PROFIT AND CONTINGENCIES IN RATEMAKING
(FIN - 12)
Russ Bingham
Vice President and Director of Corporate Research
Hartford Financial Services
Seminar on Ratemaking
Las Vegas, NV
March 11-13, 2001
1
Profit and Contingencies in Ratemaking - Outline
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Value Creation / Earnings Delivery Process
The Reported Earnings Dilemma
Building Blocks
Risk / Return Decision Framework
Integration of Pricing and Solvency Control
Risk-Adjusted Return vs Risk-Adjusted Leverage
Financial Integrity
Risk / Return Graphic and Sample Exhibit
2
The Value Creation / Earnings Delivery Process
Economic value creation begins with sound, economically based
operating actions and ends with consistent and growing
earnings.
In Insurance this process embodies the following characteristics:
 Originating policy / accident period actions create financial
results that emerge over subsequent calendar periods.
 Economic value creation measurement differs from
conventional accounting with respect to the timing of income
recognition.
 Distinct contributions to the risk / return tradeoff from
underwriting, investment and financial leverage activities.
A “complete” financial methodology should address all aspects.
3
The Reported Earnings Dilemma
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The value creating actions (including ratemaking) that begin at
the line of business level by individual policy / accident periods
subsequently “deliver” reported company wide earnings that are
clouded by the following:
 Actual (???) Results
– Delayed reporting of reality since calendar period results
aggregate the financial activity of current and prior policy /
accident periods as they emerge over time
– Substantial portion is estimation, to be restated in later calendar
periods
– Co-mingling of results across originating policy / accident periods
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GAAP/Stat accounting rules that specify the timing of income
recognition and define how “income” emerges
Other Income items (reserve adjustments, realized gains,etc.)
Historical rather than prospective view
4
“Building Blocks”: Valuation Fundamentals
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Balance sheet, income and cash flow statements
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Development “triangles” of marketing / policy / accident
period into calendar period
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Accounting valuation: conventional (statutory or GAAP) and
economic (present value)
plus
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Risk / return decision framework which deals with separate
underwriting, investment and leverage contributions
5
Policy (or Accident) / Calendar Period
Development Triangles
Balance Sheet, Income, Cash Flow
Policy
Period
Prior
1997
1998
1999
2000
2001
Reported
Calendar
1997
X
X
====
Sum
Calendar Period
Historical
1998
1999
2000
X
X
X
X
X
X
X
X
X
X
X
X
====
Sum
====
Sum
====
Sum
Future
2001
X …...
X …...
X …...
X …...
X …...
X …...
====
Sum
Total
Ultimate
--> Sum
--> Sum
--> Sum
--> Sum
--> Sum
--> Sum
Rates are set across the policy period “row” but regulatory review is
often based on the calendar “column” sum
6
Risk / Return Decision Framework – Basic Principles
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Basic principles
 Insurance = underwriting, investment and leverage
 Volatility is uncertainty of result
 Risk is exposure to loss
 Policyholder, company & shareholder risk transfer pricing
activities are a function of risk, and can be accomplished
independently of leverage
 Return is a function of volatility (greater uncertainty, greater
required return and vice versa)
 Leverage simultaneously magnifies return and volatility in
return, but NOT necessarily risk
7
Underwriting vs Investment Risk / Return
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Underwriting and Investment each contribute to risk and return
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While higher risk investments can be used in ratemaking, the risk
transfer pricing principles that apply to this added investment risk
must still be reflected
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Properly separated and priced underwriting and investment risk
largely eliminates the disagreement as to what investment strategy
should be built into premium rates. Offsetting occurs since
 Higher investment risk requires higher price (yield) OR
 Higher investment risk requires increased surplus
8
Integration of Pricing and Solvency Control
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Simultaneous determination of price and control of risk
 Risk controlled using selected risk metric(s)
 Price determined which generates return along a tradeoff
line that meets risk / return criteria
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Adequate risk-adjusted price IS the way that solvency is
maintained
 Threats to solvency are driven more by inadequate riskadjusted price than by shortages in surplus
 Ideally, any rate filed should also be supported by
– the total return that is implied by it and
– the risk criteria upon which it is based
9
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  Maintain a fixed leverage, but vary the total return based on
volatility
– This avoids allocation of surplus to lines of business
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Maintain a fixed total return, but vary leverage to adjust for
volatility
– This makes regulatory environment less contentious
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Introduction of surplus into ratemaking (via the application of a
varying leverage ratio) is optional (but helps communication).
A leverage ratio (and thus surplus) serves a similar purpose in
application as do IBNR factors, yields, expense ratios and tax rates.
While they do not exist at the individual policy level, their necessary
consideration in ratemaking requires introduction by formula.
10
Financial Integrity
Ideal Ratemaking Financial Documentation Support
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Fully integrated balance sheet, income and cash flow statements
Reconciliation of policy / accident period with calendar period
Nominal and economic valuations
Clearly and consistently stated parameter estimates
 Premium, loss and expense amount
 Timing of premium collection, loss and expense payment
 Investment yield rates
 Underwriting and investment tax rates
 Leverage ratio and method (preferably risk-based) by which
surplus flows are controlled, including distribution of profits
11
Financial Integrity(Continued)
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All ratemaking models can be reconciled with this documentation
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Ratemaking focus should be on parameter assumptions and
inputs and not be distracted by a particular model structure
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Differing and often incomplete forms of presentation make it nearly
impossible to understand and compare “opposing” approaches.
Inconsistent parameter estimation to bias outcomes is all too
common and not challenged effectively.
Ratemaking is a key component of financial management
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It is the actuary’s responsibility to see that ratemaking and related
activities are part of a disciplined financial process.
Actuaries risk being marginalized unless they adopt a bottom line,
ownership orientation. Total return is relevant, return on premium by
itself is not.
12
Figure 1
13
Figure 2
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