steve dreyer managing director, standard & poor’s scrlc meeting, june 6, 2007

CONFIDENTIAL AND PROPRIETARY.

Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s.

Copyright (c) 2007 Standard & Poor’s, a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved.

Enterprise Risk Management:Impact on Standard & Poor’s

Credit Ratings

Steve DreyerManaging Director, Standard & Poor’s

SCRLC Meeting, June 6, 2007

2.

SCRLC Meeting June 6, 2007

Permission to reprint or distribute any content from this presentation requires the written approval of Standard & Poor’s.August 2005

An Unofficial Definition

A comprehensive, forward-looking, active, iterative, permanent discipline to …

imagine, understand, identify, then mitigate, remove, or learn to live with …

anything that can destroy your company.

3.



What Motivated S&P to Introduce ERM into Credit Ratings?

• A Deeper Understanding of Management

• Force Forward Thinking

• Communicate More Clearly

and….

• Companies were “ERM-Ready”

4.



A Subtle Change in Language… and Management

Earnings…“Return on Invested Capital” “Return per Unit of Risk”

Forecasting…“Single/Limited Scenarios” “Unlimited Scenarios”

Strategy…“Making Smart Bets” “Selecting along the

Efficient Frontier”

5.



Where Has ERM Been Applied in the Ratings Process?

Financial Institutions

Insurance

Energy Firms

Other Non-Financial Sectors

6.



Significance of Risk

Low -------------------------------------- HighQ

ual

ity

of

Ris

k C

on

tro

ls

Lo

w

---

----

----

----

----

----

----

----

H

igh

When Does it Make Sense to Include ERM in Ratings?

7.



Before Formal ERM Evaluation

ER

M Q

ual

ity

Lower Higher

Low

Risk Tolerance

Low

er

H

ighe

r

Rating

High

8.



With Formal ERM Evaluation

ER

M Q

ual

ity

Lower Higher

Low

Risk Tolerance

Low

er

H

ighe

r

Rating

High

9.



Low Risk Tolerance Business Profile

5

15

10

20

10.



High Risk Tolerance Business Profile

5

15

10

20

11.



Complex Business Profile

5

15

10

20

12.



Analysis of Complex Business Profile

5

15

10

20

13.



Complex Business Model

5

15

10

20

With ERM

14.



Strategic Efficient Frontier

Risk

Rew

ard

Strategic Choices

15.



Strategic Efficient Frontier (2)

Risk

Rew

ard

Strategic Choices

Hurdle Rate

Risk Tolerance

16.




Risk

Rew

ard

Strategic Choices

Hurdle Rate

Risk Tolerance

17.



Risk

Rew

ard

Strategic Choices

Hurdle Rate

Risk Tolerance


18.



Sector Specific Application

ERM is not the same in each sector –

• The Universal ERM Framework is not a straight-jacket

blindly applied to each company

• S&P carefully explores each sector and develops an ERM

platform that makes sense for that sector

• Flexibility allows for company differences in application of

ERM

19.



Application of ERM inthe Insurance Sector

20.



Insurance Credit Ratings – 15 years ago

S&P Credit Research Report, Feb. 15, 1992Prudential Insurance Co. of AmericaFinancial Strength Rating: AAA

“Prudential tolerates more aggressive balance sheet risk than some peers.”

“Prudential has detailed methodology to compare the risk/reward tradeoffs for various investment opportunities …15% of the general account is invested in higher risk assets.”

“[mortgage] concentrations exist in California (23%), New York (10%) and New Jersey (7%)…”

21.



S&P Credit Research Report, Jan. 12, 2007Prudential Insurance Co. of AmericaFinancial Strength Rating: AA-

“…reflects Prudential's strong risk-management culture, integrated approach to risk monitoring, and excellent credit risk management capabilities.

The otherwise strong ERM is somewhat mitigated by the lack of an overall quantitative view of risk from which an adequate strategic risk management process can be formed.”

Insurance Credit Ratings – Today

22.



Insurance Scores as of October 2006

Overall ERM Evaluation(207 Insurers)

Strong12%

Excellent3%

Weak5%

Adequate80%

23.



Introduction of ERM inthe Electric Power Sector

Significance of Risk

Low ---------------------------------- High

Qu

alit

y o

f R

isk

Co

ntr

ols

Lo

w

---

----

----

----

----

----

--

Hig

h

24.



Trading Risk Management – Three Part Analysis

• Capital adequacyMeasures discrete risks of market, credit and operational risks

• Liquidity Measures exposure to collateral calls under stress scenarios

• Risk management practices – ‘PIM’Evaluation of a company’s ability to identify and monitor significant risks, limit losses and operate within well-communicated risk tolerances

New!

25.



PIM

• Policies

– Risk Culture and Structure

• Infrastructure

– Processes and Technology

• Methodology

– Measurement and Reporting

26.



PIM

METHODOLOGY

PO

LIC

IES

INFRASTRUCTURE

Risk Technology

Operations

Risk Training

Capital A

llocatio

n

Ris

k C

ult

ure

Ris

k A

pp

etit

e &

Str

ateg

y

Ris

k C

on

tro

l &

Mo

nit

ori

ng

Dis

clo

sure

an

d

Aw

aren

ess

Model Vetti

ng &

Back-Testin

gValuation M

ethods

27.



PIM Assessment Test Phase

• Initiated in April 2006; Completed in May 2007

• Goal: mapping risk management infrastructure to

what S&P concludes are best practices

• Applied to ten companies initially

– Utility and energy merchants

– Pure trading

– Oil and gas E&P

– Big and small

28.



Companies Selected

• Black Hills Corp. (BBB- / Stable Outlook)

• Constellation Energy Group Inc. (BBB+ / Negative Outlook)

• Dynegy Inc. (B / Stable Outlook)

• Edison Mission Energy (BB- / Stable Outlook)

• Exelon Corp. (BBB+ / CreditWatch Negative)

• Mirant Corp. (B+ / Stable Outlook)

• NRG Energy Inc. (B+ / Stable Outlook)

• Reliant Energy Inc. (B / Positive Outlook)

• Sempra Energy (BBB+ / Stable Outlook)

• TXU Corp. (BB / CreditWatch Negative)

29.



PIM Assessment Results Summary

• Large variation in risk management infrastructures

• Risk appetite often does not match risk management

structures and modeling resources

• Asset-based trading is less robust that pure trading

• Most policies and key system components only in

place for a few years for most companies

• Dominance of senior management in risk

identification and control

• Internal reporting is robust but external reporting is

poor across the board

30.



Next Steps

• PIM

– Revise PIM methodology from lessons learned

– Greater focus of key areas and improve assessment

efficiency

– Extend assessment to a second group of energy

companies with trading operations

– Begin to formalize risk management reporting into

internal and external reports

• ERM

– Assess ERM potential and criteria for all companies in the

energy sector

– Issue criteria later in 2007 with request for comment

31.



The Big Picture

32.



Universal ERM Structure

Risk Mgt Culture & Governance

Risk A Control

Processes

Emerging Risks Mgmt

Risk C Control

Processes

Strategic Risk Management

Risk B Control

Processes

33.





Risk A Control

Processes

Emerging Risks Mgmt

Risk C Control

Processes


Risk B Control

Processes

34.





Risk A Control

Processes

Emerging Risks Mgmt

Risk C Control

Processes


Risk B Control

Processes

35.





Risk A Control

Processes

Emerging Risks Mgmt

Risk C Control

Processes


Risk B Control

Processes

36.



Analytic services and products provided by Standard & Poor’s are the result of separate activities designed to preserve the independence and objectivity of each analytic process. Standard & Poor’s has established policies and procedures to maintain the confidentiality of non-public information received during each analytic process.

www.standardandpoors.com

steve dreyer managing director, standard & poor’s scrlc meeting, june 6, 2007

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