Russ Bingham CANE Vice President and March 23, 2005 Director of Corporate Research

1. From Ratemaking to Enterprise Risk Management (Expanding the Actuary’s Role)including2004 Proceedings Paper:Value Creation in Insurance – A Finance Perspective Russ Bingham CANE Vice President and March 23, 2005 Director of Corporate Research Hartford Financial Services

2. Outline • Basic Premises • Financial Discipline • Financial Integrity and Model • The Return Perspective • Building a Financial Discipline - History • Building Blocks – Valuation Fundamentals • Unified Financial Model • Insurance Funds Flow Schematic • Demonstration Example and Value Creation • The Risk Perspective • Background Comments on Risk / Return • Risk Coverage Ratio Risk Metric • Risk-Adjusted Return versus Risk-Adjusted Leverage • Ten Commandments of Insurance Financial Modeling

3. Basic Premises • An insurance company must have a financial discipline for dealing with risk and return – this requires a companywide commitment to the process and to the development and implementation of models that employ the appropriate concepts and methodologies throughout all operations • The same concepts and methodology should be used in all areas including ratemaking, planning, performance monitoring, incentive compensation, and ERM • The critical cornerstones are risk, price, leverage and return

4. A Financial Discipline ProcessWhat it is and what it takes to establish Financial discipline is a valuation process, supported by analytical methods and models, intended to provide timely and meaningful assessments of risk / return performance and trends associated with underwriting, investment and finance operations Conditions needed to instill a financial discipline: • Financially astute senior leadership • A committed senior management • A group (actuarial, accounting, finance) responsible for the development of “benchmark” concepts, models and operating applications • Companywide application of benchmark concepts and models in • Ratemaking • Planning • Performance monitoring • Incentive compensation • ERM • ... “All inclusive - no exceptions”

5. Financial Integrity and Model Ideal Ratemaking Model and Financial Documentation • Fully integrated balance sheet, income and cash flow statements • Policy / accident period focus with calendar period provided if needed • Nominal and economic accounting valuations • Clearly and consistently stated parameter estimates • Premium, loss and expense amount • Timing of premium collection, loss and expense payment • Investment yield rates • Underwriting and investment tax rates • Specification of risks included • Amount of capital and its cost The same methodology (and preferably the same model) that is used for ratemaking should also be used for planning, performance monitoring, financial analysis, incentive compensation, and ERM

6. Building a Financial Discipline - History 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.

7. History: (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.

8. History: (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.

9. History: (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.

10. “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) – Use economic basis for decision making to the maximum extent possible plus • Risk / return decision framework which deals with separate underwriting, investment and leverage contributions Note: Both internal and external costs must be reflected

11. Policy (or Accident) / Calendar Period Development Triangles Balance Sheet, Income, Cash Flow Calendar Period Pol./Acc. Historical Future TotalPeriod20022003200420052006Ultimate Prior X X X X X …... --> Sum 2002 X X X X X …... --> Sum 2003 X X X X …... --> Sum 2004 X X X …... --> Sum 2005 X X …... --> Sum 2006 X …... --> Sum ==== ==== ==== ==== ==== Reported Sum Sum Sum Sum Sum Benchmark focus is on the present value across a policy/accident period row. Calendar reporting focus is on the nominal value sum total down a column.

12. 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. • The “Value Creation” paper demonstrates how external capital costs, often missing from ratemaking models, are integrated in such a unified approach.

13. Insurance Funds Flow Schematic - The Risk Transfer Process

14. 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.

16. 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.

17. Economic Cost and Value Creation Components

18. Background Comments on Risk / Return • Volatility characteristics of input and output variables are a key component of risk assessment but volatility alone does not represent risk • Risk lies in the potential for adverse outcomes, which is a function of both the level of and volatility in important variables of interest • A risk-based pricing and capital attribution methodology incorporates volatility in determining levels of outcoumes in order to conform to an acceptable risk / return relationship • Policyholder level risk / return relationship is based on operating return • Shareholder level risk / return relationship is based on total return • Where possible policyholder and shareholder risks are not intermingled • Price is the lever that addresses policyholder sources of risk and capital attribution (i.e. leverage) the lever that addresses shareholder risk sources • A risk metric is a statistic derived from the distribution of outcomes of a particular variable of interest related to the occurrence of an adverse event (frequency, severity, etc.)

19. Risk Coverage Ratio Metric – “Reward to Risk” Ratio General Process for Selecting Risk Metric: 1) Identify relevant variable and generate distribution of expected outcomes, 2) Identify what constitutes an adverse event, 3) Calculate frequency and severity of adverse events across all outcomes, and 4) Calculate risk metric (if not frequency or severity).

20. Each Line is Priced to Satisfy Total Return Risk Criterion and Place Distribution on Total Risk / Return Line The price (premium) that satisfies the risk criterion, by reflecting the volatility in each line of business, places the expected total return distribution on the total risk / return line.

21. The Total Risk / Return LineRisk-Adjusted Return (Uniform Leverage) – “RAROC” The risk / return line shown assumes a uniform leverage in all lines of business (typically corporate overall average).

22. The Total Risk / Return Line:Risk-Adjusted Leverage (with Uniform Return) – “RORAC” All lines of business are restated to a uniform return (e.g.15%) with uniform volatility via altered risk-adjusted leverage.

23. Risk-Adjusted Return vs Risk-Adjusted Leverage • Two equivalent alternatives which differ in the form of presentation. At same premium & combined ratio – • RAROC - Maintain a fixed leverage, but vary the total return based on volatility • This avoids varying allocation of surplus to lines of business • RORAC - Maintain a fixed total return, but vary leverage to adjust for volatility • This makes regulatory environment less contentious

24. 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.