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