Phase II Insurance
Project
Implementation Issues
Scott Lewis
The Hartford
September 18, 2008
The 3 building blocks
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Determine the unbiased, marketconsistent, probability-weighted
estimate of cash flows
Discount the cash flows
Determine the risk margin that
market participants require for
bearing risk
Determining the unbiased estimate
of cash flows
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What must a company do to prove that its
estimate is “market consistent” and
“probability weighted”? Does it differ from
the “best estimate” we have today?
What would happen if the new principle
did not allow using deterministic methods
to produce an estimate of cash flows?
Can the estimate of undiscounted cash
flows differ from the actuarial “mean”?
Can there be a difference between the
actuary’s point estimate and
management’s estimate?
Is there a “risk margin” already in
the estimate of cash flows?
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Using conservative assumptions in actuarial
methods
Including an explicit “risk load” in cases of
highly volatile lines
Being conservative in selecting the actuarial
indication among several methods
Setting carried reserves above the mid-point of
a statistical range
Recording a reserve redundancy (the bestestimate carried reserves exceed the actuarial
indication)
“Market-consistent”
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Even if certain assumptions (like medical claim
severity) could be isolated, there is not likely
forward market data that could be used to
calibrate those assumptions
Can interest rate or inflation derivative market
rates be used as assumptions in actuarial reserve
estimates? Should these rates be “decoupled”
from loss development factors or other
assumptions used in today’s methodologies?
IASB: Estimates of frequency and severity
“should not contradict current market variables”.
The burden is to demonstrate that assumptions
are consistent with available external and internal
data
“Probability-weighted”
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Use stochastic modeling (like
bootstrapping) to build a statistical
distribution around a selected
estimate of cash flows. This
distribution of future paid losses
would be used in the calculation of
the risk margin.
Stochastic modeling could be used to
develop leverage ratios
Discounting
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Market rate versus risk free rate
If risk-free, determine what yield
curve you will use as a proxy
LIBOR-derived rates may be a viable
option (e.g. swap rates)
Select the expected payment pattern
Payment patterns
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More analysis is needed in estimating how
volatile claim payment patterns can be.
Most accounting systems today discount
only tabular (indemnity W/C) case
reserves. Systems must be modified to
accommodate discounting all case
reserves for all accident years
Need to discount IBNR as well
Companies should keep track of IBNR by
accident year
Cost of capital method
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Risk margin is based on the
difference between the assumed cost
of capital and the risk free rate
multiplied by the required capital
Implementation issues-• How to calculate total required capital
• How to attribute that capital to
reserving lines within reporting
segments
• What is the appropriate cost of capital
Required capital
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Could use stochastic modeling of loss &
LAE distributions to determine the amount
of capital that must be held to meet
defined solvency requirements.
Defining solvency requirements—
ultimately, the solvency level depends on
management’s risk tolerance (e.g 99.95%
confidence level)
But we really don’t know much about 1-in2000 year events
What should be the cost of capital?
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3rd party required return may be different
if they are buying contracts in runoff
versus an ongoing business
Consider the following possibilities for
Florida homeowners:
• 15% target ROE embedded in the Company’s
rate filing
• 5% ROE embedded in the rates approved by
the Florida Department of Insurance
• 10% return a hypothetical 3rd party would
require to be compensated for the risk of
assuming contracts in runoff
What the risk margin must consider
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Compensation for capital needed to
support-• Variability due to process risk
• Variability due to parameter risk
• Variability due to model risk
• The risk that the actual average
payment date could be different from
our selected average payment date
• The risk that the actual interest rates
could be different than our assumed
rates
Pre-claim liability: arguments against
using UEPR as a proxy for fair value
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Unearned premium does not take into
consideration what happens if there is a
significant change in cash flow estimates such as
due to:
• The effect of a change in the current accident year
reserve call
• A significant event such as a hurricane that is
about to make landfall right before quarter end
The fair value of the pre-claim liability could
change due to a change in interest rates (e.g. if
six months after policy issuance, interest rates go
down, the premium we collected is presumably less
than the amount of premium that would be charged
now and we would have a loss)
Other considerations
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Reinsurance—estimate range of
uncollectibility due to defaults and
disputes
Diversification of non-hedgeable risks
Review every reserving line every quarter?
Project management
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Get a project manager
Identify actuarial system requirements
Run general ledger in parallel
Get pro forma statements prepared early on so
you can manage investor expectations
F/S and Disclosures
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If MD&A is presented using “old GAAP”,
may need to maintain 2 sets of books
May need to provide cumulative paid loss
and reported loss triangles for gross and
ceded business, not just for net
Will likely need to disclose the effect that
emerged loss trends could have or have
had on the nominal best estimate and risk
margin of the post-claim liability. Also
disclose effect on the pre-claim liability