Transcript ERM Topics – How Much Insurance Should I Buy?

ERM Topics –
How Much
Insurance Should
I Buy?
CAS Ratemaking Seminar
March 27-28, 2003
San Antonio, TX
What Does This Have To
Do With Ratemaking?
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Nothing, if you believe actuarial
rates calculated with precision in
the home office actually get
charged to large commercial risks.
Everything, if you want to
understand the challenges faced
by commercial insurance buyers
and how they view retentions,
limits and premiums.
Analytical
Considerations
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Explore actuarial and analytical
approaches to evaluating the
question of how much insurance a
commercial enterprise should
purchase
Christopher (Kip) Bohn, ACAS, MAAA
Assistant Director and Actuary
Aon Risk Consultants, Inc.

Filling in for:
Barry Franklin, FCAS, MAAA
Managing Director & Actuary
Aon Risk Consultants, Inc.
Retain/Finance/Transfer
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The answer to the question “How
much insurance should I buy?
depends on the answers to other
questions:
How much risk is inherent in my
operations?
 How much risk can I afford to
retain?
 How much risk can I efficiently
finance?
 What are the retain/finance/insure
cost/benefit trade-offs?
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Quantifying Risk in the Enterprise
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Identify the major risks
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Gather data/solicit information
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Objective, subjective, interpretive
Develop parameters & distributions
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Choose your battles wisely
Actuarial precision is laudable, but avoid
“paralysis through analysis”
A cloudy crystal ball is better than no
crystal ball
Simulate results, derive distributions
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Correlation – measure, guess, etc.
Quantifying Risk in the Enterprise
Simulated Loss Experience - All Risks Combined
15,000
13,500
10,500
$ Losses
9,000
Annual $
7,500
Est. Pretax Earnings
6,000
Avg. Pretax Earnings
4,500
3,000
1,500
Probability
0.1%
0.5%
1.0%
5.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
80.0%
90.0%
95.0%
99.0%
99.5%
-
99.9%
$ Losses (Millions)
12,000
How Much Risk to Retain
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Benchmark ratio analysis
Where did those ratios come from?
 Do they reflect key aspects of the
organization?
 Could be considered a starting
point
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Peer comparisons
Risk appetite varies
 Just because your friend jumps of
a cliff…
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Beyond Benchmarks
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Develop framework for decision
analysis
What are the company’s financial
and operational boundaries?
Debt covenants and debt/equity
rating rationale
 What has the company promised
shareholders, analysts, etc.?
 Examine both objective and
subjective boundaries
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Beyond Benchmarks
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What are the company’s key
indicators?
Financial ratios
 Internal targets
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Incorporate risk modeling analysis
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What is the company’s “comfort
level” for the financial/operational
boundaries and key indicators?
Debt Coverage Example
ABC Corporation
Debt Coverage
Reading the graph:
Debt Coverage Ratio
165.0%
155.0%
145.0%
135.0%
Model
125.0%
115.0%
Target
105.0%
95.0%
85.0%
The vertical axis represents ABC’s 2002-2003
Debt Service Coverage Ratio. The horizontal
axis represents the probability of the ratio
being at or below the indicated level. For
example, the point indicated by the arrow
suggests that in 80% of simulated years, the
ratio is projected to be 155% or less.
75.0%
0%
20%
40%
60%
80%
100%
Probability
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ABC’s debt ratings are based on a number of factors, the most prominent of which in the
ratings analyses we have reviewed is Debt Service Coverage.
Based on our understanding of the rating agency analyses we reviewed, ABC’s rating would
likely be lowered if the Debt Service Coverage Ratio drops below 125%.
Our simulation analysis suggests that the likelihood of the Debt Service Coverage Ratio
dropping below 125%, as a result of the risk areas analyzed herein, is approximately 5%;
that is to say ABC can be 95% confident that its rating will not be lowered due to
contingencies associated with the risks analyzed.
Choosing a Program
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Based on your analysis up to this
point select retention/limit
combinations that appear to satisfy
risk bearing guidelines
Most likely, you will have identified
a range of acceptable retentions
 Be open to nonstandard retention
structures (e.g. corridors)
 Consider the limits of liability the
that the company requires
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Market The Risk
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Communicate range of retentions
company is willing to consider
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Be prepared to be flexible
Steer clear of carriers who are
outside “reasonable” price ballpark
Could indicate lack of knowledge
of coverage and/or client
 One-time savings could be less
valuable than long term
partnership
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Market Risk
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Make sure you understand not only
cost and structure differences but
policy provisions as well
Understand and quantify other
costs
Claims handling
 Premium payment terms
 Collateral requirements
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Evaluate Options
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At this stage, carrier costs are
considered fixed
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Theoretically, could build in load for
financial health of carrier
Need to somehow put all options
on an apples-to-apples basis
Goal is to determine total cost of
risk to the company
Evaluate Options
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With fixed carrier costs and
expected retained losses under the
various programs (based on our
prior analysis) known, we can
accomplish this
However, this does not reflect the
risk associated with the retained
exposure
Efficient Frontier
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To incorporate the risk component,
we can take an idea from portfolio
theory
The efficient frontier brings
together risk and reward
It also allows us the ability to throw
out carriers and options that are
not on the efficient frontier
Efficient Frontier
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Define risk as the difference
between retained loss at the
expected level and at a higher
confidence level
Define reward as total coast
savings at expected loss levels
over a guaranteed cost program
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This is just a base line - lots of
ways to define reward
Efficient Frontier
EXPECTED
REWARD
Optimal Risk Financing Structure
The Efficient Frontier
{
Expected Savings
Over Current
Program
Various risk
financing options
from the market
Current
Program
Risk
Bearing Capacity
Guaranteed Cost
Program
RISK
• Expected Reward is measured in terms of the expected savings of the risk financing structure being considered
as compared to a no-risk guaranteed cost program.
• Risk is measured in terms of variability from expected levels.
• Optimal Risk Financing Structure falls at the intersection of efficient frontier and risk-bearing capacity lines.
Efficient Frontier
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Now the question to answer is
which risk/reward combination on
the efficient frontier is the best fit
for the company
Make sure selected option fits into
Financial/operational boundaries
 Risk Appetite
 etc.
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Efficient Frontier
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This exercise provides a
framework for RELATIVE
risk/reward tradeoffs
Does not optimize risk/return in
absolute sense
 Suggests direction to move but
limited by risk transfer options &
costs actually available
 Doesn’t magically derive the “right”
answer
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