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Town Hall Session/ RCM-2 CAS 2006 Ratemaking Seminar, March 13, 2006 Louise Francis, FCAS, MAAA Francis Analytics and Actuarial Data Mining Louise.francis@data-mines.com www.data-mines.com

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How Many Risk Load Actuaries Can Dance on the Head of a Shamrock?

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Remarks Risk adjusted discount rates/internal rate of return approaches still relevantRisk adjusted discount rates/internal rate of return approaches still relevant Alternative beta calculationsAlternative beta calculations Alternative denominator for cost of equityAlternative denominator for cost of equity Some older approaches such as risk loads based on percentiles still make sense in some contextsSome older approaches such as risk loads based on percentiles still make sense in some contexts The market seems to allow for superior strategy returnsThe market seems to allow for superior strategy returns Should we think of Risk Load as a topic within ERM?Should we think of Risk Load as a topic within ERM? Should we charge a “bad data” risk load?Should we charge a “bad data” risk load?

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Financial & Actuarial Perspective Converge? Risk Load= Systematic + Frictional CostRisk Load= Systematic + Frictional Cost

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Simpler Methods are Sometimes Better To some managements, our methods of computing risk loads seems very complexTo some managements, our methods of computing risk loads seems very complex Loads based on percentiles still used often for self-insurance pools and captivesLoads based on percentiles still used often for self-insurance pools and captives

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Augmentations of Beta Base on correlation with insurance liabilitiesBase on correlation with insurance liabilities SUMBETA – (Ibbotson, Risk Premium Project)SUMBETA – (Ibbotson, Risk Premium Project) Take lag effects into accountTake lag effects into account For insurance companies generally results in larger betasFor insurance companies generally results in larger betas

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Cost of Capital Denominator What is an appropriate denominatorWhat is an appropriate denominator Usually GAAP surplusUsually GAAP surplus Smith says this is the wrong denominatorSmith says this is the wrong denominator Economic Value of Company = Market value of assets - Discounted value of liabilities + franchise value – insolvency putEconomic Value of Company = Market value of assets - Discounted value of liabilities + franchise value – insolvency put Measure change in this valueMeasure change in this value

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Return for Having an Edge: Geometric Maximization

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“Bad Data” Risk Load Moral Hazard problemMoral Hazard problem Customers supplying bad data may be poorer risks due to poorer managementCustomers supplying bad data may be poorer risks due to poorer management Information has a costInformation has a cost More uncertainty is associated with pricing based on sparse or inadequate dataMore uncertainty is associated with pricing based on sparse or inadequate data

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