FIN 12: Actuarial Considerations Re Risk and Return • Related Concurrent Sessions

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FIN 12: Actuarial Considerations Re Risk and Return

• Related Concurrent Sessions – FIN 10: Into the Workings of DCF – FIN 11: Parameter Estimation in DCF – FIN 15: The Cost of Financing from a DFA Perspective

The Book: A Safe Harbor

• • “Actuarial Considerations…” was compiled to illustrate the wide range of sound actuarial practices • It does not contain all valid approaches, but instead encourages creative solutions My goal as editor is for regulators to look beyond form to the substance of the rate filing

Benedetto Conti

Perspectives

• • • Senior Management Regulators Stakeholders

Three Audiences

Three Audiences

• • • • Their goals Their constituency Their language What the actuary can provide

Senior Management

Goals: Constituency: Language: Market position and stock price Investment Analysts and Rating Organizations Growth and ROE What the actuary can provide: Risk-adjusted ROE’s that reflect enterprise risk

Regulators

Goals: Constituency: Consumer Protection Voters and Political Leaders Language: What the actuary can provide: Excess, waste, profit (“Profit” has a

negative

tone here) Documentation that the profit is

fair

in the market

Stakeholders

Goals: Constituency: Language: What the actuary can provide: Value creation in the context of risk Same investors and consumers represented by proxy so far Invisible hand; efficient markets; supply and demand Prices that are consistent with competitive markets

Two Perspectives

• Optimal Portfolio – Marginal Effect on the Portfolio – Efficient Frontier of Risk and Return – Returns Reflect Market Portfolio – Stars: Markowitz, CAPM, APT, Black Scholes • Optimal Price – Marginal Effect on Supply and Demand – Efficient Frontier of Sales and Price – Prices Reflect Information – Stars: Adam Smith, Arrow, Debreu, Cowles, Borch

Two Perspectives

Return-on-Equity 1. Define the product in the corporate environment 2. Use comparative ROE data to allocate surplus and set ROE 3. Adjust as needed for rate filing Cost of Risk 1. Define risk in a general way and find the market cost of risk 2. Use that cost in product pricing in a corporate environment 3. Adjust as needed for rate filing

Russ Bingham

Return-on-Equity

Cost of Risk

• • Supply and demand for “risk” The underwriter takes risk premium in consideration for accepting risk transfer • The markets tell us the metric for risk, and the price per unit of risk • We can use that market cost of risk

Risk as a Commodity

Using the Market Cost of Risk

1. Find the cost of risk per unit of exposure 1.1 Determine the risk per unit of exposure 1.2 Apply the market cost per unit of risk 1.3 Determine the premium rate level 2. Optimize the portfolio 2.1 Determine the marginal risk and return to the firm from selling the product (e.g., by using DFA) 2.2 Set volume and price targets to maximize the value of the firm

Communicating to Management

• Allocate surplus and select ROE. Then, find the premium rate from DCF calculation.

• Find the premium/ price goals that maximize the value of the firm. Then, express these as allocated surplus and ROE.

Communicating to Regulators

• • DCF calculations Profit provisions –  , a cost per unit of exposure – – Q*R, a provision for profit and contingencies in the rate L*(1+  ), a risk loading • Choice of conservative assumptions

Questions

Calculation of

E

 

E

   

n

 1

p

(

j

)   

t

   0

v

(

t

|

j

)   

x

   

xp

(

x

|

t

,

j

)

dt

        

P

    

s

ln   

n

 1

p

(

j

) exp   

t

   0

v

(

t

|

j

) ln   

x

   

p

(

x

|

t

,

j

) exp 

s x

 

dt

        

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