FIN 12: Actuarial Considerations Re
Risk and Return
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Related Concurrent Sessions
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FIN 10: Into the Workings of DCF
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FIN 11: Parameter Estimation in DCF
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FIN 15: The Cost of Financing from a DFA
Perspective

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

Perspectives

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Senior Management
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Regulators
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Stakeholders

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Their goals
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Their constituency
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Their language
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What the actuary can provide

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

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

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

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

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

Return-on-Equity

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

• 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.

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

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