april 26, 2005 enterprise risk management university of illinois kevin dickson matthew peters
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April 26, 2005April 26, 2005
Enterprise Risk ManagementEnterprise Risk Management
University of IllinoisUniversity of Illinois
Kevin DicksonKevin DicksonMatthew PetersMatthew Peters
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Agenda
• About Allstate• Who are we?• ERM at Allstate: How we view ERM• ERM At Allstate: ERM in Practice
– Medical Inflation– Single State Risk– Economic Capital– Allstate Floridian
• Questions
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About Allstate
• Fortune 50 Company with $150 billion in assets• 13 major lines of insurance including Auto,
Property, Life and Commercial• Also offers retirement and investment products
and banking services• Employs almost 70,000 professionals,
including 13,000 Allstate agents and Financial specialists
• 2004 Net income of $4.54 per share on revenue of $33.9 billion
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Who are we?
Kevin Dickson, FCAS, MAAA• Director ERM• BA, Northwestern University• MBA, University of Chicago
Matthew Peters • Financial Consultant/Manager ERM• BA, Northwestern University• MBA, Northwestern University (June 2005)
Enterprise Risk ManagementEnterprise Risk Management at Allstate at Allstate
How Allstate views ERM
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What is Enterprise Risk Management?
Knowingly Take the Right Risks & the Right Amount of Risk Throughout the Enterprise
Balance & Optimize Risk vs. Return
Achieve “Efficient Frontier”
Enterprise Risk Management (ERM) is a newly evolving approach for managing risk and opportunities…
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Company Risks Industry Risks
FraudFraudFraudFraud
Environment, Environment, Health, and Health, and
SafetySafety
Environment, Environment, Health, and Health, and
SafetySafety
Credit and Credit and Liquidity Liquidity AccessAccess
Credit and Credit and Liquidity Liquidity AccessAccess
TechnologyTechnologyTechnologyTechnology
Turnover
Availability
Concentration
Complements
SecuritySecuritySecuritySecurity
InfrastructureInfrastructureInfrastructureInfrastructure
Market
GDP
Systemic Risks
Property Property Rights Rights
EnforcementEnforcement
Property Property Rights Rights
EnforcementEnforcement
Asset Risks Liability Risks Factor Risks Demand Risks Economic Risks Political Risks
Underwriting/Pricing
Catastrophe Risk
Mortality Risk
Product Design
ProductProductProductProduct
Incentive Misalignment
Labor RisksLabor RisksLabor RisksLabor Risks
Cost
Supply ChainSupply ChainSupply ChainSupply Chain
SensitivityTurnover
CustomersCustomersCustomersCustomers
Substitutes
CompetitorsCompetitorsCompetitorsCompetitors
Inflation
Credit
FinancialFinancialFinancialFinancial
Macro-Macro-EconomicEconomic
Macro-Macro-EconomicEconomic
Financial and Financial and Legal Legal
ComplianceCompliance
Financial and Financial and Legal Legal
ComplianceCompliance
To achieve business objectives, Allstate must evaluate and optimize business risks and opportunities…
Physical Physical PropertyProperty
(e.g., natural.& (e.g., natural.& man made man made
catastrophes)catastrophes)
Physical Physical PropertyProperty
(e.g., natural.& (e.g., natural.& man made man made
catastrophes)catastrophes)
Intellectual Intellectual PropertyProperty
Intellectual Intellectual PropertyProperty
People/TalentPeople/TalentPeople/TalentPeople/Talent
Reputation/ Reputation/ BrandBrand
Reputation/ Reputation/ BrandBrand
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Business Units/Business Units/Shared ServicesShared ServicesBusiness Units/Business Units/Shared ServicesShared Services
Risk vs. Return Individual Risk Management
Risk vs. Return Corporate Risk Tolerances Communication Enterprise Economic Capital
Enterprise Risk Enterprise Risk Management COEManagement COEEnterprise Risk Enterprise Risk
Management COEManagement COE
Allcorp Board/ Allcorp Board/ Audit CommitteeAudit Committee
Allcorp Board/ Allcorp Board/ Audit CommitteeAudit Committee
Enterprise Risk Council & Other Governance Committees
Enterprise Risk Council & Other Governance Committees
At Allstate, our Board and Senior Management have made strong commitments to risk management; we have established an Enterprise Risk Council, appointed a Corporate Risk Manager and established the ERM COE…
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1. Strategy /1. Strategy / Risk Risk
AppetiteAppetite
1. Strategy /1. Strategy / Risk Risk
AppetiteAppetite
3. Risk 3. Risk EvaluationEvaluation
3. Risk 3. Risk EvaluationEvaluation
5. Risk5. Risk Treatment Treatment
5. Risk5. Risk Treatment Treatment
2. Risk 2. Risk IdentificationIdentification
2. Risk 2. Risk IdentificationIdentification
6. Capital 6. Capital ManagementManagement6. Capital 6. Capital
ManagementManagement
4. Risk 4. Risk PrioritizationPrioritization
4. Risk 4. Risk PrioritizationPrioritization
Enterprise Risk Management processes are being built on the following key pillars…
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Risks may be classified in the following categories…
Financial RiskFinancial RiskFinancial RiskFinancial Risk
Operational RiskOperational RiskOperational RiskOperational Risk
Strategic RiskStrategic RiskStrategic RiskStrategic Risk
Market, credit, pricing, reserving, valuation, liquidity
Internal controls, distribution channel conflict, legal, regulatory, data quality, fraud, technology, human resources, communication skills, employment practices, class action lawsuits, market conduct and claim practices, business continuity
Strategy execution, reputation, infrastructure/processes/controls to support growth, M&A (price, fit, execution), ratings downgrade, competition
Hazard RiskHazard RiskHazard RiskHazard Risk Natural and man-made catastrophes, employee safety and health
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Nature of RiskNature of Risk RisksRisksSpeed of Speed of
EmergenceEmergence Preparedness*Preparedness*Ability to Ability to QuantifyQuantify
Hazard A1, A2, ... A1, A2, ...
Financial B1, B2, ... B1, B2, ...
Strategic C1, C2, ...C1, C2, ...
Operational D1, D2, ...D1, D2, ...
*Examples are natural catastrophes, interest rates, competition / business model, execution / controls for A, B, C, and D respectively
Following the Enterprise Risk Management process, key risks are identified, evaluated, prioritized and treated…
Illustration of Risk Identification and Assessment
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($ Billions)
$0
Enterprise Risk Tolerance Standards
Illustrative OnlyIllustrative Only
Risk BRisk B
Diversificatio
n Credit
Diversificatio
n Credit
Annualized Norm
.
Annualized Norm
.
Stat. Earnings
Stat. EarningsRisk C
Risk C
Overall Enterp
rise
Overall Enterp
rise
Tolerance “1 in
100”
Tolerance “1 in
100”
Risk DRisk D
Risk ARisk A
We are in the process of establishing overall enterprise risk tolerances and developing commensurate risk capacity by key risk…
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Communication, education and reporting will be a critical component in effectively implementing and utilizing Enterprise Risk Management at Allstate…
Quarterly Risk Reporting “Dashboard” ToolRisk Color Metric Acceptable Range ($millions) Measurement
Equity • Stat Income• Emb. Value• Surplus
• $ 12-month income variance vs. expected at 95th/99th%• $ EV variance vs. expected at 95th/99th%• $ surplus variance at 99th%
Default • Stat Income• Capital
• $ 12-month income variance vs. expected at 95th/99th%• Capital > 125% RBC at 99%
Mortality • STAT Income
• Capital
• $ 12-month income variance vs. expected at 95th/99th% stochastic• Measure 99th% ‘event’
• $ life retained face amount• $ annual payout on SS/SPIA
Liquidity • S&P Ratio• Net Liquidity
• % S&P Liquidity Ratio• $ “Net” liquidity in stress scenarios at all times
Interest
Rates
• STAT Income• A/L Duration• Capital
• $ 12-month income variance vs. expected at 95th/99th%
• < 0.75 in base, 1.25 in 3% shock• Capital > 125% RBC at 99%
Illustrative Only
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Economic Capital is the amount of capital necessary to provide a given level of safety, given a specific time horizon and tolerance for risk…
$0$0 Statutory Surplus ($ Billions)Statutory Surplus ($ Billions)
# of trials # of trials
P(NAIC Authorized Control)
P(Ratings Downgrade)
P(Ruin)P(Ruin)
Economic Modeling – Illustration
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Economic Capital per Unit of Risk
Return(% ROE)
Business ABusiness A
Businesses A & BBusinesses A & B
Businesses A, B & CBusinesses A, B & C
Efficient Frontier Illustration
Economic Capital modeling will allow us to create an efficient frontier; viewing Allstate as a portfolio of businesses, risks and opportunities…
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Summary: ERM at Allstate
• Receive the required return for a given risk level• Used to provide a coordinated assessment of all
the risks the company faces• Risks are not just viewed in the negative• Coordinate corporate risks with corporate strategy• Risks are viewed as a portfolio that can be
diversified
ERM at Allstate
ERM in Practice
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Impact of a Potential Medical Inflation Spike
Basis Pt. Increase P ( x )Operating Income
Impact ($MM's)
250 10.00% 125
400 2.00% 200
500 0.40% 250
600 0.05% 300
Although unlikely, a significant spike in the medical inflation rate could severely impact operating results.
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Impact of a Potential Medical Inflation Spike
• However, risk management action to mitigate the medical inflation risk appears to have no impact on the risk distribution.
• How is this view reconciled with the previous slide?
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
Operating Income Distribution
With Reinsurance Without Reinsurance
For Illustration Only
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Illustration: As an independent entity, “State X” has a volatility of $25m (e.g. 9 in 10 chance of making $12 million, 1 in 10 chance of losing $80 million on revenue of $40 million).
Question: If “State X” risk is completely eliminated, by how much is corporate volatility reduced?
– $100m?
– $25m?
– $23m?
– $20m?
– $10m?
What does ERM mean in a corporate setting?
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Question: Reduction in corporate volatility if “State X” risk is completely eliminated ...?
– $100m?
– $25m?
– $23m?
– $20m?
– $10m?
Answer: $1/2 m
Lessons:
1. The whole is NOT equal to the sum of the parts.
2. Rock in the pond vs. rock in the ocean.
3. The corporate (enterprise) view represents the choices available to that organization.
What does ERM mean in a corporate setting?
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Economic Capital
• Allstate uses DFA modeling to evaluate the risk level of the company
• How much money (capital) is need to run the company?• Rating agency formulas and processes provide one way of
identifying economic capital • ERM and Economic Capital Modeling is the standard for
identifying economic capital at Allstate.• Economic capital is factored into strategic decisions like
capital allocation and dividend policy
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0%
1%
2%
3%
4%
5%
6%
7%
8%
Surplus ($Millions)
Pro
ba
bil
ity
Baseline Decreased Beginning Capital
Allstate Corp Simulated Statutory Surplus
$0Bankruptcy Events
The baseline series had 5 events that resulted in bankruptcy. The second series decreased the beginning capital by $1.5 billion resulting in a 40% increase in the chance of ruin (0.02% to 0.03%)
For Illustration Only
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• Allstate Floridian is a subsidiary of Allstate Insurance Company.
• Floridian contains the property side of the Allstate business in Florida. The Auto business is held by the parent company.
• Created after Hurricane Andrew in 1992• Florida Hurricane Catastrophe Fund
– Created after Andrew as a public reinsurance fund– FHCF Structured for single major storm
ERM in Practice: Allstate Floridian 2004Floridian Background
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ERM in Practice: Allstate Floridian 20042004 Hurricane Season
• Florida had 4 major storms in 2004: Charley, Francis, Ivan, Jeanne
• $21 Billion in Insured Losses
• $2 Billion in FEMA payouts• More then 10 years of
profit in Florida eliminated by 2004 storm losses
Source: Sun-Sentinel.com
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ERM in Practice: Allstate Floridian 2004ERM Role and Response
• Assist in evaluating strategic options for the Florida property business– Stay in Manage Risk– Limit exposure, shrink business– Get out
• ERM models of Floridian – Assess proposed changes to FHCF– Evaluate Reinsurance Structures
• Match financial and risk structure with corporate strategy and performance goals
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ERM in Practice: Allstate Floridian 2004Options
• Risk Factors to Consider– Amount of capital needed for a desired rating– Configuration of the FHCF, Legislative Action– Possibility of Raising Rates, Regulator Approval– Marketing: Potential Brand Impairment– Sales of Auto Insurance ($2B in Premium)– Reinsurance options and availability
• Quantities modeling is an effective and powerful means of addressing multiple issues related to risk and the operation of the business.
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Other Applications of ERM at Allstate
• Corporate wide reinsurance analysis• Liquidity analysis• Investment portfolio decisions
– Duration – Strategic asset allocation
• Dividend and capitalization analysis• Board communication tool• Corporate governance
– Sarbanes Oxley
• Risk policy management and coordination• Risk tolerance standards• Multi-period planning
Questions?