Transcript New Approach to Ratemaking & Reserving CAS May Meeting May 9, 2006 John Kollar, ISO Russ Bingham, Hartford.

New Approach to Ratemaking
& Reserving
CAS May Meeting
May 9, 2006
John Kollar, ISO
Russ Bingham, Hartford
CAS ERM Definition
• Process
– Assess
– Control
– Exploit
– Finance
– Monitor risk
• Holistic treatment of risk
• Senior management function
• Upside and downside
Holistic Treatment of Risk
Risk
Parameters
Risk
Analysis
Pricing
Risk
Economic
Capital
URM
Interest
Rate Risk
Risk
Allocation
Reinsurance
Combined
Ratios
Some New Ratemaking & Reserving
Questions (Outline)
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What are Fair Value loss reserve estimates?
Capital adequacy?
Risk measurement by line, state, etc.?
Reinsurance? Amount? Cost? Risk transfer?
Marketing program?
Underwriting guidelines?
Underwriting cycle position?
Predictive modeling? Adverse selection?
Loss Reserve Estimates
• New Approaches
– Stochastic methods
– Bayesian estimates
– Benchmarking
– Confidence intervals
• Fair Value Accounting
– Discounted reserves
– Market Value Margin
– Convergence of FASB to IASB
Loss Reserve Adequacy
Short-Tailed vs. Long-Tailed Lines
Short-Tailed Lines
Long-Tailed Lines
Release most capital at
the end of 1st year.
Year 1 Year 2 Year 3 Year 4
Release a portion of
capital at the end of
each year.
Y1
Y2
Y3
Y4
Reserve Risk:
Average Size and Volatility of GL
Open Claims Increases Over Time
C la im A m o u n t
B ig C la im s S e ttle S lo w ly
9 5 th %
M ean
0
1
2
3
O p e n A fte r n Y e a rs
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
C o rre la tio n a n d R is k S ize
0 .2 0
0 .1 8
0 .1 6
C o rre la tio n
0 .1 4
0 .1 2
0 .1 0
0 .0 8
0 .0 6
0 .0 4
0 .0 2
0 .0 0
S iz e o f R is k
Aggregate Loss Distribution
& Implied Economic Capital
Loss A m ount
Value at Risk
T
V
a
R
0 .0
0 .1
0 .2
0 .3
0 .4
0 .5
0 .6
0 .7
C u m u la tiv e P ro b a b ility
0 .8
0 .9
Different measures of risk imply
different amounts of economic capital
Am ount
Im p lie d C a p ita l
C a p ita l
L ia b ilitie s
2 x S td . D e v .
VaR @ 99%
TVaR @ 99%
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.
Optimize reinsurance by
minimizing the cost of financing
Am ount
C o s t o f F in a n c in g In s u ra n c e
N e t C o s t o f R e in s
C o s t o f C a p ita l
No Re
C at R e
A ll R e
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
R e q u ire d C a p ita l
G ro w in g th e B u s in e s s
P ro s p e c t 1
P ro s p e c t 2
E x is tin g
S ta n d a lo n e
S ta n d a lo n e
S ta n d a lo n e
T o ta l
T o ta l
Ratemaking
Setting Combined Ratio
Targets by Line
•
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Expected losses
Expected expenses
Investment income
Cost of financing
– Cost of reinsurance
– Cost of capital (risk)
Standard Ratemaking
Exhibit
Scroll to end –>
Cost of
Financing
Target
Combined
Ratio
Set combined ratio targets by line
and overall
T a rg e t C o m b in e d R a tio s
108%
106%
104%
102%
100%
98%
96%
CMP
HO
A u to
C a ts
T o ta l
Underwriting Cycle
Pricing Risk
• Develop a number of pricing scenarios
reflecting marketplace conditions (cycle).
• For each pricing scenario:
– Adjust premiums.
– Calculate (projected) combined ratio.
– Calculate (projected) return on capital.
Predictive Modeling
Risk of Adverse Selection
• Use of other information (beyond rating
variables) to more accurately rate a policy
– Increased profits
– Reduced risk
– Lower economic capital
• Inability to select better policies and compete
with other insurers results in adverse selection
– Losses or reduced profits
– Increased downside risk
– Higher economic 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
Robust Analysis of an
Enterprise’s Risks (ERM) is
Essential to Sound Ratemaking
& Loss Reserving!