Ratemaking: An ERM Function
CAS Ratemaking Seminar
March 13 & 14, 2006
Russ Bingham, Hartford
Curt Parker, Grange Mutual
John Kollar, ISO
CAS ERM Definition
• Process
– Assess,
– Control,
– Exploit,
– Finance,
– Monitor risk
• Holistic treatment of risk
• Senior management function
• Upside and downside
ERM “Drivers”
• Improved corporate governance
– Sarbanes Oxley Act
• Consolidation
• Financial services convergence
• Globalization – International Association of
Insurance Supervisors (IAIS)
• International insurance accounting standards
– Solvency II
– International Accounting Standards Board (IASB)
• Risk management evolution
Some OTHER Ratemaking Questions
(Outline)
•
•
•
•
•
•
•
•
Adequacy of 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 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!