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New Approach to Ratemaking & Reserving CAS May Meeting May 9, 2006 John Kollar, ISO Russ Bingham, Hartford CAS ERM Definition • Process – Assess – Control – Exploit – Finance – Monitor risk • Holistic treatment of risk • Senior management function • Upside and downside Holistic Treatment of Risk Risk Parameters Risk Analysis Pricing Risk Economic Capital URM Interest Rate Risk Risk Allocation Reinsurance Combined Ratios Some New Ratemaking & Reserving Questions (Outline) • • • • • • • • What are Fair Value loss reserve estimates? Capital adequacy? Risk measurement by line, state, etc.? Reinsurance? Amount? Cost? Risk transfer? Marketing program? Underwriting guidelines? Underwriting cycle position? Predictive modeling? Adverse selection? Loss Reserve Estimates • New Approaches – Stochastic methods – Bayesian estimates – Benchmarking – Confidence intervals • Fair Value Accounting – Discounted reserves – Market Value Margin – Convergence of FASB to IASB Loss Reserve Adequacy Short-Tailed vs. Long-Tailed Lines Short-Tailed Lines Long-Tailed Lines Release most capital at the end of 1st year. Year 1 Year 2 Year 3 Year 4 Release a portion of capital at the end of each year. Y1 Y2 Y3 Y4 Reserve Risk: Average Size and Volatility of GL Open Claims Increases Over Time Claim Amount Big Claims Settle Slowly 95th % Mean 0 1 2 3 Open After n Years 4 5 6 Capital Requirements Loss Volatility Insurer A Insurer B } More Capital Less } Capital Years Expected costs Years { Correlation = More Volatility Low Correlation }Capital Line B High Correlation Insurer B Insurer A Line A Capital Total Line C Line D Total Correlation increases with volume Correlation and Risk Size 0.20 0.18 0.16 Correlation 0.14 0.12 0.10 0.08 0.06 0.04 0.02 0.00 Size of Risk Aggregate Loss Distribution & Implied Economic Capital Loss Amount Value at Risk T V a R 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 Cumulative Probability 0.8 0.9 Different measures of risk imply different amounts of economic capital Amount Implied Capital Capital Liabilities 2xStd. Dev. VaR@99% TVaR@99% Risk Measurement & (Cost of) Capital Allocation by Line, etc. Amount Diversification Benefit Standalone CMP HO Auto Cat Multiline Note capital is allocated to loss reserves Cost of Financing Risk = Cost of Capital + Net Cost of Reinsurance • Cost of capital reflects: – Release of capital as claims are resolved – Discounted at the target rate of return on capital – Rate of return on invested assets • Net cost of reinsurance is the difference of the ceded premium and the expected reinsurance recovery after it has been reduced for: – Discounted cash flows – Federal income taxes • Minimize the cost of financing risk. Optimize reinsurance by minimizing the cost of financing Amount Cost of Financing Insurance Net Cost of Reins Cost of Capital No Re Cat Re All Re Reinsurance Risk Transfer Testing Cumulative Probability Aggregate Loss Reserve Distribution 1.0 0.9 0.8 0.7 0.6 0.5 Expected losses 0.4 0.3 0.2 0.1 0.0 1,000 1,100 1,200 1,300 1,400 1,500 Loss Reserves ($Millions) 1,600 1,700 1,800 Marketing/Underwriting Strategy Reflect Risk in Planning Change Required Capital Growing the Business Prospect 1 Prospect 2 Existing Standalone Standalone Standalone Total Total Ratemaking Setting Combined Ratio Targets by Line • • • • Expected losses Expected expenses Investment income Cost of financing – Cost of reinsurance – Cost of capital (risk) Standard Ratemaking Exhibit Scroll to end –> Cost of Financing Target Combined Ratio Set combined ratio targets by line and overall Target Combined Ratios 108% 106% 104% 102% 100% 98% 96% CMP HO Auto Cats Total Underwriting Cycle Pricing Risk • Develop a number of pricing scenarios reflecting marketplace conditions (cycle). • For each pricing scenario: – Adjust premiums. – Calculate (projected) combined ratio. – Calculate (projected) return on capital. Predictive Modeling Risk of Adverse Selection • Use of other information (beyond rating variables) to more accurately rate a policy – Increased profits – Reduced risk – Lower economic capital • Inability to select better policies and compete with other insurers results in adverse selection – Losses or reduced profits – Increased downside risk – Higher economic capital Confidence Interval Around the Target Combined Ratio 1 Cumulative Probability 0.8 0.6 Target Combined Ratio (104%) CDF 0.4 0.2 0 0 20 40 60 80 100 Combined Ratio (%) 120 140 160 180 Robust Analysis of an Enterprise’s Risks (ERM) is Essential to Sound Ratemaking & Loss Reserving!