RISK / RETURN and CAPITAL ALLOCATION

RISK / RETURN and CAPITAL ALLOCATION Russ Bingham Vice President and Director of Corporate Research Hartford Financial Services CAS Spring Meeting Miami Beach, FL May 7-9, 2001

Outline • Value Creation / Earnings Delivery Process • Underwriting and Investment Value Creation • The Reported Earnings Dilemma • Risk/Return and Surplus Issues • Building Blocks • Risk / Return Decision Framework – Principles and Metrics • Integration of Pricing and Solvency Control • Total Return and Total Risk Model • Determination of Benchmark Equity • Risk-Adjusted Return vs Risk-Adjusted Leverage • Pricing for Risk and Volatility of Return • Underwriting vs Investment Risk / Return • Summary Comments and Concerns

The Value Creation / Earnings Delivery Process Economic value creation begins with sound, economically based operating actions and ends with consistent and growing earnings. In Insurance this process embodies the following characteristics: • Originating policy / accident period actions create financial results that emerge over subsequent calendar periods. • Economic value creation measurement differs from conventional accounting with respect to the timing of income recognition. • Distinct contributions to the risk / return tradeoff from underwriting, investment and financial leverage activities. A “complete” financial methodology should address all aspects.

Underwriting Value Creation • The economics of underwriting operations are reflected in an accident year oriented ROE which incorporates the following: • Policy / accident year underwriting at ultimate value. • Credit for investment income on insurance float at reasonably risk-free yield. • Discounting for the time value of money. • Expressed as a rate of return (ROE) via the ratio of benchmark income to a risk-based benchmark equity. • Equivalent to internal rate of return (IRR) on risk-based equity flows. • Delivery of a 15% ROE requires a primary focus on achievement of combined ratio targets (i.e. loss ratio and expense ratio are key levers), coupled with the timing of cash flows that result.

Investment and Finance Value Creation • The economics of investment operations are reflected in the total return on invested assets. • Investment levers are asset allocation and maturity. • Investment “lift” is generated on the entire amount of invested assets. • Investment risk requires additional risk-based benchmark equity. • Financial management of total company capital, including the use of debt, provides an added lever to enhance shareholder returns and to maintain overall financial strength.

The Reported Earnings Dilemma • The value creating actions (including ratemaking) that begin at the line of business level by individual policy / accident periods subsequently “deliver” reported company wide earnings that are clouded by the following: • Actual (???) Results • Delayed reporting of reality since calendar period results aggregate the financial activity of current and prior policy / accident periods as they emerge over time • Substantial portion is estimation, to be restated in later calendar periods • Co-mingling of results across originating policy / accident periods • GAAP/Stat accounting rules that specify the timing of income recognition and define how “income” emerges • Other Income items (reserve adjustments, realized gains,etc.) • Historical rather than prospective view

Risk / Return – Focus on Value or Earnings? • Economic Value Creation OR • Earnings Reported

Risk / Return and Surplus • a PRIMARY goal is to determine surplus needs of the company • Regulatory and rating considerations • What leverage will the company employ to manage its expected risk/return reporting profile • Consider underwriting and investment diversification / covariance • a SECONDARY goal is to attribute surplus needs to the businesses in support of the various operating areas that utilize total risk / return metrics • Underwriting and investment risk pricing activities CAN be accomplished independently of the amount of surplus required or available • Underwriting, investment and leverage are three unique components that, when brought together, create the company risk / return profile

“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) plus • Risk / return decision framework which deals with separate underwriting, investment and leverage contributions

Policy (or Accident) / Calendar PeriodDevelopment Triangles Balance Sheet, Income, Cash Flow Calendar Period Policy Historical Future Total Period19971998199920002001Ultimate Prior X X X X X …... --> Sum 1997 X X X X X …... --> Sum 1998 X X X X …... --> Sum 1999 X X X …... --> Sum 2000 X X …... --> Sum 2001 X …... --> Sum ==== ==== ==== ==== ==== Reported Sum Sum Sum Sum Sum Calendar Rates are set across the policy period “row” but regulatory review is often based on the calendar “column” sum

Risk / Return Decision Framework – Basic Principles • Basic principles • Insurance = underwriting, investment and leverage • Volatility is uncertainty of result • Risk is exposure to adverse result • Higher Underwriting and Investment returns are required when volatility is greater • Risk transfer pricing activities (policyholder, company & shareholder) are based on risk parameters • This can be accomplished independently of leverage • Total return is underwriting and investment return leveraged. • Leverage simultaneously magnifies total return and volatility in total return, but NOT necessarily risk

Risk / Return Decision Framework – Risk Metrics • Policyholder oriented risk metrics • Probability of ruin • Expected policyholder deficit (EPD) • Shareholder oriented risk metrics • Variability in total return (sR) • Sharpe Ratio • Value at risk (VAR) • Tail Value at Risk (TVAR) • Probability of surplus drawdown (PSD) • Expected Shareholder Deficit • Risk Coverage Ratio (frequency and severity of SH loss) • Others …

Total Return Risk Schematic

Comparison of Policyholder and Shareholder Risk Metrics • Shortcomings of Policyholder oriented risk metrics • Narrow focus on loss typically does not reflect • Variability in loss payment, premium amount and collection, expense amount and payment • the impact of taxes and investment income on float and surplus • Reliability of results is questionable due to basis upon extreme outcomes in tail of loss distribution • Advantages of Shareholder oriented risk metrics • Reflects all sources of variability • Captures all relevant factors that impact bottom line • Typically embodies more reliability • Shareholder focus is more in tune with broader financial marketplace • Should allow for diversification effects to be incorporated • Addresses policyholder risks • Provides an important link between price adequacy and solvency

Integration of Pricing and Solvency Control • Simultaneous determination of price and control of risk • Risk controlled using selected risk metric(s) • Price determined which generates return along a tradeoff line that meets risk / return criteria • Adequate risk-adjusted price IS the way that solvency is maintained • Threats to solvency are driven more by inadequate risk-adjusted price than by shortages in surplus • Ideally, any rate filed should also be supported by • the total return that is implied by it and • the risk criteria upon which it is based

Total Return, Volatility and Risk

Total Return Model • Fully integrated balance sheet, income and cash flow statements • Reconciliation of policy / accident period with calendar period • Nominal and economic 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 • Leverage ratio and method (preferably risk-based) by which surplus flows are controlled, including distribution of profits • ….

Total Risk Model Utilization of Return Model adapted to include • Distributional assumptions of all parameters • Risk-based pricing algorithm for underwriting and investment risk • Risk-adjusted leverage algorithm • Quantification of underwriting, investment and leverage risk/return impact

Determination of Benchmark Equity • Step 1: The variability in the amount and timing of all business cash flows are modeled to generate a distribution of returns, with all businesses using the same overall average leverage. • Step 2: A risk level is selected to be applied uniformly to each business. • For example, in normal distribution Risk could be controlled using the probability that the total return falls below the breakeven, or risk-free, rate of return. • Step 3: The price is determined which meets the specified risk condition, at the same average leverage. • Underwriting price required expressed as target combined ratio • Investment price is a required yield • Step 4: Leverage is altered to restate all returns at a single target level (e.g. 15%). • This establishes risk-adjusted leverage.

Determination of Benchmark Equity (Contd.) Step 3 establishes the risk / return tradeoff line

Determination of Benchmark Equity (Contd.) Step 4 restates all businesses to uniform 15% return with uniform volatility via altered risk-adjusted leverage

Risk-Adjusted Return vs Risk-Adjusted Leverage • Two equivalent alternatives which differ in the form of presentation At same premium & combined ratio - • Maintain a fixed leverage, but vary the total return based on volatility • This avoids allocation of surplus to lines of business • Maintain a fixed total return, but vary leverage to adjust for volatility • This makes regulatory environment less contentious • Introduction of surplus into ratemaking (via the application of a varying leverage ratio) is optional (but helps communication). A leverage ratio (and thus surplus) serves a similar purpose in application as do IBNR factors, yields, expense ratios and tax rates. While they do not exist at the individual policy level, their necessary consideration in ratemaking requires introduction by formula.

Pricing for Risk and Volatility of Return • The Risk Pricing “Line” assumes higher returns from underwriting and investment functions needed to compensate for greater volatility (i.e., uncertainty) in order to satisfy desired risk criteria • Risk pricing is independent of Leverage • Leverage magnifies underwriting and investment risk pricing lines, creating a total return line, while maintaining risk profile • Change in leverage causes total returns to move along this line • As long as prices are on risk-based line, leverage is irrelevant • YES this means that adequate risk pricing which generates a fair total return connects the interests of the shareholder and the policyholder and is in the best interest of both • Adequate returns directly control solvency risk

Underwriting vs Investment Risk / Return • Underwriting and Investment each contribute to risk and return • While higher risk investments can be used in ratemaking, the risk transfer pricing principles that apply to this added investment risk must still be reflected • Properly separated and priced underwriting and investment risk largely eliminates the disagreement as to what investment strategy should be built into premium rates. Offsetting occurs since higher investment risk requires higher price (yield) and increased surplus to achieve target ROE level

Summary Comments and Concerns • Allocation versus attribution • Objective is not simply allocation of given total company capital • Objective is better viewed as the determination of capital required to satisfy desired total company risk/return criteria which reflects the risk/return characteristics of individual underwriting and investment product risks along with the diversification benefits provided by them • The Insurance process • Insurance is a multi-period process • Liabilities, not premium, drive underwriting risk • Claims (i.e. incurred loss) may be the most significant source of underwriting risk, but other underwriting variables and all cash flows matter • Tax and investment income (on float and surplus) also important

Summary Comments and Concerns (Continued) • Delineate Underwriting, Investment and Finance risk / return contributions to assure consistency in risk pricing • Underwriting and investment risk addressed through pricing, not capital • Solvency risk is controlled by price adequacy, not capital levels • Accounting and economic value based financials differ • Choice of risk metric from among several available is critical • Capital, investment income, taxes, and IBNR, do not exist at the underwriting product level, yet all are important elements which affect risk/return and must be reflected (by formula) in the product pricing process

RISK / RETURN and CAPITAL ALLOCATION