML public

disclosures:

The average 100-year PML risk tolerance disclosure for primary and

reinsurance companies is in-line with Aon Benfield’s post-Katrina study

Event-Level Risk Tolerance: Post Katrina

Katrina Study Loss % Ranges YE 1:100 PML Disclosure

Mean As a % of Equity

Sector As % of Equity As % of Prospective

Consensus Earnings 2011 2012 2013

Primary

Insurers 3% to 6% 21% to 34% 4% 4% 4%

Reinsurers 12% to 19% 107% to 110% 13% 14% 14%


External Natural Catastrophe Risk Tolerance Considerations

A.M. Best S&P Fitch Moody’s Demotech NAIC

Net PML

Greater of:

100yr Wind,

250yr EQ

250yr

All Perils

TVaR @

various

levels

100-1,000

250yr

All Perils 100yr HU

100yr HU &

100yr EQ

Loss View Occ. Agg. Agg. Agg. Occ. Agg.

Prob. View NT NT NT NT LT NT or LT

Stress Test Yes No Yes Yes Yes No

Other considerations include premium offset, reinstatement premium, taxes, cat

modeling settings (i.e. demand surge), treatment of non-indemnity reins., etc.


Risk vs. Uncertainty Frank Knight – Risk, Uncertainty & Profit, 1921

Randomness amenable to

empirical classification and

statistical analysis

– Randomness driven by a structural, external, physical process

– Stable risk distribution parameters so past experience can be used to quantify randomness

RISK UNCERTAINTY

Randomness not easily amenable to empirical classification and statistical analysis

– Randomness driven by a behavioral process

– Unknown risk distribution, with time varying parameters

Examples:

– Casino

– Catastrophe Losses

– Auto accident frequency

Examples:

– Taleb “Black Swan” events

– Known and Unknown “Unknowns”

– Regulatory Activity


Threats to Insurers’ Financial Strength A.M. Best Special Report ‘Grey Swans’

Knockout Punch Events Slow, Painful Death Events

Mega-Catastrophe Regulation

Financial System Shock Alternative Capital

Risk Management Shortfall Emerging Underwriting Risk

Hyperinflation Interest Rate Spike

Model Error Loss of Talent / Entrepreneurial Spirit

Source: A.M. Best Special Report


The Reserve & UW Market Risk Cycle: A Structural View

-15%

-10%

-5%

0%

5%

10%

15%

55% 60% 65% 70% 75% 80% 85% 90% 95%

Accident Year Ultimate Loss Ratio at 12 Months

Ca

len

da

r Y

ea

r L

oss

Re

serv

e D

eve

lop

me

nt

Coming off the hard market

detect decrease in pricing, terms

& conditions and increase loss

pick

Hit barrier of “maximum

bookable loss ratio”, find

reasons why it will be different

this time; adequacy of initial

loss pick decreases, reserve

deficiencies build up

Dam breaks, market hardens, substantial increase in

rate leads to drop in current AY loss pick concurrent

with prior year development

Fill soft market

reserve hole

booking

conservative

initial loss ratios


A.M. Best’s Approach to Enterprise Risk Management

Risk Profile Characteristics

Line of Business Volatility

Correlation Liquidity

Policy Limits Product/Coverage

Competition Regulatory

Judicial Investments

Financial

Flexibility

Economic

Concentration Data Quality

Growth Credit Quality

Ceded Leverage Impact of

Reinsurance

Management Philosophy

Market Risk • Bonds

• Stocks

• Other

Credit Risk • Bonds

• Reinsurance

• Other

Underwriting Risk • Pricing

• Reserving

• Other

Off Balance Sheet

Operational Risk

Strategic Risk

Capital Management

Risk Identification

Risk Measurement

Risk Tolerance

Risk Culture

Risk Management Capabilities


A.M. Best: Risk Tolerance Statements

A.M. Best indicates risk tolerance

statements should define both:

1. How much money willing to

lose

2. At a certain probability level

55% gave a least one desired

metric

45% are still giving generalized

statements about “conservative”

measures or did not respond

While specific SRQ questions

have been eliminated, this topic

is still critical to rating

35%

31%

21%

10%

4%

Generic Statement

Defined Both

Defined How Much

Blank

Defined How Often

0% 20% 40%

What is managements overall appetite / tolerance for risk?

Source: Based upon 2012 ERM SRQ responses of 72 clients


A.M. Best: Largest Risk Types

What has management identified to be its largest potential threat to the overall

financial strength of the rating unit [by Risk Type]?

Source: Based upon 2012 ERM SRQ responses of 72 clients

47%

36%

9%

4%

2%

2%

0%

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

Underwriting

Market

Credit

Operational

Other

Strategic

Liquidity


S&P ERM Assessment Criteria

Culture Controls Emerging Risk Risk Models Strategic Risk

Management

Insurers with a positive score on risk management culture typically demonstrate:

Well-defined risk appetite framework

Enterprise risk profile linked to its risk appetite

Track record

Typically see:

Active involvement from the Board

Strong buy-in from senior management and business units,

Aligned with the organization's strategic goals

Clear rationales supporting the chosen risk tolerances and limits


S&P ERM Distributions from Annual Level 2 Report

4%

24%

16%

53%

3%

Very Strong

Strong

Adq. w/ SRC

Adequate

Weak

0% 20% 40% 60%

0%

25%

50%

75%

100%

Positive Neutral Negative

Sub-factor Assessments ERM Score Distribution

Source: S&P Annual ERM Report, May 2014. ERM score

distribution is for P/C only whereas sub-factor distribution is for both

P/C and L/H.

Terrorism: Rating Agency Perspective

Influence views on ERM

• Continue looking at Terrorism Exposure through an ERM perspective as TRIA is likely to be renewed in some form

• Ex: Analyzing a nuclear scenario (although no specifics guidelines are in place) is good, practical risk management in order to understand how bad things could get and track the trend over time

Focus on deterministic stress scenarios

• A.M. Best uses the largest 5-ton truck bomb loss net of reinsurance excluding TRIA as a stress event

• S&P collects information for deterministic scenarios; a 2-6 ton truck bomb with a 500ft blast radius for example

Impacts small insurers

• Large insurers have higher capital available to absorb the shock of a terrorism event

• Small insurers are usually less diversified and have greater exposure as a percent of surplus

S&P Terrorism Commentary

Capital Model:

ERM:

IICRA:

Key Terrorism Questionnaire Updates:

Quantify your gross and net (of TRIA and other reinsurance) losses if a 9/11 event were to happen today.

What steps are performed to validate model results and align them to management’s view?

What underwriting or pricing rules are in place for terrorism coverage (non- workers' compensation)? i.e. Are there discounts if the insured opts out or is it priced separately?

Describe how capacity is allocated for terrorism coverage

If TRIA coverage becomes unsatisfactory, in what capacity/pricing strategy would you offer terrorism coverage for non- workers' compensation business?

List any criteria for denying terrorism coverage

Request for large nuclear attack (5-20kt) was removed

Negative rating action seen where

modeled terrorism losses exceed

net income, deplete capital by a

sizable amount, or have high

exposure relative to peers

S&P is interested in

observing insurer’s

strategic

management as it

tries to optimize their

risk profile in

anticipation of TRIA

modification /

nonrenewal

US P&C sector currently

“Intermediate”, but may deteriorate

to “Moderate” or worse with TRIA

nonrenewal or significant increase

in deductible requirements

Rating

Implications

Key Rating Implications:


ORSA Analysis Guidance – Risk Tolerance

Establish quantitative limits and qualitative statements for

risks

Underlying risk tolerances and limits embedded in strategic

planning and business processes

Monitoring and reporting actual assessed risk versus risk

tolerance

Section 3:

Group Risk and

Prospective Solvency

Assessment

Section 1:

Risk Management

Framework

Section 2:

Assessment of Risk

Exposure

Risk

Tolerance

Guidelines

Outlined In

Draft

Handbook


Stress Scenario Framework

Stress Scenario Examples

100 yr PML Cat Loss

Adverse Reserve Development

Inflation Increase

Interest Rate Spike

Credit Spread Spike

Equity Market Decrease

Creditor Default

Combo

Stress

Scenarios

Combo

Stress

Scenarios

Combo

Stress

Scenarios

Reverse

Stress

Scenario


Energy Insurance Mutual The Real World

http://www.google.com/url?sa=i&rct=j&q=&esrc=s&frm=1&source=images&cd=&cad=rja&uact=8&ved=0CAcQjRw&url=http://cophilosophy.blogspot.com/2014/10/pascals-wager.html&ei=56FLVbWpNYGZgwTvxoDoBA&bvm=bv.92765956,d.eXY&psig=AFQjCNEiGGZm6YbcBHyPQ8XUpbdwaOnkrg&ust=1431106266636107


Introduction to Energy Insurance Mutual

Vision:

To be the premier provider of insurance and risk management services to utilities

and the energy services industry.

29

• Characterized by low frequency/high severity losses, 4-5 year duration

• Investment portfolio creates volatility with a 25% equity allocation

Corporate Risk Tolerance:

A 10%, or less, chance in any given year of losing more than 20% of surplus.

Core vales:

• Member Focus

• Integrity

• Quality

• Innovation

Strategic Goals:

• Membership

• Financial

• Business Process

• People

http://www.eimltd.com/index.cfm


EIM Financial Overview

$1,848

$1,363

$421

$823

$1,851

$1,372

$322

$890

$1,942

$1,554

$381

$958

$0 $500 $1,000 $1,500 $2,000 $2,500

Total Assets

Invested Assets

Loss reserves, net

Surplus

2014

2013

2012

(in millions)


Financial Overview

0%

50%

100%

150%

Net Lossratio

Expenseratio Combined

ratio Invest.Return

68% 9% 77%

7.2%

38%

10%

48%

6.2%

140%

9%

149%

9.2% 2014

2013

2012


EIM Financial Overview

43

49

(44)

75

43

80

46

108

76

96

(100) (50) - 50 100 150 200

12/31/2010

12/31/2011

12/31/2012

12/31/2013

12/31/2014

Net Underwriting Contribution Net Investment Contribution

(in millions)


Overview of Limits Offered

Maximum Limit Minimum Attachment

General Liability $ 100,000,000 $ 35,000,000

D&O / General Partners 50,000,000 35,000,000

Fiduciary 25,000,000 35,000,000

Property 35,000,000 Excess of underlying

deductibles


ERM – In the Beginning………

There was nothing………….

Governance……….

Framework……….

Risk Capacity

Risk Tolerance

Risk Scoring

Risk Limits

Buy in from personnel……….


ERM – Governance

Governance……….

• ERM committee

• Board reporting

• Minutes


ERM Structure - Framework

Risk Capacity

• the amount and type of risk an organization is able to support in pursuit of its business objectives

• 1/200 TVaR maintain “A” rating

Risk Tolerance

• the amount and type of risk an organization is willing to accept in pursuit of its business objectives

• 10% chance of a 20% loss on surplus

Risk Target

• the optimal level of risk that an organization wants to take in pursuit of a specific business goal

• Goals or budgets (i.e. property portfolio - $35m gross; LR; CR; ROE)

Risk Limits

• thresholds to monitor that actual risk exposure does not deviate too much from the risk target and stays within an organization’s risk tolerance/risk appetite. Exceeding risk limits will typically act as a trigger for management action


Risk Capacity – 1/200 TVaR

Risk Tolerance < 10% chance of

a 20% loss

Risk Metrics

• Insurance

• Asset

• Strategic

• Operational

$226.5m

“A”

Rating

$46.4m

ERM Framework

(in millions)

ERM Framework

771.5 896.5

0

100

200

300

400

500

600

700

800

900

1000

A- A

TVaR =

226.5m A Minimum

- $670m

A- Minimum

- $545m

12/31/14

surplus -

$958m

(in millions)


ERM Structure – Framework Risk Capacity

$0

$50,000,000

$100,000,000

$150,000,000

$200,000,000

$250,000,000

$300,000,000

$350,000,000

$400,000,000

$450,000,000

TVaR 99.5% TVaR 99.5%

Standalone Diversified

Catastrophe Risk

RI Credit

Operational

Market

Reserve Risk

Premium Risk

(in millions)


ERM Structure – Framework Use of Modeling

Investments

• Equities

• Fixed income

• Alternatives

Distributions

• Excess capital

Reinsurance

• Pricing

• Structure

Underwriting

• Pricing

• Excess capital


Allocate excess surplus to allow for significant events and determine

accumulated surplus available

Calculation of available surplus

Available capital (20% of capital & surplus of $896m) $ 179.2

1/10 VAR (75.0)

Control environment factor – 30% (54.0)

Accumulated surplus available $ 50.2

ERM Structure – Framework Use of Modeling (in millions)


ERM Structure – Framework Risk Scoring

Determine drivers of risk capicity

Calculate inherent risk associated

thereof

Evaluate mitigating controls in place

Evaluate current environment


Top Five Risks

Emerging Underwriting

Risk Bonds Equities

Reserve Adequacy

Underwriting Procedures

Risk

Enterprise Wide

Page 44

ERM Risk Scoring – Inherent Risk

Likelihood – the likelihood the given risk will occur within the

next three years

• Almost Certain

• Very Likely

• Likely

• Unlikely

• Remote

Impact – the potential financial or operational efficiency

impact that would be incurred if the given risk took place,

absent of any controls.

Use materiality


Enterprise Risk Management Top 10 Inherent Risk

Page 46

ERM Risk Scoring – Residual Risk

Controls are identified that specifically address either the

likelihood of the risk occurring or the impact it would have on

the Company.

• Key Control

• Standard Control

• Reactive Control

• Entity Level Control

Further impacted by an Environmental Risk Factor


Top 10 Inherent vs Residual Risk Heat Map


Enterprise Risk Management Buy in From Personnel


EIM Closing


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Documents

ERM: Modeling for Capacity What’s - IASA 2015/Sessions/ARF/ARF-2… · IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW ERM: Modeling for Capacity – What’s Your Appetite?