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ERM - Post 9/11

Presented by: Susan Witcraft

Guy Carpenter

July 8, 2002

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Overview

• ERM: Is it really used?

• For what is ERM valuable?

• Example

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ERM: Is it Really Used?

• ERM is a process– Has been done in varying forms as long

as companies have had to face risk

– Has become more sophisticated in recent years as tools have evolved

– Tools include DFA, RAROC, others

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ERM: Is it Really Used?

“Underestimating tail correlation coefficients in the DFA models will underestimate overall risk and the capital required to support the individual risks. . . . It is critical to understand the potential shortfalls in each analysis when using these tools to manage risk. The author believes failure to do this is one of the major reasons for rampant underpricing during the 1990s as management underestimated tail correlations (with the help of their consultants and mathematicians) and thus underestimated capital requirements in the quest for diversification.”

Bill Riker, Chapter 25, Correlation in Risk Management, page 529, bold and italics added.

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ERM: Is it Really Used?

• Several major insurers using RAROC

• Lots of insurers have considered DFA

• Many insurers have played with it

• Only a few have implemented it– Even fewer have relied heavily on the

full tool for decision making– Many have used “mini-DFA” to provide

insight on decisions

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For What is ERM Valuable?

• Asset allocation

• Reinsurance programs

• Capital adequacy

• Capital allocation

• Line of business mix

• Understanding income statement and balance sheet risks

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• Enhancing corporate communication

• Expanding actuaries’ horizons

– Overall company management

– Investments

– Improved analysis tools

For What is ERM Valuable?

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Enhancing Corporate Communication

• Successful ERM implementation requires participation of all corporate departments.

• Topics of discussion are wide-ranging.

• Participants have varying levels of knowledge of these topics.

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Expanding Actuaries’ Horizons: Overall Company Management

• Actuary – Oversees or implements model.– Understands issues important to all

constituents.– Interprets results. – Participates in decision-making process.

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Expanding Actuaries’ Horizons: Finance and Investments

• Enterprise risk management models include all corporate financial activities.

• Actuaries – Traditionally most familiar with underwriting

issues.– Must become at least conversant with economic

modeling, investment issues and finance to implement model and interpret results.

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Expanding Actuaries’ Horizons: Analysis Tools

• ERM has required actuaries to refine and expand analysis techniques.

• Examples include modeling of:– Small, large and cat claims.– Development of booked reserves.– Payment pattern variability.– Links between losses and economic conditions.– Pricing process.

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Improved Analysis Tools: Case Study

• Analysis tools can be used for other applications.• Examples:

– Reserve development and payment pattern variability for evaluating adverse development covers.

– Separation of losses into small, large and cat for evaluating excess of loss or cat covers or for evaluating adequacy of rates for lines with facultative covers.

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Case Study:Loss Portfolio Transfer

• Questions faced by company:

– What is the economic cost of each loss portfolio transfer/adverse development cover proposal?

– Does each proposal meet the auditors requirements for transfer of risk?

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Background

• $200 million of loss and LAE reserves as of 12/31/01.

• Considering capital contribution or merger.

• Significant uncertainty surrounding reserve estimates.

• Want balance sheet protection.

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Three Proposals

1. $75 million excess $175 million for $30 million.2. $50 million excess $200 million for $15 million.3. $250 million excess $0 for $190 million.

All 3 include experience account with 7% interest credit guaranteed by ceding company and a reinsurers’ margin of $10 million {$15 million for (3)}.

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Analysis Approach

• Simulate possible future payments by calendar year.

• Reflect differences in emergence patterns under varying historical reinsurance programs.

• Apply reinsurance terms to each scenario.• Auditor defines risk transfer test.• Calculate economic cost and risk transfer test.

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Overall Approach

Calendar Year Payments By Accident Year

Calendar Year Payments By Accident Year

Ending Reserve By Accident Year

Ending Reserve By Accident Year

BeginningReserve By

Accident Year

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Payments

xInflation Claim Expected

Inflation Claim Actual

PaymentsActual

x ReserveBeginning

Component)RandomRatio(Payment

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Ending Reserve

ComponentRandom ReserveinChange

ReserveEnding

Reserve Beginning x

x

InflationCost Claim Future Expected Prior

Inflation Cost Claim Future Expected Current

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Total Payments

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

115

125

135

145

155

165

175

185

195

205

215

225

235

245

255

265

275

285

295

305

315

325

335

345

355

365

Amount (in millions)

Pro

babi

lity

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Present Value of Payments

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

Amount (in millions)

Pro

babi

ltiy

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Evaluation of Proposals

ProposalFirst Year

Cost*Economic

Cost

Probability of Meeting Threshold

$75 x $175 $0 $1.5 million 34%

$50 x $200 $0 $3 million 30%

$250 x $0 $-10 million $4 million 39%

* Assumes no development.

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ERM - Post 9/11

Presented by: Susan Witcraft

Guy Carpenter

July 8, 2002