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Ratemaking & Reserving: An Enterprise Risk Management (ERM) Perspective

Ratemaking & Reserving: An Enterprise Risk Management (ERM) Perspective. Casualty Actuaries of New England September 26, 2006 John Kollar. CAS ERM Definition. Process Assess Control Exploit Finance Monitor risk Holistic treatment of risk Senior management function Upside and downside.

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Ratemaking & Reserving: An Enterprise Risk Management (ERM) Perspective

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  1. Ratemaking & Reserving:An Enterprise Risk Management (ERM) Perspective Casualty Actuaries of New England September 26, 2006 John Kollar

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

  3. Objective of ERM Increase the value of the entity…

  4. ERM “Drivers” • Improved corporate governance • Sarbanes Oxley Act • Consolidation • Financial services convergence • Globalization • Basel II • Solvency II • Fair Value Accounting (market consistent valuations) • Rating agencies – S&P, etc. • Risk management evolution

  5. EvolutionNotRevolution Against the Gods: The Remarkable Story of Risk Peter L. Bernstein

  6. Professional Societies/Associations ERM Developments

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

  8. Some ERM Pricing & Reserving Questions (Outline) • What are new tools for loss reserving? • Capital adequacy? • Capital allocation by line, state, etc.? • Reinsurance? Amount? Cost? Risk transfer? • Marketing program? • Underwriting guidelines? • Underwriting cycle position? • Predictive modeling? Adverse selection?

  9. Overcoming Limited Data(Customized Loss Reserving Tool) Development Factors

  10. Improving Data Quality and Stability(Customized Loss Reserving Tool)

  11. Enhancing Estimates with Industry Information (CLRT)

  12. Benchmarking for the Board and Senior Management (CLRT) Period 1 to Ultimate Chain Ladder with Modified Bondy Tail Factors Ratio The Sch. P data is net, includes Composite Rated Risks (CRR), and is evaluated as of 12, 24, etc. months. The ISO data is direct, excludes CRR (except as noted), and is evaluated as of 15, 27, etc. months.

  13. Placing Loss Reserves in Confidence Intervals (CLRT)

  14. Documenting Analysis (CLRT)

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

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

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

  18. Correlation increases with volume

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

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

  21. Note capital is allocated to loss reserves

  22. 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.

  23. Reinsurance Risk Transfer Testing Expected losses

  24. Marketing/Underwriting StrategyReflect Risk in Planning Change

  25. Ratemaking/PricingSetting Combined Ratio Targets by Line • Expected losses – How adequate are the reserves? • Expected expenses • Investment income • Cost of financing • Cost of reinsurance • Cost of capital (risk) – How much risk is in the pricing? Enterprise-wide risk?

  26. Standard Ratemaking Exhibit Scroll to end –>

  27. Cost of Financing Target Combined Ratio

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

  29. Confidence Interval Around the Target Combined Ratio

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

  31. Some Questions for the Reserving Actuary • What are the assumptions underlying pricing – trend, loss distribution, coverage, etc.? • Are marketing, underwriting and pricing seeking the same policyholders? • Is policyholder retention high?

  32. Robust Analysis of an Enterprise’s Risks (ERM) is Essential to Sound Loss Reserving and Ratemaking

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