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?