New Approach to Ratemaking & Reserving

1. New Approach to Ratemaking & Reserving CAS May Meeting May 9, 2006 John Kollar, ISO Russ Bingham, Hartford

2. CAS ERM Definition • Process • Assess • Control • Exploit • Finance • Monitor risk • Holistic treatment of risk • Senior management function • Upside and downside

3. Holistic Treatment of Risk Economic Capital Risk Parameters Risk Allocation Reinsurance Risk Analysis URM Pricing Risk Combined Ratios Interest Rate Risk

4. Some New Ratemaking & Reserving Questions (Outline) • What are Fair Value loss reserve estimates? • Capital adequacy? • Risk measurement by line, state, etc.? • Reinsurance? Amount? Cost? Risk transfer? • Marketing program? • Underwriting guidelines? • Underwriting cycle position? • Predictive modeling? Adverse selection?

5. Loss Reserve Estimates • New Approaches • Stochastic methods • Bayesian estimates • Benchmarking • Confidence intervals • Fair Value Accounting • Discounted reserves • Market Value Margin • Convergence of FASB to IASB

6. Loss Reserve AdequacyShort-Tailed vs. Long-Tailed Lines Short-Tailed Lines Release most capital at the end of 1st year. Long-Tailed Lines Release a portion of capital at the end of each year. Year 1 Year 2 Year 3 Year 4 Y1 Y2 Y3 Y4

7. Reserve Risk:Average Size and Volatility of GLOpen Claims Increases Over Time

8. Capital RequirementsLoss Volatility } Insurer A Insurer B More Capital Less Capital } Expected costs Years Years

9. { }Capital Line C Line D Total Total Correlation = More Volatility Capital Low Correlation High Correlation Insurer B Insurer A Line A Line B

10. Correlation increases with volume

11. Aggregate Loss Distribution& Implied Economic Capital Value at Risk TVaR

12. Different measures of risk imply different amounts of economic capital

13. Risk Measurement & (Cost of) Capital Allocation by Line, etc.

14. Note capital is allocated to loss reserves

15. Cost of Financing Risk =Cost of Capital + Net Cost of Reinsurance • Cost of capital reflects: • Release of capital as claims are resolved • Discounted at the target rate of return on capital • Rate of return on invested assets • Net cost of reinsurance is the difference of the ceded premium and the expected reinsurance recovery after it has been reduced for: • Discounted cash flows • Federal income taxes • Minimize the cost of financing risk.

16. Optimize reinsurance by minimizing the cost of financing

17. Reinsurance Risk Transfer Testing Expected losses

18. Marketing/Underwriting StrategyReflect Risk in Planning Change

19. RatemakingSetting Combined Ratio Targets by Line • Expected losses • Expected expenses • Investment income • Cost of financing • Cost of reinsurance • Cost of capital (risk)

20. Standard Ratemaking Exhibit Scroll to end –>

21. Cost of Financing Target Combined Ratio

22. Set combined ratio targets by line and overall

23. Underwriting CyclePricing Risk • Develop a number of pricing scenarios reflecting marketplace conditions (cycle). • For each pricing scenario: • Adjust premiums. • Calculate (projected) combined ratio. • Calculate (projected) return on capital.

24. Predictive ModelingRisk of Adverse Selection • Use of other information (beyond rating variables) to more accurately rate a policy • Increased profits • Reduced risk • Lower economic capital • Inability to select better policies and compete with other insurers results in adverse selection • Losses or reduced profits • Increased downside risk • Higher economic capital

25. Confidence Interval Around the Target Combined Ratio

26. Robust Analysis of an Enterprise’s Risks (ERM) is Essential to Sound Ratemaking& Loss Reserving!