2003 Thomas P. Bowles Jr. Symposium
The Key Issues
and Mission
Shaun Wang, Ph.D., FCAS
April 10, 2003
The Agenda

Reality Check

What Risks to Measure?

Benchmark Capital

Fair Value of Liabilities

Our Scientific Program
Shaun Wang
2
Reality: Poor ROE Performance
P/C Insurers vs. All Industries 1987–2002
20%
15%
10%
13
pts
5%
0%
-5%
87
88
89
90
91
92
93
94
US P/C Insurers
95
96
97
98
99
00
01
02E 03F
All US Industries
Source: Dr. Hartwig at Insurance Information Institute; Fortune
Shaun Wang
3
Source: A.M. Best, ISO, Reinsurance Association of America, Insurance Information Institute
Combined Ratio:
Reinsurance vs. P/C Industry
All Lines Combined Ratio
162.5
Reinsurance
170
Year 2001: Reinsurers did
even worse
160
150
104.9
114.4
115.7
106.5
110.0
114.3
107.7
100.5
105.6
100.8
101.6
104.8
105.8
106.5
119.2
113.6
108.5
110
105.0
106.9
120
110.5
108.8
130
115.8
126.5
140
100
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001 2002*
Shaun Wang
4
Reality Sounded A Wake-up Call

Where were the actuaries during years of severe
under-pricing and under-reserving?

Have some of the financial theories contributed
to market irrationality?

How can we maintain the continued viability of
the actuarial profession – the #1 ranked
profession?
Shaun Wang
5
In Search for Answers, We Must …

Get out of comfort zone --- traditional actuarial
mindset

Go to the deep water by understanding the risk
drivers and market dynamics

How can we project underwriting results without
knowing the level of market competition?
Shaun Wang
6
What Risks to Measure?
Traditional P&C
Risk Analysis




Expected Loss
Loss frequency & severity
Correlation between risks
Concentration of exposure
New Horizon

Business Process Risk

Competitive Game

Market cycle

Quality of Information

Reaction time

Incentive misalignment

Multiple Perspectives
Shaun Wang
7
Focus on “Business Processes”

Loss Modeling Is Only a Part of the Whole Story
1. “This company has the brightest actuaries, so it got to be
good …” --- Naïve thinking
2. One company had the state-of-the-art actuarial pricing model,
but in the end still lost so much money

Need to quantify the Business Process Risk

Top-line growth in a soft market poses a major risk

Over-crowded competitive market poses a major risk
Shaun Wang
8
A Model of Market Competition

Financial Result = Min{Quote1, …, Quotek}  Loss
where Quotek  Normal(k, k)
1. For long-tailed lines, delayed info  higher k 
higher chance of premium deficiency
2. more bidders k  higher chance of premium deficiency

The Winner’s Curse: In insurance competitive pricing,
the lowest price gets the business, but may be cursed
with financial losses
Shaun Wang
9
Competitive Game of Asset-Liability
Management


Insurers are competing in two fronts:

managing assets

managing liabilities
Prolific asset management is an “offensive
play” that necessarily weakens defense

Can score big during market boom

In the recent market meltdown, EU insurers were hurt
the most due to high concentration in stocks
Shaun Wang
10
US Insured CAT Losses (in $billion)
and Rate On Line Index (1989=100)
ROL showed big jump after
major CAT losses, and then
Source: Guy Carpenter & *III Estimate
250
came down gradually …
$28.1
$22.9
200
$16.9
150
$7.5
$2.7
$5.5
$4.7
$10.1
$8.3 $7.3
$8.3
$5.8
$4.3
$2.6
100
89
90
91
92
93
94
95
96
97
98
99
00
01
02*
Shaun Wang
11
Market Cycle & Risk Premiums

Hefty investment gains in the 1990s helped
insurance capital accumulation

Pre-Sept 11 oversupply of capital triggered very low
risk premiums

The depletion of insurance capital due to Sept 11
terrorist losses and investment losses

After Sept 11, the expected hurricane losses had not
changed, but the insurance rates jumped by more
than 30%
Shaun Wang
12
Quality of Information

Poor Quality of Information is a major risk for
(re)insurers

Information asymmetry -- major hurdle for
securitization (and reinsurers)

Value of Information?
 Think about the US search for Al Qaeda

Do we have a measure for “quality of information”?
Shaun Wang
13
Reaction Time


“Reaction Time” is an important aspect of risk

XOL reinsurance has a higher severity volatility than
proportional reinsurance. However, the reaction time
for rate increase is quicker for XOL

Rate increase delays in some regulatory jurisdictions
For long-tailed liabilities or long-term guarantees:
the ability to re-act is much limited.

You have a stack of policies written in the past

Too late to re-act
Shaun Wang
14
Incentive Misalignment


Many “risks” are created by misalignment of
incentives

Underwriters short-term goal v.s. long-tailed liabilities

Managers’ expansion of his/her own kingdom

CEO’s compensation linked to growth and acquisition
Trial Attorneys and the U.S. legal dynamics

Lawyer Contingent Fees & Punitive Damages should be
put in a trust fund for public good
Shaun Wang
15
Multiple Perspectives of Risk



Entity-specific value versus Market price

Market prices tend to exhibit local linearity

Catastrophe risk to an entity may increase more than
proportionally
Volatility

Outsider view: stochastic and random walk

Insider view: trend and direction
Risk of being short-sighted and losing perspective

NASDAQ bubble;
Variable Annuity Guarantees
Shaun Wang
16
The set of major risks depends on the
specific business /market
For Life Insurers
Traditional Risk
Analysis

Mortality/Morbidity

Lapse

Disintermediation
New Horizon

Asset management

Embedded guarantee
(VADB hedging/reserving)

Competitive Game
(distribution, expenses)

…
Shaun Wang
17
Risk Measures for Deciding
Capital Requirement and Fair Value

New Basel Capital Requirement for Insurers (IAIS)


Movement toward Fair-Value Accounting (FASB)


Parallel to the Banking Basel Accord II
Profound implications and heated debates
Internally, companies are desperately looking for better
ways of measuring risks and performance

Companies launched capital Allocation projects

Lot of confusion, misconception & practical difficulties
Shaun Wang
18
Capital Allocation, or really
Capital Consumption?

For high-risk low-return business, we want to allocate
less capital to it, but the capital consumption is high!

The capital consumption increases more than linearly
for correlated risks and high-impact losses

Knowing the capital consumption by business units can
help manage the business!

Many allocation methods rely heavily on superficial
assumptions about diversification between LOBs
Shaun Wang
19
Superficial Diversification Is Dangerous!

The pure loss generating process may show a low
correlation and high diversification benefit

From business standpoint, playing two different games
is much harder than playing just one competitive game

The contagion (or drag) effect may overwhelm any
diversification

Over-diversification increases the risk of losing touch
of reality for executives (and making bad decisions)
Shaun Wang
20
Right and Wrong Diversifications

Years of under-pricing were partially caused by the “low
correlation” argument by some multi-line players

Diversification needs to match with areas of expertise

Renaissance Re, a mono-line CAT-writer, achieves
diversification by geographic region and by peril

Expanding to a new line of business is very risky

Citigroup spun-off Travelers; GE selling ERC
Shaun Wang
21
Benchmark Capital

Other players’ capital allocation can affect you!

To avoid artificial effects of diversification, industry
benchmark capital charge is badly needed

Parameters are more important than the model

Benchmarks should reflect the inherent risks of the
business, regardless of risk portfolio

It will take a lot of fundamental analysis, expert opinion,
and timely updates
Shaun Wang
22
Did “U.S. Risk Based Capital” Help?


U.S. Benchmark RBC has only limited success:

Factor based reserve charges ignored the bigger issue of
reserve adequacy

Incentives for putting up inadequate reserves

Same capital charge factor for premium written in a hard
market versus in a soft market
Limitations due to a point-in-time measure, without
reference to future direction and sensitivity over time
Shaun Wang
23
It Is Coming! -- Fair Value of Liabilities

Actuarial Standards Setters are pushing for fair value of
liabilities

Motivated by consistent accounting treatment of assets
and liabilities

For actively traded assets, market values are readily
available

For insurance liabilities, there is no “active traded
market” --- “fair value” creates big challenges and
opportunities
Shaun Wang
24
Challenges of Fair Value Accounting


Fair value will introduce more volatilities on paper

Are we prepared for the “consequences”?

Is it better to enlarge or dampen the underwriting cycle?
Heated debate on the credit standing of the liability
holder:


There seems to be a conflict between “financial theory”
and “public interest”
We will learn a lot more today from the speakers!
Shaun Wang
25
Financial Theories for Fair Value

“CAPM with Zero beta” does not reflect reality

The Link between Insurance Stock Price and
Individual Loss Distribution is WEAK!

Insurance equity prices tend to reflect more of the
quality of company management

Renaissance Re --- mono-line writer for catastrophe
insurance, but very stable stock price appreciation
Shaun Wang
26
Fair Value: Arbitrage-free versus
Actuarial Models

Two different models, how do we reconcile them?

Frictional costs are the missing link
1. Actuarial models should be modified to reflect
available hedging in the capital market
2. Arbitrage-free models assumed complete market and
zero transaction cost (which are often not the case)
Shaun Wang
27
Reserve Deficiency for Long-tailed
Liabilities

Before tackling the fair-value question, we have a more
fundamental problem of reserve deficiency

As of 2002, P&C Industry reserve deficiency is estimated
at $120 billion – Morgan Stanley

Recently a flurry of billion$ reserve increases

In 2002, the top 300 EU companies have unfunded
pension liability > $267 billion -- WSJ

Reserve uncertainty for Long-Term-Care & Annuity
Guarantees?
Shaun Wang
28
Cycle Nature of Reserve Estimates

The adequacy of reserve estimates showed a
clear cycle over the years, coupled with the
pricing UW cycle

Pressure on short-term performance

Following the competitors

Tax smoother for some players

A slow-death sentence for many companies
Shaun Wang
29
Recent Dramas in Actuarial Reserve
Opinions

Mechanical actuarial methods can produce a wide range
of reserve estimates

In the past the lowest reserve estimates were often being
used

Recently we saw large increases in reserve estimates


Trigged by lawsuit against professional actuaries

Dramatic increases in reserve estimates may push struggling
companies off the cliff
Nowadays actuarial consulting fee is rated on the
potential legal liability of the project
Shaun Wang
30
Fair Value and Benchmark Capital Are
Intimately linked

The fair value of reserve liability necessarily contains a
risk margin --- (see Steve Philbrick 1994 paper)

These risk margins should be reflected in the capital
charge for reserve uncertainty risk

Otherwise, we create disincentives that would distort the
fair value calculation
Shaun Wang
31
Our Scientific Program


The Bowles Symposium Call Paper Program:

An overwhelming response of 25+ paper proposals

We selected 15+ proposals, which were subsequently
developed to papers
This Symposium

Joint efforts of Georgia State University, the CAS, and the
Actuarial Foundation

International event: participants from 9 countries

Industry-Academic Partnership: 5 universities
Shaun Wang
32
We Need Your Participation!

In this meeting room we have many bright minds with
deep research and industry experience

Interactive discussion is a key feature of this Symposium

It is important that you share your insights and
perspectives

Please try to be concise and clear in making your points

Have fun!
Shaun Wang
33