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Embedding ERM Setting Risk Appetite

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					             ERM Symposium
               April 2010



6E: Embedding ERM - Setting a Risk Appetite



              Gilbert Korthals
            Linda Chase - Jenkins




                Moderator
                Eric Simpson
       Embedding ERM:
     Setting a Risk Appetite
    Eric Simpson, Towers Watson, Moderator
        Chase Jenkins,
 Linda Chase-Jenkins, Towers Watson, Presenter
   Gil Korthals, GuideOne Insurance, Presenter




Risk Appetite Agenda

• Risk Appetite Trends
• Panel Discussion
     – What is risk appetite and why is it needed?
     – Best practices and metrics
     – Practical company case study
• Risk Appetite Challenges
   Within 12 months, 84% of respondents
   expect to have a documented risk
   appetite/tolerance statement
               Do you have a documented risk appetite/tolerance statement?
           N and no plans t d
           No, d      l           l
                           to develop
               within next 12 months
                                                            16%


                                                                                47%      Yes
                   No, but planned to
                    be in place within                     37%
                     next 12 months



                                          In Place             Planned Within 12 Months           Not Planned
   Small                                     34%                                44%                    22%
   Medium and Large                          57%                                33%                    10%
   Source: Towers Watson’s 2008 ERM Survey; Base: Total Respondents for Q.11.




 A number of external pressures will compel insurers--
 regardless of their size and complexity--to develop
 and operationalize risk appetite/ tolerance statements


Rating Agencies are making                    Investors are expecting greater             Regulators are requiring
  t    i     i k          t
enterprise risk management a                      t
                                                  transparency, control and
                                                                   t l d                      i b     d
                                                                                      economic-based measurement of  t f
         rating criterion                       governance, as evidenced by              risks, capital and reserves

Economic Capital models                        Sarbanes-Oxley                           Solvency II
Risk-based decisions                           Board-level interest in ERM              Swiss solvency tests
Linkage with business strategy                 SEC emphasis on reserve                  Individual Capital Assessment
Risk culture and governance                    risk disclosure




                                       Insurers need to respond to this changing
                                      landscape and capitalize on the opportunity
                                           to improve business performance

                                        Risk management
                                        Capital management
                                        Value creation
  S&P continues to push the industry’s
  ERM agenda with its recent risk
  appetite criteria release
       • S&P’s view of an insurer’s ERM framework—
         including its risk appetite--can influence and
         accelerate rating changes that are usually
         triggered by performance and balance sheet
         issues
       • To ensure at least an “adequate” score from
         S&P for both “risk culture” and “overall ERM”,
         insurers must:
               – Be able to articulate their risk appetite
               – Assess/reconcile the appropriateness of individual
                 risk limits given their overall risk appetite




Meanwhile, A.M. Best has begun to scrutinize
insurers regarding their risk appetite and limits for
their major risks

  Risk Management Stage                                             A.M. Best’s ERM Hot Buttons (*)
                                          Top risk accumulations are assessed, prioritized, and mitigated within an objective
                                          framework
Traditional Risk Management
                                          Dashboard reporting is conducted for key risk drivers comparing current
                                          metrics versus risk limits
                                          Financial projections are stress tested using deterministic risk scenarios
                                          Risk-aware culture is imbedded across the organization with clear CEO support and
                                          tone at the top
                                          Board and risk committee is engaged; CRO-type individual is effectively coordinating
                                          ERM activity
        Integrated ERM
                                          Company has a well-articulated ERM mission and corporate risk appetite
                                          statements
                                          Risk correlations are considered in the business model; emerging new risks are
                                          identified
                                          Corporate risk appetite is validated through risk quantification that leverages
                                          stochastic modeling with consistent metrics to measure and monitor risks
        EC Modeling                       across the business
      Used for Decisions                  Stochastic economic capital modeling is “used” in the strategic decision-making
                                          process
                                          Decision-making considers risk-adjusted return measures

(*) Hot Buttons = Best practices observed by Towers Watson with respect to A.M. Best’s January, 2008 ERM Methodology.
                                                                                                                                6
Definitions are not
commonly agreed on

           pp        q               p y
 • Risk appetite requires a company to consider its
   overall philosophy to risk taking and the expectations
   of shareholders; is often expressed in qualitative
   terms
 • Risk tolerance requires a company to consider in
   quantitative terms exactly how much of its capital it is
         g
   willing to lose as well as its’ tolerance around
   earnings volatility or other value metrics
 • Risk limits require a company to consider at a more
   granular level how much risk individual managers
   should be allowed to take




Why do you need
a risk appetite?

 • It’s expected: management, shareholders, employees, rating
   agencies and regulators and other stakeholders need to
   know how much risk you are willing to take, not just how
   much you currently take
 • Key to governance: Set of principles and policies that guide
   behavior for all risks
 • Guides decision making toward the optimal balance between
   risk and return
 • Provides a clear reference point to monitor risk taking, and to
   trigger appropriate action as the boundaries are approached
   (or breached)
 • Minimizes the likelihood of “surprises” when adverse risk
   events occur
The risk appetite statement
provides guidance for a variety
of key stakeholders
 1. Policyholders, Bondholders…and Regulators, Rating
    Agencies
 •   Focus is on sufficient capital and management strategies to prevent
     default
 •   Little or no interest in upside or opportunity from risk taking or the
     nature of risks
 2. Shareholders and Analysts
 •   Focus is on return on capital above the price of risk
 •   Don’t like surprises
 •   Interested in upside from risk taking; want a thorough understanding of
     the nature and distribution of risks
 3. Management and Employees
 •   Need guidance regarding risk limits
 •   Need guidance on which opportunities to pursue




Risk appetite is not captured by any one
measure due to the different interests of the
various stakeholders
                                            Risk Appetite
                       Key risk measures

       GAAP earnings        Required                                           Other risk
                                                    Risk of stat              constraints
         volatility       economic cap
                                                    insolvency
        Shareholder       Policyholder
                                                   PH + SH focus
           focus             focus

               Risk management processes, policies and procedures




                                                                      Shareholders:
                           outcome
                           Probability of




                                                                      focused on the mean outcome
                                                                      (e.g., earnings volatility)



                                                   Policyholders:
                                                   focused on the tail (e.g., EC)
Risk appetite should
address several dimensions
                                     (
 • Nature of the risks to be assumed (and not to be
   assumed)
    – Credit risk, insurance risk, equity risk, etc.
 • Amount of risk to be taken on
    – In aggregate, by risk type
    – By product, business or geography
 • Desired balance of risk versus reward


  Risk appetite becomes tangible and actionable when calibrated to the
  company’s targeted financial performance indicators




Corporate risk tolerance conveys the
actual amount the organization is
prepared to put at risk
 • Assigns quantitative targets to the performance
   indicators in the form of risk limits
 • Acceptable risk exposure examples as measured
   over a set time period (e.g., 12 months):
    – Earnings volatility limited to Y% pa
    – 95% probability of financial strength rating maintained above
      a minimum level
                         f
    – 99% probability of remaining above minimum solvency
  Corporate risk tolerance (cont’d)


        • Earnings at risk — 45% negative variance at one
            t d d deviation              b bilit )
          standard d i ti (84% probability)
        • Target rate of return on capital — 5% p.a. over risk-
          free
        • 5% chance of a necessary cut in shareholder dividend
        • No more than 5% chance of embedded value (EV)
          falling by at least 10%
          The i k tolerance l
        • Th risk t l              l for downgrade f
                               level f a d                   to
                                                   d from AA t A
          is 2% (one year in 50)
        • Economic capital budgets per business unit to not
          exceed $X billion




The Board needs to fully understand
and provide direction for the risk appetite

Management develops the strategies and plans that are consistent with the
                   Board mandate on risk taking
             Board of Directors                                                                      Management
    Sets/approves overall risk                                                         Develops business strategy, sets
    appetite and corporate risk                                                        financial targets (e.g., growth,
    tolerance that align with                                                          earnings, ROE)
    stakeholder expectations*
                                                                                       Determines overall (economic)
    Approves capital plan                                       Risk                   capital needs and performs
                                                               Contract                capital budgeting
              pp p         p
    Ensures appropriate corporate
    risk governance                                                                       Allocates capital
                                                                                       Manages business to achieve
                                                                                       results according to detailed
                                                                                       business plans and agreed risk
                                                                                       tolerances/limits

*Although the Board sets/approves the risk appetite, management provides information, analysis and recommendations to support
 these Board-level decisions.
  Best practices in risk appetite


• There is an implied contract between the Board and
  management as to how much they are willing to put at risk and
  for what level of return
• The risk appetite is articulated explicitly — transparency and
  communication to stakeholders are critical
• Risk appetite should be calibrated to the company’s targeted
  financial performance indicators
                     i is in l         d       d key individual
• A common metric i i place to understand k i di id l
  risks and how much in total is at risk across the organization
  and is used to optimize risk/return within the risk tolerance
  and risk limits




Best practices in risk appetite (cont’d)

• The risk profiles of the business units and the enterprise
  consider stress events to ensure the company can withstand
  unexpected events
• Risk limits for individual business activities are established
  through a quantitative, bottom-up aggregation process
• The top down risk tolerances are modeled and reconciled for
  consistency with the bottom up risk limits
                          appetite
• Adherence to the risk appetite, risk tolerances and risk limits is
  monitored and reported
Making the risk appetite statement
operational requires both consistent
metrics and good modeling
 • Developing a validated risk appetite statement requires a
   high level of modeling
    – Current modeling efforts at most companies cannot
       reconcile top-down tolerances with bottom-up limits
 • The ability to aggregate individual risks from different
   parts of the business into one common metric is important
   for making decisions on risk taking --- Economic Capital is
   emerging as a key tool and metric
 • EC can help provide the link between the overall risk
   tolerances and the risk limits that individual managers
   need to comply with




GuideOne: A practical case study
of establishing Risk Appetite

• Overview of the steps in our process
• Keys and challenges
• Uses for risk appetite statements
• Sample statements
     p
Background

  GuideOne s
• GuideOne’s ERM journey
• 18 months ago drafted first set of risk appetite
  statements
• Involved officers via a group meeting
• Set of statements focused on

  Absolute Risk          Practical Risk           Earnings
     of Ruin                of Ruin               Volatility
  Loss of all surplus   Regulatory intervention   Net income




What We Learned

• Failed to take hold because
   – Mostly my words
   – Didn’t engage senior management deeply
     enough
   – Didn’t put statements in context to give any
     meaning
   – Focused too much on tail events (e.g. 1 in
     500) that are hard to relate to
Risk Appetite – Round 2

• Elicited some outside help
• Developed plan to actively involve Sr.
  Management and BOD
• Engaged CEO and Chairman of the Board
  and got his approval




Objectives

• Establish common foundation &
  vocabulary for risk discussion
• Develop risk appetite and risk tolerance
  statements
• Tie results of risk appetite discussions with
  capital model output, other measurement
  tools and industry benchmarks
Primary Tool - Survey

                         p            y
• Similar to an investor profile survey
• A dozen or so common questions regarding
  risk preferences
• Took 30-45 minutes per individual
• Done in person or via phone for some of the
  directors
• Conducted by someone from the outside to
  allow individual responses to remain
  anonymous and confidential
• Compared management with director results




Major Steps

• Established survey questions
• Interviewed each board member & 10 of
  the most senior management members
• Compiled results and composed initial
  draft statements
Major Steps (cont’d)

• Met with senior management in working
  session to allow input & make them feel apart
  of the final draft statements that went to BOD
• Sent pre-read materials to the board
   – Common risk terms
                           p           y question
   – Some of the less important survey q
     results
• Two hour session with the board




Next Steps

        board’s
• Take board s feedback and input to modify
  statements
• Review with senior management & then
  board again in May
• Deliver better measurement and monitoring
  tools
• Update and refine capital modeling
• Continue to refine Risk Appetite statements
• Drive down to risk limits
Outcome

• Created qualitative risk appetite statements in
  five areas – General, Policyholder Security,
  Earnings Volatility, Liquidity and Brand Equity
• Created quantitative risk tolerance statements
  in these same five areas
• Excellent discussion with the board & good
  feedback on process
• Laid a foundation of common understanding
  of risk and risk vocabulary
• Ongoing dialogue expected at future meetings




Keys

• Personal calls by our COO to each board
  member prior to the interview
• Put survey results in context of our history,
  industry and key competitor results and
  capital model results where possible
• Figuring out the most important things to the
  board, senior management and other key
  constituents for the company to avoid
• Help them see how these statements will be
  practically used
 For example, we asked each participant
 about their willingness to sustain various
 levels of surplus declines….
                                     Tolerance for Loss of Surplus




From ‘Risk Appetite: Articulating Risk for Everyday ERM’ webcast, July 14, 2009, by Towers Watson. Used with permission.




    …and compared responses to the
    historical experience for both the
    industry and client
                    Comparison of Client’s Tolerance for Surplus
                          Losses to Historical Experience
                          L       t Hi t i l E       i




      From ‘Risk Appetite: Articulating Risk for Everyday ERM’ webcast, July 14, 2009, by Towers Watson. Used with permission.
                          Modeled Change in Surplus

                         60.0%

                         40.0%

                         20.0%
 hange in Surplus (%)




                                                                                                         70%
                          0.0%
                                                                                                                           86%
                                                                                                                                 94%
                         -20.0%

                         -40.0%
Ch




                         -60.0%

                         -80.0%

                        -100.0%
                                  0%          20%               40%                       60%                      80%             100%
                                                                         Percentile

                            * Illustrative


From ‘Risk Appetite: Articulating Risk for Everyday ERM’ webcast, July 14, 2009, by Towers Watson. Used with permission.




                        Some Ways To Use
                        Risk Appetite Statements

                          • Security standard for capital model
                          • Pricing decisions – disruption philosophy
                          • Guidance for buying reinsurance
                                  – Level of cat reinsurance protection (buy to 1 in 250 yr PML?
                                    1 in 100?)
                                  – Level of per risk or cat retention impacts earnings volatility
                          • Guide investment policy
                                  – Liquidity
                                  – Investment mix (volatility, riskiness) and quality of
                                    investments
                          • Evaluating acquisition opportunities or expansion to
                            new classes of business
   Challenges

  • Writing statements in a way to avoid
    unintended consequences
  • Defining appetite statements that satisfy
    different director’s perspectives
  • Getting everyone to fully grasp the concept of
    risk appetite statements
  • Getting statements with good measurements




   Risk Appetite Visual


• Risk appetite
  statements define
  edges of table
• Execute strategy
  anywhere on the
  table top
• Have a warning
  system when get
  close to the edge
What Influenced Setting Our
Risk Appetite Statements

•    Hi t i l performance of th company
     Historical    f          f the
•    Risk profile of senior management
•    Current capital strength
•    Current external conditions and recent
     extreme events




Sample Risk Tolerance
Statements
       Sample Statements
         p                  y
We will operate in such a way that:       Possible Measurements
    There is no more than a 0.20%      Use capital model calibrated to
    (1 in 500 years) probability of    tail events and calculate percent
    losing our entire surplus over a   of trials where surplus less than
    one year time horizon.             or equal to zero.

    There is no more than a 1% (1 in Model BCAR or stressed BCAR
    100 year) probability of an AM   ratios and the likelihood of
    Best downgrade                   dropping below the published or
                                     adjusted minimums
    The loss from a 1 in 20 year       Compare catastrophe model
    catastrophe event is less than     results to calculated economic
    10% of our economic capital.       capital
Sample Risk Tolerance
Statements (cont’d)
       Sample Statements
         p                  y
We will operate in such a way that:      Possible Measurements
 We will be able to comfortably       Compare Net Aggregate PML (1
 pay claims in a 1 in 250             in 250) to sum of cash, line of
 catastrophe year by maintaining      credit(s), and cash flow from
 liquidity through investment         expected cat losses built into
 policies and liquidity facilities.   premium

 Absent extraordinary insurance
 Ab     t t      di     i             C it l model results -
                                      Capital    d l       lt
 marketing conditions, we expect      proportion of trials with positive
 that operating income should be      operating income
 positive 5 out of 7 years




Sample Risk Tolerance
Statements (cont’d)
       Sample Statements
         p                  y
We will operate in such a way that:      Possible Measurements
 There is no more than a 1 in 50      Stress test equity investments.
 year probability that our equity     Put a risk limit in place on the
 market risk will lose more than      maximum percent equities can
 15% of our capital                   be of the portfolio.

 There is less than X% chance of Retention can be measured and
   high      fil breach of t t or
 a hi h profile b      h f trust       it d but       the likelihood
                                  monitored b t can th lik lih d
 integrity that will damage our   of a high profile breach?
 brand equity in a way that will
 result in the loss of more than
 Y% of our customers in a 12
 month period.
 When it is all said
and done, a picture
   is still worth a
 thousand words.


Does this describe
your risk appetite?




Risk Appetite Wrap-Up




                        40
  While most insurers focus on common risk
  appetite dimensions; targeted metrics vary
  widely and are just emerging…
                             Board-Level Risk Appetite                 ILLUSTRATIVE


  R    l t           i
  Regulatory & economic            Capital Statutory C it l minimum
                                 • C it l > St t t   Capital i i
  capital
  Ratings                        • Capital and earnings to support “AAA” or
                                   better
  Earnings                       • Earnings-at-Risk < X%
                                 • EPS or $ per quarter/year
  Reputation                     • Nothing that could permanently damage our
                                   brand

  Shareholder value, e.g.,       • Embedded value
                                 • Dividends
  Financial ratios, e.g.,        • Leverage Ratio < X%
                                 • Stress liquidity or cash coverage
  Charter/mission                • Achievement of specific company values




 Sample risk strategy statement:
 Munich Re

   Munich Re s
• “Munich Re’s risk strategy takes into account the interests
  of both clients and shareholders. It’s objectives are:
   – To maintain our financial strength, ensuring that our
     liabilities to our clients can be met,
   – To protect and increase the value of our shareholders’
     investment,
               g                      p
   – To safeguard Munich Re’s reputation”
• “The risk appetite is based on the capital and liquidity
  available and earnings volatility, and provides a term of
  reference for the Group’s operation divisions.


                                                     Munich Re Annual Report 2009
Sample risk appetite statement:
SCOR Re
  • “A fundamental strategic part of the framework is the risk
    appetite which for SCOR is defined as:
     – To secure a ROE of 900 bps above risk free rate over
        the cycle;
     – To provide an "A+" level of security to Group clients by
        2010;
     – To self-finance the current business plan of the Group.
  • The risk appetite is translated into practical operational
    measures (Risk Tolerances) which are designed to ensure
    that the Group respects the solvency and the return on
    capital objectives by limiting the amount of exposure to
    particular lines of business and extreme scenarios .”
                                                  SCOR Re Annual Report 2008




Sample risk limit statements:
Partner Re
  • “The Company manages its catastrophe exposures such that
    the chance of an economic loss to the Company from all
    catastrophe losses in aggregate in any one year exceeding
    $960 million has a modeled probability of occurring less than
    once every 75 years.”
  • “The Company manages its casualty and other long-tail lines
    exposure such that the chance of an economic loss to the
    Company from prior years’ deterioration in casualty and other
    long tail reserves exceeding $480 million has a modeled
    long-tail
    probability of occurring less than once every 15 years.”
  • “The Company manages its equity and equity-like exposures
    such that the chance of an economic loss to the Company of a
    severe decline in value of equity and equity-like securities
    exceeding $720 million has a modeled probability of occurring
    less than once every 75 years.”            PartnerRe Annual Report 2008
    Many insurers will be challenged to develop,
    validate, and embed risk appetite over the
    next couple of years
•    Management engages Board of Directors in discussion about risk appetite
     (qualitative) and corporate risk tolerances (quantitative)
•    The risk appetite is articulated explicitly and is directly calibrated to the company’s
     targeted financial performance indicators (e.g., capital, earnings, economic value)
•    The risk profiles of the individual business units and the overall enterprise
     consider stress events to ensure that the company can withstand unexpected
     turns of events
•    Risk limits associated with individual business activities are established,
     consistent with the overall risk appetite, through a quantitative, bottom-up
     aggregation process
•    Compliance with the corporate risk tolerances and risk limits is monitored and
     reported


        1. Articulate risk   2. Understand
                                                  3. Validate risk    Wider embedding
        strategy and         current risk
                                                  appetite            of risk appetite
        tolerance            exposure


                  Review annually — and when substantial changes to business
                                  or initiatives are undertaken




Q&A




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