Developing a Culture of Financial Discipline
Issues and Challenges for Integration of Risk and Return
Commentary and Audience Survey
Russ Bingham
Vice President Actuarial Research
CAS Spring Meeting
Lake Buena Vista, FL
Hartford Financial Services
June 17-20, 2007
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Issues to Discuss and 10 Questions to Answer
Financial Culture and Process

My Company Has Developed a Culture of Financial Discipline?

My Company Has Developed a Standardized Valuation Process and Has
Implemented it Throughout the Organization?
Modeling

My Model Contains a Full Financial Structure?

My Model Includes all Important Return Metrics?

My Model Includes all Important Risk Metrics?
Risk

My Company Utilizes a Clearly Specified Definition of Risk as Part of Its Process
of Financial Discipline?

Risk and Return are Integrated at My Company?
Economic Perspective

Economic Accounting and Capital Concepts are Understood at My Company?

My Company Has Developed an Independent, Internal Economic Capital View?

I Believe that Statutory Accounting Should be Elminated?
Three Major Challenges
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1) My Company Has Developed a Culture of Financial Discipline?
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. Sound economic,
risk-based analytics are used to support strategic and operational
decision making throughout company.
Requirements for Financial Discipline and ERM Success




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Financially astute senior leadership
A committed senior management
A technically sophisticated group (actuarial, accounting, finance)
responsible for the development of fundamental core “benchmark”
principles and their application
Development and implementation of standardized companywide
“benchmark” concepts and models
An Understanding that goal is risk/return management
1) ___ Yes
___ No
___ Somewhat
___ Intend To
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2) My Company Has Developed a Standardized Valuation Process and Has
Implemented it Throughout the Organization?

Standardized financial valuation throughout entire company

Ratemaking and product pricing

Planning

Performance monitoring

Incentive compensation

Capital attribution

Risk/return assessment

ERM

Requires integration/utilization of actuarial, accounting and finance
concepts

Valuation must consider economic perspective (i.e. cash flow oriented,
reflective of time value) and risk

The same methodology (and preferably the same model) that is used for
ratemaking should, if possible, also be used for planning, performance
monitoring, financial analysis, incentive compensation, and ERM
2) ___ Yes
___ No
___ Somewhat
___ Intend To
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3) My Model Contains a Full Financial Structure?

Fully integrated Cash Flow, Balance Sheet and Income
statements

Policy / Accident period and Calendar period perspectives

Economic and Conventional (Statutory, GAAP) accounting
valuations
3) ___ Yes
___ No
___ Somewhat
___ Intend To Build
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4) My Model Includes All Important Return Metrics?
5) My Model Includes All Important Risk Metrics?



Incorporate all sources of return - Revenue and Expense, Policyholder
and Shareholder
Incorporate all sources of risk that can be “distributionalized” – Loss,
Catastrophe Loss, Investment Yield, Cash Flow, etc.
Provide all critical risk and return performance metrics – ROE, IRR, Total
Risk-Adjusted Return, Economic Value Added, Benchmark Surplus,
Embedded Value, Probability of Ruin, EPD, TVAR, RCR, etc. in addition
to the more standard metrics (loss ratio, expense ratio, yield, etc.)
Don’t confuse models with metrics – Ideally a single model should include
as many risk and return metrics as are needed
4) ___ Yes
5) ___ Yes
___ No
___ No
___ Somewhat
___ Somewhat
___ Intend To
___ Intend To
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6) My Company Utilizes a Clearly Specified Definition of Risk as Part of Its Process
of Financial Discipline?
7) Risk and Return are Integrated at My Company?
Risk Specification



Risk sources versus Risk measurement
 Catastrophes, financial markets, etc. are sources of risk
 “Risk” resides in the potential for adverse financial outcomes, typically
those which drain company capital.
Risk metrics – generic steps for quantification
 Specify variables of Interest
 Develop outcome distributions
 Specify adverse outcome criteria
 Determine risk metric (frequency, severity, etc. of adverse outcomes)
 Risk metric is a function of the range of possible adverse outcomes,
driven by the level and volatilities of the outcomes for the variables of
interest
Risk / Return integration – a necessary step
 Sharpe Ratio
 Risk Coverage Ratio
6) ___ Yes
7) ___ Yes
___ No
___ No
___ Somewhat
___ Somewhat
___ Intend To
___ Intend To
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Alternative Risk Metrics
Policyholder oriented risk metrics (usually loss based)
Probability of ruin (POR)
Value at risk (VAR)
Tail Value at Risk (TVAR) - P&C
Conditional Tail Expectation (CTE) - Life
Expected policyholder deficit (EPD)
Shareholder oriented risk metrics (based on total income or return)
Variability in total return (sR)
Value at risk (VAR)
Tail Value at Risk (TVAR) - P&C
Conditional Tail Expectation (CTE) - Life
Probability of Income Ruin (POIR)
Probability of surplus drawdown deficit (PSD)
Severity of surplus drawdown deficit (SSD)
Expected surplus drawdown deficit (ESD)
Earnings at Risk
Risk / Return metrics
Sharpe Ratio
Risk Coverage Ratio (RCR)
- Metrics differ in choice of
variable used and in
definition of adverse event
(position in distribution)
- In one way or another all
risk measures address the
likelihood and/or the severity
of an adverse outcome
- Only Sharpe ratio and
RCR integrate risk and
return, others are an
expression of risk only
RBC and other Rating Agency measures
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Risk Coverage Ratio Risk / Return Metric – Total Return View
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8) Economic Accounting and Capital Concepts are Understood at My Company?
Internal versus External View
 Economic versus Conventional (Stat, GAAP) Accounting
 Policy / accident period versus Calendar period
 Product level versus Aggregate company
 Present value of expected future cash flows versus Reported
historical results
Risk Capital versus Rating Capital - An independent, internally derived view
of risk capital will likely not agree with the externally derived rating
agency capital view
It is important to understand what “Economic” means (e.g. economic return,
economic value, economic capital, etc.) – Generally “economic” means
“market value”, and typically involves valuation based on cash flow,
reflecting time value, and perhaps including an adjustment for risk
8) ___ Yes
___ No
___ Somewhat
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9) My Company Has Developed an Independent, Internal Economic Capital View?


External total company “constraints” must be met based on  Calendar period (e.g. reported earnings), static where revised estimates can
only be included in accounting period when revisions are made
 Conventional accounting (Stat for rating agency and regulatory, GAAP for
financial reporting)
 Backward looking (reported historical financials)
 Combined underwriting and investment results
 Rating agency capital (e.g. S&P)
 Reported
results that are estimations, not “actual”, since they will
subsequently be revised
Internal line of business decisions (can, should, must?) be made based on
financials that reflect the “purest” view of financial performance possible
 Accident period oriented, not Calendar period, and revised to include latest
estimates of ultimate values
 Economically based accounting, not Conventional (statutory or GAAP)
 Forward looking (includes future cash flow expectations)
 P&C investment risk beyond low-risk cash flow matched strategy considered
as separate investment activity, not part of underwriting
 Risk-adjustment (and capital attribution) based on independent view of risk
(using benchmark accident year, economic, cash flow, and low risk
investment structure as noted above), not the rating agency view
 Consistent with fair value accounting and economic capital principles
 Actual results will eventually emerge with retrospective look-back
9) ___ Yes
___ No
___ Somewhat
___ Intend To
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10) I Believe that Statutory Accounting Should be Elminated?

Statutory accounting is for the benefit of others, and is not used at all for
internal decision making by many (the majority of?) insurance companies

Elimination of statutory accounting statements and reporting would
provide significant expense savings

GAAP financials and fair value financials together will provide sufficient
information externally

Fair value accounting will provide more complete information that better
reflects the economics of the business
 More accurately reflects the cost of liabilities, by considering future
payment patterns
 Considers time value of money
 Reflects risk (volatility, uncertainty) of insurance
10) ___ Yes
___ No
___ Eventually
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Three Major Challenges
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Determining Required Company Total Capital – “Sizing the Pot”
Establishing Product level “Price for Risk” Relationship and
Capital (or Cost of Capital) Attribution Methodology
Controlling Required Capital Over Time (“Leverage for Return”
RAROC or RORAC perspectives) which:



Applies capital (i.e., leverage) factors in order to determine
required product level risk capital
Determines required risk capital sourcing from capital
markets and product profits
Maintains risk over time by control of 1) the flow of risk
capital and 2) the recognition and flow of profits based on
the pattern of liabilities and risk resolution over time
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