ERM and Economic Capital
Mike Lombardi FSA,FCIA,MAAA, CERA
Senior Vice President and Chief Actuary
RGA International Corporation
Toronto Canada
The Institute of Actuaries of Japan (IAJ)
March 2, 2010

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Agenda• ERM overview• Economic capital• Rating agencies’ perspectives• Highlights from Tillinghast ERM survey• ERM and the recent financial crisis• EC and reinsurance• EC and Japan• Conclusion

2

ERM Overview

3

Definition• What is ERM?
• “How an organization assesses, controls,exploits, finances and monitors risk fromall sources for the purpose of increasing
the organization’s value to stakeholders.”

4

Growing Interest• Why is ERM becoming so attractive?
• Recent corporate disasters• Increasing competition• Increasing exposure to market volatility• More complex business models• Growth of secondary market for transfer ofrisk

5

Growing Interest• Why is ERM becoming so attractive?
• More stringent regulatory environment• Emergence of better risk mitigation techniques• Global initiatives on risk management• Tangible results from early ERM adopters• Rating agencies incorporating ERM inassessments• Increasing demand from stakeholders inunderstanding insurance risks

6

Growing Interest• Another driver is dissatisfaction withhistorical ERM approach• Risk management was performed in silos• Focus was on satisfying regulatory
requirements• Different risks were “owned” by different
organizational units and managed
independently

7

Economic Capital8

Management is Dealing with Many
Complex Metrics
EconomicCapital

European
Embedded
Value

MarketConsistent
Embedded
Value

TargetCreditRatings

Statutory
Capital

KeyOperatingRatios

Value ofNew
BusinessBook
CapitalIFRS

InternalRate ofReturnGAAP

 Inconsistency

Solvency IICapital

RORAC/RAROC

Company
Leadership
Must
Overcome Confusion Information

ROEOverload9

The Complete Picture Supports
Better Business Decisions
ContingentPaid-Up

Committed Capital

Insurance Hedge

Senior Debt

Hybrid Capital

EquityRisk-Linked Securities

CapitalRisk
Transfer

RetainTransfer

10

Why EC Now?
•Multinational companies and large domestic companies haveadopted EC following European regulations requiring use ofEC metrics•Solvency II is having global impacts, including the subsidiariesof multinationals•EC has proven to be an effective device in measuring
appropriate capital needs and is being used by more and morecompanies•

Because it has proven effective, more and varied North
American firms are implementing and considering
implementing EC•

Rating agencies agree and are starting to incorporate EC
models in their view of insurance companies

11

The Risk/Capital Connection
From an economic perspective, risk and capitalmanagement work together• Capital management delivers the optimal capital
resources — both paid-up (equity, debt, preferred,hybrid) and contingent (line of credit, insurance,interest rate swaps, commodity hedge) — sufficient to:• Support the needs of a firm
• Cover the risk exposures that the firm faces• Risk management ensures the firm’s operational andfinancial exposures are controlled and supportable byits capital resources

12

The Risk/Capital Connection
Capital resources have two basic purposes:• Operational capital• used to produce goods and services such as
plant, equipment, patents, staff, inventory• Risk capital• used to support inherent volatility in operations
such as varying economic conditions,catastrophic events and uncertainties inrevenues and costs

13

EC Calculations Include All
Material Risks
Overall Risk Profile

Risk
Aggregation

MarketRisk

CreditRisk

 Interest Defaults

Rates

 Spreads

 Equities

 Counterparty

 Real Estate

Liquidity
Risk Asset/Liability

Insurance
Risk

Operational
Risk

 Mortality

 Distribution

Risk Lapses

 Systems

 Hedging Reserves

 People

Programs

14

Six Key Decisions to Make in
Building an EC Model
Period forAssessment

Definitionof Capital

Measureof Risk

Risks
to Include

Quantification
Methodology

Aggregation

123456

One Year

Statutory

Risk of Ruin

MarketStochastic
Modelling

Additiven Years

GAAPVAR

Credit

Run-Off ofPortfolio

Economic

TVAR
or CTE

InsuranceStressTesting

Variance/Covariance
Stochastic

Operational
Liquidity

FactorBased

Decisions drive EC approach and should reflect company objectives
15

Asking the Right Questions toDevelop Appropriate EC Models• For what purposes will EC be used?
• What risks will be reflected in EC?
• To what degree will the risks be integrated?
• What is the shape of the value distribution?
• How is the value distribution obtained?
• How will risk be attributed to transactions?

16What do Companies Require From an
Economic Capital System?
Business
Requirements

UseContinuous solvency
monitoring for rating andregulation



Fully reflect the business,structure and risks

Provide Economic Capital on astand alone, combined andfully allocated basis, at multiple
confidence levels and at
multiple levels of granularity

Economic profitability
measurement bybusiness and productPricing of existing andnew business

ALM and risk
management strategies
Strategic decision
making; Mergers andAcquisitions

Generate appropriate
management information foruse in all appropriate businessdecisions
Build upon the existing
actuarial systems
Include all insurance, banking
and fund managementbusiness on a consistent basis

Provide immediate updating
and what-if analysis



Be of a robust, enterprisestandard

TechnicalRequirementsAllow for all non-fungibility
constraints

Allow for the tax implications of
the groupReflect heavy-tailed
distributions and allow for tailcorrelation

Reflect the non-linearity andnon-separability of losses

Allow for and allocate
diversification benefitsAccept input from multiple
systems in multiple forms

Be flexible enough to allow forchanges in business mix, legal
structure and reporting
requirementsAllow distributed access17

Rating Agencies’ Perspectives

18

Rating Agencies’ View of EC
Have Changed•

Rating agencies are
increasingly considering
proprietary EC models
when assessing capital
adequacy•

Building economic
models into their rating
S&P
process during ERM
Developing“Quantum Risk”
reviews•

Expecting companies todemonstrate balance
between qualitative andquantitative ERM•

Linking capital adequacy
requirements directly toratings

Fitch
Introduced Proprietary
EC Model “Prism”

Evaluation
ApproachRatingAgency
Approaches
to EC

Moody’sConducts
Quantitativeand Qualitative
Analysis of EC

A.M. Best
Considers EC part ofERM

19

Tillinghast ERM Survey

20EC: The Core Metric Used in an ERM
Framework• 57% of respondents are alreadycalculating EC:• Companies in the U.K. (87%),
Bermuda (73%) and continental
Europe (70%) have embraced
calculating EC more than those inthe U.S. (44%) and Canada (37%).
Asia/Pacific (59%) lies between
these extremes• Almost 85% of large companies
and nearly 70% of medium-size
companies calculate EC, whereas
less than 40% of small companies
do so• Multiline insurers (67%) andreinsurers (79%) are more likely tocalculate EC compared to just over
50% of life and P/C companies

No, and we are not planningor considering

15%Yes28%

57%

No, but we areconsidering orplanning

Source: Tillinghast ERM survey

21While Many ERM Components are Largely
in Place, Significant Work is Required toMake Effective Use of Economic Capital• European respondents are more comfortable with their
EC calculation capabilities (71%) compared torespondents in North America (47%) and Asia/Pacific(49%)• Companies are significantly less comfortable withmanaging operational risk exposures compared toinsurance, credit and market risk exposures• Despite the ongoing credit crisis, most companies arefairly comfortable with their capabilities aroundmanagement of credit risk exposures

22

While Many ERM Components are Largely inPlace, Significant Work is Required to Make
Effective Use of Economic Capital

Appropriate capability fully in place

Reasonable capability in place; some gaps

Limited capability in place; significant work required

Capability not required

Base: Total Respondents for Q.3 How would you assess your current risk management capabilities in each of the following areas?
Please select one level of capability for each area.

23

Documentation of Risk Policies is More Extensive in
the Areas of Governance and Risk Control Compared to
EC and Risk-Based Decision Making
Overall risk management objectives

74%

Risk organization and governance structure

73%
64%

Risk monitoring and reporting processes
Risk limits (as applicable in day-to-day risk control)60%

Business continuity

60%
52%

Risk authorities and escalation procedures

50%

Risk appetite and tolerances
Risk-based decision-making processes: Reinsurance

44%

Risk-based decision-making processes: Pricing

43%

Risk-based decision-making processes: ALM

39%

Relationship of risk management objectives to corporate strategy

38%

Economic capital methodology and processes

37%

Capital management

37%
29%

Emerging risk management processes (identification, escalation, etc.)

27%

Risk-based decision-making processes: Capital Allocation
21%

Risk-based decision-making processes: Business Planning
Other
None of the above

4%
2%

Base: Total Respondents for Q.9 For which of the following do you have clearly documented risk policies? Please select all that apply.

24

Within 12 Months, 84% of Respondents Expect
to Have a Documented Risk Appetite/ToleranceStatement in Place

No, and no plans
to develop within
next 12 months• The development of risk
appetite/tolerance statements isless advanced among smaller
companies

16%

No, but
planned to
be in place
within next
12 months

47%
37%

Yes

In place

Plannedwithin 12months

Notplanned

Small

34%

44%

22%

MediumandLarge

57%

33%

10%

Base: Total Respondents for Q.11 Do you have a documented risk appetite/tolerance statement? Please select one response.

25

The Majority of Companies Have Risk Limits for TheirMajor Risks, but Only 23% Have Limits AroundOperational Risk
• In general, a higher percentage of European companies have set limits to govern risktaking than in North America. Asia/Pacific further lags North America in this respect• For example, credit risk: Europe 81% vs. North America 63% vs. Asia/Pacific 43%• In Asia/Pacific, 29% of respondents indicate that their companies have not set limits forany of these risks (Japan 47%)
Market risk

64%

Credit risk

65%Insurance risk

62%

Operational risk

None of the above

23%

13%

Base: Total respondents n=359 for Q.14 For which of the following types of risk have you set limits to govern day-to-day risk taking
within the business? Please select all that apply.

26

There is a Trend Toward Calculating EC
Over a One-Year Risk Horizon••

Use of a one-year horizon is most common:•In Europe (79%) and Asia/Pacific (75%) vs. North America (57%)•Among multiline insurers (78%) vs. life (70%) and P/C (62%)

Use of a two- to five-year period and of the runoff of the portfolio have, however,remained relatively stable since 2004:•

Use of a two- to five-year period occurs most among North America P/C insurers (38%)•Use of runoff of the portfolio occurs most among North America life insurers (31%)

2008

68%

2006

2004

13%

56%

32%

1 year12%

22%

2 to 5 years

14%

29%

Runoff of portfolio

14%

5%

15%

17%

Other

Base: Those companies that calculate EC n=206 for Q.19 Over what period do you assess risk in calculating EC? Please select one response.

27

Utilization of EC in Decision Making is Set to
Change Dramatically Over the Next Two Years
Capital adequacy assessment/capital management

21%

35%

44%

Asset/investment strategy (including hedging)

36%

32%

32%

Reinsurance purchasing

33%

33%

34%

Strategic planning and capital allocation

31%

47%

22%

Annual business planning

30%

44%

26%

Product design and pricing

28%

M&A and divestiture

15%

Performance measurement

17%

Incentive compensation 10%
Currently using

33%

39%
58%

27%

41%

42%
24%

Plan to use in next 24 months

66%
Do not use and have no future plans to use

Base: Total Respondents for Q.23 Do you currently use or plan to use Economic Capital in decision making for the following areas?
Please select one response for each area.

28

For Almost 80% of Respondents, Key Business Changes
Have Resulted From Their ERM Activities in the Past Two Years•In general, ERM programs have had greater influence in large companies than in smaller•

Particularly notable changes resulting from ERM programs have been:•For life companies, changes to asset strategy (43%)•For P/C companies, changes to reinsurance strategy (42%)•For reinsurers, changes to pricing (50%) and geographic spread (44%)
Change in risk strategy or appetite

36%

Change in asset strategy

35%

Change in reinsurance strategy

33%

Change in pricing for some or all products

31%

Change in product mix of the business23%

Change in design of some or all products (e.g., policy conditions, guarantee structures)

22%

Change in geographic spread of the business (e.g., entry/exit from some markets)

20%

Change in capitalization
OtherNone

17%
5%
22%

Base: Total Respondents for Q.25 Over the past two years, what key business changes have resulted from your ERM program? Pleaseselect all that apply.

29

ERM and the Recent
Financial Crisis

30

What Failed? ERM Concept OR Management?
•There have been weaknesses and some failures in theexecution of ERM• Modeling risk is high sensitivity to assumptions – BUT are theright assumptions used?
• Extreme tail is not fully appreciated - attitude of can’t possibly
happen• In some cases, risk managers recognized risk-related
deficiencies but were ignored by senior management• In ERM, corporate culture is everything, if senior management
doesn’t buy in, ERM is of little or no value• Risk management is more critical than ever
• ERM as a concept has not failed31

EC and Reinsurance

32

Reinsurance is Used Throughout theWorld to Manage Business Based on EC•

To define a company’s risk appetite and risk transferobjectives•

To reduce risk and volatility•

To provide a competitive alternative to debt or capitalfinancing•

Examples:• USA:
Financing redundant reserves (XXX termbusiness)• Canada: Supporting mortality improvement assumptions• UK:

Unlocking embedded value• Japan:Providing new business surplus relief33

EC and Japan34

While Interest in Managing Business Using EC
Concepts is Growing, Regulatory Changes May
Accelerate this Process• FSA is increasing solvency standards: target capital factors areincreasing in March 2012
• FSA has also announced the long term intention to move to EC• Implications?
• In Canada, EC was practiced by larger companies but wider
use of EC only emerged after strong push from regulator(OSFI)• Experience suggests that moving to an EC framework is asignificant commitment, perhaps companies in Japan
should begin making plans to implement EC now.
• One key area of EC focus would be ALM, where Japanese
insurance industry has not managed ALM risk very
effectively.

35

Conclusion

36

EC Will Grow in Importance, Increasingly
Becoming a Differentiator for Success inthe Marketplace• EC is growing in importance• The majority of large domestic and multinational
insurance companies are planning and implementing
EC• EC is a key metric within an ERM framework• EC is important to each company in today’s complex
environment• Rating agencies, as well, are increasing their focus onEC37

EC Will Grow in Importance, IncreasinglyBecoming a Differentiator for Success in
the Marketplace• EC represents a considerable undertaking• It requires analysis before and during implementation• Companies need to get started quickly while
maintaining a holistic approach to risk management• EC provides key ERM measurement data for• EC management• Leveraging throughout the enterprise in decision
making about pricing, acquisitions, hedging andmanaging tail risk38

Questions

39