The Actuary’s Evolving Role in
Enterprise Risk Management
A Case Study
2001 Casualty Loss Reserve Seminar
Barry A. Franklin, FCAS, MAAA
Managing Director
Aon Risk Consultants
“Risk” per the CAS
Statement of Principles on
Property & Casualty Ratemaking
• Random variation from expected cost.
– Reflected in cost of capital assumption.
– Influences the underwriting profit provision.
• Systematic variation of estimated costs from
expected costs.
– Reflected in the contingency provision.
Risk from the CFO’s Perspective
Risk Financing Alternatives
Retained Risk
Predictable losses having elements of high frequency,
low severity and high confidence levels. Self
financing
Working
Retained
Layer
Risk
Risk
Working Layer Risk
Losses which can be anticipated and budgeted over a
longer period of time. Financing to minimize unusual
year -to-year impact on balance sheet, income
statement and cash flow
Catastrophe Risk
Long term, less predictable and potentially severe
risks. Financing to transfer risk to insurance or
capital markets
Catastrophe
Risk
Financial Engineering
Designing the optimal structure accessing the total
insurance and capital markets
Efficient Frontier for Risk Financing
EXPECTED
REWARD
Optimal Risk Financing Structure
The Efficient Frontier (Green)
Expected
Savings
Over
Current
Program
{
Various risk
financing options
Current
Program
Risk
Bearing Capacity
Guaranteed
Cost
Program
RISK
• Expected Reward is measured in terms of the expected savings of the risk financing structure being considered
as compared to a no-risk guaranteed cost program
• Risk is measured in terms of variability from expected reward
• Optimal Risk Financing Structure determined such that risk bearing capacity is attained
Case Study - ABC Corporation
• Based on composite and re-scaled individual
company data, industry information,recent
press releases and some pure “guestimates”
• Quantify risks individually and in the aggregate
• Measure earnings impact of events not
currently covered
• Determine theoretical risk capital for selected
level of earnings “protection”
ABC Corporation -Assumptions
•
•
•
•
•
Market Cap = $4.28 Billion
Net Income = $545 Million (ttm)
EPS = $4.72 (ttm); Share Price = $38.12
Effective Tax Rate = 35%
Exposures can be transferred at pretax
nominal cost (expenses offset PV factor)
ABC Risk Bearing Capacity - I
FYE
EPS
Net
Income
12/31/2000
12/31/2001
12/31/2002
4.72
5.07
5.42
545.0
585.3
626.3
Pretax
Income
Pretax
Earnings
Growth
838.5
900.5
963.5
7.4%
7.0%
Margin to
Hit 6.5%
7.5
4.5
115.5 million shares outstanding.
Amounts in millions, with the exception of EPS and percentage measures.
Assuming achieving 6.5% annual EPS growth is critical to ABC maintaining its valuation
multiples, a pretax uninsured (unbudgeted) loss of $7.5 million would materially threaten
ABC's financial performance in 2001, $4.5 million in 2002.
ABC Risk Bearing Capacity - II
FYE
Net
Income
Div.
Paid
Retained
Earnings
Ending
Equity
Return on
Average
Margin to
Equity
Hit 14.5%
12/31/2000
12/31/2000
12/31/2002
545.0
585.3
626.3
173.2
190.5
209.6
371.8
394.8
416.7
3,671.8
4,066.6
4,483.3
15.1%
14.7%
24.3
6.4
115.5 million shares outstanding.
Amounts in millions, with the exception of EPS and percentage measures.
Assuming ABC's valuation depends on its ability to grow dividends at 10% annually and
maintain a return on average equity of 14.5%, a pretax loss of $24.3 million would
materially threaten ABC's financial performance in 2001, $6.4 million in 2002.
ABC Corporation Risks - I
• Hazard/Legal Risks
–
–
–
–
–
–
Property
Business Interruption
Automobile Liability
General Liability
Products Liability
Employment Practices
–
–
–
–
Crime
D&O
Foreign
E&O
ABC Corporation Risks - II
• Financial Risks
– Credit
– Fiduciary
• Strategic Risks
– Product Selection
– R&D Investments
• Operational Risks
–
–
–
–
–
Warranty
Product Recall
Political
Intellectual Property
Strike
Case Study - Hazard Risk
ABC Corporation Hazard Risk
600
500
Avg. NI
NI (Agg)
$Loss (Sum)
300
NI (Sum)
$Loss (Agg)
200
Avg. Loss
Probability of Exceedence
0%
1%
10%
20%
30%
40%
50%
60%
70%
80%
90%
0
99%
100
100%
$Millions
400
Case Study - Financial Risk
ABC Corporation Financial Risk
800
600
NI (Agg)
400
$Loss (Sum)
NI (Sum)
200
$Loss (Agg)
Avg. Loss
Probability of Exceedence
0%
1%
10%
20%
30%
40%
50%
60%
70%
80%
90%
-200
99%
0
100%
$Millions
Avg. NI
Case Study - Operational Risk
ABC Corporation Operational Risk
2,000
1,500
Avg. NI
1,000
$Loss (Sum)
NI (Sum)
500
$Loss (Agg)
Avg. Loss
Probability of Exceedence
0%
1%
10%
20%
30%
40%
50%
60%
70%
80%
90%
-500
99%
0
100%
$ Millions
NI (Agg)
Case Study - Strategic Risk
ABC Corporation Strategic Risk
800
Loss ($Millions)
400
200
Probability of Exceedence
0%
1%
10%
20%
30%
40%
50%
60%
70%
80%
90%
-200
99%
0
100%
$Millions
600
Avg. NI
NI (Agg)
$Loss (Sum)
NI (Sum)
$Loss (Agg)
Avg. Loss
Case Study - Composite Risk
ABC Corporation Composite Risk
3,000
2,500
2,000
1,500
NI (Agg)
$Loss (Sum)
1,000
NI (Sum)
$Loss (Agg)
500
Avg. Loss
0
Probability of Exceedence
0%
1%
10%
20%
30%
40%
50%
60%
70%
80%
90%
-1,000
99%
-500
100%
$Millions
Avg. NI
ABC Corporation - Risk Portfolio
• To protect earnings from $7.5 million to the “1
in 100 year” level on a pretax basis:
– transfer $1.06 billion if risks treated individually;
– transfer $335 million if risks treated as a portfolio.
• Risk finance cost difference of $17.0 million.
– $0.10 in after-tax EPS.
– Nearly $90 million in market capitalization at
current P/E multiple.
ABC Corporation - Implications
• Pre-tax risk finance cost is $14.4 million,
which translates into $0.08 per share in after
tax EPS.
• Provides protection against EPS impact
between $0.04 and $1.89 per share.
• Reduces EPS volatility from 23% to 17%
– Long term reduction in volatility of this magnitude
could increase valuation multiple by as much as 40%
(using CAPM and Dividend Growth Model)
ABC Corporation - Strategy
• Investigate potential risk financing/transfer
structures providing desired EPS protection.
• Pre-tax transfer costs exceed $7.5 million
– look at impact of “insurable” risks only
– search for most effective program with
marginal pre-tax cost of $7.5 million or less
– look at less severe upper bound (1 in 50 year?)
– consider cost savings in potential restructure of
existing underlying risk transfer programs
ABC Corporation - Caveats
• Not all risks to Net Income are included.
– some insurable risks due to lack of data;
– general economic risks - interest rates, etc.
• “Portfolio Effect” potentially overstated
– not all correlations reflected
– company may already look at some risks in
portfolios (integrated insurance programs, e.g.)
• Valuation impact based on CAPM, assumes
beta directly reduced by CV reduction