1 RCM 2: Risk and Return Analysis (in Ratemaking and Elsewhere) Russ BinghamRatemaking Seminar Vice President Actuarial ResearchSalt Lake City, Utah Hartford Financial ServicesMarch 13-14, 2006

2 Corporate Objective: Financial Discipline Financial discipline is a valuation process, supported by analytical methods and models, intended to provide timely and meaningful assessments of risk / return performance and trends associated with underwriting, investment and finance operations. Sound economic, risk-based analytics are used to support strategic and operational decision making throughout company. Conditions needed to instill a financial discipline: Financially astute senior leadership A committed senior management A group (actuarial, accounting, finance) responsible for the development of “benchmark” concepts, models and operating applications Companywide application of benchmark concepts and models as the standard for financial valuation in:  Ratemaking and product pricing  Planning  Performance monitoring  Profitability studies  Incentive compensation  Acquisition analysis  Capital attribution  Risk/return assessment  ERM Valuation should be on an Economic Basis (i.e. cash flow oriented) and Reflect Risk

3 Risk / Return and the Risk Transfer Process Risk Transfer Activities  Underwriting funds flow between policyholders and company  Investment funds flow between company and financial markets  Finance capital funds flow between financial markets and company Risk Transfer Characteristics  Transfer of cash between two parties for a future expected benefit to both  Benefits uncertain as to amount and/or timing  Price for the transfer of risk based on fundamental Risk / Return tradeoff in which higher risk requires higher price Risk / Return Relationship  Applies to all risk transfer activities  Risk and Return measured from the same variable (distribution) The same risk / return tradeoff paradigm should apply to all risk transfer activities to the extent possible

4 Alternative Risk Metrics Policyholder oriented risk metrics  Probability of ruin (POR)  Expected policyholder deficit (EPD) Shareholder oriented risk metrics  Variability in total return (s R )  Sharpe Ratio  Value at risk (VAR)  Tail Value at Risk (TVAR)  Tail Conditional Expectation (TCE)  Probability of Income Ruin (POIR)  Probability of surplus drawdown deficit (PSD)  Severity of surplus drawdown deficit (SSD)  Expected surplus drawdown deficit (ESD)  Risk Coverage Ratio (RCR) RBC and other Rating Agency measures Only Sharpe ratio and RCR integrate risk and return, others are an expression of risk only In one way or another all risk measures address the likelihood and/or the severity of an adverse outcome Metrics differ in choice of variable used and in definition of adverse event (position in distribution)

5 Risk / Return Integration in Practice Risk measurement is a combination of the probability that returns will fall below breakeven, together with the average severity of such outcomes  “Loss” = Shortfall from breakeven return  “Risk” = (Loss Frequency) x (Mean Loss Severity) RCR (Risk Coverage Ratio) integrates risk and return Risk-Based Pricing - higher price dictated when volatility and risk is greater  Establishes risk / return tradeoff whose slope is RCR  Independent of surplus Two forms of risk-adjustment can be use when translating to total return (ROE)  Risk-Adjusted Return - higher absolute total return when risk is greater, with uniform leverage (e.g. 3/1 leverage ratio in all lines) OR  Risk-Adjusted Leverage - lower leverage when risk is greater, with uniform total return (e.g. 15% ROE in all lines) Price related to risk, leverage related to total return

6 Risk Coverage Ratio Risk Metric Policyholder Operating Return Level Shareholder Total Return Level

7 Connecting Risk and Return - Risk Adjustment Alternatives RAROC: Risk-Adjusted Return On Capital RORAC: Return On Risk-Adjusted Capital (varying return with uniform leverage) (uniform return with varying leverage)

8 Appendix: Economic and Risk-Based Orientation and Premises for P&C Internal line of business decisions are made based on financials that reflect the “purest” view of financial performance possible  Accident period oriented, NOT Calendar period, revised to include latest estimates of ultimate values  Economically based accounting, NOT Conventional (statutory or GAAP)  Forward looking (includes future cash flow expectations)  Investment risk beyond ‘AA’ cash flow matched strategy considered as separate investment activity, NOT underwriting  Risk-adjustment (and capital attribution) based on independent view of risk (using benchmark accident year, economic, cash flow, and low risk investment structure as noted above), NOT the rating agency view External total company “constraints” must be met based on  Calendar period (e.g. reported earnings), static where revised estimates can only be included in accounting period when revisions are made  Conventional accounting (Stat for rating agency and regulatory, GAAP for financial reporting)  Backward looking (reported historical financials)  Combined underwriting and investment results  Rating agency capital (e.g. S&P)