1 RISK AND RETURN: DEBATING ALTERNATIVE MODELING “APPROACHES” (FIN - 10) Russ Bingham Vice President and Director of Corporate Research Hartford Financial Services Seminar on Ratemaking Tampa, FL March 7-8, 2002

2 Outline l Value Creation / Earnings Delivery Process l Risk/Return – Focus on Value or Earnings? l Building Blocks l Risk / Return Principles l Risk / Return Decision Framework – Risk Metrics l Comparison of Policyholder and Shareholder Risk Metrics l Dealing With Uncertainty and Risk – Two Key Questions l Comprehensive Total Risk / Total Return Model l What Differences?

3 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: l Originating policy / accident period actions which lead to financial results that emerge over subsequent calendar periods. l Economic value creation measurements which differ from conventional accounting with respect to the timing of income recognition. l Distinct contributions to the risk / return tradeoff from underwriting, investment and financial leverage activities. A “complete” financial methodology should address all these aspects.

4 Risk / Return – Focus on Value or Earnings? l Economic Value Creation OR l Earnings Reported

5 “Building Blocks”: Valuation Fundamentals l Balance sheet, income and cash flow statements l Development “triangles” of marketing / policy / accident period into calendar period l Accounting valuation: conventional (statutory or GAAP) and economic (present value) plus l Risk / return decision framework which deals with separate underwriting, investment and leverage contributions

6 Policy (or Accident) / Calendar Period Development Triangles Balance Sheet, Income, Cash Flow Calendar Period Policy HistoricalFuture Total Period Ultimate Prior X X X X X …... --> Sum 1999 X X X X X …... --> Sum 2000 X X X X …... --> Sum 2001 X X X …... --> Sum 2002 X X …... --> Sum 2003 X …... --> Sum ==== ================ Reported Sum Sum Sum Sum Sum Calendar 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

7 Risk / Return Principles l Insurance = underwriting, investment and leverage l Volatility is uncertainty of result l Risk is exposure to adverse result l Higher Underwriting and Investment returns are required when volatility is greater l Risk transfer pricing activities (policyholder, company & shareholder) are based on risk parameters l This can be accomplished independently of leverage l Total return is underwriting and investment return leveraged l Leverage simultaneously magnifies total return and volatility in total return, but NOT necessarily risk l 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.

8 Total Return, Volatility and Risk

9 Risk / Return Decision Framework – Risk Metrics l Policyholder oriented risk metrics l Probability of ruin l Expected policyholder deficit (EPD) l Shareholder oriented risk metrics Variability in total return (  R ) l Sharpe Ratio l Value at risk (VAR) l Tail Value at Risk (TVAR) l Expected Shareholder Deficit l Probability of surplus drawdown (PSD) l Risk Coverage Ratio (RCR) l Others … l 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

10 Total Return Risk Schematic

11 Comparison of Policyholder and Shareholder Risk Metrics l Shortcomings of Policyholder oriented risk metrics l 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 l Reliability of results is questionable due to basis upon extreme outcomes in tail of loss distribution l Inconsistency between measures of risk and return make management of the risk/return tradeoff difficult l Advantages of Shareholder oriented risk metrics l Reflects all sources of variability l Captures all relevant factors that impact bottom line l Typically embodies more reliability l Shareholder focus is more in tune with broader financial marketplace l Should allow for diversification effects to be incorporated l Addresses policyholder risks l Provides an important link between price adequacy and solvency l Consistency in measures of risk and return

12 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: l What price should be charged (i.e. what is appropriate risk-adjusted return)? l How much capital is needed (i.e. what is appropriate risk-adjusted leverage)?

13 The Answer: A Comprehensive Total Risk / Total Return Model l Fully integrated balance sheet, income and cash flow statements l Calendar period financial results developed from “current and prior” policy / accident period contributions l Nominal and economic valuations l Clearly and consistently stated parameter estimates l Premium, loss and expense amount l Timing of premium collection, loss and expense payment l Investment yield rates l Underwriting and investment tax rates l Leverage ratio and method (preferably risk-based) by which surplus flows are controlled, including distribution of profits l Risk-based pricing algorithm for underwriting and investment risk l Risk-adjusted leverage algorithm l Distributional outcomes of all key risk and return measures l Quantification of underwriting, investment and leverage risk/return relationship

14 What Differences? All methodologies are fundamentally reconcilable l Comprehensive Total Risk / Total Return model encompasses all approaches and methodologies l ALL differences ultimately result from modeling CHOICES Differences in presentation result from choices with respect to: l Calendar or policy/accident period perspective l Accounting focus on reported or economic basis l Metrics used to measure risk and return l Time frame emphasized l Other...