Deloitte & Touche

Risk-Adjusted Capital Management

CAS/SOA ERM Symposium

July 30, 2003

Sim Segal, FSA, MAAA

Senior Manager

Deloitte & Touche

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Agenda

What is capital management?

The capital management process and its evolution

Practical application of capital management

Keys to success

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Capital has two components

Capital is wealth . . .

. . . ”used” or ”available for use” . . .

. . . in the production of more wealth.

American Heritage Dictionary

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Assets

Total Capital = Required + Available

UsedRequired capital

Available capital

Total capital

Liabilities

Available for use

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Capital management is managing both required and available capital

Required capital management

Available capital management

Maintain available capital at optimal level, balancing:

a) Future growth needs

b) Drag on returns

c) Capital flexibility

Maximize risk-based capital performance measure, within

constraints

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Capital management is managing both required and available capital

Required capital management

Maximize risk-based capital performance measure, within

constraints

Maintain available capital at optimal level, balancing:

a) Future growth needs

b) Drag on returns

c) Capital flexibility

Focus of today’sdiscussion

Available capital management

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Agenda

What is capital management?

The capital management process and its evolution

Practical application of capital management

Keys to success

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The Capital management process has five steps

1. Define required capital

2. Allocate required capital

3. Select a capital measure to evaluate performance

4. Set a hurdle rate

5. Maximize capital measure, within constraints

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Capital management has evolved in the insurance industry

1. Required Capital 2. Capital Allocation 3. Capital Measure 4. Hurdle Rate

Zero (ignored in pricing)

Multiple of RBC (Statutory)

Multiple of RBC plus accounting adjustments (GAAP, but Stat-based)

Value-at-Risk (VaR) (GAAP)

Company level

Segment level

Line of business or product line level

Policy level

Customer level

Producer level

Internal Rate of Return (IRR)

Return on Investment (ROI)

Return on Equity (ROE)

Return on Capital (ROC)

Benchmark

Long-Term Weighted Average Cost of Capital

(WACC)

WACC based on dynamic risk-free rate

WACC based on dynamic risk-free rate

anddynamic risk premium

Embedded Value (EV) or Fair Value (FV)

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Agenda

What is capital management?

The capital management process and its evolution

Practical application of capital management

Keys to success

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Example: Public Multiline Financial, Inc.

Step 1: Define required capital

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Downgrade by rating agency

Action by state insurance

departmentEconomic ruin

Loss of competitive standing ?

??

?

?

??

Required capital is risk-based . . . but what risk is being addressed?

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Required capital addresses multiple risks related to disparate constituencies

Regulatory Capital

Rating Agency Capital

Benchmark Capital

Economic CapitalTotal Required Capital

To avoid regulatory action

To maintain current debt or financial strength ratings

To maintain a given probability of avoiding ruin

To match the capital level of a key competitor

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Example: Public Multiline Financial, Inc.

Step 1: Define required capital

Required capital is Value-at-Risk (VaR), using a one-year time horizon and a 99.9% confidence level

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Loss Rate

Pro

bab

ilit

y

Confidence Level

95%95% 99%99% 99.9%99.9%

IllustrativeIllustrative

Value-at-Risk (VaR) is based on a stochastic analysis of economic ruin

Value-at-Risk Capital

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Example: Public Multiline Financial, Inc.

Step 1: Define required capital

Step 2: Allocate capital

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Allocating capital further down in the organization facilitates more decision-making

Strategic decisions, e.g.:Growth

Market exit

Tactical decisions, e.g.:Pricing

Mix of product portfolio

Transactional decisions, e.g.:Retention efforts

Cross-selling

Producer compensation decisions

Policy

Product

Policy Policy. . .

Product Product. . .

Policy

Segment Segment Segment. . .

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Example: Public Multiline Financial, Inc.

Step 1: Define required capital

Step 2: Allocate capital

Capital is allocated down to the product level

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Example: Public Multiline Financial, Inc.

Step 1: Define required capital

Step 2: Allocate capital

Step 3: Select a capital measure to evaluate performance

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Each capital measure offers a unique focus

ROI emphasizes rate of return

ROE measures efficiency of usage of equity capital

ROC illustrates the ability to generate earnings per dollar of total capital

EV quantifies the dollar contribution to shareholder value

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Case study: ROE-based compensation has disadvantages vs. EV-based compensation

Hurdle rate = 15%

Situation ROE-based* plan EV-based plan

Value is created:

Management in a 20% ROE line of business decides to add a 16% ROE project

Penalized Rewarded

Value is destroyed:

Management grows a 12% ROE business

Rewarded Penalized

* Compensation plan based on ROE and earnings

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Example: Public Multiline Financial, Inc.

Step 1: Define required capital

Step 2: Allocate capital

Step 3: Select a capital measure to evaluate performance

Capital measure is Embedded Value (EV)

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Embedded Value (EV)

Value of surplus

Value of inforce business

Discounted value of distributable earnings from inforce business*

Distributable surplus

* Includes target surplus

Embedded Value (EV) is a function of distributable earnings / surplus from inforce

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-3

-2

-1

0

1

2

3

4

0 1 2 3 4 5 6 7 8 9 10

Adjusted statutory net income *

Target surplus released (consumed)

* Adjusted to replace investment income on surplus with investment income on target surplus

Distributable earnings reflects changes in total surplus and target surplus

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Example: Public Multiline Financial, Inc.

Step 1: Define required capital

Step 2: Allocate capital

Step 3: Select a capital measure to evaluate performance

Step 4: Set a hurdle rate

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The hurdle rate is management’s estimate of its risk-return position on the efficient frontier

Return

Risk

Rf

m

Rm

?

?

0

XX

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Hurdle rate setting methods involve tradeoffs between simplicity, accuracy and stability

Method Simplicity Accuracy Stability of Measure

Benchmarking Easiest Poor Poor

Long-term weighted average cost of capital (WACC)

Moderately complex

Moderate Fair

WACC based on dynamic risk-free rates

Moderately complex

High Good

WACC based on dynamic risk-free rates and dynamic risk premium

Most complex

Highest Best

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Example: Public Multiline Financial, Inc.

Step 1: Define required capital

Step 2: Allocate capital

Step 3: Select a capital measure to evaluate performance

Step 4: Set a hurdle rate

Hurdle rate is WACC based on dynamic risk-free rates, with uniform hurdle rates throughout the enterprise

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Example: Public Multiline Financial, Inc.

Step 1: Define required capital

Step 2: Allocate capital

Step 3: Select a capital measure to evaluate performance

Step 4: Set a hurdle rate

Step 5: Maximize capital measure, within constraints

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Dynamic modeling clarifies potential impact of projects on embedded value (EV)

($millions)

Product EV EVLine Investment Mortality Expense Lapse Baseline Chg

A -2% 245.3 2.5 B 0.10% -1% -5% -2% 174.9 5.6 C -5% 5% 60.2 (0.6) D -10% 28.0 0.8

Total LOB 508.4 8.3

Projected Change in Assumptions

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Constraint of maintaining the RBC ratio is more complex when using Value-at-Risk (VaR)

Required capital (VaRC)

1.0 B

Available capital

0.3 B

Required capital (200% RBC)

1.2 B

Available capital

0.1 B

Statutory

GAAP

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Summary: practical applications of capital management

Strategic:

Manage stock analysts, e.g., reveal under-valued businesses

Strategic planning, e.g., project capital needs, quantify impact on capital ratios

Risk management, e.g., estimate probability of ruin and impact on stock price

Tactical:

Funding decisions, e.g., identify stock repurchase opportunities

Risk-return tradeoff decisions

Identifying highest value-added projects

Asset-liability management (ALM)

Provide incentive compensation aligned with increasing value

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Agenda

What is capital management?

The capital management process and its evolution

Practical application of capital management

Keys to success

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Keys to success

Define required capital with deference to all key constituencies

Allocate capital as far down in the organization as possible

Select a capital measure that aligns with your goals

Align incentive compensation with the capital measure

Avoid fallacy of the “correct” hurdle rate

Manage constraints carefully while maximizing capital measure

Employ a disciplined process to setting or changing assumptions

Provide management with the tools to understand the impact of decisions on the capital measure

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Deloitte & Touche

CAS/SOA ERM Symposium

July 30, 2003

Sim Segal, FSA, MAAA

Senior Manager

Deloitte & Touche

Risk-Adjusted Capital Management

Thank You!