1. CAS Ratemaking Seminar RCM-1 Logic, Fallacies, and Paradoxes in Risk/Profit Loading in Ratemaking: A Socratic Dialogue
Introductory Remarks by Glenn Meyers
ISO Innovative Analytics
March 17, 2008

2. Insurer Risk and Capital Management Perspective
Risk based capital
The insurer's risk, as measured by its stochastic distribution of outcomes, provides a meaningful yardstick that can be used to set capital requirements.
Insurer risk management
The insurer manages its business to get the best return on its cost of capital.

3. Steps for Insurer Capital Management in Ratemaking
Determine total capital for insurer
Determine rate of return on that capital
Allocate capital to business segment
Calculate cost of business segment holding that allocated capital
My remarks today address this part of the problem.

4. Insurer Risk Management
Reserve Risk contributes to the need for capital and hence it contributes to the ($) cost of capital.
How long you need to hold capital is a consideration in determining an acceptable price.

5. The Cash Flow for Underwriting Insurance
Investors provide capital
Through the insurer they:
Receive premium income
Pay losses and other expenses
Receive investment income
Invested at interest rate i%
Release capital as liabilities become certain.

6. Net out the loss and expense payments
Investors provide capital
Through the insurer they:
Receive profit provision in the premium
Receive investment income from capital as it is being held.
Release 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

7. Define Terms Allocated Capital invested in year t Provision for Profit
Insurer’s return on invested assets
Insurer’s target return on capital Ct P i r

8. Calculating the Profit Provision

9. Calculating the Profit Provision Another Formula

10. Profit = 1,348 = 2.2% of Initial Liability
Sample Calculation
Profit = 1,348 = 2.2% of Initial Liability

11. Main Obstacles to Overcome
Prediction This how actuaries will include the cost of capital in future insurance costing.
Main Obstacles to Overcome
Fuzzy relationship between risk and capital
Insurers are starting to build internal capital models
Examples EU Solvency II, British FSA, S&P
Quantification of all risks
Underwriting risk and reserving risk
Asset risk - Several commercial models
Operational risk
Other
Consensus
Will not come until above issues are substantially settled.