RCM-1 Risk and Return Considerations in Ratemaking
Russ Bingham
Vice President and Director of Corporate Research
Hartford Financial Services
Seminar on Ratemaking
Philadelphia, PA
March 11-12, 2004
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Outline
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Financial Model Building Blocks
Risk / Return Decision Framework
Financial Integrity
Does Your Model ...
Price, Risk, Leverage and Return
Ten Commandments of Insurance
Financial Modeling
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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)
plus
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Risk / return decision framework which deals with separate
underwriting, investment and financial leverage contributions
3
Policy (or Accident) / Calendar Period
Development Triangles
Balance Sheet, Income, Cash Flow
Policy
Period
Prior
2000
2001
2002
2003
2004
Reported
Calendar
2000
X
X
====
Sum
Calendar Period
Historical
2001
2002
2003
X
X
X
X
X
X
X
X
X
X
X
X
====
Sum
====
Sum
====
Sum
Future
2004
X …...
X …...
X …...
X …...
X …...
X …...
====
Sum
Total
Ultimate
--> Sum
--> Sum
--> Sum
--> Sum
--> Sum
--> Sum
Rates are set across the policy period “row” but regulatory review is
often based on the calendar “column” sum
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Risk / Return Decision Framework – Basic Principles
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Insurance = underwriting, investment and financial leverage
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Volatility is uncertainty of result
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Risk is exposure to loss
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Policyholder, company & shareholder risk transfer pricing
activities are a function of risk, and can be accomplished
independently of leverage
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Underwriting and Investment returns are a function of
volatility (greater uncertainty, greater required return and
vice versa)
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Risk / Return Decision Framework – Basic Principles
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Total return is underwriting and investment return
leveraged
Leverage simultaneously magnifies total return and
volatility in total return, but NOT necessarily risk
Leverage is the process by which surplus is introduced in
order to provide a financial buffer against adverse
outcomes (and also to allow for the expression of results in
the standard ROE language of management)
Cost of capital is as important as cost of underwriting
Ultimately, risk and return should be expressed in the
same metric
Principles apply to underwriting and investment activities
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Financial Integrity
Ideal Ratemaking Financial Documentation Support
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Fully integrated balance sheet, income and cash flow
statements
Policy / accident period focus with calendar period provided
if needed
Nominal and economic accounting valuations
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
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Financial Integrity(Continued)
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All ratemaking models can be reconciled with this documentation
Ratemaking focus should be on parameter assumptions and
inputs and not be distracted by a particular model structure
 Differing and often incomplete forms of presentation make it
nearly impossible to understand and compare “opposing”
approaches
 Inconsistent parameter estimation, leading to biased
outcomes, is all too common and is not challenged effectively
Ratemaking is a key component of financial management
 It is the actuary’s responsibility to see that ratemaking and
related activities are part of a disciplined financial process
 Actuaries risk being marginalized unless they adopt a bottom
line, ownership orientation - total return in comparison to the
cost of capital is relevant, for example, whereas return on
premium by itself is not
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Does Your Model . . .
Reflect all costs?
Reflect all risks?
Provide all metrics?
Apply to underwriting and investment
activities?
Facilitate the application of fundamental
risk / return principles?
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Price, Risk, Leverage and Return
Price for Risk, Leverage for Return
What is Risk, and how is it reflected in the Price?
What is the working Risk / Return Tradeoff?
What determines Leverage?
What is the Cost of Capital and how is it incorporated?
What is the Economic Value Added?
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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
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