1. Ratemaking: An ERM Function CAS Ratemaking Seminar March 13 & 14, 2006 Russ Bingham, Hartford Curt Parker, Grange Mutual John Kollar, ISO

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

3. ERM “Drivers” Improved corporate governance – Sarbanes Oxley Act Consolidation Financial services convergence Globalization – International Association of Insurance Supervisors (IAIS) International insurance accounting standards –Solvency II –International Accounting Standards Board (IASB) Risk management evolution

4. Some OTHER Ratemaking Questions (Outline) Adequacy of 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 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 Y1 Y2 Y3 Y4

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

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

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

9. Correlation increases with volume

10. Aggregate Loss Distribution & Implied Economic Capital Value at Risk TVaRTVaR

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

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

13. Note capital is allocated to loss reserves

14. 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.

15. Optimize reinsurance by minimizing the cost of financing

16. Reinsurance Risk Transfer Testing Expected losses

17. Marketing/Underwriting Strategy Reflect Risk in Planning Change

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

19. Standard Ratemaking Exhibit Scroll to end –>

20. Cost of Financing Target Combined Ratio

21. Set combined ratio targets by line and overall

22. 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.

23. 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

24. Confidence Interval Around the Target Combined Ratio

25. Robust Analysis of an Enterprise’s Risks (ERM) is Essential to Sound Ratemaking!