www.guycarp.com

AIRC Seminar, Taipei, April 16, 2010

Establishing and Managing Risk Tolerances within an ERM Framework

1Guy Carpenter

Implication of the Financial Crisis

2Guy Carpenter

Financial Crisis Impacts Firms Differently

3Guy Carpenter

ERM Did Help (S&P)

http://www2.standardandpoors.com/spf/pdf/media/ERM_NA_Insurers_05_27_09.pdf

4Guy Carpenter

ERM Did Help (S&P)

http://www2.standardandpoors.com/spf/pdf/media/ERM_NA_Insurers_05_27_09.pdf

5Guy Carpenter

In Light of Financial Crisis, What Have We Learned about ERM?

What happened– Significant market value lost 2nd half of 2008 through 1st half of 2009

Companies punished disproportionately– Cost of external capital increased, those companies with available

(internal) capital were quickest to recover

Validated the importance of– Managing solvency– Managing profitable growth

Transparent, predictable earnings– Robust corporate governance

Highlighted value of establishing and managing clear risk tolerances within an ERM environment

6Guy Carpenter

Discussion Agenda

Establishing risk tolerances within an ERM framework– Definition of risk profile, risk appetite and risk tolerance– Implementation approach (corporate governance)

Qualitative and quantitative methods for managing individual risk areas– Insurance risk– Asset risk– Operational risk

Systematic methods of managing enterprise risk tolerances– Traditional financial ratio analysis– Comparison of actual capital to economic capital (managing solvency

risk)– Evaluation of earnings volatility (managing profitable growth)

Reinsurance strategy and risk tolerances

Establishing Risk Tolerance within an ERM Framework

8Guy Carpenter

Definitions

Risk Profile: the broad parameters a firm considers in executing its business strategy in its chosen market space.

Risk Appetite: the level of uncertainty a company is willing to assume given the corresponding reward associated with the risk. A company with a high risk appetite would be a company accepting more uncertainty for a higher reward, while a company with a low riskappetite would seek less uncertainty, for which it would accept a lower return

Risk Tolerance: a stated amount of risk a company is willing and able to keep in executing its business strategy — in other words, the limits of a company’s capacity for taking on risk.

Risk Tolerance Statements are Actionable

9Guy Carpenter

Taiwan Insurance BureauERM Guidelines for Insurance Industry (2010) – Risk Appetite and Limit (Tolerance)

Risk Appetite: the degree of uncertainty an insurer is willing to accept in pursuing its value– Reflects philosophy and therefore influences the risk management

culture

Insurer should be aware of the followings when setting risk appetite:– Operation strategy and objective, growth, risk and return– Should manage through qualitative and quantitative measures

Board of Directors should exam risk appetite annually

Risk Limit (Tolerance) is based on risk appetite and nature of the risks– Monitor periodically and mitigate if limits exceeded

10Guy Carpenter

Theoretical Example

Risk Profile

Multi-line property and casualty insurance company

Where stakeholders WANT the company to compete (Core Risk):

Risk selection, claims, distribution channels, expense structure, strategic execution

Where investors DON’T want the company to compete (Non-Core Risks) :

Cat risk in excess of peers, excessive underwriting volatility, aggressive asset risk, operational risk

11Guy Carpenter

Theoretical Example, Continued

Risk Appetite– Target ROE of 12% with volatility consistent with industry

Risk Tolerance– Solvency management related

Maintain capital in excess of 250% of regulatory RBCNet cat PML at 1/100 limited to 10% of capitalNet cat PML at 1/250 limited to 15% of capitalRemote chance of asset loss greater than 10% of capital in any year

– Earnings related 1 in 15 year probability underwriting losses exceeds 100% of budgeted income1 in 5 year probability underwriting losses exceed 25% of budgeted income

– Reputation relatedNot have a cat loss in excess of peers (market share basis)

12Guy Carpenter

General Implementation Approach

YesYesIntegrate risk tolerances through organization

YesYesYesEstablish core and non-core risks with associated risk tolerances

YesYesYesEstablish overall risk tolerances

YesYesArticulate risk appetite

YesYesArticulate risk profile

Board Approval

GroupBusiness Unit

13Guy Carpenter

Risk Tolerance Implementation Approach for Multi-National InsurerBoard of Directors

Identify risks particularly important in business operations– Sign-off on mitigation strategy for the most significant risks

identified

Approve risk management system and organization

Review and approve the risk capital allocated to each business unit based on overall risk tolerance

Monitor and implement review of risk management performance

From Presentation to Rating Agency by Multi-National Insurer

14Guy Carpenter

Risk Tolerance Implementation Approach for Multi-National InsurerGroup Risk Management Committee (reports to Board)

Members– Chief Risk Officer – Business unit managers in charge of risk management and

executive in charge of business unit– Observer: internal audit senior manager

Responsibilities– Upgrade entire risk management system – Assign departments to manage key risks (specific insurance,

asset and operational risks as identified by Board)Facilitate information sharing among the departments

– Review capital allocation plan prepared by planning department– Monitor the retained risk with the allocated capital at group and

business unit levelsRequire plan from business unit if retained risk is exceeded

From Presentation to Rating Agency by Multi-National Insurer

15Guy Carpenter

Risk Tolerance Implementation Approach for Multi-National InsurerRole of Business Unit Risk Management Function (Reports to CRO)

Responsibility to comprehensively control and monitor– Underwriting risk within risk tolerances– Asset management risk

Monitor compliance to various limits– Operational risk

Key indicators (as developed by departments)

Assist management achieve performance targets which integrate risk tolerance goals– Risk adjusted return – 35% weighting

Based on group target ROE– Budgeted earnings – 35% weighting– Net written premium target – 30% weighting

From Presentation to Rating Agency by Multi-National Insurer

16Guy Carpenter

Risk Tolerance Implementation Approach for Multi-National InsurerRisk Tolerance Quantification at Group and Business Unit Level

Group: hold capital in excess of amount to support desired S&P rating

Business unit: Holding Co allocates capital to each business unit based on a 0.5% chance of default (once every 200 years)– Operations in each business unit conduct business and take risks

appropriate to the amount of allocated capital

Other

Hold Co

Main Non-Life Other A Other BLife

Domestic Non-Life

Overseas Insurance

Financial Services

Personal Comm Auto PA

Risk tolerance of the group

Capital allocation to each business unit

From Presentation to Rating Agency by Multi-National Insurer

17Guy Carpenter

Comparison of Example with Taiwan Insurance Bureau GuidelinesRisk Management Organizational Structure and Responsibilities

Clear responsibility framework (upward and downward)

Board of Directors– Identify significant risks, assure efficiency of risk management and

take the final responsibilityGroup and business unit level

– Consider the capital requirements, accounting and operation policies that have influences on capital allocation

Risk Management Committee– Report to Board of Directors– Set and implement risk management policy, structure,

organizational functions as well as the qualitative and quantitative management standards

– Assist all units in risk management activities– Adjust risk types, risk limit allocation and risk bearing based on the

environment changes– Coordinate the communications between units

18Guy Carpenter

Comparison of Example with Taiwan Insurance Bureau GuidelinesRisk Management Organizational Structure and Responsibilities

Risk Management Unit– Monitor, measure and evaluate everyday risks and implementation – Independent from other units

Authority from the Board of Directors and Risk Management Committee

Business Unit Head– May assign risk management personnel in each business unit– Responsible for the daily risk management and reporting; take necessary

countermeasures

Business Unit– Identify risks and monitor on regular basis– Assure risk tolerances are implemented effectively, report if limits exceeded– Assist in the development of risk models – Comply with the relevant laws and regulations and corporate risk

management policies.

Audit Unit – Check the implementation status of risk management in each unit

19Guy Carpenter

Comparison of Example with Taiwan Insurance Bureau GuidelinesRisk Control and Management

Senior management should establish the risk management philosophy– Board should examine risk appetite yearly

Insurance risk management culture must be operated as a system– Not the sole responsibility of risk management department

Measure and compile the risks of the whole company, including market, credit risks and compare with the risk appetite

The relationship of return and risk appetite should be considered in measuring the profitability of different lines of business and investment– Reward/bonus/compensation should be based on long term

profitability and performance

Should develop economic capital quantitative measuring techniques and Own Risk and Solvency Assessment to strengthen capital management

20Guy Carpenter

Qualitative and Quantitative Methods for Managing Significant Risk Areas

22Guy Carpenter

Managing Insurance RiskQualitative

Policy evaluation– Legality, market competition, rate fairness

Adequacy of administrative system– Underwriting system, policy, authority guidelines

Adequate reinsurance plans– Net risk retentions, reinsurance limits set consistent with risk

tolerance guidelines– Correlation between risk limit and risk accumulation

23Guy Carpenter

Managing Insurance RiskQuantitative

P&C– Consistent with risk tolerance metrics, stochastically model

attritional, large and cat lossesCat models used for earthquake, typhoon and flood- Understanding exposure, data quality is critical- Scenario evaluation to understand “tail”

- Can be historical (Typhoon Morakat)- Non-modeled perils generally assumed to be covered within

reinsurance limits– Reserving risk

Actuarial methods to develop ranges

Life– Profit and sensitivity testing (i.e., new business strain, adverse

mortality etc.)

24Guy Carpenter

Insurance Risk ExampleResults

Gross Loss and ALAE

Net Loss and ALAE Underwriting Gain Net Income

Mean $921 M $734 M $35 M $146 MStdDev $194 M $116 M $168 M $176 M

ProbabilityReturn Period

Gross Loss and ALAE

Net Loss and ALAE Underwriting Gain Net Income

25.00% $791 M $656 M $153 M $245 M40.00% $850 M $695 M $91 M $195 M50.00% $889 M $720 M $51 M $163 M60.00% $931 M $746 M $9 M $129 M75.00% $1,013 M $794 M ($65 M) $70 M80.00% 5 $1,049 M $815 M ($96 M) $45 M90.00% 10 $1,156 M $875 M ($182 M) ($35 M)95.00% 20 $1,267 M $934 M ($239 M) ($94 M)98.00% 50 $1,424 M $1,013 M ($358 M) ($213 M)99.00% 100 $1,561 M $1,081 M ($432 M) ($288 M)99.60% 250 $1,762 M $1,193 M ($514 M) ($371 M)

Metrics

25Guy Carpenter

Insurance RiskUnderstanding Catastrophic Risk Scenarios

26Guy Carpenter

Managing Asset RiskQualitative

Market– Transparent understanding of investment classes, securities, trading parties

Complicated or significant investments have appropriate review and authorization

– Limits for available for sale vs. trading

Credit risk– Before purchase

Risk limits set by investment classification / type and ratings based on risk tolerances

- Process for how to deal with violations– After purchase

On-going review of credit status (warning system)- Macro trends and individual securities- Change risk limits as appropriate

Liquidity risk– Cash flow strategy under normal and stressed scenario

27Guy Carpenter

Managing Asset RiskQuantitative

Stochastic testing of market and credit risk through DFA model and economic scenarios– Product, group and enterprise wide– VaR often used as metric

Sensitivity and stress testing (with mitigation plan)– Historical or assumed – Review expected credit loss (exposure * probability of default * loss

given default)

Special consideration for Life insurance– Falling interest rates or narrowing spreads can negatively impact

capital to support products- Mitigated by asset / liability matching

- Cash flows should be covered by bonds with high credit quality

- Match not only change in value of bonds, but rate of change (convexity)

28Guy Carpenter

Managing Asset Risk – Use of Economic ScenariosBackground

Economic scenarios are simulated sets of assumptions about selected metrics that describe economic conditions over time– Variables can include:

Inflation of various typesGDPInvested asset returnsUnemploymentExchange ratesetc.

– Time frame can:Be at specified time intervalsFor a specified number of years

A key component of economic scenario sets is appropriately reflected correlation amongst variables and over time

29Guy Carpenter

Managing Asset Risk – Use of Economic ScenariosBackground

Uses of economic scenarios for non-life insurers– Inflation assumptions for use in modeling losses and contract

indexes– Invested asset return assumptions for modeling investment income

and appreciation– Other metrics to parameterize underwriting cycles, exposure

changes and other variables influenced by economic conditions

Sources– Vendors– In the U.S., the CAS publishes ESGs

30Guy Carpenter

Managing Asset Risk – Use of Economic ScenariosExample of Variables Used by a DFA tool (in this case GC’s MetaRisk)

Inflation– Type – (CPI, Medical, Wage)– Annual simulated values

Bonds– Type & quality – Yield curves at t=0 and each year end– Defaults - % of market value defaulting & loss given default

Stocks– Type – Appreciation– Dividend yield

Property/real estate– Type – defined by user in header record– Total return

31Guy Carpenter

Managing Operational Risk

Qualitative– Risk identification, prioritization and management through

operational processRisk ledger common tool

– Compliance officer common– Proactively manage litigation risk (including contracts)– Crisis management

Quantitative– Emerging area of study– Current approach is often combination of scenario testing and

factor based

32Guy Carpenter

Managing Operational Risk Heat Maps

Operational Risk

Latent Losses

BU 3 BU 4

FraudCatastrophic Risk

Claims System Failure

TotalBU 2BU 1

Market Risk

Latent Losses

BU 3 BU 4

Equity DeclineCatastrophic Risk

Interest Rate

TotalBU 2BU 1

Credit Risk

Latent Losses

BU 3 BU 4

Reinsurance RecCatastrophic Risk

Asset Downgrades

TotalBU 2BU 1

Liability Risk

Latent Losses

BU 3 BU 4

Reserving RiskCatastrophic Risk

Underwrit ing Risk

TotalBU 2BU 1

Operational Risk

Latent Losses

BU 3 BU 4

FraudCatastrophic Risk

Claims System Failure

TotalBU 2BU 1

Market Risk

Latent Losses

BU 3 BU 4

Equity DeclineCatastrophic Risk

Interest Rate

TotalBU 2BU 1

Market Risk

Latent Losses

BU 3 BU 4

Equity DeclineCatastrophic Risk

Interest Rate

TotalBU 2BU 1

Credit Risk

Latent Losses

BU 3 BU 4

Reinsurance RecCatastrophic Risk

Asset Downgrades

TotalBU 2BU 1

Liability Risk

Latent Losses

BU 3 BU 4

Reserving RiskCatastrophic Risk

Underwrit ing Risk

TotalBU 2BU 1

Liability Risk

Latent Losses

BU 3 BU 4

Reserving RiskCatastrophic Risk

Underwrit ing Risk

TotalBU 2BU 1

Systematic Methods of Managing Enterprise Risk Tolerances

34Guy Carpenter

Managing Enterprise Risk Tolerances Financial Ratio Analysis

Non-life LifeSolvencyChange in NPW -10% -- +22% -1 -- +29%NPW to Equity 0.4 -- 0.6 5.0 -- 15.0Net Liabilities to Equity 1.3 -- 1.8 13.0 -- 18.5

Asset and Credit RiskHigher Risk Assets to Equity 30% -- 46% 400% -- 765%Reinsurers' Share of Gross Tech Reserves 5% -- 45% < 1%Net Retention Ratio 50% -- 60% > 95%

Reserve AdequacyLoss & LAE Reserves to Equity 1.0 -- 1.3 12.0 -- 17.0Net Tech Reserve to NPW (NL only) 110% -- 155% --

Expected Ranges

Note: Ratios calculated using 8 years of financial data from A.M Best data base

35Guy Carpenter

Managing Enterprise Risk Tolerances Financial Ratio Analysis

Non-life LifeLiquidityLiquid Assets to Total Liabilities 98% -- 118% 45% -- 75%Current Liquidity = cash and unaffiliated assets / net liab 122% -- 148% 78% -- 95%Overall Liquidity = total assets / net liabilities 125% -- 150% 80% -- 98%

ProfitabilityLoss Ratio (Benefits paid to NPW for life) 48% -- 62% 29% -- 57%Expense Ratio 32% -- 52% 16% -- 81%Combined Ratio (NL only) 89% -- 101% --Operating Ratio (NL only) 85% -- 91% --Return on Revenue (NPW) 7.8% -- 14.4% -3.3% -- 4.9%Net Investment Return (excl capital gains) 2.5% -- 3.5% 3.7% -- 4.9%Change in Equity -6.1% -- 16.5% -10.5% -- 15.9%Return on Equity 3.1% -- 12.5% 0.3% -- 21.5%

Expected Ranges

Note: Ratios calculated using 8 years of financial data from A.M Best data base

36Guy Carpenter

Managing Enterprise Risk TolerancesComparison of Actual Capital to Economic Capital

Economic capital: amount needed to finance core retained risk subject to desired level of risk tolerance

Maintain a balance between actual capital held by the company and the economic capital

Firms hold excess capital (i.a., a cushion) above economic capital– To provide for contingencies– To support growth– Ensure continuation of existing

dividend or other capital management strategies

ActualCapital

EconomicCapital +Cushion

37Guy Carpenter

Comparison of actual capital to RBC amount– Class I (>300%), Class II (200% - 300%), Class III (<200%)

Stress test (Non-Life)– Insurance risk

1 in 200 year natural catastrophe eventThe most adverse scenarios of 1) Natural CAT, 2) Fire event, 3) Nuclear event, 4) Flu and 5) Major traffic accident

– Credit riskDefault from largest reinsurance partner

– Asset riskStocks – market value drop of 50%Interest rate – increase / decrease by 100 BPTS – or 50% of the original rateExchange rate – US exchange rate depreciated by 10%

Managing Enterprise Risk Tolerances Comparison of Actual Capital to Economic Capital - Regulatory Comparison

38Guy Carpenter

Managing Enterprise Risk Tolerances Comparison of Actual Capital to Economic Capital – Rating Agency Comparison

S&P and A.M. Best have developed and refined proprietary risk-based capital adequacy models, generally covering insurance, asset (including credit) and operational risk

A.M. Best (BCAR) S&P Insurance Capital Model (ICM)

39Guy Carpenter

Managing Enterprise Risk Tolerances Comparison of Actual Capital to Economic Capital – Use of Internal Models

Asset Class Duration/MaturityCredit

UnderwritingRisk (Incl. Cat)

Frequency and Severity Distributions

ReinsuranceDefault Credit Ratings

Reserve Adjustments

Severity Distributions

Operational Risk Factors

EarningsEarnings

EconomicEconomicCapitalCapital

A common progression for companies to develop an economic capital model is:

1. Ratio analysis and economic capital adequacy analysis using regulatory or rating agency factor based models

2. Development of partial DFA model using simulated amounts for selected areas such as underwriting risk

3. Development of full DFA modelClear Risk Tolerances Are Necessary to Calibrate Economic Capital

40Guy Carpenter

Economic Capital Model Validation Process

Validate / Test the Model

Implement / Phase In the Model

Build / Enhance the Model

Digestible“What Is This?”

Comfort-building“What Can You Live

With?”

Pilot Test“What Will the

World Look Like?”

1. Technology – creating / advancing the risk modeling

2. Understanding – familiarization with the model, inputs and outputs

3. Process – modifying the way the company makes decisions

4. Opinion – managing the implication4 Fr

onts

4 Fronts

41Guy Carpenter

Managing Solvency Example: SCOR Capital Management Approach

Source: 2008 SCOR Annual Report

Risk Tolerance Defines Internal RBC

42Guy Carpenter

Managing Solvency Example: SCOR Capital Management Approach

Source: Investor Day - 2009

43Guy Carpenter

44Guy Carpenter

Premium Investment income & taxesGross written 171,845,714 Investment income 14,415,170Gross earned 166,581,714 Underwriting & investment income 12,976,326Ceded 6,212,161 Income taxes and other 4,474,558Net earned 160,369,553

Net Income 8,501,768Loss Standard Deviation 6,147,544Direct loss & LAE 113,525,950 CV 0.7Ceded loss & LAE 6,106,483Net retained loss & LAE 107,419,467 Ratios

Loss & LAE ratio 66.98%Expenses U/W expense ratio 33.91%Direct 54,388,930 Combined ratio 100.90%Ceding commission 0 Leverage ratio 154.16%Net expenses 54,388,930

Ending surplusNet underwriting results -1,438,844 Mean ending surplus 104,024,769

1:100 89,206,0161:250 86,723,3931:500 74,163,166

Solvency

Comparison of Actual Capital to Economic Capitaland Evaluation of Earnings Volatility

Earnings Volatility

45Guy Carpenter

0.0

50.0

100.0

150.0

200.0

250.0

300.0

350.0

400.0

-20.00 -10.00 0.00 10.00 20.00 30.00 40.00

Ave(ROE)

Pric

e/B

ook

Low: SD<9Med: 9<=SD<16High: SD>=16Low RegMed RegHigh Reg

Scope: 40 quarters of earnings (1998Q2 to 2008Q1) for 74 publicly traded property casualty insurance companies, divided into three equal size groups based on SD(ROE)

Low VolatilitySlope=8.4

Medium VolatilitySlope=6.7

High VolatilitySlope=1.9

Managing Enterprise Risk Tolerance Why Establish Risk Tolerances for Earnings Volatility?

Result: Statistical regression shows price to book benefit of higher ROE’s was reduced as volatility increases

Check Out Related Publication on GCCapitalIdeas.com

46Guy Carpenter

Evaluation of Earnings VolatilityHedge the Noise and Strengthen the Signal

Information is contained in earnings– Helps investors (or others) to determine changes in underlying firm

value, and– Predict future earnings

SIGNAL – some changes in earnings are indeed informative of a change in value which will persist into future earningsNOISE – some earnings surprises are random and carry no information about future earningsThe more Signal and less Noise, the more earnings convey a clearer picture of changes in firm value and become stronger predictors of future earnings

47Guy Carpenter

Time Now

Earn

ings

Note wide band of uncertaintyin predicting future

Volatility makes it difficult to see what is going on and how value is changing

Note narrow band of uncertainty in predicting future

Gives clearer trend of how value is evolving

Future

Evaluation of Earnings VolatilityEnhancing Predictability Through Hedging (Noise vs. Signal)

Raw Earnings

Hedged Earnings

Slide from Specialty Seminar

Reinsurance Strategy and Risk Tolerances

49Guy Carpenter

Best Practices for Reinsurance Strategy Development

Identify Risk Tolerance

Benchmarks

Identify Risk Tolerance

Benchmarks

Measure, Decompose

Risk

Measure, Decompose

Risk

Evaluate Alternatives

Against Benchmarks

Evaluate Alternatives

Against Benchmarks

Evaluate Financial Context

Evaluate Financial Context

Solvency, ProfitabilityReputation

AssumptionsResults

Cost / Benefit

50Guy Carpenter

Reinsurance EffectivenessCost Benefit Choices

Cat

Surplus Share

Quota Share

Per Risk

EOL

Working Layer

Solvency

Capital protection

Capital efficiency

Profitability

Various measures of volatility (underwriting results, pre-tax income, loss ratio etc.).

Profitable Growth

Risk adjusted profitability

Ratings / regulatory achievement

Reinsurance

OptionReinsurance Effectiveness Approach – Framed by Risk

Tolerances

51Guy Carpenter

Capital Efficiency ExampleCost of Reinsurance Capital in 5 Steps

Step 1 – Determine the Company’s Risk Tolerance– Risk Tolerance = a stated amount of risk a company is willing and/or

able to keep in executing its business strategy Consists of a measure of risk, a probability level and a threshold- Measure of Risk = Value at Risk (VaR), Tail Value at Risk

(TVaR),- Probability level = 1-in-100 Years (99.00%-ile), 1-in-150 Years

(99.33)- Threshold = loss (based on measure and probability) not greater

than x

Step 1: Choose Risk Tolerance MetricYear end net assets 18,394Single year loss to capital threshold 10%Return period for loss to capital 100

52Guy Carpenter

Capital Efficiency ExampleCost of Reinsurance Capital in 5 Steps

Step 2 – Using a DFA Tool (such as MetaRisk), create the distributions and identify the loss value associated with the chosen risk tolerance metric for each structure– Modeling full economic balance sheet (assets, credit risk etc.) will

produce more accurate result

Step 2: Identify Loss Value for Risk Tolerance MetricPre-tax underwriting loss for impacted Lines at 100 Year VaRNo non-marine surplus treaty 1,000With non-marine surplus 300

53Guy Carpenter

Capital Efficiency ExampleCost of Reinsurance Capital in 5 Steps

Step 3 – Equate the capital needed to support the stated risk tolerance for each structure– Loss value at the chosen risk tolerance metric divided by the

single year loss to capital threshold

Step 4 – Calculate the marginal capital “released” by the change in reinsurance– Difference between the capital needed for each alternative and

the and the baseline structure

Step 3: Equate Capital Need with Loss Value Pre-tax underwriting loss divided by single year loss thresholdNo non-marine surplus treaty 10,000 =1000 / 10%With non-marine surplus 3,000 =300 / 10%

Step 4: Calculated Marginal Capital "Released" 7,000 =10000-3000

54Guy Carpenter

Capital Efficiency ExampleCost of Reinsurance Capital in 5 Steps

Step 5 – Calculate the cost of marginal capital “released”– Accounting cost - difference in mean pre-tax income– Economic cost - expected value of the excess of additional ceded

premium (including reinstatements) over additional ceding commissions and additional loss recoveries

Discounted values

Step 5: Cost of Marginal Capital Released (Economic Basis)Mean ceded premium for non-marine surplus 1,200Mean ceded loss & ALAE and ceding commission 870Net cost 330 =1,200 - 870Cost of marginal capital released 4.71% =330 / 7,000

55Guy Carpenter

Economic Value Added Through ReinsuranceExtension of Example

EVA = (r – c) x K

EVA = Economic Value Added

r = Return on Capital = 16%

c = Cost of Capital = 4.71%

K = Capital released = $7M

EVA = (16% - 4.71%) x $7M = $790,000

56Guy Carpenter

Summary Thoughts

The benefit of establishing and managing risk tolerances has been reinforced by the financial crisis – Predictable earnings raises valuations– Solvency management protects capital for times when it is most

expensive to replenish

Risk tolerances are:– A foundational component of ERM and capital management– Actionable and implemented at the risk and enterprise level– Helpful for evaluating reinsurance purchases

Leveraging data quality, tools and technology no longer something on the horizon– Cat modeling, scenario tools, portfolio management, DFA,

economic scenarios etc.

57Guy Carpenter

Disclaimer for Presentation

The data and analysis provided by Guy Carpenter herein or in connection herewith are provided for the participants (the Participants) of the AIRC Seminar is “as is,” without warranty of any kind whether express or implied. The analysis is based upon data provided by or obtained from external sources, the accuracy of which has not been independently verified by Guy Carpenter. Neither Guy Carpenter, its affiliates nor their officers, directors, agents, modelers, or subcontractors (collectively, “Providers”) guarantee or warrant the correctness, completeness, currentness, merchantability, or fitness for a particular purpose of such data and analysis. The data and analysis are intended to be used solely for the purpose of the Seminar and Participants shall not disclose the work product to any third party, except its reinsurers, auditors, rating agencies and regulators, without Guy Carpenter’s prior written consent. In the event that Participants discloses the data and analysis or any portion thereof to any permissible third party, the Participants shall adopt the data and analysis as its own. In no event will any Provider be liable for loss of profits or any other indirect, special, incidental and/or consequential damage of any kind howsoever incurred or designated, arising from any use of the data and analysis provided herein or in connection herewith.

Statements or analysis concerning or incorporating tax, accounting or legal matters should be understood to be general observations or applications based solely on our experience as reinsurance brokers and risk consultants and may not be relied upon as tax, accounting or legal advice, which we are not authorized to provide. All such matters should be reviewed with the Participants own qualified advisors in these areas.