Elicitation & Elucidation of Risk Preferences Working Party 2005 CAS Annual Meeting Session C 21 Parr Schoolman / David Ruhm

Elicitation & Elucidation of Risk Preferences: AUDIENCE QUESTIONS Without looking up any information, estimate Wal-Mart’s 1999 revenue: Without looking up any information, estimate Wal-Mart’s 1999 revenue: Put an upper and lower bound around your estimate, so that you are 95% confident that your range surrounds the actual quantity: Lower Bound________ Upper bound________ Put an upper and lower bound around your estimate, so that you are 95% confident that your range surrounds the actual quantity: Lower Bound________ Upper bound________

Elicitation & Elucidation of Risk Preferences: AUDIENCE QUESTIONS Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice and she participated in antinuclear demonstrations. Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice and she participated in antinuclear demonstrations. Rank order the following 8 descriptions in terms of the probability (likelihood) that they describe Linda: Rank order the following 8 descriptions in terms of the probability (likelihood) that they describe Linda: a. Linda is a teacher in an elementary school. a. Linda is a teacher in an elementary school. b. Linda works in a bookstore and takes yoga classes. b. Linda works in a bookstore and takes yoga classes. c. Linda is active in the feminist movement. c. Linda is active in the feminist movement. d. Linda is a psychiatric social worker. d. Linda is a psychiatric social worker. e. Linda is a member of the League of Women Voters. e. Linda is a member of the League of Women Voters. f. Linda is a bank teller. f. Linda is a bank teller. g. Linda is an insurance salesperson. g. Linda is an insurance salesperson. h. Linda is a bank teller who is active in the feminist movement. h. Linda is a bank teller who is active in the feminist movement.

Elicitation & Elucidation of Risk Preferences: AUDIENCE QUESTIONS You are out of town at a business meeting that runs late. As soon as you can break away, you head to the airport to catch the last flight home. If you miss the flight, which is scheduled to leave at 8:30 PM, you will have to stay overnight and miss an important meeting the next day. You run into traffic and do not get to the airport until 8:52 PM. You run to the gate, arriving there at 8:57 PM. When you arrive, either: You are out of town at a business meeting that runs late. As soon as you can break away, you head to the airport to catch the last flight home. If you miss the flight, which is scheduled to leave at 8:30 PM, you will have to stay overnight and miss an important meeting the next day. You run into traffic and do not get to the airport until 8:52 PM. You run to the gate, arriving there at 8:57 PM. When you arrive, either: (A) You find out that the plane left on schedule at 8:30 PM, or (B) You see the plane depart, having left the gate at 8:55 PM. Which is more upsetting (circle one)? A B Neither

Elicitation & Elucidation of Risk Preferences: INTRODUCTION Risk Management & Risk Measurement requirements are increasing: Risk Management & Risk Measurement requirements are increasing: Sarbanes-Oxley Sarbanes-Oxley Rating Agency pressures Rating Agency pressures CEO Attestations of Financial Statements CEO Attestations of Financial Statements Result: Result: Companies are being required to have documented Risk Management Policies and Procedures Companies are being required to have documented Risk Management Policies and Procedures

Elicitation & Elucidation of Risk Preferences: PURPOSE These requirements provide an opportunity for management to institute a consistent viewpoint regarding risk: These requirements provide an opportunity for management to institute a consistent viewpoint regarding risk: Some tradeoffs are acceptable, some are not Some tradeoffs are acceptable, some are not Some tradeoffs are preferable to others Some tradeoffs are preferable to others Without a consistent policy on decisions: Senior management input on tradeoffs is confined to highest level of decisions Senior management input on tradeoffs is confined to highest level of decisions Unconnected, ad hoc business unit decisions Unconnected, ad hoc business unit decisions

Elicitation & Elucidation of Risk Preferences: PURPOSE Objective Rational framework for making decisions Rational framework for making decisions Explicit evaluations of risk vs. return Explicit evaluations of risk vs. return Management risk preferences codified Management risk preferences codified Decision consistency Decision consistency Enterprise implementation Enterprise implementation

Elicitation & Elucidation of Risk Preferences: KEY STEPS Key Steps for determining a Firm’s “Risk Policy”: Key Steps for determining a Firm’s “Risk Policy”: Define Risk Unambiguously Define Risk Unambiguously Assess Context Assess Context Determine Risk Measures Determine Risk Measures Ascertain Risk Preferences (i.e., find consensus) Ascertain Risk Preferences (i.e., find consensus)

Elicitation & Elucidation of Risk Preferences: KEY STEPS Define Risk Unambiguously Define Risk Unambiguously What do you mean by “Risk”? What do you mean by “Risk”? Risk of losing money or of “missing plan”? Risk of losing money or of “missing plan”? Reduction in accounting book value (or income) or lost market capitalization? Reduction in accounting book value (or income) or lost market capitalization? Ultimate value or mark to market shortfall? Ultimate value or mark to market shortfall?

Elicitation & Elucidation of Risk Preferences: KEY STEPS Define Risk Unambiguously (continued) Define Risk Unambiguously (continued) What are the firms’ key risks? What are the firms’ key risks? Financial Financial Operational Operational Competitive Competitive Strategic Strategic For what time horizon? For what time horizon?

Elicitation & Elucidation of Risk Preferences: KEY STEPS Define Risk Unambiguously (continued) Define Risk Unambiguously (continued) A useful risk definition is: A useful risk definition is: Specific, rather than ambiguous Specific, rather than ambiguous Accepted by involved parties Accepted by involved parties As comprehensive as needed As comprehensive as needed

Elicitation & Elucidation of Risk Preferences: KEY STEPS Examples of heuristics that could be given specific operating definitions: Examples of heuristics that could be given specific operating definitions: Build in enough profit margin to insulate capital against unexpected events and unknowable factors. (profit measure) Build in enough profit margin to insulate capital against unexpected events and unknowable factors. (profit measure) Don’t over-concentrate the underwritten risks. (percentile) Don’t over-concentrate the underwritten risks. (percentile) Do business in markets where the company has an identifiable, durable operating advantage. (margin) Do business in markets where the company has an identifiable, durable operating advantage. (margin) Don’t write what you don’t know. (parameter variability) Don’t write what you don’t know. (parameter variability) Don’t deal with untrustworthy parties. (historical data) Don’t deal with untrustworthy parties. (historical data) Avoid mass tort exposure. (exposure type’s aggregate loss) Avoid mass tort exposure. (exposure type’s aggregate loss)

Elicitation & Elucidation of Risk Preferences: KEY STEPS Risk Definition Examples: Risk Definition Examples: Accident Year Total Return shortfall relative to cost of capital Accident Year Total Return shortfall relative to cost of capital Rolling 4-quarter income shortfall relative to cost of capital Rolling 4-quarter income shortfall relative to cost of capital Statutory Surplus decline over the next year Statutory Surplus decline over the next year Ratings downgrade probability over the next 5 years Ratings downgrade probability over the next 5 years

Elicitation & Elucidation of Risk Preferences: KEY STEPS Context Context Corporate Culture Corporate Culture Financial Characteristics Financial Characteristics Perspectives of Key Decision Makers Perspectives of Key Decision Makers

Elicitation & Elucidation of Risk Preferences: KEY STEPS Context - Corporate Culture Context - Corporate Culture Age of Organization Age of Organization Tenure of Current Management Tenure of Current Management Company History Company History

Elicitation & Elucidation of Risk Preferences: KEY STEPS Context - Financial Characteristics Context - Financial Characteristics Financial Strength Financial Strength Size of Firm Size of Firm Ownership Structure Ownership Structure Stock vs. Mutual Stock vs. Mutual Privately held vs. Public Privately held vs. Public

Elicitation & Elucidation of Risk Preferences: KEY STEPS Context - Key Decision Makers Context - Key Decision Makers Sales background vs. financial background Sales background vs. financial background Perceived relative importance of top line Perceived relative importance of top line Time in career could influence risk appetite Time in career could influence risk appetite Life vs. P&C Life vs. P&C Life: Cognizant of persistency, investment risks Life: Cognizant of persistency, investment risks P&C: Cognizant of catastrophe, reserve risks P&C: Cognizant of catastrophe, reserve risks

Elicitation & Elucidation of Risk Preferences: KEY STEPS Risk Measures Risk Measures Objective Objective Transparent Transparent Appropriate Appropriate Timeliness vs. Accuracy Trade-off Timeliness vs. Accuracy Trade-off IT and Budget resource constraints IT and Budget resource constraints Understandable Understandable

Elicitation & Elucidation of Risk Preferences: KEY STEPS Risk Measures - Objectivity Risk Measures - Objectivity Objective: Probability of 2005 reported net income being negative. Objective: Probability of 2005 reported net income being negative. Not too objective: Probability of very high net losses for accident year Not too objective: Probability of very high net losses for accident year 2005.

Elicitation & Elucidation of Risk Preferences: KEY STEPS Risk Measures - Transparency Risk Measures - Transparency Transparent: Probability of a net loss for the line or segment. Transparent: Probability of a net loss for the line or segment. Not so transparent: The beta of the line or segment’s net income distribution. Not so transparent: The beta of the line or segment’s net income distribution.

Elicitation & Elucidation of Risk Preferences: KEY STEPS Risk Measures – Appropriateness Risk Measures – Appropriateness Appropriate: Short-term net income distribution for property catastrophe lines. Appropriate: Short-term net income distribution for property catastrophe lines. Not that appropriate: Short-term net income distribution for long-tail lines and lines whose principal risk is surplus drain. Not that appropriate: Short-term net income distribution for long-tail lines and lines whose principal risk is surplus drain.

Elicitation & Elucidation of Risk Preferences: KEY STEPS Ascertaining Risk Preferences Ascertaining Risk Preferences Survey methods have been developed for marketing Survey methods have been developed for marketing Conjoint Analysis Conjoint Analysis Quality Functional Deployment (QFD) Quality Functional Deployment (QFD) Multi-Attribute Utility Theory (MAUT) Multi-Attribute Utility Theory (MAUT) Many others as noted in paper Many others as noted in paper

Elicitation & Elucidation of Risk Preferences: KEY STEPS Ascertaining Risk Preferences (continued) Ascertaining Risk Preferences (continued) Survey methods from marketing: Survey methods from marketing: Example: used to find out car buyers’ preferences Example: used to find out car buyers’ preferences Younger buyers: styling, performance more important Younger buyers: styling, performance more important Family buyers: space, seating, mileage more important Family buyers: space, seating, mileage more important These are tradeoffs of desirable features These are tradeoffs of desirable features Could be used for management risk preferences Could be used for management risk preferences Determine acceptable tradeoffs Determine acceptable tradeoffs Isolate those risks that management considers more important / quantify relative importance Isolate those risks that management considers more important / quantify relative importance

Elicitation & Elucidation of Risk Preferences: BIASES Key Biases Key Biases Framing – Loss (Risk Seeking) vs. Gain (Risk Averse) Framing – Loss (Risk Seeking) vs. Gain (Risk Averse) An uncertain loss is preferred to a sure loss An uncertain loss is preferred to a sure loss A sure gain is preferred to an uncertain gain A sure gain is preferred to an uncertain gain Overconfidence in accuracy of estimates Overconfidence in accuracy of estimates More easily remembered  seems more probable More easily remembered  seems more probable Catastrophe Risk Catastrophe Risk Terrorism Risk Terrorism Risk Asbestos Asbestos Anchoring & Adjustments Anchoring & Adjustments Representativeness Representativeness Regret Avoidance Regret Avoidance

Elicitation & Elucidation of Risk Preferences: BIASES - FRAMING Question 1: In addition to your initial wealth, you are given $1,000 and then have to choose from among the following choices: A)Receive $1,000 with prob. p=.5 or receive $0 with prob. 1-p=.5. B)Receive $500 with probability p=1. Results: A: 25 B: 72 Question 2: In addition to your initial wealth, you are given $2,000 and then have to choose from among the following choices: A)Lose $1,000 with prob. p=.5 or lose $0 with prob. 1-p=.5. B)Lose $500 with probability p=1. Results: A: 60 B: 35

Elicitation & Elucidation of Risk Preferences: BIASES - FRAMING Question 1: You have just learned that the sole supplier of a crucial component is going to raise prices. Two alternative plans have been formulated to counter the effect of the price increase. The expected Impact is: Plan A)If this plan is adopted, the company’s costs will increase by $4,000,000. Plan B) If this plan is adopted, there is a 1/3 probability that there will be no cost increases, and a 2/3 probability that the company’s costs will increase by $6,000,000. Which do you prefer? Results:A: 36 B: 61 Question 2: You have just learned that the sole supplier of a crucial component is going to raise prices. The price increase will cost the company an additional $6,000,000 in supply costs. Two alternative plans have been formulated to counter the effect of the price increase with savings in other parts of the company. The anticipated consequences of these two plans are: Plan A) If this plan is adopted, the company will save $2,000,000 in operating expenses. Plan B) If this plan is adopted, there is a 1/3 probability that the company will save $6,000,000 in operating expenses, and a 2/3 probability that no savings will be achieved. Which do you prefer? Results:A: 84B: 12

Elicitation & Elucidation of Risk Preferences: BIASES - OVERCONFIDENCE Without looking up any information, estimate Wal-Mart’s 1999 revenue: Without looking up any information, estimate Wal-Mart’s 1999 revenue: Put an upper and lower bound around your estimate, so that you are 95% confident that your range surrounds the actual quantity: Lower Bound________ Upper bound________ Put an upper and lower bound around your estimate, so that you are 95% confident that your range surrounds the actual quantity: Lower Bound________ Upper bound________ 23 out of 80 actuarial students’ intervals contained the actual figure ($166.8 billion). 23 out of 80 actuarial students’ intervals contained the actual figure ($166.8 billion). The actual probability that a randomly selected student’s range contained the actual figure was 29%, far less than 95%. The actual probability that a randomly selected student’s range contained the actual figure was 29%, far less than 95%.

Elicitation & Elucidation of Risk Preferences: BIASES - REPRESENTATIVENESS Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice and she participated in antinuclear demonstrations. Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice and she participated in antinuclear demonstrations. Rank order the following 8 descriptions in terms of the probability (likelihood) that they describe Linda: Rank order the following 8 descriptions in terms of the probability (likelihood) that they describe Linda: a. Linda is a teacher in an elementary school. a. Linda is a teacher in an elementary school. b. Linda works in a bookstore and takes yoga classes. b. Linda works in a bookstore and takes yoga classes. c. Linda is active in the feminist movement. c. Linda is active in the feminist movement. d. Linda is a psychiatric social worker. d. Linda is a psychiatric social worker. e. Linda is a member of the League of Women Voters. e. Linda is a member of the League of Women Voters. f. Linda is a bank teller. f. Linda is a bank teller. g. Linda is an insurance salesperson. g. Linda is an insurance salesperson. h. Linda is a bank teller who is active in the feminist movement. h. Linda is a bank teller who is active in the feminist movement. 52 out of 80 actuaries ranked “h” more likely than “f”! 52 out of 80 actuaries ranked “h” more likely than “f”!

Elicitation & Elucidation of Risk Preferences: BIASES – REGRET AVOIDANCE You are out of town at a business meeting that runs late. As soon as you can break away, you head to the airport to catch the last flight home. If you miss the flight, which is scheduled to leave at 8:30 PM, you will have to stay overnight and miss an important meeting the next day. You run into traffic and do not get to the airport until 8:52 PM. You run to the gate, arriving there at 8:57 PM. When you arrive, either: You are out of town at a business meeting that runs late. As soon as you can break away, you head to the airport to catch the last flight home. If you miss the flight, which is scheduled to leave at 8:30 PM, you will have to stay overnight and miss an important meeting the next day. You run into traffic and do not get to the airport until 8:52 PM. You run to the gate, arriving there at 8:57 PM. When you arrive, either: (A) You find out that the plane left on schedule at 8:30 PM, or (B) You see the plane depart, having left the gate at 8:55 PM. Which is more upsetting (circle one)? A B Neither Results: A: 3 B: 60 Neither: 16