Program Design and Pricing Options for Integrated Risk Policies

1. Program Design and Pricing Options for Integrated Risk Policies Will Dove, Centre Group Casualty Actuarial SocietyFinancial Risk Management SeminarApril 12-13, 1999 – Denver, CO

2. out of our minds What is Integrated Risk? • Single contract covering both traditional insurance risks and other risks • Insurance policy • Surety bond • Corporate guarantee • Put option • Contingent equity/liquidity contract

3. out of our minds What is Integrated Risk? • Examples of other risks • Business risk • Credit risk • Liquidity risk • Market risk • Foreign exchange rates • Commodity prices • Asset prices

4. out of our minds What is Integrated Risk? • How is coverage provided? • Coverage part • Indexed retention or limit • Investment credit to experience account

5. out of our minds Coverage Trigger • Accounting: goal is to stabilize accounting results (income statement, balance sheet) • Economic/Cash Flow: goal is to stabilize future cash flows/asset values

6. out of our minds Advantages of Integrated Risk • Can allow customer to purchase less coverage on more flexible terms • Single limit available to cover a broad collection of risks can be superior to a collection of smaller limits each covering a single risks • Administrative efficiency: fewer pieces of paper to manage • Can facilitate transactions, reduce equity requirements and/or cost of debt in some circumstances

7. out of our minds Disadvantages of Integrated Risk • Soft insurance markets can provide insurance at less than cost for some period of time • Contracts must be individually structured: lot of work, can involve significant costs • May require changes to traditional risk management practices

8. out of our minds How can economies be achieved? • Total risk management • Insurer and customer must take a holistic risk management approach instead of stapling together multiple policies that are separately priced • Customer • Must integrate risk management and other financial management functions (e.g. treasury) to evaluate pricing and coverage terms • Insurer

9. out of our minds How can economies be achieved? • Insurer • Must integrate underwriting/pricing/reserving for insurance and other risks: risk premium example • Assume that risk premium is proportional to variance of losses • Let A denote traditional insurance losses, B denote other losses covered by an integrated contract • Expected losses E(A+B)=E(A)+E(B) • Risk premium kVar(A+B)=k[Var(A)+Var(B)+2Cov(A,B)] • If Cov(A,B)<0 then insurer can pass benefit on to the customer through reduced risk premium only if it retains both risks A and B on the same balance sheet • Insurer must consider correlation of new contract with its existing risk portfolio as part of the underwriting process

10. out of our minds Accounting Issues • FAS 133: Hedge vs investment vs insurance accounting

11. out of our minds Examples of Integrated Risk Transactions • Basket Aggregate program for US-based multinational: multiple property and casualty coverage, foreign exchange risks • USAir: Collateral substitution program covering WC loss payments contingent on airline’s credit worthiness and asset value risk • Lan Chile: Credit enhancement of notes supported by credit card receivables • Canadian Airlines: Senior debt put option combining credit risk and asset value risk