1. Strategic Insurance Purchasing In The 21 st Century ASTIN & Casualty Actuarial Society Seminar on Reinsurance July 12, 2001 1:15 – 2:00 PM Deloitte & Touche Kevin Bingham 860.543.7345 John Slusarski 860.543.7366

2. Introduction Background –Target audience –Authors Evolution of Insurance Purchasing Decision Strategic Insurance Purchasing, Why Now Convergence: Options and Insurance Dynamic Financial Analysis and Reinsurance Strategic Insurance Purchasing in the 21 st Century Closing Thoughts

3. Evolution of Insurance Purchasing Decision

4. Evolution Limited review of organization’s actual data –Purchase guaranteed cost policies –Retain risk/reflect organization’s own experience using different insurance programs Large deductibles Retrospectively rated policies –Benchmarking Anticipated loss rate x payroll Multiple of calendar payments Limited scenario testing (deterministic) –Captives –“What if” scenarios for insurance purchases Insurance exposure modeling (stochastic) –Frequency/severity modeling 21 st Century?

5. Strategic Insurance Purchasing, Why Now?

6. Financial community –Value At Risk (VaR), Economic Value Added (EVA TM ) –BASLE Accord – Expansion of Pillar 1 –CFA exams (quantitative methods, Monte Carlo simulation) –CNBC, Bloomberg, CNN FN, Internet Clients (and auditors) asking for confidence levels High profile examples/unique capital market solutions –Bowie bonds –Arby’s securitization –Innovative insurance solutions Hardening market Convergence of financial services industry Dynamic Financial Analysis (DFA)

7. Convergence: Options and Insurance

8. Convergence of Financial Services Industry and terminology Actuary CFA Leverage the growing financial knowledge of most risk managers, chief risk officers and corporate decision makers to explain the similarities of insurance and investment options. OR

9. Convergence: Options and Insurance A call option is the right, but not the obligation, to buy a security for a specified price (exercise price) on or before a specified date. Table 1 displays the value of a call option with a $70 exercise price (excluding transaction costs).

10. Convergence: Options and Insurance Insurance programs can be viewed as combinations of purchased and sold call options: –The exercise price of the call option is equal to the client’s SIR, deductible or reinsurance attachment point –For EOL and AEOL contracts, the exercise price of the sold call option is equal to the attachment point plus the insured limit –The call options last for one year, with the expiration date equal to the last day of the accident year

11. Convergence: Options and Insurance Table 2 displays a $250,000 SIR or large deductible using a call option with a strike price of $250,000.

12. Convergence: Options and Insurance Much easier for most investment and risk managers to understand the importance of purchasing insurance strategically using the option analogy. Although actual conversion is difficult, understanding insurance in terms of options is a helpful exercise for risk managers and actuaries. KEY POINT – Just as the fundamentals underlying stock and bond investments change each year, so do the insurance risks facing an organization (e.g., hardening market, acquisitions, new exposures, etc.).

13. Dynamic Financial Analysis and Reinsurance

14. DFA and Reinsurance - Background The term DFA originated in the property-casualty insurance industry. The objective was to provide an integrated system for evaluating major risk elements affecting a company’s overall financial performance and economic value. Why the term DFA? –Dynamic: interaction of key variables under multiple scenarios and management actions. –Financial: use modern financial economics to project variables –Analysis: examine impact on both the economic value and financial statements 1 of the firm. 1. Insurers prepare financials under two separate accounting methods; U.S. GAAP and Statutory accounting principles.

15. DFA and Reinsurance - Background Past v.s. Future –Deterministic v.s. Stochastic: Expected Value 100 v.s. Distribution Around Expected Value –Fragmented v.s. Integrated Approach to Risk Analysis –Integration of Internal and External Risk Factors –Time Horizons of Over One Year 100

16. DFA and Reinsurance - Background Deterministic # Policies 100 X Premium / Policy 20 = Total Premium 2,000 X 1 - Operating Ratio.13 = Operating Profit 260 DFA # Policies X Premium / Policy X 1- Oper. Ratio = Operating Profit 100 20 0.13 260

17. DFA and Reinsurance - Background InvestmentsUnderwriting Reinsurance Business Strategies Management Interventions

18. DFA and Reinsurance - Background 99% Confidence Level 0 Premiums Ending Capital xFinancialForecast HistoricalPlan x

19. DFA and Reinsurance - Variables In simple terms, DFA models consider a set of external variables and a set of internal variables. External variables - price takers: –Interest rate levels –Inflation rates –Capital market prices and total returns –Pricing cycles and price elasticities –Natural catastrophes –Changes in loss levels from case law, jury awards, claims consciousness, etc. Internal Variables - management decisions: –Premium rate levels actions –Reinsurance program –Underwriting guidelines –Marketing plans and distribution mechanism –Outstanding liability reserve practices –Investment strategy –Expense management

20. DFA Applications Reinsurance optimization –Reinsurance module from DFA model –Majority of DFA work done to date Asset and liability hedging strategies Investment portfolio management Demutualization Credit risk modeling Operational risk modeling SBU operational strategies and planning Strategic options analysis for mergers and acquisitions Risk adjusted capital management Rating agency management New products and market development Tax optimization

21. Strategic Insurance Purchasing in the 21 st Century

22. Mathematical modeling of all risk factors (DFA) Enterprise risk management mitigates variability in financial results from ALL the organization’s major risks (i.e., not just insurance) –Insurance exposures –Asset returns (e.g., Intel example) –Projected sales –Production costs –Tax revenue Examples –Captives –Insurance companies –Unique projects Efficient frontier

23. SIP in the 21 st Century Efficient Frontier

24. Strategic Insurance Purchasing in the 21 st Century Answer key management questions –Insurance Specific What is the organization’s annual insurance cost and the confidence level feeding financial plan? What is the cost/benefit analysis for the insurance option selected versus other options (e.g., XOL versus AEOL, 250 SIR versus 500 SIR)? What is the variability of the organization’s insurance costs? How well is the company protected against catastrophic losses? –Enterprise wide focus What is the confidence level feeding financial plan for all risks? What circumstances may cause the company’s financial statements to be impaired (e.g., asset portfolio decline, top line revenue drop, multiple events occurring simultaneously)? What investment mix and reinsurance protection produces the highest return for the lowest level of risk (i.e., efficient frontier)?

25. Closing Thoughts “If it ain’t broke, don’t fix it” risk management approach no longer acceptable –Hardening market –Financial pressure from management/shareholders Technology –Computer processing speed –@Risk, Crystal Ball, Excel Ability to leverage financial “thought ware” –RiskMetrics and VaR –Investment community knowledge Demand for quantitative enterprise risk management Applying and leveraging DFA research/publicity

26. Closing Thoughts DFA EPD VaR EVA RAROC Ruin RBC BCAR Insurance Manufacturing Retail Banking