RCM – 4: From Enterprise Risk Management to Ratemaking
How the Hartford’s Benchmark Methodology
Approaches Risk, Price, Leverage and Return Across its Operations
Russ Bingham
Vice President and Director of Corporate Research
Hartford Financial Services
Seminar on Ratemaking
New Orleans, LA
March 9-11, 2005
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Outline
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Basic Premises
Background Comments
Operating Return
Operating Return Risk / Return Line
Operating Return as a Basis for Risk Pricing
Risk Coverage Ratio Risk Metric
Total Return
The Total Risk / Return Line
 Risk-Adjusted Return Uniform Leverage
 Risk-Adjusted Leverage Uniform Return
Calibration of Risk Metric
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Basic Premises
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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
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The same concepts and methodology should be used in all
areas including ratemaking, planning, performance
monitoring, incentive compensation, and ERM
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The critical cornerstones are risk, price, leverage and return
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Background Comments
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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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Operating Return
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Operating Income is underwriting income and investment income
on policyholder float (surplus and investment income on surplus is
excluded).
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Operating Return (OR) is operating income expressed relative to
policyholder (PH) liabilities (or their asset equivalent):
 Benchmark OR = NPV[u/w + PH inv inc] / NPV[liabilities]
 Investment return on PH funds minus cost of PH funds
 IRR of policyholder level cash flows
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Operating Risk / Return Line
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OR risk / return line is set based on risk metric.
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The slope of the risk / return line is equivalent to the Sharpe ratio
(z-value) in a normal distribution.
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Inherent OR volatility differs among lines of business.
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Risk-based price is determined which reflects each line’s volatility
and satisfies risk metric.
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Risk can be reduced by increasing slope of risk / return line which
forces an increase in price.
PRICE IS RISK-BASED
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Operating Return as a Basis for Risk Pricing
The price (premium) that reflects the volatility in each line of business and satisfies
the risk criterion places the expected operating distribution on the risk / return line.
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Each Line is Priced to Satisfy Specified Risk Criterion Which
Places Distribution on Operating Risk / Return Line
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Total Return
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Total Return is Operating Return Levered plus the Investment
Return on Surplus:
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ROS = OR x L/S + r
– OR = (U + r L) / L
– L / S is leverage ratio
– r is after-tax, benchmark yield on investments
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Operating Risk / Return characteristics remain when
translated to Total Return:
 Risk breakeven threshold shifts from OR=0 to ROE=r.
 L/S is a multiplier that affects return and volatility similarly
without disrupting risk/return relationship.
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Each Line Priced Satisfies Total Return Risk Criterion and
Places Distribution on Total Risk / Return Line
The price (premium) that satisfies the operating return risk criterion, by reflecting
the volatility in each line of business, places the expected total return distribution
on the total risk / return line. The operating return profile translates to total return.
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Risk / Return Characteristics Translate From Operating
to Total Return
The total return RCR risk metric is the same as the operating return RCR.
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The Total Risk / Return Line
Risk-Adjusted Return (Uniform Leverage)
The risk / return line shown assumes a uniform leverage in all lines of business
(typically corporate overall average).
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The Total Risk / Return Line:
Risk-Adjusted Leverage (with Uniform Return)
All lines of business are restated to a uniform 15% return with uniform volatility
via altered risk-adjusted leverage.
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Risk-Adjusted Return vs Risk-Adjusted Leverage
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Two equivalent alternatives which differ in the form of
presentation. At same premium & combined ratio –
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Maintain a fixed leverage, but vary the total return based
on volatility
– This avoids varying allocation of surplus to lines of
business
Maintain a fixed total return, but vary leverage to adjust for
volatility
– This makes regulatory environment less contentious
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Calibration of Risk Metric
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The risk metric is calibrated to insure that the risk–adjusted
leverage ratios when applied to all lines of business produce an
underwriting risk equity consistent with rating and other capital
requirements.
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Benchmark underwriting leverage ratios (liability / surplus) are
determined which are used in numerous applications (pricing,
planning, monitoring).
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Calibration considerations:
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Shift from benchmark accident year (present value of future equity
needs) to a calendar perspective to support current and previous
business writings;
Incorporate investment risk equity and debt.
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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 aspects
6. Thou shalt include all sources of company, policyholder and shareholder
revenue and expense embodied in the insurance process
7. Thou shalt reflect all risk transfer activities
8. Thou shalt not separate risk from return
9. Thou shalt not omit any perspective or financial metric that adds
understanding
10. Thou shalt allow differences in result only from clearly identified
differences in assumption, and not from model omission
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