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

CAS ERM Definition Process Holistic treatment of risk Assess Control Exploit Finance Monitor risk Holistic treatment of risk Senior management function Upside and downside

Holistic Treatment of Risk Economic Capital Risk Parameters Risk Allocation Risk Analysis URM Reinsurance Pricing Risk Combined Ratios Interest Rate Risk

Some New Ratemaking & Reserving Questions (Outline) 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 Release most capital at the end of 1st year. Long-Tailed Lines Release a portion of capital at the end of each year. Year 1 Year 2 Year 3 Year 4 Y1 Y2 Y3 Y4

Reserve Risk: Average Size and Volatility of GL Open Claims Increases Over Time

Capital Requirements Loss Volatility } Insurer A Insurer B More Capital Less Capital } Expected costs Years Years

Correlation = More Volatility { Correlation = More Volatility Capital }Capital Low Correlation High Correlation Insurer B Insurer A Line D Total Line C Total Line A Line B

Correlation increases with volume

Aggregate Loss Distribution & Implied Economic Capital Value at Risk TVaR

Different measures of risk imply different amounts of economic capital

Risk Measurement & (Cost of) Capital Allocation by Line, etc.

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

Reinsurance Risk Transfer Testing Expected losses

Marketing/Underwriting Strategy Reflect Risk in Planning Change

Ratemaking Setting Combined Ratio Targets by Line 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

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

Robust Analysis of an Enterprise’s Risks (ERM) is Essential to Sound Ratemaking & Loss Reserving!