ERM Value Creation and the International Insurer

Wayne Fisher

Executive Director, ERMII

Why emphasize “international” ERM creates value for all insurers The risks and opportunities are greater for

international insurers: Multiple regulators Diversification complexities/liquidity/F/X Far-flung operations and cultures Emerging risks Aggregation and correlation complexities Data consistency

Demands and Risks are greater Solvency II, SST, ICA SOX S&P risk analysis ART products/ new competition for risk transfer Awareness of long term guarantees Competitors are more global Risks are more global/unforeseen aggregations and correlations All resulting in increased Board awareness (Regulators, too)

And with a “show me” attitude

CEOs respond to the challenge ““…a global financial services company of our size must manage its

risks comprehensively… in the end, we must arrive at an integrated view. This point is shared by rating agencies and regulators, two important partners in the risk dialogue. Our response to these challenges consists in a further strengthening of our risk management function and in developing an enterprise-wide framework.”

James Schiro, April 20, 2006 at Zurich Financial Services‘ AGM

ERM benefits impact all stakeholders….

Customers Shareholders

Regulator Ratings

View of future earnings and

sustainability is impacted by

perception of risk and its

management.

= SHV

Rating Agencies now looking

at ERM. Risk management

therefore impacting the

price of capital. = Cost

of Capital

Want well managed insurers

who can manage the risks

that they face.

= Customer

Value

Capital regimes mean that

risk management is having

an impact on the level of

capital required.

= Regulatory

Capital

Management

Employees

Regulators have the same views… When introducing the new capital rules in 2002 the FSA said:

"The main benefits of this proposed framework are that it meets our overall aim of reducing the probability of prudential failure, in a cost efficient way that creates greater transparency in the arrangements for setting regulatory capital levels, while at the same time promoting a strong culture of risk management."

In the Financial Risk Outlook 2006 they indicate further work is required: “General insurers have also been subject to our new ICAS regime since January

2005. Although firms’ risk-management frameworks generally appear to be improving, their depth of analysis and use of quantitative techniques in determining their individual capital assessment have varied widely, largely reflecting the diverse nature of the general-insurance industry.”

The FSA’s new ARROW Framework indicates a lighter touch for good risk managers: “By taking a more overtly risk-based approach to our assessment of whether

firms are operating in line with these principles we can create incentives for firms to do the right thing in return for a regulatory dividend – that is less regulatory intervention.” (Draft document at present)

= Regulatory Capital

Meeting Regulators expectations will provide benefits in less required capital…

Regulators throughout Europe are moving to more “risk based” solvency requirements

New risk areas include concentration risk, interdependencies and accumulation risk, loss potential in extreme stress scenarios, operational and ALM risk

With an aim to implement capital requirements that are specific to an insurer’s risk profile, and that: Reflect all relevant risks Encourage, reward and build on internal risk management Encourage development and use of internal risk models Reflect economic realities…fair value valuations Are principles based

And the better the “story”...identification, assessment and quantification of risk…the lower the required capital

= Regulatory Capital

And favourable financial strength ratings lower capital costs…

“Standard & Poor's Ratings Services has always strongly emphasized an insurer's risks and how they are managed when forming an opinion of that insurer's financial strength or creditworthiness. Beginning in October 2005, we strengthened our emphasis further when we added a formal evaluation of insurer enterprise risk management (ERM) capabilities to the rating process.”

“Strong ERM insurers have exceeded the Adequate criteria for risk control and have a vision of their overall risk profile, an overall risk tolerance, a process for developing the risk limits from the overall risk tolerance that is tied to the risk-adjusted returns for the various alternatives, and a goal of optimizing risk-adjusted returns. In addition, Strong programs have robust processes to identify and prepare for emerging risks. Standard & Poor's expects ERM to be a competitive advantage for these insurers over time.”

= Cost of Capital

Investors benefit from both the reduction in statutory capital and less operating losses…

More consistent earnings through optimizing diversification and hedging peak risks

Higher growth through more favorable pricing due to less required capital

Lower cost of capital with more favorable financial strength ratings…and lower required statutory capital

Quality of earnings enhanced through more effective risk capital allocations

Board confidence for acquisitions and similar initiatives through confidence in risk framework

Incentive for management to influence operational risk exposures and lower operational risk required capital

Clear benefit with Solvency II/ SST/ ICA

= Regulatory Capital

Diversification is a key to value ERMII Research Workshop in Lyon, FR Constraints key to optimizing economic capital

allocation Liquidity key to regulatory acceptance Correlations usually underestimated for tail or

extreme scenarios Actuaries/economists and causality models Lower capital requirements may result in more

competitive pricing

ERM Value Drivers Cost of Risk = Expected loss + Cost of Capital Expected loss – risk limits and monitoring,

aggregation and correlation modeling, identification and hedging of peak exposures

Cost of capital – diversification, correlation, liquidity, agreed risk tolerance, comprehensiveness and sophistication of ERM

Capturing diversification value isn’t easy Diversification value requires understanding

dependencies; “causal” modeling versus “loss modeling”

“Trapped” capital reduces group diversification benefit; requires credible analysis and modeling

Intra-group transactions provide leverage Higher societal costs from requiring excess

capital; rationale for accepting diversification Explore cost of alternatives for “second event”

capital replacement options

Future “ERM Value Add” ERMII research initiatives

Discussed at the Lyon research workshop How to harmonize the treatment of risks of

different time horizons in a market consistent manner

Benchmarks for correlation models Diversification effect from regulatory constraints

on liquidity and capital flows; related impact on pricing and competitiveness

Employees benefit, too…

Employees Benefit, too Employees want to feel comfortable that their employer will be

around to pay their salary and pension Most people want to work for a company that takes risk seriously

especially with regard to incident management, security and Health and Safety

In some domains employee forums are taking an interest in the risk management and assurance activities of the company

Also has a potential impact on recruitment via the same drivers as customers

As do Customers… Improved customer service quality.

For an insurer, one example would be better control over the setting of terms and conditions, which can minimize disputes in claims paying. A knock-on effect of improved customer service quality would be increased customer retention.

Another customer benefit would be more confidence in the insurer due to increased financial stability and operational control.

Potentially more favorable pricing due to lower capital requirements Greater financial strength, with capital linked to risk

= Customer Value

ToDo’s to realizing ERM Value “Walk the Talk” with embedding ERM into the corporate DNA Credible risk reporting and limit adherence with monitoring at all

levels Realistic risk modeling with emphasis on data, aggregation and

correlation modeling in stress scenarios Explore alternative approaches for second or third event incidents,

versus cost of additional capital Leverage societal costs of excessive capital