Russ Bingham
Vice President Actuarial Research
Hartford Financial Services
Ratemaking Seminar
Atlanta, GA
March 8-9, 2007
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 The Environment
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Companywide Process of Financial Discipline
Requirements for Financial Discipline
Standardizing Financial Valuation
 Modeling
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Financial Model Integrity
Broadly Inclusive of All Risk and Return Variables and Metrics
 Risk-Based Pricing Principles
 Broadening the Actuarial Role – From Ratemaking to ERM
Suggestions for What Actuaries Will Need to Know / Do in the Future
 Internal versus External Perspectives
Economic and Risk-Based Orientation and Premises
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The Environment
Companywide Process 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.
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The Environment
Requirements for Financial Discipline
Conditions needed to instill a financial discipline:
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Financially astute senior leadership
A committed senior management
A group (actuarial, accounting, finance) responsible for the development of fundamental core “benchmark” principles and their application
Standardized companywide application of benchmark concepts and models
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The Environment
Standardizing Financial Valuation
Standardized financial valuation throughout entire company
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Ratemaking and product pricing
Planning
Performance monitoring
Profitability studies
Incentive compensation
Acquisition analysis
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
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Modeling
Financial Model Integrity
“Ideal” Financial Model for Ratemaking and Other Applications
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Fully integrated balance sheet, income and cash flow statements
Policy / accident period and calendar period perspectives
Nominal and economic accounting valuations
Risk and Return Incorporated / Integrated
Underwriting, Investment and Finance activities included
 Clearly and consistently stated parameter estimates
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Premium, loss and expense amount
Timing of premium collection, loss and expense payment
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Investment yield rates
Underwriting and investment tax rates
Specification of risks included
Amount of capital and its cost etc.
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
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Modeling
Broadly Inclusive of All Risk and Return Variables and Metrics
 Incorporate all sources of return - Revenue and Expense
 Incorporate all sources of risk that can be “distributionalized” – Loss,
Catastrophe Loss, Investment Yield, Cash Flow, etc.
 Provide all critical 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
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Risk-Based Pricing Principles
 Risk Pricing Objective is to insure that all operating activities (lines of business in underwriting as well as alternative investments) conform to a consistent risk / return relationship
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Pricing ideally sets all operating activities’ return/risk ratio to the same benchmark standard, so that strategic opportunity decisions can be made on a level playing field
 The corporate financial goal is distributed equitably among areas through pricing and capital allocation, in relation to risk
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Internal Diversification and external (e.g. ratings) factors influence this relationship
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Broadening the Actuarial Role - From Ratemaking to ERM
Suggestions for What Actuaries Will Need to Know / Do in the Future
 Understand the nature of risk(s) and how they relate to pricing (e.g., how is risk reflected in pricing) – (also related to reserve range estimation)
 The internal and external costs faced by insurance companies (e.g., what is the cost of capital and how does it affect pricing)
 Speak the same language as management (combined ratio, ROE, etc.)
 Understand and incorporate other financial metrics (e.g., economic value added, etc.) and be an advocate for advancing the state of the art
 Understand investment and finance activities and their impact as well as underwriting oriented ones
 Be able to connect with other financial perspectives (e.g., accounting , finance)
Actuaries need to understand a broad range of financial perspectives, integrate those that are relevant into ratemaking activities, and be able to communicate with a varied audience, doing whatever is necessary to become part of the company’s financially-based decision making process
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Internal versus External Perspectives
Economic and Risk-Based Orientation and Premises
Internal line of business decisions are made based on financials that reflect the “purest” view of financial performance possible
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Accident period oriented, not Calendar period, and revised to include latest estimates of ultimate values
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Economically based accounting, not Conventional (statutory or GAAP)
Forward looking (includes future cash flow expectations)
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 lookback
 External total company
“constraints” must be met based on -
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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)
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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
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