Enterprise Risk Management Overview Ernst & Young LLP ERM: Basic Elements • Global Focus – Pricing risk – Operational Risk • Suitability of accounting treatment – Reflecting real earnings – Matching revenue to risk • Common framework comparing different types of risks – Determining impact of different kinds of risk – “Extreme Risk” Enterprise Risk Management for Health Entities Slide 2 How Relevant to Health Industry ? • More Homogenous Risk – Less dramatic “extreme risk” – “Death of a thousand cuts” • Little ALM Impact – Cash In – Cash Out – Short tail without much investment-supported pricing • Extremely wide variety of unknowns – Market, economy, regulation, providers, contractual, business – Common excuse for simple view is actually its extreme complexity Enterprise Risk Management for Health Entities Slide 3 How Relevant ? Example of Extreme P&C Risk Catastrophic Event Calls on Assets Cash Flow Impairment Cost of Capital Rises Possible Health Carrier Version Understate IBNP Miss Pricing & Earnings Earnings & Surplus Drop Enterprise Risk Management for Health Entities Cost of Capital Rises Slide 4 How Relevant : Current Observations • Recent Results – Favorable to Very Favorable • Challenges – Even in Favorable Times – Observations by Regulators and/or Boards – Public – Profits coincident with Premium Increases – Using Capital Wisely? • Anticipated Future Challenges – Responses to Affordability – Product/Network Development – Administrative Costs – Lower Premium Base • How structured are carrier processes and abilities to measure and articulate the risks they face? Enterprise Risk Management for Health Entities Slide 5 Health Processes : Current Observations • Traditional viewpoint – essentially pricing risk – Business risk, operations, business continuation not linked except by RBC – Soft linkage on items like acquisitions or new ventures • Risks tend to be more homogenous – RBC-based measurement is becoming a common tool – Loosely quantified capital and vitality needs, short horizon timeframe • Risk-Reward Trade-offs – Product-specific targets - approximates pricing credibility – Steered by broad market consensus or anecdotal competitive limitation – Surplus contribution tends to be budget-based • Budgeting and Projection Process – Static or Deterministic – at best, some scenarios considered – Function of volume, trended costs, and bottom line – Target-driven cycle – adjust volume and price until “acceptable” Enterprise Risk Management for Health Entities Slide 6 Benchmarking: Surplus Levels RBC Levels - Top 20 Carriers 60.0% Distribution of Companies 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% < 1.0 1.0 - 2.0 2.0 - 3.0 3.0 - 4.0 4.0 - 5.0 5.0 - 6.0 6.0 - 7.0 7.0 - 8.0 > 8.0 Ratio to ACL 1998 1999 2000 2001 Enterprise Risk Management for Health Entities Slide 7 Benchmarking: Surplus Levels RBC Levels - BCBS Plans 35.0% Distribution of Companies 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% < 1.0 1.0 - 2.0 2.0 - 3.0 3.0 - 4.0 4.0 - 5.0 5.0 - 6.0 6.0 - 7.0 7.0 - 8.0 > 8.0 Ratio to RBC 1998 1999 2000 2001 Enterprise Risk Management for Health Entities Slide 8 Realized U/W Profits – Top 20 Carriers Underwriting Gains - Top 20 Carriers 60.0% Distribution of Companies 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% < -8% -8% to -5% -5% to -3% -3% to -1% -1% to 1% 1% to 3% 3% to 5% 5% to 8% > 8% % of Revenue 1997 1998 1999 2000 2001 Enterprise Risk Management for Health Entities Slide 9 Realized U/W Profits – BCBS Plans Underwriting Gains -- BCBS Plans 45.0% 40.0% Distribution of Companies 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% < -8% -8% to -5% -5% to -3% -3% to -1% -1% to 1% 1% to 3% 3% to 5% 5% to 8% > 8% % of Revenue 1997 1998 1999 2000 2001 Enterprise Risk Management for Health Entities Slide 10 Expanding the Dialogue - Pressures • Targets – Data suggest some implied target – greater than RBC – Profit targets roughly linked to building surplus • Capital Markets – Cheap debt is buying some time as well – Europe / Banking has moved to Economic Capital – Life and P&C Carriers starting RAROC – Analyst and market considerations • Process – Above measures force more analytical linkages – Improving the credibility of the planning process – Need to recognize unique Health Industry requirements Enterprise Risk Management for Health Entities Slide 11 Expanding the Dialogue • Surplus – Broader recognition of risk / reward mix – Better quantification of viability and capital needs – Rationalization / Justification of surplus needs • Health Profit Targets – Improved risk-reward equation by product – Required surplus contribution should be risk-based • Budgeting and Projections Process – Improving the linkage between capital needs and budget targets – Stochastic modeling – potentially RAPM / RAROC • Return – % of Premium still OK – may be converted from other measures – ROI target “denominator” --- RBC, Economic Capital Enterprise Risk Management for Health Entities Slide 12 Capital and Surplus Management for Health Entities Surplus and Appropriate Returns Benchmarking: RBC Measurement Market/Asset Liability Management Risk H3 H1 Underwriting Risk Credit Risk • Asset Devaluation • Asset Concentration Operational / • Reinsurance • Capitation • Receivables Business Risk H4 H2 • Admin Risk • Rapid Growth • ASO • Product Specific Risk • Managed Care Credit • Rate Guarantees H0 • Interest in Affiliates H 0 H1 H 2 H 3 H 4 2 Enterprise Risk Management for Health Entities 2 2 Slide 14 2 Using RBC to define Risk/Return • Capital allocation was not among the RBC development goals • Positive Aspects – Commonly accepted base – Ruin Theory with Monte Carlo simulations – Recognizes specific risk elements • Issues – Broadly based factors = “average” – Some political compromise – Observations imply target is some multiple of RBC floor Enterprise Risk Management for Health Entities Slide 15 Alphabet Soup: Measures and Metrics • Economic Value Added (EVA) – Rate of return versus cost of capital – Not a ratio, converted into % for planning – Often a multi-year projection of results • Dynamic Financial Analysis (DFA) – Stochastic modeling - P&C Carriers – Typically multi-year proposition with emphasis on asset impacts • Return on Equity ( ROE or ROI ) – Question is --- what is the denominator ? – RBC can work – at least based on ruin theory – RBC is a broad measurement of risk by product • Risk-Adjusted Return on Capital (RAROC / RAPM) – Economic Income / Economic Capital – Requires some form of modeling of risks assumed – Works well when comparing diverse lines of business Enterprise Risk Management for Health Entities Slide 16 Using Economic Capital for Risk / Return • Positive Aspects – Specifically addresses business risks for the carrier – Comparing lines of business or new ventures – Can directly tie budgeting process to surplus needs – Possible emerging standard in other sectors • Issues – Can require more sophisticated modeling – Judgment calls on some factors and distributions – Not yet commonly accepted approach Enterprise Risk Management for Health Entities Slide 17 Economic Capital or RAROC Measures Market/Asset Liability Management Risk Underwriting Risk • • • • • • • • Changes in interest rates • Equities Volatility • Fixed income Volatility Credit Risk • Default risk Operational / Business Risk • • • • • • • • • • Medical trend volatility Lapse Mortality Morbidity Catastrophic Reserve volatility Multi-option choice Enterprise Risk Management for Health Entities Litigation Disaster recovery Claim fraud Market conduct Claim rework costs New competitors New products Regulatory Tax law changes Capitation Issues Slide 18 Measuring Economic Capital Probability of loss LOB A LOB B Earnings Earnings Uniform risk (e.g., 99.75%) Uniform risk (e.g., 99.75%) Zero losses 0% Expected level of loss Potential “unexpected” losses requiring capital for LOB A Loss rate Potential “unexpected” losses requiring capital for LOB B 100% 0% Enterprise Risk Management for Health Entities Loss rate 100% Slide 19 Economic Capital or RAROC Measures Underwriting Risk • • • • • • • Factors modeled using stochastic outcomes Medical trend volatility Lapse Mortality Morbidity Catastrophic Reserve volatility Multi-option choice Enterprise Risk Management for Health Entities Slide 20 Expanding the Dialogue – Linkages Premium Investment Income Balance Sheet Surplus Benefits Solvency Investment Expenses Taxes Viability External Capital Service Improvement Contribution to Surplus Enterprise Risk Management for Health Entities Slide 21 Linking the Pieces Budgeting RBC “ + ” Surplus Capital Allocation RAROC Premium Investment Income Regulatory Benefits Capital Costs Admin Expenses Taxes Investment Capital Budget Strategic Plan Viability Contribution to Surplus Enterprise Risk Management for Health Entities Slide 22