1. RCM-4 Ratemaking, Capital Allocation and Risk Metrics
Russ Bingham
Vice President and Director of Corporate Research
Hartford Financial Services
Seminar on Ratemaking
San Antonio, TX
March 26-28, 2003

2. Outline Financial Model Building Blocks Does Your Model . . . ?
Price, Risk, Leverage and Return
Ten Commandments of Insurance Financial Modeling

3. “Building Blocks”: Valuation Fundamentals
Balance sheet, income and cash flow statements
Development “triangles” of marketing / policy / accident period into calendar period
Accounting valuation: conventional (statutory or GAAP) and economic (present value)
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 Historical Future Total
Period Ultimate
Prior X X X X X … > Sum
X X X X X … > Sum
X X X X … > Sum
X X X … > Sum
X X … > Sum
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. 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?

6. Talking Points 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?

7. Ten Commandments of Insurance Financial Modeling
1. Thou shall build only models that have an integrated set of balance sheet, income and cash flow statements
2. Thou shall remain rooted in a policy period orientation and develop calendar period results from this base
3. Thou shall reflect both conventional and economic accounting perspectives - guided by economics, constrained by conventions
4. Thou shall recognize the separate contributions from each of underwriting, investment and finance activities
5. Thou shall be guided by the risk / return relationship in all aspects

8. Ten Commandments of Insurance Financial Modeling
6. Thou shall include all sources of company, policyholder and shareholder revenue and expense embodied in the insurance process
7. Thou shall reflect all risk transfer activities
8. Thou shall not separate risk from return
9. Thou shall not omit any perspective or financial metric that adds understanding
10. Thou shall allow differences in result only from clearly identified differences in assumption, and not from model omission