Research Double-Header
Don Mango, FCAS, MAAA
CAS Vice President of Research
Director of Research and Development,
GE ERC
Midwest Actuarial Forum
September 24, 2003
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Agenda
1.
2.
CAS Research Revision: official
CAS business as the VP of
Research and Development
Capital Consumption: latest
prize-winning paper
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CAS Research Revision
Don Mango
CAS VP Research &
Development
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Problem Statements
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No keepers of the state of the
science
Need for survey papers, syllabus
material
Research overload via Call Papers
Role/function of the PCAS unclear
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Proposed Solutions
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Rein in Call Paper programs
Establish Working Paper and Model
repository on the CAS Website
Institute Working Parties
Establish Research Corners and
Working Party sessions at the
major seminars
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Why Call Papers?

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Bottom-up, fast-track research
source.
Stimulate communication,
discussion and sharing.
Good in concept, in practice is
another story.
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Call Paper Forum

Not a top-tier professional journal
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Not peer reviewed.
Inclusive editorial policy.
Inconsistent review and prize standards.
Inconsistent appearance and structure of
papers.
Not enough editorial oversight.
Contributes to members’ filtration and
overload problems.
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Call Papers

Not generating discussion
Solitary practitioners produce, present
 No context, follow-up, formal
discussion

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Not leading to systematic progress
of the science
No referencing standards, context
 No clear advancement of the science

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Call Papers 
Working Papers

Many CPs are the equivalent of working
papers within academia

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Posted on websites and discussion forums
Works-in-progress, on their way to peerreviewed journals
We can still have bottom-up idea
generation, idea sharing, and discussion
by establishing a Working Paper (and
Model) repository on the CAS Website
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Working Paper Repository
Categorized by research area
 Members can post and comment on
posts (mini-reviews)
 Items receiving a lot of activity can
be the material for the Research
Corners at the major seminars

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Call Paper Refinement
Less often (~biennial)
 More editorial oversight

Subject to the new CAS Research Paper
template
 Impose length requirements (<30
pages)
 Must adhere more closely to the
subjects of the Call

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Working Parties
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Essentially a collective call paper task
force
Collective = group effort, single group
work product
Ideas come from the members attending
major seminar
Seminar has presentation of prior year’s
work, selection of next year’s topics
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Working Parties
Group effort forces discussion during
the production of the product
 Oversight by research committee
 Can enforce editorial standards,
referencing, ensure that current
state of the science is documented,
as well as context and scope of new
research

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Working Parties

An easy to implement answer that
helps on many fronts:
Solitary  Group
 Bottom-up + Top-down
 Consistency in format, referencing, etc.
 Member involvement
 Natural seminar cycle supports it

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Working Parties
Four WPs kicked off at 2003 RCM
Seminar
 Reserve Variability (led by Roger
Hayne) kicked off at 2003 CLRS
 More to come

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Publications Task Force
Impact and notoriety of PCAS
outside the CAS is essentially NIL
 Forum is used / abused
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Large bodies of work published without
formal peer review
Considering some radical surgery

Maybe we join the NAAJ
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Capital Consumption
Don Mango
Director of Research
and Development
GE ERC
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Why Even Consider This?
Despite significant efforts
throughout the industry, capital
allocation has yet to be effectively
implemented in (re)insurance
 This alternative method also has
strong linkages to financial theory,
while more accurately representing
the actual capital usage of insurance

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Problem Statements
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Capital allocation is a de facto paradigm
 a requirement or necessity
But insurance capital usage is
fundamentally different than it is for
manufacturing, being in fact the mirrorimage in time
For these decision evaluation processes,
capital allocation is sufficient but not
necessary
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Problem Statements
Even worse, the resulting
insurance IRR framework is now
completely fictional (“imputed”),
since no capital is transferred or
returned
 However, insurance capital is
consumed when results are worse
than planned

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Actually
This IS capital allocation
for insurance, done right
But I needed new
terminology to shake
loose the old thought
processes
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Core Paradox
 Manufacturers need capital
committed to support the
operation…
 …and they actually use it, spending
it on materials, operations, labor…
 …and it’s invested in their business,
in the production of their goods.
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Core Paradox
 Insurance companies need capital
committed to support the
operation…
 …but they can’t actually use it (or
not too much of it anyway)…
 …and it’s not invested in their
business, but in financial
instruments.
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Two Bets

Bet #1
You pay me $10 now
 I might pay you $50 later

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Bet #2
I pay you $10 now
 You might have to pay me $50 later

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Payoff Diagrams
Bet #1
60
50
40
30
20
10
0
-10
Now
Later
-20
Bet #2
20
10
0
-10
Now
Later
-20
-30
-40
-50
-60
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Bet #1
Spend then Maybe Receive
You spend now, hope to receive later
 You spend NOW, voluntarily
 With the odds I give you, you can
compute an expected value and
decide if you want to make the bet

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Bet #2
Receive then Maybe Spend
You receive now, hope you don’t
have to spend later
 You MAY spend LATER, contingent
on something happening
 With the odds I give you, you can
compute an expected value and
decide if you want to make the bet

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Capital?

Bet #1 = $10
You spend $10 capital NOW no matter
what
 The capital investment is current and
certain – i.e., not contingent
 The capital is allocated = spent =
consumed
 Natural capacity constraint = your
budget
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Capital?

Bet #2 = $???
I should be sure you have $40 available
LATER, but you don’t spend anything
NOW
 If Bet #2 hits, you spend $40 capital
LATER
 Capital expenditure (= allocation) is
contingent and in the future
 Capacity constraints = ???

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Allocation vs Consumption

Two different but equally valid
frameworks for
Treating capital
 Evaluating insurance business
segments
 Developing indicated prices for
reinsurance
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Nearly orthogonal
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Allocation vs Consumption

1.
2.
3.
Three questions:
What do you do with the total
capital?
How do you evaluate business
segments?
What does it mean to be in a
portfolio?
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Allocation vs Consumption
Question 1: What happens to the total capital?
Allocation
Consumption
 Divided up among the
 Left intact
segments.
 Each segment has the right
 Either by explicit
to “call” upon the total capital
allocation, or assignment
to pay its operating deficits
of the marginal change in
or shortfalls
the total capital
requirement from adding
the segment to the
remaining portfolio
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Allocation vs Consumption
Question 2: How are the segments evaluated?
Allocation
Consumption
 Give the allocations to
 Give each segment “access
each segment
rights” to the entire capital
 Evaluate each segment’s  Evaluate each segment’s
return on their allocated
potential calls (both
capital
likelihood and magnitude) on
the total capital
 Must clear their hurdle
rate
 Must pay for the likelihood
and magnitude of their
potential calls
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Allocation vs Consumption
Question 3: What does being in a portfolio mean?
Allocation
Consumption
 Being standalone with
 Being standalone with
less capital
potential access to all the
capital
 But still having access to
all the capital if
 But all other segments have
necessary, although it is
similar access rights
unclear how this is
reflected

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The difference between having your own
kiddie pool and joining a swim club
This is THE CRITICAL SLIDE!
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Options Framework
The company capital pool is giving
each reserving segment a series of
options to draw upon (consume)
the capital
 These options

Expire unused if segment meets or
beats Plan
 Are exercised if segment’s results
deteriorate
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Options Framework
Similar to a Line of Credit (LOC)
 A contingent loan, with full
expectation to be reimbursed
 This is a valid alternative financial
analogue
 Much closer to the way capital
actually gets used by an insurer
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Options Beware
“Options” does not imply BlackScholes formula
 For one thing, we cannot hedge
our exposure
 We must price it from first
principles  modeled payoff
distribution and internal risk
charges
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Details of the Framework
Scenario analysis
 Default-free discounting
 Scenario-level capital consumption
 Evaluation of capital consumption
using a “quasi~utility” approach
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Scenario Capital
Consumption
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Experience fund
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From Finite Reinsurance
Fund into which goes all revenue, from
which comes all payments
Bakes in investment income
When the fund is exhausted, but further
payments still need to be made,
exercise the Call Option for capital
That capital gets spent  CONSUMED
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Chart 1: Capital Consumption Profile Over Time
Short versus Long Tail with 120% Loss Ratio
$20,000
$18,000
$16,000
Short Tail
Long Tail
$14,000
$12,000
$10,000
$8,000
$6,000
$4,000
$2,000
$0
1
2
3
4
5
6
7
8
9
10
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Capital Call Cost Function
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Risk-based overhead expense loading
Pricing decision variable
Application of utility theory
Borch (1961):
To introduce a utility function which the
company seeks to maximize, means
only that such consistency requirements
(in the various subjective judgments
made by an insurance company) are put
into mathematical form.
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Implicit Preferences
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Preferences buried in Kreps’ “Marginal
Standard Deviation” risk load approach:
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The marginal impact on the portfolio
standard deviation is our chosen functional
form for transforming a given distribution of
outcomes to a single risk measure.
Risk is completely reflected, properly
measured and valued by this transform.
Upward deviations are treated the same as
downward deviations.
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Capital Call Cost Function
Make the implicit explicit
 Express your preferences explicitly,
in mathematical form, and apply
them via a utility function
 The mythical “Risk Appetite”
 Enforce consistency in the many
judgments being made
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THANK YOU!
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