Enterprise Risk Management
DEPARTMENT
NAME
Enterprise Risk Management at
Nationwide
September 18, 2008
Al Schulman, Vice President-Enterprise Risk Management
The Nationwide View
Nationwide Vision
Requirements
Significant Risks…
• Risk classification
• Identification and assessment
• Risk appetite / limits
…are clearly understood,…
• Metrics
• Reporting
• Training and communications
…proactively managed…
• Clear roles and authority
• Tools
• Controls / transfer / financing
…and consistently monitored by
Nationwide….
… in the context of achieving our
business objectives and strategy…
September 11, 2008
• Standard language
• Reporting
• Independent assurance and oversight
• Link to strategy / planning
• Risk-adjusted performance metrics
Page 2
Nationwide ERM Framework
– Risk Governance
– Planning
– Execution
– Evaluation
– Infrastructure, Communication & External
Environment
September 11, 2008
Page 3
Nationwide ERM Framework
GOVERNANCE
• Risk Governance & Culture
• Risk Policies
• Roles & Authorities
Framework
Feedback
Legal, Regulatory, & Compliance
PLAN
EVALUATE
Insurance
• Strategic Planning
• Capital Allocation
• Risk Capacity, Appetite &
Limits
Operational
• Risk Adjusted Performance
• Capital Adequacy
• Risk Modeling
Strategic
Market
Credit
Identify
Analyze
Manage
Monitor
EXECUTE
Objectives
Infrastructure
• ERM Tools
• Common Language
• Risk Classification Framework
September 11, 2008
Measure
Aggregation
Communication
• Internal Risk Management
Partnerships
• Training & Communications
External Environment
•
•
•
•
Rating Agencies & Regulators
Competitors & Best Practices
Customers
Counterparties
Page 4
Risk Governance Guiding Principles
 Business areas retain accountability for managing their own risks
 Enterprise perspective
 Proactive rather than reactive
 Independent assurance (e.g., Independent Audit)
 Clearly assigned responsible / accountable parties
 Transparency of accountability, communication, decision making,
and information flows
 Regular re-evaluation to ensure appropriate evolution
September 11, 2008
Page 5
Nationwide ERM Framework
GOVERNANCE
• Risk Governance & Culture
• Risk Policies
• Roles & Authorities
Framework
Feedback
Legal, Regulatory, & Compliance
PLAN
EVALUATE
Insurance
• Strategic Planning
• Capital Allocation
• Risk Capacity, Appetite &
Limits
Operational
• Risk Adjusted Performance
• Capital Adequacy
• Risk Modeling
Strategic
Market
Credit
Identify
Analyze
Manage
Monitor
EXECUTE
Objectives
Infrastructure
• ERM Tools
• Common Language
• Risk Classification Framework
September 11, 2008
Measure
Aggregation
Communication
• Internal Risk Management
Partnerships
• Training & Communications
External Environment
•
•
•
•
Rating Agencies & Regulators
Competitors & Best Practices
Customers
Counterparties
Page 6
Core Framework Components
The three components of the framework are Risk Capacity, Appetite, and Limits, all of which are logically
aligned to achieve a common long-term goal: maximization of economic value subject to risk tolerances.
Capacity
Appetite
Limits
September 11, 2008
• Capacity represents the maximum amount of risk that can be supported by the company,
expressed as an aggregate capital dollar amount
• Risk Capacity is determined considering the following:
– Available capital
– Ability to raise capital (access to capital markets)
– Earnings strength and stability, including planned growth in capital over time
• Amount of risk that management and the Board are willing to take, given available risk
capacity, our risk preferences, and our strategic business objectives
• Risk Appetite serves as an overall guide to resource and capital allocation
• Business strategy should be aligned with risk appetite
• Allocation of Appetite to individual risk types, business units, and additional dimensionality
(or combinations thereof) based upon capital requirements relative to potential returns and
risk concentrations
• Serve to effectively control our significant risks within the context of our overall risk appetite
• Should be expressed in specific metrics appropriate for a given risk
• Should reflect enterprise Risk Preferences and align to support strategic plans and capital
allocation
• Should be set at a level which may be periodically tested (i.e., limits should be established at
levels that may be exceeded at times)
Page 7
Risk Capacity, Appetite, and Limits Framework:
Conceptual Model
Nationwide’s risk Capacity, Appetite, and Limits framework expresses tolerance for losses:
• for three different loss magnitudes (severity)
• considering likelihood over both a one and three year horizon (probability)
• reflecting both rating agency and economic measures of risk and capital
Capital Volatility
Severe Downgrade
Insolvency
“Gradually leaking hull”
“Hole in the side of the ship”
“Ship sinks”
What is the
acceptable
probability of…
…having capital adequacy
decline over three years?
…dropping below a minimum
acceptable rating level in a
single year?
…becoming insolvent in a
single year?
Examples of
risk events:
• High inflation environment
(multi-year)
• Large catastrophe
• Large catastrophe
• Severe equity market
decline
• Severe operational /
continuity event
• High trade combined ratio +
high growth environment
Severity
Severity
September 11, 2008
Loss Magnitude
Severity
+
Page 8
Risk Capacity, Appetite, and Limits Framework:
Appetite Quantification and Dashboard
A dashboard is utilized to reflect a chosen risk appetite and exposure levels relative to the
chosen appetite. The example below is illustrative.
Capital Volatility
Severe Downgrade
Insolvency
Model
Economic
Rating Agency
Rating Agency
Economic
Rating Agency
Horizon
Multi-year
Multi-year
Single year
Single year
Static
Loss Severity
Tolerance
Required loss severity ($) periodically calculated for each dimension considering capital and risk profile.
<X%
X-Y%
>Y%
<X%
X-Y%
>Y%
X%
Capital Required
for Ratings Targets
Modeled
Probability
Z%
Z%
Z%
≤X%
AA-
AA3
A+
Within Tolerance
Warning Level
Appetite Violation
September 11, 2008
Page 9
Risk Capacity, Appetite, and Limits Framework:
CAL Risk Modeling Tools
Nationwide’s CAL framework calculations use two principal risk modeling tools:
Enterprise Required Economic Capital
(REC) model
• Tool for measuring economic capital
adequacy
• 1 year view of risk
• “Extreme Tail” focused
• REC used in determining Risk
Adjusted Return on Capital (RAROC)
Dynamic Financial Analysis (DFA)
model
• Statutory, GAAP, and economic views
• Multi-year view of risk
• More centrally focused
• Robust stochastic economic simulation
capabilities
• Enables more “complete” view of risk (central vs. tail, 1 year vs. 4, Economic
vs. Statutory vs. GAAP, etc.)
• Periodic calibration exercises to test models, assumptions, sensitivity, etc.
September 11, 2008
Page 10
Nationwide ERM Framework
GOVERNANCE
• Risk Governance & Culture
• Risk Policies
• Roles & Authorities
Framework
Feedback
Legal, Regulatory, & Compliance
PLAN
EVALUATE
Insurance
• Strategic Planning
• Capital Allocation
• Risk Capacity, Appetite &
Limits
Operational
• Risk Adjusted Performance
• Capital Adequacy
• Risk Modeling
Strategic
Market
Credit
Identify
Analyze
Manage
Monitor
EXECUTE
Objectives
Infrastructure
• ERM Tools
• Common Language
• Risk Classification Framework
September 11, 2008
Measure
Aggregation
Communication
• Internal Risk Management
Partnerships
• Training & Communications
External Environment
•
•
•
•
Rating Agencies & Regulators
Competitors & Best Practices
Customers
Counterparties
Page 11
Nationwide Risk Management Cycle
There are five elements of best practice risk management execution
Identify
Measure
What risks exist?
How much is at risk?
• Identify potential risk
events
• Investigate emerging
risks
• Classify risk events
• Gather actual loss data
• Document Contributing
Factors, Controls and
Key Risk Indicators
• Consider possible
impacts
• Uncover possible gaps
• Etc.
• Measure direct
exposure
• Consult experts
• Benchmark industry
performance
• Run potential loss
models
• Measure actual impact
• Perform scenario
analysis
• Gather anecdotal facts
regarding risk exposure
• Etc.
Data
September 11, 2008
Analyze
What do we want to do
with the risk?
• Compare to risk
preferences
• Look at aggregate
measures
• Prioritize against other
risks
• Create strategies and
recommendations for
risk management
actions (terminate,
treat, tolerate, transfer)
• Get feedback and
appropriate approvals
from risk owners and
oversight committees
• Etc.
Information
Manage
Do something about it
• Implement
recommended actions
• Execute projects
• Improve / add internal
controls
• Change policies and
procedures
• Make investments
• Sell assets
• Acquire hedges
• Acquire reinsurance
• Do nothing
• Etc.
Monitor
Did the management
strategy work?
• Ensure actions took
place
• Compare current results
with previous results
• Compare current results
with expected results
• Generate and distribute
reports
• Etc.
Action
Page 12
Nationwide ERM Framework
GOVERNANCE
• Risk Governance & Culture
• Risk Policies
• Roles & Authorities
Framework
Feedback
Legal, Regulatory, & Compliance
PLAN
EVALUATE
Insurance
• Strategic Planning
• Capital Allocation
• Risk Capacity, Appetite &
Limits
Operational
• Risk Adjusted Performance
• Capital Adequacy
• Risk Modeling
Strategic
Market
Credit
Identify
Analyze
Manage
Monitor
EXECUTE
Objectives
Infrastructure
• ERM Tools
• Common Language
• Risk Classification Framework
September 11, 2008
Measure
Aggregation
Communication
• Internal Risk Management
Partnerships
• Training & Communications
External Environment
•
•
•
•
Rating Agencies & Regulators
Competitors & Best Practices
Customers
Counterparties
Page 13
Risk Diversification
Credit
Market
Product
Strategic
Legal & Reg.
Operational
1. Characterize
the risk
distributions
2. Combine
distributions
3. Measure
required
capital
Correlations, Dependencies
EL
Solvency
Standard
4. Attribute
capital to
products and
business units
Economic Capital
September 11, 2008
Page 14
RAROC Overview
•
Risk Adjusted Return on Capital - Economic view of capital adequacy and
risk adjusted returns
RAROC
=
Total Return
Required Economic Capital (REC)
How much are we earning on
the capital that we have
committed to our businesses?
CAPITAL PRODUCTIVITY
Compare RAROC with
Hurdle Rate (Cost of Capital)
September 11, 2008
How much capital is needed
to protect us to a given
solvency standard (AA)?
CAPITAL ADEQUACY
Compare Required Economic Capital
with Available Economic Capital
Page 15
Enterprise Capital and RAROC Applications
• Applications
– Capital adequacy
• Including future Rating Agency capital adequacy
determination
– Performance measurement & Incentive compensation
– Strategic planning & Capital allocation
– Product Structure & Pricing
– Risk Transfer
– Expense Allocation
September 11, 2008
Page 16
Nationwide ERM Framework
GOVERNANCE
• Risk Governance & Culture
• Risk Policies
• Roles & Authorities
Framework
Feedback
Legal, Regulatory, & Compliance
PLAN
EVALUATE
Insurance
• Strategic Planning
• Capital Allocation
• Risk Capacity, Appetite &
Limits
Operational
• Risk Adjusted Performance
• Capital Adequacy
• Risk Modeling
Strategic
Market
Credit
Identify
Analyze
Manage
Monitor
EXECUTE
Objectives
Infrastructure
• ERM Tools
• Common Language
• Risk Classification Framework
September 11, 2008
Measure
Aggregation
Communication
• Internal Risk Management
Partnerships
• Training & Communications
External Environment
•
•
•
•
Rating Agencies & Regulators
Competitors & Best Practices
Customers
Counterparties
Page 17
ERM Tool – Ops Risk Information Architecture
ERM
Compliance
Common Information Architecture
 Common Dimensional Hierarchies
(Classification and Aggregation)
 Common Metrics Definitions
HR
 Common Reporting
 Common Workflow
Privacy
 Shared Risk and Control Data
 Shared Mitigation Activity Data
Internal Audits
 Shared Internal and External Loss Data
IT Security / Continuity
Management
September 11, 2008
Page 18
Nationwide ERM Framework
GOVERNANCE
• Risk Governance & Culture
• Risk Policies
• Roles & Authorities
Framework
Feedback
Legal, Regulatory, & Compliance
PLAN
EVALUATE
Insurance
• Strategic Planning
• Capital Allocation
• Risk Capacity, Appetite &
Limits
Operational
• Risk Adjusted Performance
• Capital Adequacy
• Risk Modeling
Strategic
Market
Credit
Identify
Analyze
Manage
Monitor
EXECUTE
Objectives
Infrastructure
• ERM Tools
• Common Language
• Risk Classification Framework
September 11, 2008
Measure
Aggregation
Communication
• Internal Risk Management
Partnerships
• Training & Communications
External Environment
•
•
•
•
Rating Agencies & Regulators
Competitors & Best Practices
Customers
Counterparties
Page 19
Strategic Asset Allocation Process
ALM Modeling
·
·
Liability Valuation
Liability Cash Flow
Liability
Simulation
·
·
·
Asset
Simulation
·
·
September 11, 2008
Optimization
& Risk
Assessment
·
Inflation
Interest Rates
Asset class
returns
Policy
Targets
Portfolio
Target
Analysis
DFA
&
VaR
Economic &
Capital Market
Simulation
Investment Policy
·
·
Portfolio Objectives
and Constraints
Portfolio Efficient
Frontiers
Value at Risk
Analysis
Portfolio
Benchmark
Client
Risk
Appetite
Risk Limit
Sensitivity
Analysis
Risk Limits
&
Budget
Investment Appreciation
Investment Cash Flow
Page 20
Total P&C Efficient Frontier
Economic Value Efficient Frontier - Base Case
End of 2010
Change in Economic Value ($millions)
500
J
400
I
H
Same Risk Portfolio
300
G
200
E
Same Rew ard Portfolio
F
100
D
0
-650
-550
-450
C -350
-250
-150
-50
50
150
250
350
450
550
-100
Current Portfolio
B
-200
-300
-400
A
-500
Increase/Decrease to Economic Risk ($millions)
(Relative to standard deviation under Current Portfolio)
September 11, 2008
Page 21
Total P&C Efficient Frontier
Asset Allocation (%):
Taxable Bonds
Tax-Exempt Bonds
Equity
Alternative Assets
Current
Portfolio
65%
16%
16%
3%
Fixed Income Duration
3.5
Change in Economic Value - %
Increase / Decrease in Risk - %
Change in Economic Value - $
Increase / Decrease in Risk - $
September 11, 2008
0.0%
0.0%
-
Same Risk
A
D
E
F
G
K
39%
40%
12%
9%
57%
40%
0%
3%
48%
40%
3%
9%
44%
40%
7%
9%
39%
40%
12%
9%
35%
40%
16%
9%
28%
40%
25%
7%
5.0
1.7
4.3
4.7
4.9
5.2
6.8
1.1% -3.1%
0.0% -19.3%
0.1%
-7.2%
0.6%
-3.8%
1.0%
-0.2%
171.1
0.0
1.4% 2.8%
3.5% 17.6%
(492.2)
19.1
97.6 166.7 230.8
(601.1) (224.9) (118.0)
(6.6) 108.2
441.6
545.3
Page 22
Asset/Liability Interaction
• Think of liabilities as negative assets
– Expected duration based on historical payout patterns
– Actual duration includes systematic and idiosyncratic volatility
• Inflation sensitivity
• Residual volatility
– Claims practices
– Mix of coverages/perils
– Litigation practices
• Impact on efficient frontier driven by several characteristics
– Inflation sensitivity and responsiveness
– Payout pattern (expected duration)
– Volatility of duration
September 11, 2008
Page 23
Inflation and Economic Value
Avail. Econ. Capital (end year 4)
$35bn
$30bn
$25bn
$20bn
$15bn
Average inflation (years 1-4)
$10bn
-2%
In low inflation environments erosion of
AEC is driven by catastrophe risk
September 11, 2008
0
+2%
+4%
+6%
Nationwide is able to increase
premia to keep up with inflation
changes
+8%
+10%
+12%
+14%
Nationwide not able to reset premia significantly
enough to protect AEC in high inflation or
inflation changing regimes
Page 24
Asset/Liability Management – Inflation Modeling
• Investment portfolio optimization requires a defined view of inflation
sensitivity and responsiveness with respect to reserves and new
business
• Generally, losses have a low correlation with inflation, but a high
sensitivity to inflation
• Key questions:
– Inflation Modeling
• What is expected inflation over the model horizon?
• What is inflation volatility over the model horizon?
– Liability modeling
• How sensitive are your reserves to inflation? New losses? If less than fully
sensitive, why?
• How does expected inflation change when actual inflation occurs?
• How quickly does pricing react to a change in expected inflation?
September 11, 2008
Page 25
US Inflation History
US CPI and CORE CPI inflation
% y-o-y
16
Inflation: low and stable
Inflation: high and persistent
Fed inflation fighting, core inflation falling
14
12
10
8
CPI avg: 6.6%
6
CPI avg: 3.1%
4
CPI avg: 1.4%
2
0
-2
52
55
58
61
64
67
70
73
76
79
CPI
82
85
88
91
94
97
00
03
06
CORE CPI
2
September 11, 2008
Page 26
Enterprise Risk Management – Role of Actuaries
• ERM provides actuaries with an opportunity to use their
understanding of the business and its risks to increase their
strategic role within the organization
– Data provider
• Limited – Reserves, ultimate losses
• Expanded – Payout patterns, volatility assumptions, correlations
– Subject matter expert
– Risk model developer/owner
– Risk management partner
• If the actuarial profession doesn’t step up to the challenge of
ERM, others will. Who understands the business better than
you?
September 11, 2008
Page 27