Profit and Contingencies- An International Perspective

1. Profit and Contingencies-An International Perspective FIN-28 CAS Seminar on Ratemaking March 9-10, 2000 Hotel del Coronado San Diego, California Benedetto Conti Chief Non-Life Actuary Winterthur Insurance Group P.O. Box 286 8401 Winterthur Switzerland Benedetto.Conti@winterthur.ch

2. „Parallel to this has been the increasing acceptance of „shareholder value“ as the yardstick by which management performance ought to be measured. This trend, which began in the English speaking countries in the 1980s, is now spreading to continental Europe where it is increasingly accepted that that the most important measure of corporate performance is whether management has produced shareholder value.” (p.21) „Still there is widespread resistance, especially in Europe, to the idea that creating value for shareholders should be management‘s top priority.“ (p.36) OECD Financial Market Trends, No 69 February 1998 Shareholder Value

3. Life and Non-Life (Million USD) The 15 members of the European Union • Austria • Belgium • Denmark • Finland • France • Germany • Greece • Ireland • Italy • Luxembourg • Netherlands • Portugal • Spain • Sweden • United Kingdom

4. Density and penetration (Non-Life) • Density:Gross direct premium per inhabitant • Penetration:Gross direct premium in % GDP

5. Number of Non-Life Insurance Companies • In many European countries, the number of insurers will decrease • The process of consolidation will continue at a high speed

6. Retention ratio • Retention ratio = Net written premium/Total gross premium • Proportional treaties (quota share and surplus) still very popular

7. Direct Motor in % of Total direct (both gross)

8. References • Insurance Statistics Yearbook 1990-1997OCDE, Paris, 1999ISBN 92-64-05858-3www.oecd.orgOECD Center Washington2001 L Street N.W.Suite 650Washington, DC 20036-4922Phone (202) 785 6323Toll free (800) 456 6323Fax (202) 785 0350E-mail washington.contact@oecd.orgInternet www.oecdwash.org

9. Europe • In Europe, P&C actuaries are very much confronted with actuarial considerations regarding risk and return in insurance pricing. • The main driver of the interest stems from top management’s interest in internal performance measurement based on value creation.

10. Fairness of prices less a concern than in USA • A part from some lines, mainly related to social security (health, workmen’s comp, …) there is no widespread need for the European actuary to yield a scientific justification on the fairness of the prices. • For an European Actuary, it is surprising to read as first chapter of a book on Insurance pricing a contribution on “The Legal perspective: …”.

11. Compliance with Profession’s Principles is less a concern than in USA • To my knowledge, in almost no European Country are the profession’s Statements of Principles regarding ratemaking as detailed and rich as in USA. • European actuaries do not face the topic in a training on such principles.

12. The issue has been addressedsince many years … • Nevertheless, the question of the determination of the fair loading is part of actuarial training since many decades. • In the past, after the presentation of several approaches for modelling the issues, the textbook ended with the remark: “The selection of this parameter is not the actuary’s, but top management’s decision.”

13. … but remained an arcane science • Top management had no clue on actuarial science*, the actuary couldn’t even imagine himself knocking at the door of top management and asking: “Please, select the parameter!” • The models used by actuaries were well understood within the rating department, depending on the market cycle more or less appreciated by the Underwriting and Marketing Department, but remained an arcane science outside those groups. By the way: My views are not necessarily identical with those of the co-sponsors of the program, nor my employers nor my insurance Group’s clients.

14. The world has changed … It all began beginning of the nineties … • “We need better instruments to steer our company” • “We do not know where we make money or where we lose money” • “We need better, risk-adjusted instruments to set the benchmark” • “We need better instruments to steer our asset and our insurance risk” • …

15. The world has changed … • People started realising that a consistent internal performance measurement cannot be limited to return on premium based on accounts with discounted reserves with same ROP to all lines and classes of insurance.

16. Return on premium … • In those times, return on premium was the privileged benchmark for setting return-targets. • The emergence of the necessity to “risk-adjust” the benchmark very quickly started bringing the return on equity into the game.

17. … is replaced by Value Creation • Top management gets interested in actuarial. • Top management wants to determine the parameter! • The actuary is faced with the necessity to communicate to top management very complex issues.Have you ever thought about how to visualise the difference between a 1% and 0.2% ruin probability? I succeeded by showing a mortality table! (But models linking ratings to survival probabilities of companies at different time horizons are more useful to facilitate a final decision.)

18. Risk has many facets … • Solvency:the main driver of the necessary capital,and • Volatility:Management’s first concern is to meet the business plan! • Different stakeholders have a different perception of risk!

19. … and many measures • Statutory accounts • Accounts based on GAAP reflecting earnings • Fair (“mark to market”) valuation (future IAS?) • Embedded value • Appraisal value • …

20. The juggling art of plate spinning • Managing a company is very similar to the juggling art of plate spinning. • It cannot be learnt by reading a textbook on analytical mechanics.

21. Additional sources of complexity … • The emergence of large financial conglomerates embracing all insurance and banking activities. • Necessity to implement a consistent performance measurement with a value creation model model embracing all Divisions.

22. Additional sources of complexity … • Language, communication, culture, traditions(for the banker “risk premium” has a different meaning than for the actuary). • The emergence of a multitude of consultants and the explosion of terminology and concepts.

23. Too simple solvency regulations in Europe • If the solvency regulations were more sophisticated than they are, this would yield an accepted starting basis on which to base first capital allocation schemes. • This is to some extent mitigated by the fact that the capital requirement of larger insurance companies is more driven by rating agencies than by regulators.

24. Personal views • The implementation of an efficient value based management system can only be successful if it is so simple that it can be understood by many persons. • Have the courage to propose simple solutions, fight for the implementation of simple solutions, complex actuarial models will not be supported by all those who create value, they will not survive.

25. Personal views • The internal management process should be aligned to the communication of the company to the external world. • E.g.: if the objective communicated to the external world is “15% return on GAAP equity”, set the same hurdle rate to all divisions, products, lines, …, and split the GAAP equity additively such that the total is the sum of the parts.

26. Personal views • Such capital allocation process should be based on a simple and transparent “formula” whose components are intuitively easily understood. • My favourite: % of premium, % of loss reserves at beginning of the year, and, if more than risk-free returns are allocated to the insurance result, a % of invested assets (reserves+allocated capital).

27. Personal views • Fine tune the percentages in the back-office with sophisticated models, but use simple words to communicate to the external world. • Use net present values of free cash-flows AND, equivalently, of any “accounting-based” measure of yearly value created to evaluate (strategic) business plans, but use more simple accounting-based measures of the yearly performance.

28. Conditional Expected Deviation from the business plan Z = X+Y = random variable = “result” of total portfolio Z composed of two sub-portfolios X and Y Measure the risk of X as its contribution to the deviation of Z from the business plan µZ as: Risk(X) := E[ X-µX I Z- µZ<-c ]

29. The new paradigma • Top management wants to select the parameter. • Actuaries must assist top management in this process. • Actuaries must help in implementing the new measure through the whole organisation. • All that requires new skills in communication! • No room for ROP, but focus on ROallocatedE!(Changes in premium bad indicators for changes in risk!)