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Linkage of Risk, Capital and Financial Management
John J. Kollar, FCAS, MAAA, CPCU, RWW
November 12, 2007
Outline
• ERM wave
• ERM – quantification
• Some linkage indicators
Enterprise Risk Management (ERM)• Enterprise-wide perspective
– Holistic– Consistency
• Risk of loss/Opportunity for gain– Quantification of uncertainty– Consistent metrics
• Board & Executive management– Clear objectives & expectations– Appropriate resources (team)– Regular reports to the Board
ERM “Drivers”• Financial services convergence
– Gramm-Leach Bliley Act
• Improved corporate governance– Sarbanes Oxley Act (SOX)
• Consolidation– Acquisitions (opportunities)
• Rating agencies– S&P, etc.
• Risk management evolution – not revolution
ERM “Drivers”• Globalization
– Basel II (banks)– International Assoc. of Insurance Supervisors (IAIS)
• Guidance Papers – ERM, internal models• ERM Practice Paper (IAA)• NAIC monitoring
– Principles Based Reserving (life, pension, etc.)– Risk Focused Surveillance (examinations)
– Convergence of FASB to IASB• Fair Value Accounting – discounting, risk margins• SEC proposed rule – use of International Financial
Reporting Standards for foreign firms
Solvency II – Aims• Establish solvency standard to match risks
• Encourage risk control in line with IAIS principles
• Harmonize across European Union
• Assets and liabilities on fair value basis consistent with IASB if possible
• Set higher solvency standard than currently to permit timely intervention
• Approach broadly consistent with Basel II
Professional Societies/Associations ERM Developments
COSO CAS
SOA GARP
PRMIA RIMS
ERM-II Etc.
Build on Existing Programs• Mission statement
• Vision
• Strategic plan – opportunities
• Disaster recovery plan
• SWOT analysis
• Budget analysis
• Corporate objectives
• Incentive compensation
• Asset liability management
• Reinsurance program
Quantify Risks & Opportunities
• Establish a database to be used in measuring and monitoring risks– Data quality
• Acquire information to– Supplement insurer’s own data– Benchmark to industry data– Evaluate opportunities
Aggregate Risks & Opportunities• Reflect correlation/diversification among risks
and opportunities
• Use catastrophe model to reflect geographic concentration
• Identify metrics that can be used to analyze aggregates– Risk appetite metric (Board)– Return on risk adjusted capital (RORAC)– Economic capital
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Cumulative Probability
Lo
ss A
mo
un
t
Aggregate Loss Distribution& Implied Economic Capital
Value at Risk
TVaR
Risk Measurement & (Cost of) Capital Allocation by Line, etc.
CMP HO Auto Cat Multiline
Am
ou
nt
Diversification Benefit
Standalone
Optimize Mix of Capital and Reinsurance Relative Costs
Net Cost ofReinsurance
Cost of Capital
Investment Income
Income Tax Deduction
Confidence Interval Around the Target Combined Ratio
0
0.2
0.4
0.6
0.8
1
0 20 40 60 80 100 120 140 160 180
Combined Ratio (%)
Cu
mu
lati
ve
Pro
ba
bili
ty
CDFTarget Combined
Ratio (104%)
Marketing/Underwriting StrategyReflect Risk in Planning Change
Growing the Business
Standalone Standalone Standalone Total Total
Req
uir
ed C
apit
al
Prospect 1Prospect 2Existing
Reflect Pricing Risk• Develop a distribution of pricing scenarios
reflecting marketplace conditions (cycle):– Pricing– Coverage changes– Policyholder selection
• Determine a distribution of financial results:– Adjust premiums– Calculate (projected) combined ratio– Calculate (projected) return on capital
Some Linkage Indicators• Uncertainty reflected in capital and
financials as well as in risk management– Market valuations of assets & liabilities– Risk/capital allocated by business unit
• Consistent objectives– Corporate financials– Incentive compensation
• Consistent strategic decision making• One set of books• Corporate culture
