The Key Issues and Mission

1. The Key Issues and Mission Shaun Wang, Ph.D., FCAS

2. The Agenda • Reality Check • What Risks to Measure? • Benchmark Capital • Fair Value of Liabilities • Our Scientific Program

3. Reality: Poor ROE PerformanceP/C Insurers vs. All Industries 1987–2002 13 pts Source: Dr. Hartwig at Insurance Information Institute; Fortune

4. Source: A.M. Best, ISO, Reinsurance Association of America, Insurance Information Institute Combined Ratio:Reinsurance vs. P/C Industry Year 2001: Reinsurers did even worse

5. Reality Sounded A Wake-up Call • Where were the actuaries during years of severe under-pricing and under-reserving? • Have some of the financial theories contributed to market irrationality? • How can we maintain the continued viability of the actuarial profession – the #1 ranked profession?

6. In Search for Answers, We Must … • Get out of comfort zone --- traditional actuarial mindset • Go to the deep water by understanding the risk drivers and market dynamics • How can we project underwriting results without knowing the level of market competition?

7. Traditional P&C Risk Analysis Expected Loss Loss frequency & severity Correlation between risks Concentration of exposure New Horizon Business Process Risk Competitive Game Market cycle Quality of Information Reaction time Incentive misalignment Multiple Perspectives What Risks to Measure?

8. Focus on “Business Processes” • Loss Modeling Is Only a Part of the Whole Story • “This company has the brightest actuaries, so it got to be good …” --- Naïve thinking • One company had the state-of-the-art actuarial pricing model, but in the end still lost so much money • Need to quantify the Business Process Risk • Top-line growth in a soft market poses a major risk • Over-crowded competitive market poses a major risk

9. A Model of Market Competition • Financial Result = Min{Quote1, …, Quotek}  Loss • where Quotek Normal(k, k) • For long-tailed lines, delayed info  higher k higher chance of premium deficiency • more bidders k higher chance of premium deficiency • The Winner’s Curse: In insurance competitive pricing, the lowest price gets the business, but may be cursed with financial losses

10. Competitive Game of Asset-Liability Management • Insurers are competing in two fronts: • managing assets • managing liabilities • Prolific asset management is an “offensive play” that necessarily weakens defense • Can score big during market boom • In the recent market meltdown, EU insurers were hurt the most due to high concentration in stocks

11. US Insured CAT Losses (in $billion) and Rate On Line Index(1989=100) ROL showed big jump after major CAT losses, and then came down gradually … Source: Guy Carpenter & *III Estimate

12. Market Cycle & Risk Premiums • Hefty investment gains in the 1990s helped insurance capital accumulation • Pre-Sept 11 oversupply of capital triggered very low risk premiums • The depletion of insurance capital due to Sept 11 terrorist losses and investment losses • After Sept 11, the expected hurricane losses had not changed, but the insurance rates jumped by more than 30%

13. Quality of Information • Poor Quality of Information is a major risk for (re)insurers • Information asymmetry -- major hurdle for securitization (and reinsurers) • Value of Information? • Think about the US search for Al Qaeda • Do we have a measure for “quality of information”?

14. Reaction Time • “Reaction Time” is an important aspect of risk • XOL reinsurance has a higher severity volatility than proportional reinsurance. However, the reaction time for rate increase is quicker for XOL • Rate increase delays in some regulatory jurisdictions • For long-tailed liabilities or long-term guarantees: the ability to re-act is much limited. • You have a stack of policies written in the past • Too late to re-act

15. Incentive Misalignment • Many “risks” are created by misalignment of incentives • Underwriters short-term goal v.s. long-tailed liabilities • Managers’ expansion of his/her own kingdom • CEO’s compensation linked to growth and acquisition • Trial Attorneys and the U.S. legal dynamics • Lawyer Contingent Fees & Punitive Damages should be put in a trust fund for public good

16. Multiple Perspectives of Risk • Entity-specific value versus Market price • Market prices tend to exhibit local linearity • Catastrophe risk to an entity may increase more than proportionally • Volatility • Outsider view: stochastic and random walk • Insider view: trend and direction • Risk of being short-sighted and losing perspective • NASDAQ bubble; Variable Annuity Guarantees

17. Traditional Risk Analysis Mortality/Morbidity Lapse Disintermediation New Horizon Asset management Embedded guarantee (VADB hedging/reserving) Competitive Game (distribution, expenses) … The set of major risks depends on the specific business /market For Life Insurers

18. Risk Measures for DecidingCapital Requirement and Fair Value • New Basel Capital Requirement for Insurers (IAIS) • Parallel to the Banking Basel Accord II • Movement toward Fair-Value Accounting (FASB) • Profound implications and heated debates • Internally, companies are desperately looking for better ways of measuring risks and performance • Companies launched capital Allocation projects • Lot of confusion, misconception & practical difficulties

19. Capital Allocation, or really Capital Consumption? • For high-risk low-return business, we want to allocate less capital to it, but the capital consumption is high! • The capital consumption increases more than linearly for correlated risks and high-impact losses • Knowing the capital consumption by business units can help manage the business! • Many allocation methods rely heavily on superficial assumptions about diversification between LOBs

20. Superficial Diversification Is Dangerous! • The pure loss generating process may show a low correlation and high diversification benefit • From business standpoint, playing two different games is much harder than playing just one competitive game • The contagion (or drag) effect may overwhelm any diversification • Over-diversification increases the risk of losing touch of reality for executives (and making bad decisions)

21. Right and Wrong Diversifications • Years of under-pricing were partially caused by the “low correlation” argument by some multi-line players • Diversification needs to match with areas of expertise • Renaissance Re, a mono-line CAT-writer, achieves diversification by geographic region and by peril • Expanding to a new line of business is very risky • Citigroup spun-off Travelers; GE selling ERC

22. Benchmark Capital • Other players’ capital allocation can affect you! • To avoid artificial effects of diversification, industry benchmark capital charge is badly needed • Parameters are more important than the model • Benchmarks should reflect the inherent risks of the business, regardless of risk portfolio • It will take a lot of fundamental analysis, expert opinion, and timely updates

23. Did “U.S. Risk Based Capital” Help? • U.S. Benchmark RBC has only limited success: • Factor based reserve charges ignored the bigger issue of reserve adequacy • Incentives for putting up inadequate reserves • Same capital charge factor for premium written in a hard market versus in a soft market • Limitations due to a point-in-time measure, without reference to future direction and sensitivity over time

24. It Is Coming! -- Fair Value of Liabilities • Actuarial Standards Setters are pushing for fair value of liabilities • Motivated by consistent accounting treatment of assets and liabilities • For actively traded assets, market values are readily available • For insurance liabilities, there is no “active traded market” --- “fair value” creates big challenges and opportunities

25. Challenges of Fair Value Accounting • Fair value will introduce more volatilitieson paper • Are we prepared for the “consequences”? • Is it better to enlarge or dampen the underwriting cycle? • Heated debate on the credit standing of the liability holder: • There seems to be a conflict between “financial theory” and “public interest” • We will learn a lot more today from the speakers!

26. Financial Theories for Fair Value • “CAPM with Zero beta” does not reflect reality • The Link betweenInsurance Stock Price andIndividual Loss Distribution is WEAK! • Insurance equity prices tend to reflect more of the quality of company management • Renaissance Re --- mono-line writer for catastrophe insurance, but very stable stock price appreciation

27. Fair Value: Arbitrage-free versus Actuarial Models • Two different models, how do we reconcile them? • Frictional costs are the missing link • Actuarial models should be modified to reflect available hedging in the capital market • Arbitrage-free models assumed complete market and zero transaction cost (which are often not the case)

28. Reserve Deficiency for Long-tailed Liabilities • Before tackling the fair-value question, we have a more fundamental problem of reserve deficiency • As of 2002, P&C Industry reserve deficiency is estimated at $120 billion – Morgan Stanley • Recently a flurry of billion$ reserve increases • In 2002, the top 300 EU companies have unfunded pension liability > $267 billion -- WSJ • Reserve uncertainty for Long-Term-Care & Annuity Guarantees?

29. Cycle Nature of Reserve Estimates • The adequacy of reserve estimates showed a clear cycle over the years, coupled with the pricing UW cycle • Pressure on short-term performance • Following the competitors • Tax smoother for some players • A slow-death sentence for many companies

30. Recent Dramas in Actuarial Reserve Opinions • Mechanical actuarial methods can produce a wide range of reserve estimates • In the past the lowest reserve estimates were often being used • Recently we saw large increases in reserve estimates • Trigged by lawsuit against professional actuaries • Dramatic increases in reserve estimates may push struggling companies off the cliff • Nowadays actuarial consulting fee is rated on the potential legal liability of the project

31. Fair Value and Benchmark Capital Are Intimately linked • The fair value of reserve liability necessarily contains a risk margin --- (see Steve Philbrick 1994 paper) • These risk margins should be reflected in the capital charge for reserve uncertainty risk • Otherwise, we create disincentives that would distort the fair value calculation

32. Our Scientific Program • The Bowles Symposium Call Paper Program: • An overwhelming response of 25+ paper proposals • We selected 15+ proposals, which were subsequently developed to papers • This Symposium • Joint efforts of Georgia State University, the CAS, and the Actuarial Foundation • International event: participants from 9 countries • Industry-Academic Partnership: 5 universities

33. We Need Your Participation! • In this meeting room we have many bright minds with deep research and industry experience • Interactive discussion is a key feature of this Symposium • It is important that you share your insights and perspectives • Please try to be concise and clear in making your points • Have fun!