risk management in todays uncertain environment 3 2009

Jason A. JonesE -ma i l : j j o n e s@ J on e sS t r a t e g yC on su l t i n g . c omPhone : ( 732 ) 476 -6387

Be rmuda , Ma r ch 19 – 20 , 2009

Risk Management in Today’s Uncertain Environment

Parad igm Shi f t f rom Risk to Uncerta inty

The Risk Management Agenda for 2009

Re-assessing Investment Risk

Fixing Broken Risk Models

Managing to Higher Capital Requirements

Proactive Cycle Management

Focus on Counterparty Risk

About Jones St rategy Consu l t ing

Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

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Overview

Paradigm Shift from Risk to Uncertainty

3/17/2009Copyright 2009, Jones Strategy Consulting, Inc.

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A new approach to risk management is needed to address uncertainty, not just risk

� The financial crisis put uncertainty at the fore

� What’s the difference?� Risk – randomness with known probability

� Car accident frequency, odds of royal flush in poker

� Uncertainty – randomness with unknown probability

� Impact of global warming, outcome of financial crisis

� Risk models can measure risk but not uncertainty, so models are not enough

� A new thinking is required



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Wrong thinking:� Everything can be assessed in a mathematical model

� Human behavior and risk arbitrage don’t matter

� Inter-relationships among risks are simple enough to be quantified (e.g., correlations or copulas)

Better thinking:� Look for multiple ways of evaluating risk

� Uncertainty is affected by human behavior

� The past is not always a reliable indicator of the future

� Complex systems can’t be modeled with “hard science”



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It is, I think, particularly in periods of acknowledged crisis that scientists have turned to philosophical analysis as a device for unlocking the riddles of their field. Scientists have not generally needed or wanted to be philosophers.

- Thomas Kuhn

The Risk Management Agenda for 2009


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� Re-assessing Investment Risk

� Fixing Broken Risk Models

� Managing to Higher Capital Requirements

� Proactive Cycle Management

� Focus on Counterparty Risk

The Risk Management Agenda for 2009Re-assessing Investment Risk


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� Investment risk appeared artificially low due to:� Trend of rising financial leverage 1984–2007

� Untested structured finance and derivative products hid risk and leverage

� Issues hurting investments today:� Systemic de-leveraging

� Uncertain public policy response to financial crisis

� Mortgage defaults keep rising

� Investment risk is being re-assessed:� De-risking for liquidity and capital preservation

� Focus on gross risk rather than net risk

The Risk Management Agenda for 2009Fixing Broken Risk Models


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� Many risk models are seriously flawed� Economic capital models are proving unstable

� Catastrophe models substantially under-estimated losses from hurricanes Ike (2008) and Katrina (2005)

� Models don’t capture the whole picture (risks or uncertainties that go unconsidered – lack of imagination)

� Rare events are hard to model due to unreliable data



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Loss of model credibility� AIG’s economic capital model indicated enough capital to

withstand 1-in-2000-year loss – 3 months before AIG’s collapse!

� On the folly of modeling 1-in-2000-year events (AKA 99.95% confidence level over 1-year horizon):Putting this into historical perspective, it means withstanding World Wars I and II, the Great Depression, the death of 30% to 60% of Europe’s population during the Black Death in the 1340’s, the fall of the Roman Empire, and countless other catastrophes and cataclysms in the past two millennia. No company on earth could find a credible way to model all of these risks, let alone manage capital requirements with such a model.- Quarterly Insurance Round-up: Third Quarter 2008, Jones Strategy

Consulting

� So why are ING, Allianz and others modeling at “confidence levels” of 99.95% or higher?



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� What’s the solution?� Assess risk in multiple ways

� No black box models

� Use techniques to reduce model error

� Remove from portfolio any risks which are: not understood, unlimited or un-quantifiable

� Use risk limits as safety nets

� Model the whole loss distribution (good, bad and the ugly):

� Good: 1-in-2 year scenario, expected loss

� Bad: 1-in-20-year scenario, use reliable in-sample data

� Ugly: Very rare scenarios that can’t be modeled statistically – use scenario analysis, sensitivity analysis

� Control and manage risk - don’t just measure it

� Management judgment

The Risk Management Agenda for 2009Managing to Higher Capital Requirements


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� Insurers need more capital� Risk is elevated due to financial crisis and soft market

� Investment losses took a big toll on capital

� Top 10 P/C insurers lost 25% of their capital in 2008

� Frozen capital markets – no more “just in time capital”

� Actions to take� Retain capital – hold steady or cut dividends and share

buybacks

� Favor de-risking and rate adequacy over market share

The Risk Management Agenda for 2009Managing to Higher Capital Requirements


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Company

Shareholders’ Equity

12/31/2008

Shareholders’ Equity

12/31/2007 Change

Hartford Ins Group 9,268 19,204 -51.7%

American International Group, Inc 52,710 95,801 -45.0%

Allstate Ins Group 12,641 21,851 -42.1%

CNA Ins Cos 6,877 10,150 -32.2%

Liberty Mutual Ins Cos 10,160 12,366 -17.8%

W.R. Berkley Group 3,046 3,570 -14.7%

Progressive Ins Group 4,215 4,936 -14.6%

Berkshire Hathaway Ins 109,267 120,733 -9.5%

Chubb Group of Ins Cos 13,432 14,445 -7.0%

Travelers Ins Companies 25,319 26,616 -4.9%

Total 246,935 329,672 -25.1%

Figures in $ millions

The Risk Management Agenda for 2009Proactive Cycle Management


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� The soft market continues� Global recession means lower insurance demand, downward

rate pressure and more competition

� Forecast: Return of hard market (2010); Rate adequacy (2011)

� Investments will not help� Expect investment losses and low investment income in 2009

� Key actions to manage the cycle� Better metrics

� Control terms and conditions

� Be careful of new business

� Allocate capital

� Build a foundation of accountability

� Act quickly and aggressively

Watch for changes in loss cost inflation or deflation!

See my white paper, Managing the Underwriting Cycle

The Risk Management Agenda for 2009Proactive Cycle Management


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� Insurance rates keep declining� MarketScout:

� P/C rates fell 8% in February 2009

� Rate of decline is down from double digits

� Declines across all classes

� Cumulative rate decline exceeded 32% since February 2005!

� Reinsurers are turning the corner� Guy Carpenter report on January 2009 renewals:

� Prop/cat rates up 8% and casualty rates up 5%

The Risk Management Agenda for 2009Focus on Counterparty Risk


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� Counterparty risk is everywhere� Investments

� Derivatives / hedges

� Policyholders and agents

� Reinsurers

� Insurer responses:� Diversifying reinsurance programs

� Focusing on gross exposures (not just net)

� Re-evaluating policyholder behavior and agent balance receivables

� Reducing counterparty concentrations

� Investment de-risking

The Risk Management Agenda for 2009Focus on Counterparty Risk


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� Use your own due diligence and judgment!…regulators and investors should return to the tool they used to assess credit risk before they began delegating responsibility to the credit rating agencies. That tool is called judgment.

- New York Times, March 16, 2009, page A23. Opinion piece “Rated F for Failure” by Jerome S. Fons and Frank Partnoy.

Reinsurance and Insurance Risk,

Finance, and Strategy:

ERM

Rating Agency Relations

Cycle Management

Risk Metrics and Reporting

Counterparty Credit Risk

Capital Management

Copyright 2009, Jones Strategy Consulting, Inc. 3/17/2009

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About Jones Strategy Consulting

3/17/2009

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Copyright 2009, Jones Strategy Consulting, Inc.

402 Main Street, Suite 100-329Metuchen, NJ 08840

www.JonesStrategyConsulting.com

risk management in todays uncertain environment 3 2009

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