Risk Transfer Testing of Reinsurance Contracts A Summary of the Report by the CAS Research Working Party on Risk Transfer Testing CAS Ratemaking Meeting.

Slides:



Advertisements
Similar presentations
CAS 2004 Spring Meeting Presentation of Proceedings Paper DISTRIBUTION-BASED PRICING FORMULAS ARE NOT ARBITRAGE-FREE DAVID RUHM DAVID RUHM DISCUSSION BY.
Advertisements

Chapter 4 Return and Risks.
Chapter 4 Return and Risk. Copyright ©2014 Pearson Education, Inc. All rights reserved.4-2 The Concept of Return Return –The level of profit from an investment,
Chapter 4 Return and Risks.
1 Math 479/568 Casualty Actuarial Mathematics Fall 2014 University of Illinois at Urbana-Champaign Professor Rick Gorvett Session 12: Reinsurance I October.
Engineering Economic Analysis Canadian Edition
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF BANGLADESH ICAB CPE on Insurance Accounts under IFRS 4 Presented by: Md Shahadat Hossain, FCA October 28, 2008.
Presenting DFA Results to Decision Makers Spring 2008 Midwest Actuarial Forum.
Reinsurance Presentation Example 2003 CAS Research Working Party: Executive Level Decision Making using DFA Raju Bohra, FCAS, ARe.
Casualty Loss Reserve Seminar Risk Transfer Accounting.
Chapter McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. 1 A Brief History of Risk and Return.
Reserve Variability Modeling: Correlation 2007 Casualty Loss Reserve Seminar San Diego, California September 10-11, 2007 Mark R. Shapland, FCAS, ASA, MAAA.
Company Enterprise Risk Management & Stress Testing Case Study.
1-1. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin 1 A Brief History of Risk & Return.
1 Developing a Culture of Financial Discipline Issues and Challenges for Integration of Risk and Return Commentary and Audience Survey Russ BinghamCAS.
A Brief History of Risk and Return
Reinsurance Risk Transfer Testing Methods and Management of Process
The Role of the ENTERPRISE in Risk Management Richard Goldfarb, FCAS Ernst & Young Casualty Actuaries in Reinsurance Seminar New York, NY June 1-2, 2006.
Distribution-Based Pricing Formulas are not Arbitrage-Free The Risk Discount Function The Casualty Actuarial Society Spring 2003 Meeting Marco Island,
The Role of the Actuary in a General Insurance Company Yangon, Myanmar 14 July 2014 Scott Yen.
IAS/IFRS Insurers and IAS / IFRS Frank Helsloot (AXA Group Belgium) Luxembourg 23 February 2005 ALACConference.
Casualty Actuarial Society – Washington, D.C. September 18-19, 2008 Ian Sterling, FCAS, MAAA Risk Transfer – Actuarial Perspective.
Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 1 A Brief History of Risk and Return.
1 The Integration of Risk and Return in Practice - From Ratemaking to ERM Russ BinghamRatemaking Seminar Vice President Actuarial ResearchSalt Lake City,
Portfolio Management Lecture: 26 Course Code: MBF702.
1 RCM-1 Broadening and Evolving the Ratemaking Role in Insurance Company Management Russ BinghamRatemaking Seminar Vice President Actuarial Research Atlanta,
Capital Allocation Survey. Purpose of Allocating Capital  Not a goal in itself  Used to make further calculations, like adequacy of business unit profits,
Risk Metrics in an Integrated Financial Discipline David L. Ruhm The Hartford Insurance Group 2004 Bowles ERM Symposium Session CS 3B: Risk Metrics.
Advancements in Territorial Ratemaking Allocating Cost of Catastrophe Exposure May 2006 CAS Spring Meeting Stephen Fiete.
1 Practical ERM Midwestern Actuarial Forum Fall 2005 Meeting Chris Suchar, FCAS.
1 Concurrent Session: Risk Transfer (FAS 113) Presentation by Michael G. Wacek Casualty Loss Reserve Seminar September 12, 2005.
Chapter McGraw-Hill/IrwinCopyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. A Brief History of Risk and Return 1.
RMK and Covariance Seminar on Risk and Return in Reinsurance September 26, 2005 Dave Clark American Re-Insurance Company This material is being provided.
MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell.
Engineering Economic Analysis Canadian Edition
DFA and Reinsurance Structuring Presented by Joseph W. Wallen, FCAS General Re Capital Consultants CAS Ratemaking Seminar March 9-10, 2000 General Reinsurance.
1 Ch 7: Project Analysis Under Risk Incorporating Risk Into Project Analysis Through Adjustments To The Discount Rate, and By The Certainty Equivalent.
1 Evaluating Reinsurance Pricing and Optimization from Cedants’ Perspective Donald Treanor Zurich North America Commercial CAS Spring Meeting, Quebec,
The Cost of Financing Insurance Version 2.0 Glenn Meyers Insurance Services Office Inc. CAS Ratemaking Seminar March 8, 2002.
This document is incomplete without the accompanying discussion; it is confidential and intended solely for the information and benefit of the immediate.
©2015 : OneBeacon Insurance Group LLC | 1 SUSAN WITCRAFT Building an Economic Capital Model
Risk Analysis in Capital Budgeting. Nature of Risk Risk exists because of the inability of the decision-maker to make perfect forecasts. the risk associated.
FAS 113 Considerations on Risk Transfer Testing Gary Venter & Paul Brehm CLRS 2002.
The Cost of Financing Insurance with Emphasis on Reinsurance Glenn Meyers ISO CAS Ratemaking Seminar March 10, 2005.
David Lightfoot Guy Carpenter - Instrat Solvency II – The March Towards Economic Capital Models CAS Spring Meeting – June 19, 2007.
Portfolio wide Catastrophe Modelling Practical Issues.
2000 CLRS - September 18th CAS Fair Value Task Force White Paper Methods of Estimation Louise Francis Francis Analytics and Actuarial Data Mining, Inc.
IRS/Actuary Actuary’s Perspective by Alan E. Kaliski, FCAS, MAAA.
Risk Transfer In The Real World Presentedby Jane C. Taylor, FCAS, MAAA Junction Consulting, Inc. Casualty Loss Reserve Seminar Boston, MA September 12,
26 September 2005 Stephen Lowe Survey Results / Overview of Methods CAS Limited Attendance Seminar on Risk and Return in Reinsurance.
Stochastic Excess-of-Loss Pricing within a Financial Framework CAS 2005 Reinsurance Seminar Doris Schirmacher Ernesto Schirmacher Neeza Thandi.
Swiss Re Investors, Inc. Z Z Issues Related to Insurance Securitization Dan Isaac Swiss Re Investors, Inc. Presented: 2000 CAS Special Interest Seminar.
1 A Stochastic Approach to Recognizing Profits of Finite Products Jeffrey W. Davis, FCAS, MAAA Casualty Actuarial Society Reinsurance Seminar July 2001.
Z Securitization Stephen Philbrick © 1999, Swiss Re Investors All Rights Reserved.
1 CS-19 Risk Tools and Modeling - Risk Tolerances and Limits Russ Bingham Vice President and Director of Corporate Research Hartford Financial Services.
1 RCM – 4: From Enterprise Risk Management to Ratemaking How the Hartford’s Benchmark Methodology Approaches Risk, Price, Leverage and Return Across its.
March 11-12, 2004 Finite Reinsurance - Where’s the Risk? David Molyneux, FCAS, MAAA PartnerRe New Solutions Inc.
0 Allocating the Cost of Capital Practical Examples Daniel Isaac CAS Spring Meeting May 19-22, 2002.
Capital Allocation for Property-Casualty Insurers: A Catastrophe Reinsurance Application CAS Reinsurance Seminar June 6-8, 1999 Robert P. Butsic Fireman’s.
1 RCM 2: Risk and Return Analysis (in Ratemaking and Elsewhere) Russ BinghamRatemaking Seminar Vice President Actuarial ResearchSalt Lake City, Utah Hartford.
Money and Banking Lecture 11. Review of the Previous Lecture Application of Present Value Concept Internal Rate of Return Bond Pricing Real Vs Nominal.
1 RISK AND RETURN: DEBATING ALTERNATIVE MODELING “APPROACHES” (FIN - 10) Russ Bingham Vice President and Director of Corporate Research Hartford Financial.
Proceedings Paper Value Creation in Insurance – A Finance Perspective Russ Bingham CAS Annual Meeting Vice President andNov , 2004 Director.
1 Casualty Actuarial Society Annual Meeting FASB Invitation to Comment Bifurcation of Insurance and Reinsurance Contracts November 14, 2006 Joseph B. Sieverling.
Product Classification and DPFs Session 6
The Integration of Risk and Return in Practice
Market-Risk Measurement
PROFIT AND CONTINGENCIES (FIN-28)
1 The roles of actuaries & general operating environment
Risk Transfer - What Changes Are On The Horizon?
Presentation transcript:

Risk Transfer Testing of Reinsurance Contracts A Summary of the Report by the CAS Research Working Party on Risk Transfer Testing CAS Ratemaking Meeting March 2008 David L. Ruhm, FCAS

Background AAA Committee on Property and Liability Financial Reporting (COPLFR) requested input on risk transfer testing, 2005 CAS formed Working Party on Risk Transfer Testing to respond to AAA request (Michael Wacek, chair) Working Party Report issued, Summer 2005 More developments since – see AAA and NAIC websites

Background, continued Paper on Working Party Report published in Variance, Spring 2007 (Ruhm & Brehm) Paper briefly describes 2 risk measurement methods in Working Party Report: –Expected reinsurer deficit (ERD) –Right-tailed deviation (RTD) Paper also describes risk coverage ratio (RCR) method, which is related to ERD

Scopes of WP report, Variance paper Working Party took accounting rules as given –Merits of accounting rules not debated Focus was on risk transfer testing methods Variance paper provides a brief summary of some key material from WP Report –Also includes risk coverage ratio (RCR) –Interested parties should read the full WP Report

Risk measurement: Practical uses Better risk control, including ERM context –“You can manage only what you can measure” Pricing and strategic planning –Ensure expected profit is adequate compensation for amount of risk assumed Risk-based capital allocation –Capital ~ risk  adequate price ~ adequate ROC

Risk measurement: Accounting If a contract “transfers risk” it can receive insurance accounting treatment –If not, premiums are treated as “deposits” and net results are amortized into earnings over time –Insurance accounting is often preferred Risk transfer requirements are similar for GAAP and Stat –GAAP: FAS 113 –Stat: SSAP 62

SSAP 62 highlights Reinsurer must assume “significant” insurance risk –Requires non-remote probability of significant variation in amount & timing of payments by reinsurer “Reasonably possible” that reinsurer may realize a “significant” loss –Based on NPV of all cash flows between ceding & assuming companies under reasonably possible outcomes (emphasis added).

WP proposed testing framework Three-step process –1. Determine if contract transfers “substantially all the risk” – if so, stop. Assumed downside essentially same as cedant’s original –2. Determine whether or not risk transfer is “reasonably self-evident” – if so, stop. E.g., cat x/s, x/s w/no loss sensitive features –3. Calculate recommended risk metrics and compare values to critical threshold values.

Expected reinsurer deficit (ERD) Uses probability distribution of net economic outcomes (NPV of cash flows) Critical point = $0 gain = economic breakeven Formula: ERD = pT / P –p = probability of net loss –T = average conditional loss severity –P = expected premium

Expected reinsurer deficit (ERD) Concepts inherent in ERD: –“Risk zone” is area in distribution where economic loss exists in terms of negative NPV –Risk = loss frequency x average loss severity –Base in denominator = expected premium, measuring risk per $1 premium

ERD example Simple example of ERD calculation –Aggregate excess $250m excess of $500m –Settlement 1 year after inception –Investment yield = 4.00% (1-yr risk-free rate available at inception) –Premium = $10m at inception

ERD example Loss distribution (dollars in $000) Ceded lossProbabilityNPV(gain) $ 0 96% $ 10,000 $ 50,000 2%($ 38,077) $150,000 1%($134,231) $250,000 1%($230,385) $ 5,000 Expected value $ 5,192 Cond’l loss severity($110,193)

ERD example Simple example of ERD calculation, continued –Probability of net loss = p = 4% –Average conditional loss severity: (38,077 x 2% + 134,231 x 1% +230,385 x 1%) / 4% –“T” = TVaR(96%) = $110,193 –ERD = pT / P = (4%) (110,193) / 10,000 = 44.1% –By comparison, 10% chance of 10% loss = 1.0% ERD

ERD steps 1. Produce the probability distribution of net present value gain, including all flows (real examples have more flows). 2. Identify the “risk zone” part of the distribution containing net losses. 3. Measure probability of loss and average conditional severity when it occurs. 4. Apply the ERD formula.

Comparisons to other metrics Other popular metrics have a similar structure: –Based on distribution of a key financial item –Specific threshold point of the distribution –Measurement of frequency and/or severity VaR (value-at-risk): –Key financial item: net gain / (loss) of capital –Threshold point: Percentile, such as 5 th –Measurement is severity of percentile point –“What level of loss is possible at an outside chance?” –10/10 rule: VaR(90%) > 10% of premium –Fixes frequency independently of particular contract’s details –Doesn’t measure severity beyond percentile

Comparison to other metrics TVaR (tail value-at-risk), CTE (conditional tail expectation): –Key financial item: net gain in capital, or net economic gain –Threshold point: Percentile, such as 5 th –Measurement is average severity beyond percentile point (“tail”) –“What’s the average loss of capital in the worst 5% of cases?” –Fixes frequency independently of particular contract’s details –Doesn’t capture the likelihood of a net loss –ERD connection: T = TVaR(1-p), p = probability of loss 10/10 rule: A contract passing 10/10 will pass a 1% ERD test, but not the other way around – cat excess example

Risk coverage ratio (RCR) Replace ERD’s premium denominator with expected gain from NPV distribution (“E[G]” in formulas below) Formulas: As risk per $1 of return: RCR, % form = pT / E[G] As expected profit per unit of risk assumed: RCR = E[G] / pT All components come from the economic gain distribution Risk / return metric on economic value

RCR example Same example as above –Probability of net loss = p = 4% –Average conditional loss severity = T = $110,193 –E[G] = Expected gain = $5,192 –RCR % = pT / E[G] = (4%) (110,193) / 5,192 = 84.9% –Risk concentration embedded in expected return = 84.9%

Advantages / applications Advantages of ERD and RCR –Cutoff point is economic breakeven, rather than a statistical percentile Realized impact of risk on companies is in dollar, rather than percentile, terms –Includes all loss events, rather than only the most extreme events –Captures both frequency and severity in one metric –RCR is not affected by “traded dollars” in premium –RCR measures the risk/return tradeoff in terms of economic gain Applications of RCR –Risk-based pricing –Risk-based capital allocation (see paper for reference)

Right-tailed deviation (RTD) Some Working Party members prefer risk measures based on distributional transforms over ERD –Transforms may have added benefits, some added complexity Right-tailed deviation (RTD) proposed by Shaun Wang Define F*(x) = 1 – [1 – F(x)] 0.5 F* is F with the tail stretched out – a risk-loaded distribution F*(x) ≤ F(x), which means E* ≥ E RTD = E* – E = risk load

RTD example Loss distribution (dollars in $000) Ceded loss F(x) F*(x) $ 0 96% 80% $ 50,000 98% 86% $150,000 99% 90% $250, %100% Expected value$5,000$34,000 RTD = $34,000 - $5,000 = $29,000

RTD example RTD risk transfer test: Maximum qualified premium = α(RTD) α parameter could be between 3 and 5; WP observed 4 may be too low. In example, using α = 5: Maximum qualified premium = $145m

RTD advantages F*(x) is a new “loss” distribution – all the usual methods apply –Easy to risk-price layers of coverage –Other advantages – see Wang’s papers “Maximum qualified premium” concept opens door to qualifying part of premium in some cases, instead of “all or nothing”

Conclusion The WP Report is a significant contribution to the literature on risk transfer: –Defined a structured process to narrow down contracts that have to be tested –Described two risk metrics that appear superior to the test: ERD and RTD –1% ERD suggested as one possible threshold

Conclusion Further research recommended: –Level 1: Consensus thresholds –Level 2: Other methods, including quantitative definitions of terms and incorporating parameter uncertainty (Paper only) 3 rd research area: Develop the actuarial perspective on risk transfer, independent of current accounting rules.