1 RCM-1 Risk and Return Considerations in Ratemaking Russ Bingham Vice President and Director of Corporate Research Hartford Financial Services Seminar on Ratemaking Philadelphia, PA March 11-12, 2004

2 Outline l Financial Model Building Blocks l Risk / Return Decision Framework l Financial Integrity l Does Your Model... l Price, Risk, Leverage and Return l Ten Commandments of Insurance Financial Modeling

3 “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 financial leverage contributions

4 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 2000 X X X X X …... --> Sum 2001 X X X X …... --> Sum 2002 X X X …... --> Sum 2003 X X …... --> Sum 2004 X …... --> Sum ==== ================ Reported Sum Sum Sum Sum Sum Calendar Rates are set across the policy period “row” but regulatory review is often based on the calendar “column” sum

5 Risk / Return Decision Framework – Basic Principles l Insurance = underwriting, investment and financial leverage l Volatility is uncertainty of result l Risk is exposure to loss l Policyholder, company & shareholder risk transfer pricing activities are a function of risk, and can be accomplished independently of leverage l Underwriting and Investment returns are a function of volatility (greater uncertainty, greater required return and vice versa)

6 Risk / Return Decision Framework – Basic Principles 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 Leverage is the process by which surplus is introduced in order to provide a financial buffer against adverse outcomes (and also to allow for the expression of results in the standard ROE language of management) l Cost of capital is as important as cost of underwriting l Ultimately, risk and return should be expressed in the same metric l Principles apply to underwriting and investment activities

7 Financial Integrity Ideal Ratemaking Financial Documentation Support l Fully integrated balance sheet, income and cash flow statements l Policy / accident period focus with calendar period provided if needed l Nominal and economic accounting 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 Specification of risks included l Amount of capital and its cost

8 Financial Integrity(Continued) l All ratemaking models can be reconciled with this documentation l Ratemaking focus should be on parameter assumptions and inputs and not be distracted by a particular model structure l Differing and often incomplete forms of presentation make it nearly impossible to understand and compare “opposing” approaches l Inconsistent parameter estimation, leading to biased outcomes, is all too common and is not challenged effectively l Ratemaking is a key component of financial management l It is the actuary’s responsibility to see that ratemaking and related activities are part of a disciplined financial process l Actuaries risk being marginalized unless they adopt a bottom line, ownership orientation - total return in comparison to the cost of capital is relevant, for example, whereas return on premium by itself is not

9 Does Your Model... Reflect all costs? Reflect all risks? Provide all metrics? Apply to underwriting and investment activities? Facilitate the application of fundamental risk / return principles?

10 Price, Risk, Leverage and Return Price for Risk, Leverage for Return What is Risk, and how is it reflected in the Price? What is the working Risk / Return Tradeoff? What determines Leverage? What is the Cost of Capital and how is it incorporated? What is the Economic Value Added?

11 Ten Commandments of Insurance Financial Modeling 1. Thou shalt build only models that have an integrated set of balance sheet, income and cash flow statements 2. Thou shalt remain rooted in a policy period orientation and develop calendar period results from this base 3. Thou shalt reflect both conventional and economic accounting perspectives - guided by economics, constrained by conventions 4. Thou shalt recognize the separate contributions from each of underwriting, investment and finance activities 5. Thou shalt be guided by the risk / return relationship in all aspects 6. Thou shalt include all sources of company, policyholder and shareholder revenue and expense embodied in the insurance process 7. Thou shalt reflect all risk transfer activities 8. Thou shalt not separate risk from return 9. Thou shalt not omit any perspective or financial metric that adds understanding 10. Thou shalt allow differences in result only from clearly identified differences in assumption, and not from model omission