A.M. Best s New Risk Management Standards

A.M. Best s New Risk Management Standards Stephanie Guethlein McElroy, A.M. Best Manager, Rating Criteria and Rating Relations Hubert Mueller, Towers Perrin, Principal March 24, 2008

Introduction A.M. Best (Best) issued enterprise risk management (ERM) criteria for insurers on 1/25/08 Insurance companies have a growing interest in ERM to: Respond to increased rating agency and investor scrutiny Optimize their capital allocation from a risk/reward perspective Insurers view their Best rating as critical, and their interest in ERM will grow given the rating and BCAR implications of Best s criteria 1

Discussion outline Highlights of A.M. Best s New ERM Methodology Comparison of A.M. Best's ERM Analysis vs. Principles-Based Solvency Regimes Impact on Company Ratings, BCAR and ERM Practices Rating Agencies Views on ERM Implementing ERM ERM in Action: Calculating Economic Capital (EC) using Stress Testing 2

Insurance industry continues to respond to risk dynamics Risk sources and complexity have increased over time Dynamic Financial Analysis ERM and Economic Capital Risk Cash Flow Testing Cash Flow Testing Asset-Liability Management Asset-Liability Management Traditional Risk Management Traditional Risk Management Time 3

What is risk management? Objectives of any prudent Risk Management system (including ERM): To manage exposure to potential earnings and capital volatility To maximize value to stakeholders Risk management is not risk avoidance Companies make money by prudently taking risks Need to get paid for the risk you are taking Goal is NOT to eliminate risk, but to understand it and manage it 4

Highlights of Best s ERM Methodology 5

Industry risk profile trends High A High Risk Profile Earnings and Capital Volatility Low Low Low Risk Profile Product Complexity A. Exposure to Earnings and Capital Volatility increasing, reflecting the impact of terrorism and CAT exposures on loss ratios and reinsurance costs; additional risk and costs related to more complex products; and general economic conditions B. Product Complexity increasing due to market demand for more sophisticated products and additional guarantees, as well as heightened competition and regulatory scrutiny B High 6

What s new about ERM is the E ERM is the process through which insurers identify, quantify and manage risk on an enterprise-wide, holistic basis ERM takes into consideration the individual risks at hand, as well as any correlations and interdependencies of risk across the entire organization Insurers that create a more structured, integrated risk framework and apply it prudently can Increase the value of the firm and Provide financial security to the organization 7

Key highlights Insurers need to adopt ERM practices appropriate for their risk profile The importance of ERM to a company s rating will vary based on an insurer s: Complexity Relative earnings and capital volatility Financial flexibility Traditional risk management strength Best expects complex companies to more fully adopt ERM and demonstrate usage of EC modeling in their decision making BCAR requirements will be closely linked to Best s opinion of a company s ERM strength and its volatility Relative volatility based on qualitative and quantitative factors An insurer s ERM strength will be based on Best s assessment of a company s ERM practices relative to its ERM evaluation 8

Traditional risk management defined Fundamental policies and procedures of identifying, quantifying and managing specific risks individually Little or no interaction/communication/alignment among risk managers Silo approach to risk management Five Categories of Risk Credit Market Underwriting Operational Strategic 9

Best s five major categories of risk Credit Market Underwriting Operational Strategic Default Downgrade Disputes Sovereign Settlement lag Concentration Equities Other assets Currency Concentration Basis Reinvestment Liquidity ALM Interest rate sensitivity Underwriting process Pricing Reserve development Product design Basis Frequency Severity Lapse Longevity Mortality and morbidity Monetary controls Financial reporting Legal controls Distribution IT systems Regulatory Training Turnover Data capture Competition Demographic/ social change Negative publicity Rating downgrade Customer demands Regulatory/ political capital Availability Technological Policyholder optionality Concentration Economic environment 10

Traditional risk management framework Senior Management E RM and EC Modeling Establish risk-aware culture, with proper alignment of management incentives Implement improved risk identification and management Develop sophisticated risk measurement tools Capital Management Traditional Risk Management Practices and Controls Best expects insurers to incorporate selected ERM elements in their traditional RM Framework, ultimately transitioning to fully developed Enterprise Risk Management 11

While one size does not fit all, Best expects all insurers to incorporate selected elements of ERM Common Elements Non-Complex Insurers Complex Insurers Foster risk-aware culture Identify, monitor and manage risk on a quantitative basis Consider the impact of risk correlations in business model Identify and manage new emerging risks Use internal economic capital (EC) models in decision making 12

Comparison of A.M. Best's ERM Analysis vs. Principles-Based Solvency Regimes 13

Best s Perspectives on Solvency II Promotes greater emphasis on risk management, sound controls and governance, and transparency at a time when the industry needs to focus on these issues Establishes an efficient, integrated platform for supervision of diverse insurance groups Embraces use of internal capital models within a two-tiered solvency approach Internal (economic) capital models if meet requirements Rules-based (static) model for all other insurers 14

Solvency II and Best s Process Common Themes Quantitative and qualitative solvency assessment Internal capital models will be given increasing weight in rating evaluation Independent review and/or certification of internal models and risk management process encouraged Increasing due diligence related to ERM Encouraging increased disclosure Expanding Influence Regulators are embracing principles-based solvency approach How will proposed two-tiered solvency requirements be viewed by smaller companies? Concerns include an unlevel playing field Currently Best is reviewing BCAR model, assessing future direction of model and how to incorporate internal models into overall rating evaluation 15

Impact on Company Ratings and BCAR Company meetings BCAR requirements Published ratings and reports 16

Impact #1: Company meetings Risk Management has always been a component of the qualitative review of each insurer, whether or not it was explicitly stated Evolving ERM questions have been added to data requests in recent years to reflect the importance of risk management Company preparation for A.M. Best meetings, the effectiveness of meeting presentations, additional data requests and company responses to Best s ERM questions can indicate the level of ERM within an organization Best s standards for making relative comparisons within its internal rating review process are expected to evolve Best does not provide an explicit ERM evaluation report to companies; however, elements of a company s ERM practices may be addressed in company reports or releases 17

Best s typical meeting agenda Executive Summary Strategic Business Review Financial Review Operational Review Catastrophe Risk Management Enterprise Risk Management (formalized in 2007) Best s Rating Feedback * Best s discussion of risk management practices and ERM may be interspersed throughout the meeting, or may be included in a separate, comprehensive ERM discussion. (Source: A.M. Best s Rating Methodology, January, 25, 2008). 18

Sample of A.M. Best ERM questions ERM Culture To what extent does your company engage in risk management? What is your company s risk appetite and how is it established? Describe ERM responsibilities as well as Board and senior management responsibilities ERM Identification and Management Are risks evaluated in an integrated framework? How does the company govern and control its top risk exposures? Identify your organization s largest risk scenarios How are they monitored/mitigated? How does the company handle risk in its infrastructure and systems? ERM Measurement of Risk How is risk quantified within the organization? What models/data are used? Does the company perform scenario testing? How are economic, geographic, regulatory, legislative and judicial risks handled? What capital modeling is performed? How is correlation contemplated among the top risks? 19

Impact #2: BCAR requirements Companies Without EC Output (Most of the U.S. Industry) Best is employing a carrot and stick approach, with its BCAR requirements more closely linked to a company s relative ERM strength and volatility An insurer with strong ERM and low volatility can operate closer to the BCAR guideline for its rating level An insurer with weak ERM and high volatility needs to maintain capital that is several notches above Best s BCAR guidelines Companies With EC Output Best is encouraging leading edge insurers to share their EC output Companies with strong ERM and EC modeling capabilities may have capital requirements that fall below Best s BCAR guidelines, provided the EC output is: Used by management in strategic decision-making Produced by an EC model that Best views as robust 20

Best s traditional BCAR approach Stronger RM = Lower BCAR Requirement to start Weaker RM = Higher BCAR Requirement to start PLUS a steeper slope as volatility increases Weak Risk Management BCAR Strong Risk Management BCAR Guidelines Low High Exposure to Earnings and Capital Volatility 21

Best s revised BCAR approach Best will consider allowing insurers to maintain lower BCAR levels relative to the guideline for its rating if they demonstrate: Superior traditional risk management fundamentals Superior capital management and financial flexibility Strong ERM characteristics Strong EC modeling capabilities Weak Risk Management BCAR Strong Risk Management BCAR Guidelines Low High Exposure to Earnings and Capital Volatility 22

Impact #3: Published ratings and reports Highly rated insurers without superior ERM and strong EC capabilities could face ratings pressure over time Separate ERM opinions are not expected to be published In the near term, rating rationales and press releases will likely provide insight as to Best s view of a company s relative ERM strength ERM commentary will appear in Best s Insurance Reports over time 23

Rating Agencies Views on ERM 24

Rating agencies views of capital adequacy and ERM have evolved recently Considering proprietary models when assessing capital adequacy Building economic capital (EC) models into their rating process Expecting balance between qualitative and quantitative ERM Linking capital adequacy requirements directly to ratings Excellent capital adequacy and stable outlook reported S&P Developing Quantum Risk evaluation approach Fitch Introduced proprietary EC model Prism Rating agency approaches to EC A.M. Best Considers EC part of ERM framework Moody s Conducts quantitative and qualitative analysis of EC 25

Key takeaways from A.M. Best s views on ERM ERM framework needs to include an enterprise-wide view and process on the identification, quantification and management of risks on a holistic basis ERM framework should include development of an EC model, at least for large insurers Risk management capabilities are a key factor in determining BCAR capital requirement A.M. Best will consider allowing companies to have lower BCAR levels for a given rating, but they must exhibit strong ERM A.M. Best will expand use of company-provided capital models in developing capital requirements with rating evaluation process 26

Standard & Poor s (S&P): A strategic view of insurance company ERM S&P Emphasizes Strategic Enterprise Risk Management Risk-based capital Adopted in the 1990s/updated in 2007 Enhanced capital modeling Relying more on EC for analytical purposes Capital formula S&P considers a company s total adjusted capital and compares with estimated target capital Company-specific Modeling and measurement of risk must be specific to the company to support its retained risks EC is evaluated as part of ERM assessment/rating Strong or Excellent ERM rating required for a ratings upgrade and/or partial recognition of EC model Vast majority of companies receive an Adequate ERM rating Weak ERM rating may result in Credit Watch More emphasis on EC is expected during 2008 27

S&P: ERM quality classifications Excellent Strong Adequate Weak Advanced capabilities to identify, measure, manage all risk exposures within tolerances Advanced implementation, development and execution of ERM parameters Consistently optimizes risk-adjusted returns throughout the organization Clear vision of risk tolerance and overall risk profile Risk control exceeds adequate for most major risks Has robust processes to identify and prepare for emerging risks Incorporates risk management and decision making to optimize riskadjusted returns Has fully functioning control systems in place for all of their major risks May lack a robust process for identifying and preparing for emerging risks Performing good, classical, silo-based risk management Process to optimize risk-adjusted returns not fully developed Incomplete control process for one or more major risks Inconsistent or limited capabilities to identify, measure or manage major risk exposures Source: Standard & Poor s. 28

As of year-end 2007, only 13% of insurers had received strong or excellent ERM ratings from S&P Overall ERM Evaluation (207 Insurers All Sectors) Weak 3% Excellent 5% Strong 8% 84% Adequate Source: Standard & Poor s (January 2008). 29

Fitch Ratings: Proprietary EC model Prism is Fitch s New EC Model First released in June 2006 Global and fully stochastic captures risks, recognizing diversifications and concentrations Uses real-world runoff methodology Available for life, health and non-life, introducing Prism first in the U.S., U.K., Germany and France Works with companies models and considers overall risk management Provides partial credit for hedging In November 2007, Fitch released a report on the EC capital adequacy of 99 U.S. insurers (life/non-life) 30

Moody s: Holistic View of Risk Management Moody s view of risk management is based on four pillars 1. Risk governance 2. Risk mitigation 3. Risk measurement 4. Risk infrastructure and intelligence Ratings connect amount of capital on balance sheet with ERM Converging regulatory and economic views of capital adequacy Calculating EC focuses on areas to be included in modeling Emerging risks, asset liability, mismatches, operational risk EC modeling provides: Understanding of an effective risk management framework Common risk language across the firm View of relationships and tradeoffs between different risks 31

Implementing ERM 32

ERM has come a long way Risk Owner Chief Executive and Board ERM Chief Financial Officer DFA Chief Actuary CFT Product Actuary ALM Product Risks Business Line Risks Breadth of Risk Business Entity Risks All Risks 1950s 1980s 1990s 2000s 33

Five key principles for implementing ERM ERM serves strategic purpose not for audit ERM generates economic value ERM is focused on managing risks in an integrated manner, as a portfolio of risks ERM considers both downside risks and upside opportunities ERM is best operationalized by making it part of the normal business process 34

Ultimately, ERM works best when integrated into the decision-making processes and overall company strategy Impact of Risk-Management Decisions ERM Analysis Business Plan Insurable Risks Mortality Property/Casualty Human Resources Market Risks Interest rate Equity markets Foreign exchange Other Assets Current Assets Fixed Assets Expenses Costs Taxes Liabilities Current Liabilities Long-Term Liabilities Equity Revenues Operating Income Credit Risks Net Income Other Income Operational Risks Business Risks Business interruption Corporate image, brands Economic cycles Cash Flow Begin End Operation Operation Investment Investment Financing Financing 35

Successful companies are able to maximize value by relating a firm s decisions on the risks they take to decisions on the capital they use Towers Perrin s ERM Risk-Value Framework THEORY Portfolio of Enterprise Risks Operating the Business Financing the Business Return on Risk IN EXCESS OF Capital Costs PRACTICE PRACTICE Operating income less expenses MINUS Costs of equity, debt, insurance Economic Value THEORY Portfolio of Capital Resources ERM helps you find better ways to operate and finance your business 36

ERM links risk strategy to the organization and processes that drive decision making ERM Framework Governance Organization Strategy Accountability: Roles and responsibilities Risk definition Goals and objectives Risk tolerance levels and guidelines Identify Quantify Solve Execute Process Tools Monitoring and Reporting 37

Implementing ERM: A four-stage process at any level of the firm EC as a Key Metric for Quantifying Risk Identify Quantify Solve Execute What are my risks? Who is watching them? How much do they weigh? What is their impact? What can we do about them? How do we decide? How do I take action? What value does it create? 38

Best practices Successful ERM implementation requires participation by the Board and C-level executives (Culture) Includes the development of an effective ERM policy (Governance) Implementation of EC as a key metric for quantifying risk (Risk Measurement) Implementation of an effective ERM dashboard (Reporting) Integration of ERM and business strategy (Implementation) 39

Key findings from the Towers Perrin and Economist Intelligence Unit Risk and Opportunity Study Senior insurance industry managers were optimistic and confident at the time of our study (3Q07), just before the credit crisis and other economic issues started to emerge Top risks and opportunities share many similarities with our crossindustry results, but value of equities and credit quality are key differences Life and P/C companies have different perspectives on risks and opportunities risk appetite of P/C companies is higher than that of Life companies Insurance companies competing on product innovation are the most risk aggressive; those competing on customer service and product quality are the least aggressive ERM excellence tempers risk appetite and the potential for overconfidence in managing risks and opportunities 40

ERM in Action: Calculating EC Using Stress Testing 41

Calculating EC using stress testing requires some key decisions Decision 1: Period for Assessment Decision 2: Definition of Capital Decision 3: Measure of Risk Decision 4: Risks to Include Decision 5: Quantification Methodology Decision 6: Aggregation One year n years Run-off of portfolio Statutory GAAP Economic Risk of ruin VAR TVaR or CTE Market Credit Insurance Operational Liquidity Stochastic Modeling Stress Testing Factorbased Additive Variance/ Covariance Stochastic Implemented by a majority of multinational insurers and adopted/ proposed for: UK ICA regime, Swiss Solvency Test, EU Solvency II 42

Calculating EC via stress testing: Four stages to implementing the Towers Perrin FastTrack EC approach Step 1 Develop an economic view of the business Economic assessment of assets and liabilities Step 2 Identify key risks and determine levels of stress to be applied Stress events to quantify key risks Step 3 Apply stresses to the economic balance sheet EC requirement for each key risk Step 4 Aggregate individual risk capital results, allowing for correlation effects Total EC requirement for your business 43

By combining models, insurance companies are able to measure diversification benefits Enterprise Diversification Benefit Economic Capital Sum of P/C Segments Sum of Life/Health Segments P/C diversification effect Life/Health diversification effect Aggregated P/C Business Aggregated Life/Health Business Cross-sector diversification effect Aggregated Total 44

Sample EC Results: Market and credit risk typically dominate EC Concentrated EC Diversified Insurance Risk Operational Risk Market Risk Operational Risk Market Risk Credit Risk Insurance Risk Credit Risk Source: Tillinghast Client Studies. 45

Questions and Answers Stephanie Guethlein McElroy Manager, Rating Relations and Rating Criteria A.M. Best Company Ambest Road Oldwick, NJ 08858 Telephone: 1-908-439-2200 ext. 5128 Fax: 1-908-439-3077 E-mail: stephanie.mcelroy@ambest.com Web: www.ambest.com Hubert Mueller, FSA CERA MAAA Principal Towers Perrin 175 Powder Forest Drive Weatogue, CT 06089-9658 Telephone: 1-860-843-7079 Fax: 1-860-843-7001 E-mail: hubert.mueller@towersperrin.com Web: www.towersperrin.com 46