The Cost of Financing Insurance Version 2.0 Glenn Meyers Insurance Services Office Inc. CAS Ratemaking Seminar March 8, 2002

The Cost of Financing Insurance Version Web Site Use DFA to set profitability targets by line on insurance “The Cost of Financing Insurance” –Sets forth the underlying theory “An Analysis of the Underwriting Risk of DFA Insurance Company” –Applies “Cost” paper to a very realistic situation. Downloadable spreadsheets

Set Profitability Targets for an Insurance Company The targets must reflect the cost of capital needed to support each division's contribution to the overall underwriting risk. The insurer's risk, as measured by its statistical distribution of outcomes, provides a meaningful yardstick that can be used to set capital requirements.

Volatility Determines Capital Needs Low Volatility

Volatility Determines Capital Needs High Volatility

Additional Considerations Correlation –If bad things can happen at the same time, you need more capital. We will come back to this shortly.

The Negative Binomial Distribution Select  at random from a gamma distribution with mean 1 and variance c. Select the claim count K at random from a Poisson distribution with mean . K has a negative binomial distribution with:

Multiple Line Parameter Uncertainty Select b from a distribution with E[b] = 1 and Var[b] = b. For each line h, multiply each loss by b.

Multiple Line Parameter Uncertainty A simple, but nontrivial example E[b] = 1 and Var[b] = b

Low Volatility b = 0.01 r = 0.50

Low Volatility b = 0.03 r = 0.75

High Volatility b = 0.01 r = 0.25

High Volatility b = 0.03 r = 0.45

About Correlation There is no direct connection between r and b. Small insurers have large process risk Larger insurers will have larger correlations. Pay attention to the process that generates correlations.

Correlation and Capital b = 0.00

Correlation and Capital b = 0.03

Additional Considerations Reinsurance –Reduces the need for capital –Is the cost of reinsurance less than the cost of capital it releases? How long the capital is to be held –The longer one holds capital to support a line of insurance, the greater the cost of writing the insurance. –Capital can be released over time as risk is reduced.

Additional Considerations Investment income generated by the insurance operation –Investment income on loss reserves –Investment income on capital

The Cost of Financing Insurance Includes –Cost of capital –Transaction cost of reinsurance Transaction Cost of Reinsurance = Total Cost - Expected Recovery

The To Do List Allocate the Cost of Financing back each underwriting division. Express the result in terms of a “Target Combined Ratio” Is reinsurance cost effective?

Doing it - The Steps Determine the amount of capital Allocate the capital –To support losses in this accident year –To support outstanding losses from prior accident years Include reinsurance Calculate the cost of financing.

Step 1 Determine the Amount of Capital Decide on a measure of risk –Tail Value at Risk Average of the top 1% of aggregate losses Example of a “Coherent Measure of Risk –Standard Deviation of Aggregate Losses Expected Loss + K  Standard Deviation –Both measures of risk are subadditive  (X+Y) <=  (X) +  (Y) i.e. diversification reduces total risk.

Step 1 Determine the Amount of Capital Note that the measure of risk is applied to the insurer’s entire portfolio of losses.  (X) = Total Required Assets Capital determined by the risk measure. C = r(X) - E[X]

Step 2 Allocate Capital How are you going to use allocated capital? –Use it to set profitability targets. How do you allocate capital? –Any way that leads to correct economic decisions, i.e. the insurer is better off if you get your expected profit.

Better Off? Let P = Profit and C = Capital. Then the insurer is better off by adding a line/policy if:  Marginal return on new business  return on existing business.

OK - Set targets so that marginal return on capital equal to insurer return on Capital? If risk measure is subadditive then: Sum of Marginal Capitals is  Capital Will be strictly subadditive without perfect correlation. If insurer is doing a good job, strict subadditivity should be the rule.

OK - Set targets so that marginal return on capital equal to insurer return on Capital? If the insurer expects to make a return, e = P/C then at least some of its operating divisions must have a return on its marginal capital that is greater than e. Proof by contradiction If then:

Ways to Allocate Capital #1 Gross up marginal capital by a factor to force allocations to add up. Economic justification - Long run result of insurers favoring lines with greatest return on marginal capital in their underwriting. Appropriate for stock insurers. I use it because it is easy.

Ways to Allocate Capital #2 Average marginal capital, where average is taken over all entry orders. Shapley Value Economic justification - Game theory Appropriate for mutual insurers

Ways to Allocate Capital #3 Line headed by CEO’s kid brother gets the marginal capital. Gross up all other lines. Economic justification - ???

Allocate Capital to Prior Years’ Reserves Target Year prospective Reserve for one year settled Reserve for two years settled Reserve for three years settled etc

Step 3 Reinsurance Skip this for now

Step 4 The Cost of Financing Insurance The cash flow for underwriting insurance Investors provide capital - In return they: Receive premium income Pay losses and other expenses Receive investment income –Invested at interest rate i% Receive capital as liabilities become certain.

Step 4 The Cost of Financing Insurance Net out the loss and expense payments Investors provide capital - In return they: Receive profit provision in the premium Receive investment income from capital as it is being held. Receive capital as liabilities become certain. We want the present value of the income to be equal to the capital invested at the rate of return for equivalent risk

Step 4 The Cost of Financing Insurance

Back to Step 3 Reinsurance and Other Risk Transfer Costs Reinsurance can reduce the amount of, and hence the cost of capital. When buying reinsurance, the transaction cost (i.e. the reinsurance premium less the provision for expected loss) is substituted for capital.

Step 4 with Risk Transfer The Cost of Financing Insurance The Allocated $$ should be reduced with risk transfer.

Step 4 Without Risk Transfer The Cost of Financing Insurance

Example ABC Insurance Company Five Lines –GL 5 lags –PL 5 lags, slower payout than GL –AL 3 lags –Prop 1 lag –Cat 1 lag 2% chance of big loss

Example ABC Insurance Company The first four lines move together with user input of covariance generator, b. Cat line is independent of other lines. All parameters can be changed. Spreadsheet is downloadable. Look at spreadsheet

Results of Sample Inquiries The cost of capital increases with correlation. If reinsurance prices go up –Optimal amount of reinsurance goes down –Cost of financing goes up

Example DFA Insurance Company Diversified multi-line insurance company Northeast/Midwest exposure Some cat exposure Details on CAS web site for DFA Call Paper Program

Example DFA Insurance Company Generated aggregate loss distributions using: –ISO claim severity distributions by lag –WC distributions by lag from an independent state rating bureau –Covariance generators from ISO study that varied by line and lag –Reinsurance information Calculated marginal TVaR and Standard Deviations and then allocated capital.

Covariance Generators Can be estimated from data “Estimating Between Line Correlations Generated by Parameter Uncertainty” Paper gives posterior likelihood for covariance generators and parameters for negative binomial claim count distribution.

Conclusion on Correlation You need to use the data from several insurers to get reliable estimates of covariance generators. Covariance generators vary by line and settlement lag.

Example DFA Insurance Company Downloadable spreadsheet Aggregate loss distributions calculated outside the spreadsheet All other parameters can be changed Multiple reinsurance strategies placed on spreadsheet Look at spreadsheet

Discuss the Reinsurance Recommendation Recommend no reinsurance Cost of financing is less with no reinsurance. A more conventional look –From the cat model Max loss = 60% of capital 100 year loss = 11% of capital

Discuss the Reinsurance Recommendation Motivation for buying reinsurance –Solvency protection? –Profitability protection? How much expected profitability are they giving up by buying reinsurance?

Concluding Remark Work originally done for 2001 DFA Call Paper program. Great call paper topic!