From Ratemaking to Enterprise Risk Management
(Expanding the Actuary’s Role)
including
2004 Proceedings Paper:
Value Creation in Insurance – A Finance Perspective
Russ Bingham
Vice President and
Director of Corporate Research
Hartford Financial Services
CANE
March 23, 2005
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Outline
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Basic Premises
Financial Discipline
Financial Integrity and Model
The Return Perspective
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The Risk Perspective
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Building a Financial Discipline - History
Building Blocks – Valuation Fundamentals
Unified Financial Model
Insurance Funds Flow Schematic
Demonstration Example and Value Creation
Background Comments on Risk / Return
Risk Coverage Ratio Risk Metric
Risk-Adjusted Return versus Risk-Adjusted Leverage
Ten Commandments of Insurance Financial Modeling
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Basic Premises
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An insurance company must have a financial discipline for dealing
with risk and return – this requires a companywide commitment to
the process and to the development and implementation of models
that employ the appropriate concepts and methodologies throughout
all operations
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The same concepts and methodology should be used in all areas
including ratemaking, planning, performance monitoring, incentive
compensation, and ERM
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The critical cornerstones are risk, price, leverage and return
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A Financial Discipline Process
What it is and what it takes to establish
Financial discipline is a valuation process, supported by analytical methods
and models, intended to provide timely and meaningful assessments of
risk / return performance and trends associated with underwriting,
investment and finance operations
Conditions needed to instill a financial discipline:
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Financially astute senior leadership
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A committed senior management
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A group (actuarial, accounting, finance) responsible for the development of
“benchmark” concepts, models and operating applications
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Companywide application of benchmark concepts and models in
 Ratemaking
 Planning
 Performance monitoring
 Incentive compensation
 ERM
 ... “All inclusive - no exceptions”
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Financial Integrity and Model
Ideal Ratemaking Model and Financial Documentation
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Fully integrated balance sheet, income and cash flow statements
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Policy / accident period focus with calendar period provided if needed
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Nominal and economic accounting valuations
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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
 Specification of risks included
 Amount of capital and its cost
The same methodology (and preferably the same model) that is used for
ratemaking should also be used for planning, performance monitoring,
financial analysis, incentive compensation, and ERM
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Building a Financial Discipline - History
The objective is to create a process of financial discipline which
enhances the creation of economic value and the subsequent delivery
of reported earnings.
Basic concepts implemented and published
1987 Internal line of business, accident year benchmark ROE introduced
for ratemaking and performance measurement.
1989 Proposition 103 testimony - proposing DCF and economic valuation
models in ratemaking.
1990 Proceedings “Discounted Return - Measuring Profitability and
Setting Targets” - documentation of basic approach and concepts.
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History: (Continued)
Refinement of important rate of return principles
1993 Proceedings (1) “Surplus - Concepts, Measures of Return, and
Determination” and (2) “Rate of Return - Policyholder, Company, and
Shareholder Perspectives” - developing rate of return and surplus
concepts further.
Conceptual and structural elements of model(s) reconciliation
1999 Actuarial Considerations Regarding Risk and Return text (1)
“Fundamental Building Blocks of Insurance Profitability Measurement”
and (2) “Cash Flow Models in Ratemaking” - discussing fundamental
principles and modeling considerations which result in equivalent
and/or reconcilable outcomes.
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History: (Continued)
Risk / return integration and rate of return / solvency connection
2000 Proceedings
(1) “Risk and Return: Underwriting, Investment and Leverage Probability of Surplus Drawdown and Pricing for Underwriting and
Investment Risk” - to incorporate methodology within risk / return
framework and deal with rate of return and solvency in an
integrated manner.
(2) “The Direct Determination of Risk-Adjusted Discount Rates and
Liability Beta” - to demonstrate mathematical connection between
equity beta and liability beta.
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History: (Continued)
Integration of economic value concepts
2004 Proceedings
“Value Creation in Insurance – A Finance Perspective” - to
incorporate economic valuation into SINGLE financial model that
encompasses ratemaking and (virtually) ALL other applications
which measure financial performance in an insurance company.
This extends the focus from internal revenue and expense items to
include external costs of capital.
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“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) – Use economic basis for decision
making to the maximum extent possible
plus
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Risk / return decision framework which deals with separate
underwriting, investment and leverage contributions
Note: Both internal and external costs must be reflected
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Policy (or Accident) / Calendar Period Development Triangles
Balance Sheet, Income, Cash Flow
Calendar Period
Pol./Acc.
Period
Prior
2002
2003
2004
2005
2006
Reported
2002
X
X
====
Sum
Historical
2003
2004
X
X
X
X
X
X
X
====
Sum
====
Sum
Future
2005
2006
X
X
X
X
X
X
X
X
X
X
X
====
====
Sum
Sum
…...
…...
…...
…...
…...
…...
Total
Ultimate
--> Sum
--> Sum
--> Sum
--> Sum
--> Sum
--> Sum
Benchmark focus is on the present value across a policy/accident period row.
Calendar reporting focus is on the nominal value sum total down a column.
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Unified Financial Model

Ratemaking models and approaches are too often overly narrow in
focus (and thus limit the actuary’s role)
 May not be integrated with other company assessments of profit
and value creation
 May not provide all metrics that management likes to see
 May not include both internal and external costs
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A single, all-inclusive financial model can be created which supports
virtually all insurance company financial performance assessment,
including ratemaking, and serves to act as a critical source of
managment decision making.
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The “Value Creation” paper demonstrates how external capital costs,
often missing from ratemaking models, are integrated in such a
unified approach.
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Insurance Funds Flow Schematic - The Risk Transfer Process
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Demonstration Example - Assumptions
For underwriting function activities:
 103.1% Combined ratio
 $9,700 Premium, collected without delay when written
 $10,000 Loss, single payment at end of year 3
 $0 Expense
 35% Income tax rate, no delay in payment
 6.0% Low-risk investment interest rate before-tax, 3.9% after-tax
 No loss discount tax or unearned premium tax
 3.0 Liability/surplus ratio
 15.0% Cost of underwriting equity
For investment function activities:
 6.2% Investment interest rate before-tax, 4.65% after-tax, assuming a 25% tax rate
 20% Investment equity / underwriting equity ratio, equivalent to using
a 20:1 (liability plus underwriting equity) / investment equity ratio
 15.0% Cost of investment equity
For finance function activities:
 6.2% Investment interest rate before-tax, 4.65% after-tax, assuming a 25% tax rate
 25% Debt / total equity ratio
 8.0% Cost of debt before-tax, 5.2% after-tax.
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Demonstration Example – Financial Recap
Item
Amount
Funds Rate
10,000
-15.00%
Net Cost / Value
Functional Accounting
Source / Cost of Funds
Underwriting Equity
-1,500
Underwriting
Investment Equity
2,000
-15.00
-300
3,000
-5.20
-156
30,000
-0.70
-210
Investment
Debt
Finance
Underwriting Liabilities
Underwriting
Use / Value of Funds
Underwriting Liabilities
30,000
3.90%
1,170
10,000
3.90
390
40,000
0.75
300
2,000
4.65
93
3,000
4.65
140
45,000
-0.16
-74
Underwriting
Underwriting Equity
Note: Financial amounts are
expressed in nominal value (i.e. not
discounted), and represent the sum
total over the policy lifetime of each
respective item.
Underwriting
Inv. Lift on Underwriting
Investment
Investment Equity
Investment
Debt
Finance
Total
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Economic Cost and Value Creation Components
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Background Comments on Risk / Return
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Volatility characteristics of input and output variables are a key component
of risk assessment but volatility alone does not represent risk
Risk lies in the potential for adverse outcomes, which is a function of both
the level of and volatility in important variables of interest
A risk-based pricing and capital attribution methodology incorporates
volatility in determining levels of outcoumes in order to conform to an
acceptable risk / return relationship
Policyholder level risk / return relationship is based on operating return
Shareholder level risk / return relationship is based on total return
Where possible policyholder and shareholder risks are not intermingled
Price is the lever that addresses policyholder sources of risk and capital
attribution (i.e. leverage) the lever that addresses shareholder risk sources
A risk metric is a statistic derived from the distribution of outcomes of a
particular variable of interest related to the occurrence of an adverse event
(frequency, severity, etc.)
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Risk Coverage Ratio Metric – “Reward to Risk” Ratio
General Process for Selecting Risk Metric: 1) Identify relevant variable and
generate distribution of expected outcomes, 2) Identify what constitutes an
adverse event, 3) Calculate frequency and severity of adverse events across all
outcomes, and 4) Calculate risk metric (if not frequency or severity).
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Each Line is Priced to Satisfy Total Return Risk Criterion and
Place Distribution on Total Risk / Return Line
The price (premium) that satisfies the risk criterion, by reflecting the volatility in each line
of business, places the expected total return distribution on the total risk / return line.
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The Total Risk / Return Line
Risk-Adjusted Return (Uniform Leverage) – “RAROC”
The risk / return line shown assumes a uniform leverage in all lines of business
(typically corporate overall average).
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The Total Risk / Return Line:
Risk-Adjusted Leverage (with Uniform Return) – “RORAC”
All lines of business are restated to a uniform return (e.g.15%) with uniform
volatility via altered risk-adjusted leverage.
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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 –
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RAROC - Maintain a fixed leverage, but vary the total return
based on volatility
– This avoids varying allocation of surplus to lines of business
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RORAC - Maintain a fixed total return, but vary leverage to
adjust for volatility
– This makes regulatory environment less contentious
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Ten Commandments of Insurance Financial Modeling
1. Thou shalt build only models that have an integrated set of balance sheet,
income and cash flow statements
2. Thou shalt remain rooted in a policy period orientation and develop
calendar period results from this base
3. Thou shalt reflect both conventional and economic accounting perspectives
- guided by economics, constrained by conventions
4. Thou shalt recognize the separate contributions from each of underwriting,
investment and finance activities
5. Thou shalt be guided by the risk / return relationship in all aspects
6. Thou shalt include all sources of company, policyholder and shareholder
revenue and expense embodied in the insurance process
7. Thou shalt reflect all risk transfer activities
8. Thou shalt not separate risk from return
9. Thou shalt not omit any perspective or financial metric that adds
understanding
10. Thou shalt allow differences in result only from clearly identified
differences in assumption, and not from model omission
Do not confuse models with metrics.
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