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From Ratemaking to Enterprise Risk Management (Expanding the Actuary’s Role)
including2004 Proceedings Paper:
Value Creation in Insurance – A Finance Perspective
Russ Bingham CANE
Vice President and March 23, 2005
Director of Corporate Research
Hartford Financial Services
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Outline
Basic Premises Financial Discipline Financial Integrity and Model The Return Perspective
Building a Financial Discipline - History Building Blocks – Valuation Fundamentals Unified Financial Model Insurance Funds Flow Schematic Demonstration Example and Value Creation
The Risk Perspective Background Comments on Risk / Return Risk Coverage Ratio Risk Metric Risk-Adjusted Return versus Risk-Adjusted Leverage
Ten Commandments of Insurance Financial Modeling
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Basic Premises
An insurance company must have a financial discipline for dealing with risk and return – this requires a companywide commitment to the process and to the development and implementation of models that employ the appropriate concepts and methodologies throughout all operations
The same concepts and methodology should be used in all areas including ratemaking, planning, performance monitoring, incentive compensation, and ERM
The critical cornerstones are risk, price, leverage and return
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A Financial Discipline ProcessWhat it is and what it takes to establish
Financial discipline is a valuation process, supported by analytical methods and models, intended to provide timely and meaningful assessments of risk / return performance and trends associated with underwriting, investment and finance operations
Conditions needed to instill a financial discipline: Financially astute senior leadership A committed senior management A group (actuarial, accounting, finance) responsible for the development of
“benchmark” concepts, models and operating applications Companywide application of benchmark concepts and models in
Ratemaking Planning Performance monitoring Incentive compensation ERM ... “All inclusive - no exceptions”
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Financial Integrity and Model
Ideal Ratemaking Model and Financial Documentation Fully integrated balance sheet, income and cash flow statements Policy / accident period focus with calendar period provided if needed Nominal and economic accounting valuations Clearly and consistently stated parameter estimates
Premium, loss and expense amount Timing of premium collection, loss and expense payment Investment yield rates Underwriting and investment tax rates Specification of risks included Amount of capital and its cost
The same methodology (and preferably the same model) that is used for ratemaking should also be used for planning, performance monitoring, financial analysis, incentive compensation, and ERM
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Building a Financial Discipline - History
The objective is to create a process of financial discipline which enhances the creation of economic value and the subsequent delivery of reported earnings.
Basic concepts implemented and published
1987 Internal line of business, accident year benchmark ROE introduced for ratemaking and performance measurement.
1989 Proposition 103 testimony - proposing DCF and economic valuation models in ratemaking.
1990 Proceedings “Discounted Return - Measuring Profitability and Setting Targets” - documentation of basic approach and concepts.
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History: (Continued)
Refinement of important rate of return principles
1993 Proceedings (1) “Surplus - Concepts, Measures of Return, and Determination” and (2) “Rate of Return - Policyholder, Company, and Shareholder Perspectives” - developing rate of return and surplus concepts further.
Conceptual and structural elements of model(s) reconciliation
1999 Actuarial Considerations Regarding Risk and Return text (1) “Fundamental Building Blocks of Insurance Profitability Measurement” and (2) “Cash Flow Models in Ratemaking” - discussing fundamental principles and modeling considerations which result in equivalent and/or reconcilable outcomes.
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History: (Continued)
Risk / return integration and rate of return / solvency connection
2000 Proceedings
(1) “Risk and Return: Underwriting, Investment and Leverage - Probability of Surplus Drawdown and Pricing for Underwriting and Investment Risk” - to incorporate methodology within risk / return framework and deal with rate of return and solvency in an integrated manner.
(2) “The Direct Determination of Risk-Adjusted Discount Rates and Liability Beta” - to demonstrate mathematical connection between equity beta and liability beta.
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History: (Continued)
Integration of economic value concepts
2004 Proceedings
“Value Creation in Insurance – A Finance Perspective” - to incorporate economic valuation into SINGLE financial model that encompasses ratemaking and (virtually) ALL other applications which measure financial performance in an insurance company. This extends the focus from internal revenue and expense items to include external costs of capital.
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“Building Blocks”: Valuation Fundamentals
Balance sheet, income and cash flow statements
Development “triangles” of marketing / policy / accident period into calendar period
Accounting valuation: conventional (statutory or GAAP) and economic (present value) – Use economic basis for decision making to the maximum extent possible
plus
Risk / return decision framework which deals with separate
underwriting, investment and leverage contributions
Note: Both internal and external costs must be reflected
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Policy (or Accident) / Calendar Period Development Triangles
Balance Sheet, Income, Cash FlowCalendar Period
Pol./Acc. Historical Future Total Period 2002 2003 2004 2005 2006 Ultimate
Prior X X X X X …... --> Sum 2002 X X X X X …... --> Sum 2003 X X X X …... --> Sum
2004 X X X …... --> Sum2005 X X …... --> Sum2006 X …... --> Sum
==== ==== ==== ==== ==== Reported Sum Sum Sum Sum Sum
Benchmark focus is on the present value across a policy/accident period row.Calendar reporting focus is on the nominal value sum total down a column.
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Unified Financial Model
Ratemaking models and approaches are too often overly narrow in focus (and thus limit the actuary’s role) May not be integrated with other company assessments of profit
and value creation May not provide all metrics that management likes to see May not include both internal and external costs
A single, all-inclusive financial model can be created which supports virtually all insurance company financial performance assessment, including ratemaking, and serves to act as a critical source of managment decision making.
The “Value Creation” paper demonstrates how external capital costs, often missing from ratemaking models, are integrated in such a unified approach.
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Insurance Funds Flow Schematic - The Risk Transfer Process
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Demonstration Example - Assumptions
For underwriting function activities:
103.1% Combined ratio
$9,700 Premium, collected without delay when written
$10,000 Loss, single payment at end of year 3
$0 Expense
35% Income tax rate, no delay in payment
6.0% Low-risk investment interest rate before-tax, 3.9% after-tax
No loss discount tax or unearned premium tax
3.0 Liability/surplus ratio
15.0% Cost of underwriting equity
For investment function activities:
6.2% Investment interest rate before-tax, 4.65% after-tax, assuming a 25% tax rate
20% Investment equity / underwriting equity ratio, equivalent to using a 20:1 (liability plus underwriting equity) / investment
equity ratio
15.0% Cost of investment equity
For finance function activities:
6.2% Investment interest rate before-tax, 4.65% after-tax, assuming a 25% tax rate
25% Debt / total equity ratio
8.0% Cost of debt before-tax, 5.2% after-tax.
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Demonstration Example – Financial RecapItem Amount Funds Rate Net Cost / Value
Functional Accounting
Source / Cost of Funds
Underwriting Equity 10,000 -15.00% -1,500
Underwriting
Investment Equity 2,000 -15.00 -300
Investment
Debt 3,000 -5.20 -156
Finance
Underwriting Liabilities 30,000 -0.70 -210
Underwriting
Use / Value of Funds
Underwriting Liabilities 30,000 3.90% 1,170
Underwriting
Underwriting Equity 10,000 3.90 390
Underwriting
Inv. Lift on Underwriting 40,000 0.75 300
Investment
Investment Equity 2,000 4.65 93
Investment
Debt 3,000 4.65 140
Finance
Total 45,000 -0.16 -74
Note: Financial amounts are Note: Financial amounts are expressed in nominal value (i.e. not expressed in nominal value (i.e. not discounted), and represent the sum discounted), and represent the sum total over the policy lifetime of each total over the policy lifetime of each respective item.respective item.
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Economic Cost and Value Creation Components
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Background Comments on Risk / Return
Volatility characteristics of input and output variables are a key component of risk assessment but volatility alone does not represent risk
Risk lies in the potential for adverse outcomes, which is a function of both the level of and volatility in important variables of interest
A risk-based pricing and capital attribution methodology incorporates volatility in determining levels of outcoumes in order to conform to an acceptable risk / return relationship
Policyholder level risk / return relationship is based on operating return Shareholder level risk / return relationship is based on total return Where possible policyholder and shareholder risks are not intermingled Price is the lever that addresses policyholder sources of risk and capital
attribution (i.e. leverage) the lever that addresses shareholder risk sources A risk metric is a statistic derived from the distribution of outcomes of a
particular variable of interest related to the occurrence of an adverse event (frequency, severity, etc.)
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Risk Coverage Ratio Metric – “Reward to Risk” Ratio
General Process for Selecting Risk Metric: 1) Identify relevant variable and General Process for Selecting Risk Metric: 1) Identify relevant variable and generate distribution of expected outcomes, 2) Identify what constitutes an generate distribution of expected outcomes, 2) Identify what constitutes an adverse event, 3) Calculate frequency and severity of adverse events across all adverse event, 3) Calculate frequency and severity of adverse events across all outcomes, and 4) Calculate risk metric (if not frequency or severity). outcomes, and 4) Calculate risk metric (if not frequency or severity).
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Each Line is Priced to Satisfy Total Return Risk Criterion and Place Distribution on Total Risk / Return Line
The price (premium) that satisfies the risk criterion, by reflecting the volatility in each line The price (premium) that satisfies the risk criterion, by reflecting the volatility in each line of business, places the expected total return distribution on the total risk / return line.of business, places the expected total return distribution on the total risk / return line.
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The Total Risk / Return LineRisk-Adjusted Return (Uniform Leverage) – “RAROC”
The risk / return line shown assumes a uniform leverage in all lines of business The risk / return line shown assumes a uniform leverage in all lines of business (typically corporate overall average).(typically corporate overall average).
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The Total Risk / Return Line:Risk-Adjusted Leverage (with Uniform Return) – “RORAC”
All lines of business are restated to a uniform return (e.g.15%) with uniform All lines of business are restated to a uniform return (e.g.15%) with uniform volatility via altered risk-adjusted leverage.volatility via altered risk-adjusted leverage.
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Risk-Adjusted Return vs Risk-Adjusted Leverage
Two equivalent alternatives which differ in the form of presentation. At same premium & combined ratio –
RAROC - Maintain a fixed leverage, but vary the total return based on volatility
– This avoids varying allocation of surplus to lines of business
RORAC - Maintain a fixed total return, but vary leverage to adjust for volatility
– This makes regulatory environment less contentious
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Ten Commandments of Insurance Financial Modeling
1. Thou shalt build only models that have an integrated set of balance sheet, income and cash flow statements
2. Thou shalt remain rooted in a policy period orientation and develop calendar period results from this base
3. Thou shalt reflect both conventional and economic accounting perspectives - guided by economics, constrained by conventions
4. Thou shalt recognize the separate contributions from each of underwriting, investment and finance activities
5. Thou shalt be guided by the risk / return relationship in all aspects6. Thou shalt include all sources of company, policyholder and shareholder
revenue and expense embodied in the insurance process7. Thou shalt reflect all risk transfer activities8. Thou shalt not separate risk from return9. Thou shalt not omit any perspective or financial metric that adds
understanding10. Thou shalt allow differences in result only from clearly identified
differences in assumption, and not from model omission
Do not confuse models with metrics.Do not confuse models with metrics.
