Ratemaking & Reserving: An Enterprise Risk Management (ERM) Perspective

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Ratemaking & Reserving:
An Enterprise Risk Management
(ERM) Perspective
Casualty Actuaries of New England
September 26, 2006
John Kollar
CAS ERM Definition
• Process
– Assess
– Control
– Exploit
– Finance
– Monitor risk
• Holistic treatment of risk
• Senior management function
• Upside and downside
Objective of ERM
Increase the value of the entity…
ERM “Drivers”
• Improved corporate governance
– Sarbanes Oxley Act
• Consolidation
• Financial services convergence
• Globalization
– Basel II
– Solvency II
– Fair Value Accounting (market consistent
valuations)
• Rating agencies – S&P, etc.
• Risk management evolution
Evolution
Not
Revolution
Against the Gods: The
Remarkable Story of Risk
Peter L. Bernstein
Professional Societies/Associations
ERM Developments
COSO
CAS
SOA
GARP
PRMIA
RIMS
ERM-II
Etc.
Holistic Treatment of Risk
Risk
Parameters
Reserving
Risk
Pricing
Risk
Economic
Capital
URM
Interest
Rate Risk
Risk
Allocation
Reinsurance
Combined
Ratios
Some ERM Pricing & Reserving
Questions (Outline)
•
•
•
•
•
•
•
•
What are new tools for loss reserving?
Capital adequacy?
Capital allocation by line, state, etc.?
Reinsurance? Amount? Cost? Risk transfer?
Marketing program?
Underwriting guidelines?
Underwriting cycle position?
Predictive modeling? Adverse selection?
Development Factors
Overcoming Limited Data
(Customized Loss Reserving Tool)
Improving Data Quality and Stability
(Customized Loss Reserving Tool)
Enhancing Estimates with
Industry Information (CLRT)
Com m ercial Auto Liability -- ALAE Included
Cape Cod w ith Weibull Tail Factor on 10 Years Data
180,000,000
156,567,178
160,000,000
138,540,206
128,338,295
140,000,000
Reserves
120,000,000
107,721,060
100,000,000
80,000,000
60,000,000
40,000,000
20,000,000
0
Insurer Data, Link
Insurer Data w ith ISO
Ratios, and Tail Factor Link Ratios and Tail
Factor
ISO Data Scaled to
Insurer Level
Mix of Insurer (40%)
and Scaled ISO (60%)
Data
Benchmarking for the Board and
Senior Management (CLRT)
Period 1 to Ultimate
Chain Ladder with Modified Bondy Tail Factors
14. 000000
12. 000000
Ratio
10. 000000
8. 000000
6. 000000
4. 000000
2. 000000
0. 000000
Schedule P
Ot her Liab
Occurrence
ISO
Prem Ops
All Tables
Wit h CRR
ISO
Prem Ops
Table 1
ISO
Prem Ops
Table 2
ISO
Prem Ops
Table 3
ISO
Prem Ops
Tables
1, 2, & 3
The Sch. P data is net, includes Composite Rated Risks (CRR), and is evaluated as of 12, 24, etc. months. The
ISO data is direct, excludes CRR (except as noted), and is evaluated as of 15, 27, etc. months.
Placing Loss Reserves in
Confidence Intervals (CLRT)
Documenting Analysis (CLRT)
Reserve Risk:
Average Size and Volatility of GL
Open Claims Increases Over Time
Claim Amount
Big Claims Settle Slowly
95th %
Mean
0
1
2
3
Open After n Years
4
5
6
Capital Requirements
Loss Volatility
Insurer A
Insurer B
}
More
Capital
Less
} Capital
Years
Expected costs
Years
{
Correlation = More Volatility
Low
Correlation
}Capital
Line
B
High
Correlation
Insurer B
Insurer A
Line
A
Capital
Total
Line
C
Line
D
Total
Correlation increases with
volume
Correlation and Risk Size
0.20
0.18
0.16
Correlation
0.14
0.12
0.10
0.08
0.06
0.04
0.02
0.00
Size of Risk
Aggregate Loss Distribution
& Implied Economic Capital
Loss Amount
Value at Risk
T
V
a
R
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
Cumulative Probability
0.8
0.9
Risk Measurement & (Cost of)
Capital Allocation by Line, etc.
Amount
Diversification Benefit
Standalone
CMP
HO
Auto
Cat
Multiline
Note capital is
allocated to
loss reserves
Cost of Financing Risk =
Cost of Capital + Net Cost of Reinsurance
• Cost of capital reflects:
– Release of capital as claims are resolved
– Discounted at the target rate of return on capital
– Rate of return on invested assets
• Net cost of reinsurance is the difference of the
ceded premium and the expected reinsurance
recovery after it has been reduced for:
– Discounted cash flows
– Federal income taxes
• Minimize the cost of financing risk.
Reinsurance Risk Transfer Testing
Cumulative Probability
Aggregate Loss Reserve Distribution
1.0
0.9
0.8
0.7
0.6
0.5
Expected losses
0.4
0.3
0.2
0.1
0.0
1,000
1,100
1,200
1,300
1,400
1,500
Loss Reserves ($Millions)
1,600
1,700
1,800
Marketing/Underwriting Strategy
Reflect Risk in Planning Change
Required Capital
Growing the Business
Prospect 1
Prospect 2
Existing
Standalone
Standalone
Standalone
Total
Total
Ratemaking/Pricing
Setting Combined Ratio
Targets by Line
• Expected losses – How adequate are the
reserves?
• Expected expenses
• Investment income
• Cost of financing
– Cost of reinsurance
– Cost of capital (risk) – How much risk is in the pricing?
Enterprise-wide risk?
Standard Ratemaking
Exhibit
Scroll to end –>
Cost of
Financing
Target
Combined
Ratio
Underwriting Cycle
Pricing Risk
• Develop a number of pricing scenarios reflecting
marketplace conditions (cycle):
– Pricing
– Coverage changes
– Policyholder selection
• For each pricing scenario:
– Adjust premiums.
– Calculate (projected) combined ratio.
– Calculate (projected) return on capital.
Confidence Interval Around the
Target Combined Ratio
1
Cumulative Probability
0.8
0.6
Target Combined
Ratio (104%)
CDF
0.4
0.2
0
0
20
40
60
80
100
Combined Ratio (%)
120
140
160
180
Predictive Modeling
Risk of Adverse Selection
• Use of other information (beyond rating
variables) to more accurately rate a policy
– Increased profits
– Reduced risk
– Less economic capital
• Inability to select better policies and compete
with other insurers results in adverse selection
– Losses or reduced profits
– Increased downside risk
– More economic capital
Some Questions for the
Reserving Actuary
• What are the assumptions underlying
pricing – trend, loss distribution,
coverage, etc.?
• Are marketing, underwriting and pricing
seeking the same policyholders?
• Is policyholder retention high?
Robust Analysis of an
Enterprise’s Risks (ERM) is
Essential to Sound Loss
Reserving and Ratemaking
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