Enterprise Risk Management Perspectives
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1 Enterprise Risk Management Perspectives Enterprise Risk Management Symposium Chicago, Illinois March 30, 2007 Joan Lamm Tennant, PhD Gen Re Capital Consultants
2 Enterprise Risk Management: Perspectives Experiential Perspective: Consultant to U.S. Property-Casualty Insurer Director of a Publicly-Traded Property-Casualty Insurer Financial Economist
3 Perspective: Consultant Role of ERM in Building a Sustainable Competitive Advantage GRCC began in 1997 Initially to assist Gen Re Evaluate tradeoffs between credit risk in fixed income portfolio versus equity market risk from an enterprise perspective Developed technological platform Gross, Ceded, Net Within a few years, evolved as a consulting practice Key motivation strengthen risk discipline of cedants GRCC continues to work with property-casualty insurers Assimilate behaviorally to managing risk from an enterprise perspective Develop empirical capabilities Apply mindset and empirics to strategic choices, both strategic and tactical
4 Perspective: Consultant Where is the Industry? Most are on the ERM Journey The Investment Behaviorally, becoming aware of Enterprise Risk Broadly identifying, prioritizing and assessing risk Developing empirical capabilities Capitalizing on the Investment Linking enterprise-wide risk metrics to corporate risk appetite and economic capital Using enterprise risk metrics to frame and evaluate both strategic and tactical alternatives
5 Perspective: Consultant How might ERM drive change in the industry? Strengthen Strategic and Tactical Decision Processes Rating Agencies Allow management the opportunity to be proactive advocates of their risk position and economic capital Corporate Governance Drive transparency on issues of risk-to-capital Create a risk partnership with governors Risk Products May accelerate the convergence of insurance and capital markets
6 Perspective: Director Role of ERM In Corporate Governance Goal of Corporate Governance Reform The ultimate goal of governance reform is the belief that a strong Board with independent voices, knowledge of the business risk and drivers, and willingness to challenge management can effectively perform its oversight role, protecting the interests of owners, and promoting the longterm health of the company. Characteristics of good Corporate Governors Independence Knowledge of the business risk and drivers Willingness to challenge management
7 Perspective: Director Corporate Governors Approve of Risk Tolerance Guidelines and Maintain Adherence Value Created Risk Balance Sheet Business Plan Economic Capital Risk Tolerance
8 Perspective: Director Selective: Involving The Board In Business Risk Enterprise Project Management Office (EPMO) EPMO established in 2000 Collaborative broad-based decision making body of the organization Measures strategic fit and alignment with goals Allocates capital to projects Eliminates project scope creep through controlled requirements process Project Methodology with risk focus Risk identification and mitigation built into project templates Ownership of risks identified at executive level (sponsor), senior management level (acceptor) and project management level (manager) Risk management on large projects is built into Annual Cash Incentive Program (ACIP) goals as compensation incentives
9 Perspective: Director Selective: Involving The Board In Business Risk Critical Capital Decisions Requiring Board s Involvement as Risk Partners Knowledge Management Reinsurance Share Repurchase
10 Perspective: Director Elements of Financial Strength Proactive Capital Management Earnings Returned to Shareholders ($ in Millions) % % 37.7% 25.2% 26.0% 18.9% % 75% 50% 25% 0% Annual Earnings Share Repurchase % Earnings Returned Dividends paid
11 Perspective: Director Long Term Shareholder Value $20 Book Value Dividends $0.35 $0.40 $0.44 $15 $0.30 $0.31 $17.34 $18.81 $15.79 $10 $13.74 $12.26 $5 $ % CAGR
12 Perspective: Financial Economist Why Manage Risk? Rating Agencies Regulatory Requirements Actually, good business discipline that will Design successful business plans Better align management Transparency and awareness with Boards More efficient use of capital Avoid crowding out investment opportunities
13 DANGER OF ALLOCATING ALL CAPITAL Adding a New Division DIVISION A + B EXPECTE D LIABILITIE S 200 CASH FLOW 16 CAPITAL CONSTANT DEFAULT 100 ROE 16% C A+B+C % Cost of Capital = 12.5%
14 DANGER OF ALLOCATING ALL CAPITAL Adding a New Division ALLOCATE ALL CAPITAL DIVISIONS IDENTICAL IN RISK AND CORRELATIONS - ALL WOULD HAVE SIMILAR CAPITAL ALLOCATIONS OF 125/3 = EACH CAPITAL ALLOCATED TO C CASH FLOW 4 ROE 9.6% Decision Reject (9.6% < 12.5%) MERTON PEROLD MARGINAL CAPITAL OF C IS 25 ( ) CAPITAL ALLOCATED TO C CASH FLOW 4 ROE 16% > 12.5 ACCEPT Decision Accept (16% < 12.5%)
15 The ERM Journey Identify Risk Strengthen Risk Culture Measure Risk Link Risk to Capital Execute Strategic Decisions
16 Enterprise Risk Management Perspectives CAS / SOA / PRMIA Enterprise Risk Management Symposium March 28-30, 2007 Shyam Venkat PricewaterhouseCoopers LLP
17 Panel Members Bev Margolian, Chief Risk Officer, Manufacturers Life Insurance Company Dr. Joan Lamm-Tennant, Practice Leader Gen Re CC and Wharton Executive Education Moderator: Shyam Venkat, Partner, PricewaterhouseCoopers Slide 2
18 Enterprise Risk Management (ERM) has become an important part of major insurers corporate risk management culture Ratings agencies have contributed to the acceleration of this trend - Separate assessment of enterprise risk management capabilities as part of overall rating agency evaluation - Economic capital model/diversification benefit as distinct considerations - Desire for no surprises culture and to see breakdown of silos for more holistic view Implementation of ERM practices allows the firm to proactively assess and manage its risk profile and capital needs, leading to value creation and competitive advantage - Overall risk process and control evaluation, monitoring, and impact assessment - Quantification of exposures by risk type - Risk-based capital measurement, allocation, and strategic risk management Slide 3
19 Implementation of ERM tools facilitates refinement of business strategy and execution Embedding risk management into combined business processes Business Cycle Strategy Definition Budget / Plan Business Execution Control Performance Evaluation Validate / Refine Strategy ERM Components CAPITAL LIMITS POLICY PROCEDURES REPORTING ANALYSIS Re-allocate Capital / Limits Management Challenges Explicit integration of risk in strategic plans Set risk appetite and ensure its consistency with strategy Integrate financial and risk-capital planning Allocate capital to business units and risk activities Manage key risk indicators related to meeting performance targets Enterprise risk management policy standards and controls including consistent limit structure Consistent risk measures and aggregation Aggregated enterprise risk/performance reports External reporting Risk and performance data infrastructure Slide 4
20 Banks have evolved broader risk management activities differently than insurance companies as driven by several factors Near-death experiences suffered by banks during the late 80s and early 90s; not so in insurance (yet) More cohesive banking regulatory regime with a concerted safety & soundness push; insurers must contend with multiple regulations at the state level in the U.S. Banks impacted more by the immediacy of the mark-to-market discipline; similar practices have been slower to take hold within insurance companies Slide 5
21 Insurance and banking industries sharing similar opinions regarding ERM overall, based upon recent survey results across both industries PwC / Economist Intelligence Unit briefing Creating value: Effective risk management in financial services, March 2007 Timing differences - banking industry further ahead on adoption curve No discernable geographic differences Slide 6
22 Banking and insurance sectors share similar activities within their risk management functions. Insurance Banking Instilling a culture of risk awareness throughout the organization 42% 47% Measuring and monitoring risk 39% 43% Enabling line-of-business managers to make better business decisions 26% 33% Identifying new and emerging risks 30% 46% Communicating key risks to the executive team 23% 41% Source: PwC and Economist Intelligence Unit, March % 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% Slide 7
23 Both banks and insurance companies believe their risk management functions add more value than they did three years ago No more value, 8% Don't know, 5% Substantially less value, 2% Slightly less value, 0% Insurance No more value, 17% Don't know, 7% Substantially less value, 0% Slightly less value, 0% Banking Substantially more value, 46% Substantially more value, 47% Slightly more value, 39% Slightly more value, 30% Source: PwC and Economist Intelligence Unit, March 2007 Slide 8
24 Banks and insurance companies reap similar benefits from risk management Insurance Banking We have a better relationship with regulators 64% 70% We have a better reputation with analysts and rating agencies 47% 50% We are able to improve returns relative to the risks taken 43% 45% We have better and timelier data on our internal performance 40% 47% 0% 10% 20% 30% 40% 50% 60% 70% 80% Source: PwC and Economist Intelligence Unit, March 2007 Slide 9
25 Banks and insurance companies have different views on the risks that pose the greatest potential threat to their market value Insurance Banking Regulatory Risk 38% 63% Business/ Strategic Risk 47% 63% Market Risk 52% 60% Reputational Risk Operational Risk 45% 51% 53% 57% Credit Risk 50% 73% 0% 10% 20% 30% 40% 50% 60% 70% 80% Source: PwC and Economist Intelligence Unit, March 2007 Slide 10
26 Regulatory pressure is perceived to be the most significant driver of change for banks and insurance companies risk management programs Insurance Banking Regulatory pressures 43% 66% Increased focus on risk management on the part of senior management and the Board 33% 34% Aim of increasing value of risk management to the business 30% 31% Source: PwC and Economist Intelligence Unit, March % 10% 20% 30% 40% 50% 60% 70% Slide 11
27 Effective ERM underpins the calculation of economic capital, which helps company boards and management to balance diverse interests of internal and external stakeholders Internal Views Business Units Emphasis on business opportunities Pressure to grow revenue Growth External Views Value Creation Capital Productivity Risk vs. Reward Shareholders/ Investors Focus on stock price performance Pressure to maximize value creation Expect attractive returns on capital Returns Economic Capital Risk Management Risk Emphasis on control of earnings volatility and sustainability Focus on risk levels, profile and trends Financial Strength Capital Adequacy Risk vs. Capital Capital Debt holders / Policyholders Rating Agencies / Regulators Emphasis on capital structure Minimize risk of default Sound risk management practices Slide 12
28 Banks, life insurance companies, and P&C insurance companies allocate different levels of capital to different types of risk Capital Allocation 100% Operational Risk Credit Risk Insurance Risk Market Risk 90% 80% 70% 30% 55% 44% 46% 44% 60% 50% 40% 30% 20% 10% 0% 49% 23% 21% 20% 4% 42% 17% 25% 31% 13% 10% 12% 12% Banks Life P&C Diversified Insurance Financial Conglomerates *Source: PwC analysis using externally available investor reporting data and PwC industry studies. Slide 13
29 Although Economic Capital is starting to be widely used by insurance companies, banks are ahead in the implementation of the concept and in the extraction of its benefits Insurance Banking Companies Using / Allocating Economic Capital 64% 82% Incorporated Economic Capital in Risk-Based Pricing 61% 73% Use Economic Capital in Rating Agency Discussions 45% 54% Incorporated Economic Capital in Performance Measurement 35% 82% Source: PwC and Economist Intelligence Unit, March % 10% 20% 30% 40% 50% 60% 70% 80% 90% Slide 14
30 Banks confirmed the effectiveness of risk-based capital measures in greater numbers than insurance companies Insurance Banking Satisfying Regulatory Requirements (e.g., capital adequacy) Greater understanding of risk on part of business units More efficient allocation of capital to lines of business Greater profitability for individual lines of business Clearer reporting and disclosure to shareholders More appropriate pricing levels 40% 40% 68% 52% 65% 52% 61% 48% 57% 52% 46% 76% More appropriate remuneration packages for senior executives 24% 29% 0% 10% 20% 30% 40% 50% 60% 70% 80% Source: PwC and Economist Intelligence Unit, March 2007 Slide 15
31 Of the top 50 banks, ~70% use Economic Capital and ~50% disclose results DISCLOSURES NORTH AMERICA EUROPE Usage of EC Yes No JAPAN / AUSTRALIA 16 TOTAL 34 Capital Allocated to BU EC RWA None EC results by BU Annually Quarterly EC by risk type Number of Companies Source: PwC analysis Slide 16
32 The economic capital-related disclosures by financial institutions suggest some interesting shifts in riskadjusted performance and allocated capital ROEC 35% 30% Commercial Banking Net Income 2002 Net Income 2003 Net Income 2004 Net Income 2005 Consumer Banking 25% 20% 15% 10% Investment Management Wholesale Banking 5% Total ROEC 16% 23% 25% 26% SVA $13.6B. $41B. $60B. $79B. 0% 5% 15% 25% 35% 45% Economic Capital as % of Total Economic Capital Source: PwC analysis Slide 17
33 Analysis of Economic Capital disclosures suggests less active management of capital levels and their link to credit ratings Top 50 Banks Disclosures 14% 12% 10% 8% 6% 4% 2% EC as % of RWA Tier 1 Ratio TOTAL RC 0% AA AA- A+ A A- North America Source: PwC analysis Non-North America Slide 18
34 As a result of these disclosures, some interesting benchmarking possibilities can be performed Economic Capital vs. Tier-1 Capital 16% 14% 12% 10% 8% 6% 4% 3.8% 3.1% 2.7% 4.2% 4.4% 3.3% 4.9% 2.7% 3.3% 3.8% 3.6% 3.4% 3.6% 2.7% 2% 2.6%3.1% 1.6% 1.6% 0% Bank 1 Bank 2 Bank 3 Bank 4 Bank 5 Average Excess Total Capital EC/RWA Tier 1 Mgmt Target Source: PwC analysis Slide 19
35 Investors currently attach greater significance to the more transparent and traditional measure of return on book equity rather than to return on economic capital 20% 15% Accounting View Price to Book, proportional to Shareholder Value Added TTM R 2 = % 40% Economic View Price to Book, proportional to Shareholder Value Added TTM R 2 = Equity Spread (ROE - Cost of Equity) 10% 5% 0% Equity Spread (ROEC - Cost of Equity) 30% 20% 10% 0% -5% -10% -10% Price-to-Book (December 2004) -20% Price-to-Book (December 2004) Source: PwC analysis Slide 20
36 Insurance companies have encountered some challenges in their implementations of ERM Not leveraging and integrating existing ERM practices already in place Risk management not aligned with business drivers, objectives, and stakeholders Lack of integration of ERM program with internal strategic and operational planning Lack of dedication of sufficient and appropriately credentialed resources Lack of appreciation that successful ERM implementations can be long term projects to embed risk structure and thinking into the organization, not a quick fix. Focusing too heavily on ERM processes and technology without an understanding of the basic principles Lack of budget commitments Lack of sponsorship from senior management Slide 21
37 In 2007 and beyond, insurance companies will continue to pursue implementation of ERM best practices with emphasis on certain key areas Alignment of risk appetite and performance Continued improvement of technology capability and data quality Enhancements of risk-based capital models to include more risk types Enhancement of disclosures Slide 22
38 2007 PricewaterhouseCoopers LLP. All rights reserved. "PricewaterhouseCoopers" refers to PricewaterhouseCoopers LLP (a Delaware limited liability partnership) or, as the context requires, other member firms of PricewaterhouseCoopers International Ltd., each of which is a separate and independent legal entity. *connectedthinking is a trademark of PricewaterhouseCoopers LLP.
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