2004 Proceedings Paper Value Creation in Insurance – A Finance Perspective

1. 2004 Proceedings PaperValue Creation in Insurance – A Finance Perspective Russ Bingham CAS Annual Meeting Vice President and Nov 15 - 17, 2004 Director of Corporate Research Montreal, Quebec Hartford Financial Services

2. Outline • Historical Perspective – Building a Financial Discipline • Building Blocks – Valuation Fundamentals • Unified Financial Model • Insurance Funds Flow Schematic • Demonstration Example • Ten Commandments of Insurance Financial Modeling

3. Historical PerspectiveBuilding a Financial Discipline The objective is to create a process of financial discipline which enhances the creation of economic value and the subsequent delivery of reported earnings. Basic concepts implemented and published 1987 Internal line of business, accident year benchmark ROE introduced for ratemaking and performance measurement. 1989 Proposition 103 testimony - proposing DCF and economic valuation models in ratemaking. 1990 Proceedings “Discounted Return - Measuring Profitability and Setting Targets” - documentation of basic approach and concepts.

4. Historical Perspective: (Continued) Refinement of important rate of return principles 1993 Proceedings (1) “Surplus - Concepts, Measures of Return, and Determination” and (2) “Rate of Return - Policyholder, Company, and Shareholder Perspectives” - developing rate of return and surplus concepts further. Conceptual and structural elements of model(s) reconciliation 1999 Actuarial Considerations Regarding Risk and Return text (1) “Fundamental Building Blocks of Insurance Profitability Measurement” and (2) “Cash Flow Models in Ratemaking” - discussing fundamental principles and modeling considerations which result in equivalent and/or reconcilable outcomes.

5. Historical Perspective: (Continued) Risk / return integration and rate of return / solvency connection 2000 Proceedings (1) “Risk and Return: Underwriting, Investment and Leverage - Probability of Surplus Drawdown and Pricing for Underwriting and Investment Risk” - to incorporate methodology within risk / return framework and deal with rate of return and solvency in an integrated manner. (2) “The Direct Determination of Risk-Adjusted Discount Rates and Liability Beta” - to demonstrate mathematical connection between equity beta and liability beta.

6. Historical Perspective: (Continued) Integration of economic value concepts 2004 Proceedings “Value Creation in Insurance – A Finance Perspective” - to incorporate economic valuation into SINGLE financial model that encompasses ratemaking and (virtually) ALL other applications which measure financial performance in an insurance company. This extends the focus from internal revenue and expense items to include external costs of capital.

7. “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) plus • Risk / return decision framework which deals with separate underwriting, investment and leverage contributions Both internal and external costs must be reflected

8. Unified Financial Model • Ratemaking models and approaches are too often overly narrow in focus (and thus limit the actuary’s role) • May not be integrated with other company assessments of profit and value creation • May not provide all metrics that management likes to see • May not include both internal and external costs • A single, all-inclusive financial model can be created which supports virtually all insurance company financial performance assessment, including ratemaking, and serves to act as a critical source of managment decision making. • This paper demonstrates how external capital costs, often missing from ratemaking models, are integrated in such a unified approach.

9. Insurance Funds Flow Schematic - The Risk Transfer Process

10. Demonstration Example - Assumptions For underwriting function activities:  103.1% Combined ratio  $9,700 Premium, collected without delay when written  $10,000 Loss, single payment at end of year 3  $0 Expense  35% Income tax rate, no delay in payment  6.0% Low-risk investment interest rate before-tax, 3.9% after-tax  No loss discount tax or unearned premium tax  3.0 Liability/surplus ratio  15.0% Cost of underwriting equity For investment function activities:  6.2% Investment interest rate before-tax, 4.65% after-tax, assuming a 25% tax rate  20% Investment equity / underwriting equity ratio, equivalent to using a 20:1 (liability plus underwriting equity) / investment equity ratio  15.0% Cost of investment equity For finance function activities:  6.2% Investment interest rate before-tax, 4.65% after-tax, assuming a 25% tax rate  25% Debt / total equity ratio  8.0% Cost of debt before-tax, 5.2% after-tax.

12. Demonstration Example – Financial Recap Note: Financial amounts are expressed in nominal value (i.e. not discounted), and represent the sum total over the policy lifetime of each respective item.

13. Economic Cost and Value Creation Components

14. Ten Commandments of Insurance Financial Modeling 1. Thou shalt build only models that have an integrated set of balance sheet, income and cash flow statements 2. Thou shalt remain rooted in a policy period orientation and develop calendar period results from this base 3. Thou shalt reflect both conventional and economic accounting perspectives - guided by economics, constrained by conventions 4. Thou shalt recognize the separate contributions from each of underwriting, investment and finance activities 5. Thou shalt be guided by the risk / return relationship in all aspects 6. Thou shalt include all sources of company, policyholder and shareholder revenue and expense embodied in the insurance process 7. Thou shalt reflect all risk transfer activities 8. Thou shalt not separate risk from return 9. Thou shalt not omit any perspective or financial metric that adds understanding 10. Thou shalt allow differences in result only from clearly identified differences in assumption, and not from model omission Do not confuse models with metrics.