1. New Approach to Ratemaking & Reserving
CAS May Meeting
May 9, 2006
John Kollar, ISO
Russ Bingham, Hartford

2. CAS ERM Definition Process Holistic treatment of risk
Assess
Control
Exploit
Finance
Monitor risk
Holistic treatment of risk
Senior management function
Upside and downside

3. Holistic Treatment of Risk
Economic
Capital
Risk
Parameters
Risk
Allocation
Risk
Analysis
URM
Reinsurance
Pricing
Risk
Combined
Ratios
Interest
Rate Risk

4. Some New Ratemaking & Reserving Questions (Outline)
What are Fair Value loss reserve estimates?
Capital adequacy?
Risk measurement by line, state, etc.?
Reinsurance? Amount? Cost? Risk transfer?
Marketing program?
Underwriting guidelines?
Underwriting cycle position?
Predictive modeling? Adverse selection?

5. Loss Reserve Estimates
New Approaches
Stochastic methods
Bayesian estimates
Benchmarking
Confidence intervals
Fair Value Accounting
Discounted reserves
Market Value Margin
Convergence of FASB to IASB

6. Loss Reserve Adequacy Short-Tailed vs. Long-Tailed Lines
Short-Tailed Lines
Release most capital at the end of 1st year.
Long-Tailed Lines
Release a portion of capital at the end of each year.
Year 1 Year 2 Year 3 Year 4
Y Y Y3 Y4

7. Reserve Risk: Average Size and Volatility of GL Open Claims Increases Over Time

8. Capital Requirements Loss Volatility}
Insurer A
Insurer B
More Capital
Less Capital }
Expected costs
Years
Years

9. Correlation = More Volatility{
Correlation = More Volatility
Capital
}Capital
Low Correlation
High
Correlation
Insurer B
Insurer A
Line D
Total
Line C
Total
Line A
Line B

10. Correlation increases with volume

11. Aggregate Loss Distribution & Implied Economic Capital
Value at Risk
TVaR

12. Different measures of risk imply different amounts of economic capital

13. Risk Measurement & (Cost of) Capital Allocation by Line, etc.

14. Note capital is
allocated to
loss reserves

15. Cost of Financing Risk = Cost of Capital + Net Cost of Reinsurance
Cost of capital reflects:
Release of capital as claims are resolved
Discounted at the target rate of return on capital
Rate of return on invested assets
Net cost of reinsurance is the difference of the ceded premium and the expected reinsurance recovery after it has been reduced for:
Discounted cash flows
Federal income taxes
Minimize the cost of financing risk.

16. Optimize reinsurance by minimizing the cost of financing

17. Reinsurance Risk Transfer Testing
Expected losses

18. Marketing/Underwriting Strategy Reflect Risk in Planning Change

19. Ratemaking Setting Combined Ratio Targets by Line
Expected losses
Expected expenses
Investment income
Cost of financing
Cost of reinsurance
Cost of capital (risk)

20. Standard Ratemaking
Exhibit
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21. Cost of
Financing
Target
Combined
Ratio

22. Set combined ratio targets by line and overall

23. Underwriting Cycle Pricing Risk
Develop a number of pricing scenarios reflecting marketplace conditions (cycle).
For each pricing scenario:
Adjust premiums.
Calculate (projected) combined ratio.
Calculate (projected) return on capital.

24. Predictive Modeling Risk of Adverse Selection
Use of other information (beyond rating variables) to more accurately rate a policy
Increased profits
Reduced risk
Lower economic capital
Inability to select better policies and compete with other insurers results in adverse selection
Losses or reduced profits
Increased downside risk
Higher economic capital

25. Confidence Interval Around the Target Combined Ratio

26. Robust Analysis of an Enterprise’s Risks (ERM) is Essential to Sound Ratemaking & Loss Reserving!