RISK AND RETURN: ALTERNATIVE MODELING “APPROACHES”

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RISK AND RETURN:
ALTERNATIVE MODELING “APPROACHES”
Russ Bingham
Vice President and Director of Corporate Research
Hartford Financial Services
CANE
March 20, 2002
1
Outline
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Value Creation / Earnings Delivery Process
Risk/Return – Focus on Value or Earnings?
Building Blocks
Risk / Return Principles
Risk / Return Decision Framework – Risk Metrics
Comparison of Policyholder and Shareholder Risk Metrics
Dealing With Uncertainty and Risk – Two Key Questions
Comprehensive Total Risk / Total Return Model
What Differences?
2
The Value Creation / Earnings Delivery Process
Economic value creation begins with sound, economically based
operating actions and ends with a consistent and growing
distribution of earnings.
In Insurance this process embodies the following characteristics:
 Originating policy / accident period actions which lead to financial
results that emerge over subsequent calendar periods.
 Economic value creation measurements which differ from
conventional accounting with respect to the timing of income
recognition.
 Distinct contributions to the risk / return tradeoff from underwriting,
investment and financial leverage activities.
A “complete” financial methodology should address all these aspects.
3
Risk / Return – Focus on Value or Earnings?
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Economic Value Creation
OR
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Earnings Reported
4
“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 leverage contributions
5
Policy (or Accident) / Calendar Period
Development Triangles
Balance Sheet, Income, Cash Flow
Policy
Period
Prior
1999
2000
2001
2002
2003
Reported
Calendar
1999
X
X
====
Sum
Calendar Period
Historical
2000
2001
2002
X
X
X
X
X
X
X
X
X
X
X
X
====
Sum
====
Sum
====
Sum
Future
2003
X …...
X …...
X …...
X …...
X …...
X …...
====
Sum
Total
Ultimate
--> Sum
--> Sum
--> Sum
--> Sum
--> Sum
--> Sum
Rates and Economic valuation are oriented across the policy period “row”
but regulatory review and wall street focus are typically on the calendar
“column” sum
6
Risk / Return Principles
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Insurance = underwriting, investment and leverage
Volatility is uncertainty of result
Risk is exposure to adverse result
Higher Underwriting and Investment returns are required when
volatility is greater
Risk transfer pricing activities (policyholder, company &
shareholder) are based on risk parameters
 This can be accomplished independently of leverage
Total return is underwriting and investment return leveraged
 Leverage simultaneously magnifies total return and volatility in
total return, but NOT necessarily risk
Diversification / covariance benefits with respect to underwriting,
investment and finance (i.e. surplus) exist in the aggregate
beyond the sum of individual businesses and functions.
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Total Return, Volatility and Risk
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Risk / Return Decision Framework – Risk Metrics
Policyholder oriented risk metrics
 Probability of ruin
 Expected policyholder deficit (EPD)
 Shareholder oriented risk metrics
 Variability in total return (sR)
 Sharpe Ratio
 Value at risk (VAR)
 Tail Value at Risk (TVAR)
 Expected Shareholder Deficit
 Probability of surplus drawdown (PSD)
 Risk Coverage Ratio (RCR)
 Others …
 RBC and other Rating Agency measures
In one way or another all risk measures address the
likelihood and/or the severity of an adverse outcome
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Total Return Risk Schematic
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Comparison of Policyholder and Shareholder Risk Metrics
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Shortcomings of Policyholder oriented risk metrics
 Narrow focus on loss typically does not reflect variability in loss payment,
premium amount and collection, expense amount and payment and the
impact of taxes and investment income on float and surplus
 Reliability of results is questionable due to basis upon extreme outcomes
in tail of loss distribution
 Inconsistency between measures of risk and return make management of
the risk/return tradeoff difficult
Advantages of Shareholder oriented risk metrics
 Reflects all sources of variability
 Captures all relevant factors that impact bottom line
 Typically embodies more reliability
 Shareholder focus is more in tune with broader financial marketplace
 Should allow for diversification effects to be incorporated
 Addresses policyholder risks
 Provides an important link between price adequacy and solvency
 Consistency in measures of risk and return
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Dealing With Uncertainty and Risk Two Key Questions
A critical modeling objective is to provide a framework for
addressing the risk / return tradeoff, specifically
addressing the following two questions:
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What price should be charged (i.e. what is appropriate
risk-adjusted return)?
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How much capital is needed (i.e. what is appropriate
risk-adjusted leverage)?
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The Answer:
A Comprehensive Total Risk / Total Return Model
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Fully integrated balance sheet, income and cash flow statements
Calendar period financial results developed from “current and
prior” policy / accident period contributions
Nominal and economic 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
 Leverage ratio and method (preferably risk-based) by which
surplus flows are controlled, including distribution of profits
Risk-based pricing algorithm for underwriting and investment risk
Risk-adjusted leverage algorithm
Distributional outcomes of all key risk and return measures
Quantification of underwriting, investment and leverage risk/return
relationship
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What Differences?
All methodologies are fundamentally reconcilable
 Comprehensive Total Risk / Total Return model encompasses all
approaches and methodologies
 ALL differences ultimately result from modeling CHOICES
Differences in presentation result from choices with respect to:
 Calendar or policy/accident period perspective
 Accounting focus on reported or economic basis
 Metrics used to measure risk and return
 Time frame emphasized
 Other . . .
Name calling: Models and Statistics related to return, risk, value, etc.
 ROE, IRR, Probability of Ruin, EPD, Sigma of Return (sR),
Sharpe Ratio, NPV, Embedded Value, EVA, VAR, RAROC,
DFA, ERM, . . .
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