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Thinking about Decision Making

Thinking about Decision Making . Rich Clement: Underwriting Decisions Rick Leavitt: Actuarial Decisions Issues Simulation Game Theory. Underwriting Decisions . Difficulties In Underwriting. Limited to poor information Quick turnaround time Competition – Acquisition/Irrational Pricing

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Thinking about Decision Making

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  1. Maine Event 2004 Thinking about Decision Making • Rich Clement: Underwriting Decisions • Rick Leavitt: Actuarial Decisions • Issues • Simulation • Game Theory

  2. Maine Event 2004 Underwriting Decisions

  3. Maine Event 2004 Difficulties In Underwriting Limited to poor information Quick turnaround time Competition – Acquisition/Irrational Pricing Multiple Products Tenure of underwriters – size of accounts Economic conditions Evaluation periods are too short Most volatile time period

  4. Maine Event 2004 Difficulties In Underwriting Limited Tools/Consistently Changing Tools Changing plan designs – move to employee contributions New sales and underwriting territories Aging workforce Obesity – co-morbid conditions Pressure on underwriting gain from poor investment income Limitations to Home Office Partners

  5. Maine Event 2004 Difficulties In Underwriting Mind space for LTD Increasing medical costs Churning business Employer’s “attitude” towards employee’s Regulatory issues Internal meetings Profitable Growth Goals

  6. Maine Event 2004 Traditional U/W Response

  7. Maine Event 2004 Traditional U/W Response Risk Analysis Read and Understand the RFP Why is case out to bid? Who is the broker? Partner with sales on strategy. Who is employer? – Financial Underwriting Manual rates SIC, OCC, Area factors

  8. Maine Event 2004 Traditional U/W Response Risk Analysis (continued) Plan design features Experience evaluation Cause and effect Most recent period is volatile Credibility Other perspectives Claims, actuarial, similar customers trust yourself

  9. Maine Event 2004 New Approaches Track Decisions Competitive advantage Learn from your mistakes Evaluate # of claims Strategic direction Understand where you make money Maintain underwriting discipline – mistakes sell “Hit them were they ain’t” – Ty Cobb

  10. Maine Event 2004 Actuarial Decisions …. Harder than I thought “All you need in this life is ignorance and confidence; then success is sure” - Mark Twain “The greatest obstacle to discovery is not ignorance - it is the illusion of knowledge” - Daniel Boorstein

  11. Maine Event 2004 Actuarial Decision Making 1980’s actuary: Conduct an experience study and recommend rate modifications 21st Century Actuary: ??? “Actuaries are professionals who provide expert advice and relevant solutions for business and societal problems that involve economic risk” ….SOA Promotional Material Given difficult business environment, it is not enough just to get the pricing right.

  12. Maine Event 2004 2004 Disability Product Strategy *** Strategy Options *** • “Slow and Steady Wins the Race” • Develop Appropriate Pricing and Stay the Course • You might need investor and management education • “Decisive and Aggressive” • Identify Target Markets and Attack Aggressively • Fix Mistakes as you Go

  13. Maine Event 2004 2004 Disability Product Strategy *** Strategy Options *** • 3. Market Intelligence: “Hit ‘em where they ain’t” • Exploit Undeveloped Market Niches • 4. “Execution, execution, execution” • Improve Distribution Efficiency/UW Decision Making • Reduce Administrative Expenses and Cost of Capital • Risk Evaluation Tools = Smart Decision Making

  14. Maine Event 2004 Actuarial Decisions: LTD Why is it so hard to get the pricing right? 1. Volatility of Loss

  15. Maine Event 2004 Loss Volatility

  16. Maine Event 2004 Actuarial Decisions: LTD Why is it so hard to get the pricing right? • Volatility of Loss – Random versus external impacts • Loss takes a long-time to develop

  17. Maine Event 2004 LTD Components of Loss

  18. Maine Event 2004 Actuarial Decisions: LTD Why is it so hard to get the pricing right? • Volatility of Loss – Random versus external impacts • Loss takes a long-time to develop • Product Complexity

  19. Maine Event 2004 LTD Product Complexity • Risk Drivers are Correlated (Isolation of Risk is Impossible)

  20. Maine Event 2004 Example of Risk Dependence

  21. Maine Event 2004 Actual Manual Rates

  22. Maine Event 2004 Actual Manual Rates (Cont)

  23. Maine Event 2004 Actual Manual Rates (Cont)

  24. Maine Event 2004 Manual Rate Volatility

  25. Maine Event 2004 Actuarial Decision Making So Let’s see…. Disability Rates are all over the place Trends are hard to predict and hard to track Some Carriers are buying Market share Some Carriers are behaving, uh, irrationally Investors want short-term results on a long-term product What is an actuary to do??

  26. Maine Event 2004 One Approach: Simulation Simulate Reality and Test Various Strategies But…. Need to simplify may eliminate key dynamics Be careful not to assume your outcomes Test outcomes and relationships for “Reasonability” (Need Reality Check)

  27. Maine Event 2004 Example: Sales/Profit Model Assumptions: All Carriers have identical expertise Average Rate = Best Estimate of Cost Sale depends on Rate (5% Threshold) Incumbent has rate advantage on renewal Some Cases will take almost any rate increase Some Cases will leave regardless of renewal action

  28. Maine Event 2004 New Sales Price Elasticity

  29. Maine Event 2004 Persistency Model

  30. Maine Event 2004 Scenario 1: On Target Pricing No Rate Increase on Renewal

  31. Maine Event 2004 Scenario 2: Modest Acquisition:Break-even Pricing, 10% Increase on Renewal

  32. Maine Event 2004 Scenario 3: Aggressive Acquisition:Priced at a Loss, 20% Increase on Renewal

  33. Maine Event 2004 Scenario 4: Light Acquisition:Two Renewal Increases limited to 5%

  34. Maine Event 2004 Scenario 5: Classic Underwriting Cycle

  35. Maine Event 2004 Scenario Outcomes

  36. Maine Event 2004 Scenario Outcomes (Years 6-10)

  37. Maine Event 2004 Other Approaches? Can Game Theory Help?? The theory of games is a theory of decision making in complex situations… when the outcome is uncertain (chance) and there are competing goals (other players) 1944, John Von Neumann – “Theory of Games and Economic Behavior” 1948, John Nash – “Nash’s Equilibrium” – identifies existence of optimal Strategy

  38. Maine Event 2004 Game Theory Categories Zero-Sum versus Non Zero-Sum 2 Person versus Multi-person Cooperative versus Non-Cooperative

  39. Maine Event 2004 Optimal Strategies?? Equilibrium Strategy Defined as a strategy in which you will have no regrets regardless of what the other players do Nash Equilibrium – 1948 An equilibrium strategy exists for all two-person games zero-sum and non-zero sum

  40. Maine Event 2004 Prisoner’s Dilemma Question: What is the equilibrium strategy?

  41. Maine Event 2004 Prisoner’s Dilemma You and your partner are caught leaving the scene of a crime with no other evidence. You are placed in separate rooms and pressured to testify. What should you do?

  42. Maine Event 2004 Prisoner’s Dilemma Best Possible Payoff: Keep Silent If you keep silent and your partner testifies, you will regret decision If you testify: Partner keeps silent: You go free (Good decision) Partner Testifies: Lesser charge (Good decision) Both Partners testify = Nash Equilibrium

  43. Maine Event 2004 Prisoner’s Dilemma Nash Equilibrium minimizes expected payout. Is this really the optimal strategy? What strategy would you use over multiple games?

  44. Maine Event 2004 Multi-player Games Complicated by Possibility of Alliances Start-up company offers the following bonuses 24K Actuary Underwriter 20K 16K Claims 27K if all three join Who should join? How much should each get?

  45. Maine Event 2004 Multi player Games Option 1: All three join and get $9K each Option 2: Actuary and Underwriter get $12K each … but wait, Claims person offers the underwriter $13 (keeping $3) Actuary offers the claims person $4 (keep $16) Underwriter offers the claims person $5 (keeping $11) … where will the negotiation end up?

  46. Maine Event 2004 Multi-player Games Any solution is unstable. There can always be an alliance with another player that works better for one member of the alliance. No Optimal Solution: Too often all parties end up with nothing

  47. Maine Event 2004 Game Theory Interesting, but… N-player, non-zero sum, cooperative games are poorly understood. Game Theory can characterize optimal solutions, but does not do well at identifying actual solutions Defining player utility in real life is difficult Games are more fun to play than they are to study…

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