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The Evolving Role of Entreprise RiskConsiderations in Ratemaking

FIN-13 CAS Seminar on RatemakingMarch 07-08, 2002The Tampa Marriott Waterside, Tampa, Florida

Benedetto ContiChief ActuaryWinterthur InsuranceP.O. Box 2868401 WinterthurSwitzerlandBenedetto.Conti@winterthur.ch

27 March 2002

0. My objective

• Illustrate a simple model for enhancing classical tools of financial management with the value dimension.

• Base such illustration on the planning process.

• For simplicity, illustrate the planning of one single policy.

• Exclude the investment risk from the example.

37 March 2002

1. What is the value dimension?

“Managers today arebeing bombarded byan endless barrage ofsophisticated newmanagement

concepts,each with fancy nameand its own glossary oftechnical jargon.“(Rutledge)

47 March 2002

1. What is the value dimension?

In simple words, one can

say that “Value BasedManagement” is theprocess of enhancingclassical financial

toolsused for performancemeasurement withcost of capital.

57 March 2002

1. What is the value dimension?

In classical tools used for

financial management,the interests of allstakeholders in aninsurance company are“modelled”, with theexception of theshareholder’s interest.

• Insured:incurred losses,policyholder dividends

• Agents, brokers, ...:acquisition costs

• Employees:lae and other expenses

• State:taxx charge

• Shareholder:???

67 March 2002

1. What is the value dimension?

77 March 2002

1. What is the value dimension?

87 March 2002

2. The model

• Asset management outsourcedNo explicit asset management expensesReturn on investments net of management expenses

• Taxes paid at 31.12.

• Required solvency capital at 01.01.YYYY:x % of expected premium YYYYy % of loss reserves at 01.01.YYYY

• Planning one policyduration one yearincepting at 01.01.2003

• Premium paid in one instalmentat 01.01.2003

• Acquisition costs paid in one instalment at 01.01.2003

• Losses and LAE paid at 31.12.

• Other management expensespaid 50% at 01.01.2003,50% at 31.12.2003

97 March 2002

2. The model

• See enclosed workbook, worksheet "Input".The yellow fields are input-fields.

• See enclosed workbook, worksheet "Income Statement"

• See enclosed workbook, worksheet "Balance Sheet"

107 March 2002

Input

Model i nputPremi um (pai d at 01. 01. 2003) 100

Acqui si t i on costs (pai d at 01. 01. 2003) 10%

Other expenses (50%@01. 01. 2003, 50%@31. 12. 2003): 5%

Loss Rati o ( i ncl udes (A+U)LAE): 89. 301%Pay- out pattern of the l osses and l ae (@31. 12. ) : 2003 2004 2005 2006

30% 30% 30% 10%

Return on i nvestments (net of management expenses) : 3%

Tax rate: 30%

Requi red sol vency capi tal at 01. 01. 13% of premi um earned duri ng the year

10% of provi si ons for unpai d cl ai ms at 01. 01.

Cost of capi tal : 6%

1. 5750. 1520. 000

117 March 2002

Income Statement

I ncome Statement01. 01. 2003 2003 2004 2005 2006

Premi um 100. 000

Acqui si t i on costs - 10. 000

Pai d cl ai ms and l ae - 26. 790 - 26. 790 - 26. 790 - 8. 930Loss Res. @ 31. 12. previ ous 62. 511 35. 720 8. 930Loss Res. @ 31. 12. current - 62. 511 - 35. 720 - 8. 930Change i n l oss reserves - 62. 511 26. 790 26. 790 8. 930I ncurred l oss - 89. 301 0. 000 0. 000 0. 000

Other expenses - 5. 000

Underwri ti ng resul t - 4. 301 0. 000 0. 000 0. 000

Return on i nvestments 3. 015 2. 063 1. 179 0. 295

Operati ng resul t before taxes - 1. 286 2. 063 1. 179 0. 295

Taxes 0. 386 - 0. 619 - 0. 354 - 0. 088

Operati ng resul t af ter taxes - 0. 900 1. 444 0. 825 0. 206

Cost of capi tal - 0. 780 - 0. 375 - 0. 214 - 0. 054

"Resul t af ter cost of capi tal " - 1. 680 1. 069 0. 611 0. 153NPV 0. 000

Di vi dend - 13. 000 5. 849 4. 123 3. 504 1. 099NPV 0. 000

127 March 2002

Balance Sheet

Bal ance Sheet31. 12. 2002 01. 01. 2003 31. 12. 2003 01. 01. 2004 31. 12. 2004 01. 01. 2005 31. 12. 2005 01. 01. 2006 31. 12. 2006 01. 01. 2007

Assets

I nvestments 13. 000 74. 611 68. 762 43. 415 39. 292 13. 327 9. 823 1. 099

Li abi l i t i es

Loss Reserves 62. 511 62. 511 35. 720 35. 720 8. 930 8. 930 0. 000

Equi ty 13. 000 12. 100 6. 251 7. 695 3. 572 4. 397 0. 893 1. 099

137 March 2002

2. The model

• In the given example, the combined ratio is 104.3 %.

Negative underwriting result in the first year, zero underwriting results in subsequent years.

• The model shows the following series ofoperating results after taxes:-0.900, 1.444, 0.825, 0.206. The sum is 1.575.

Remark: In the first year, we allocated a "negative" tax to this specific policy, as the negative operating result before taxes of this policy will yield to tax savings.

147 March 2002

2. The model

• The value dimension is brought into the game byadding the line "cost of capital".

The series of "Result" after cost of capital:-1.680, 1.069, 0.611, 0.153. The sum is 0.152.

In a planning model it is common practice to discount those values to the beginning of the period at cost of capital:

The obtained value is 0. Writing this policy will reward the invested capital at a "fair" cost, but will not create value for the shareholder. Creating value means creating returns in excess of the cost of capital!

157 March 2002

2. The model

• The "result" after cost of capital as presented here is commonly called EVA: Economic Value Added.

• The acronym EVA® is a registered trademark of Stern Stewart & Co.

167 March 2002

2. The model

• At the bottom of the "Income Statement" sheet, we show a calculation of the free cash flows.

• At inception of the policy, the shareholder must provide capital of 13 to ensure the solvency.

• At the end of the period 2003, 2004, 2005, 2006,5.849, 4.123, 3.504, 1.099 are paid to the shareholder in form of dividends, as those amounts are not necessary to ensure the solvency in the following period.

• The net present value of those "free" cash-flows, discounted at cost of capital, is equal to the NPV of the EVAs.

177 March 2002

2. The model

• The equivalence of the NPV of the EVAs and the NPVs of the free cash-flows is a well-known fact. This theorem can be traced back to the thirties in a paper of D. Preinreich (1938).

In Germany, it is also known as theorem of W. Lücke (1955).

• It seems that the theorem has been re-discovered by Modigliani and Miller in their well-known paper of 1961.

187 March 2002

3. Integration in a planning framework

• See enclosed workbook, worksheets "Classical View" and "Value Dimension".

• Experience in using this framework in a planning context

• A major valued driver is growth

Growth is a major risk (new business with less own records, management capacities)

Difficulty of quantifying therisk in / risk capital to be allocated to growth!

197 March 2002

Classical View

2002 2003 2004 2005 2006 2007 2008 . . .<=1996199719981999200020012002200320042005200620072008. . .

Pri or years+ Current year= Bottom Li ne X' XXX X' XXX X' XXX X' XXX

Accounti ng yearsAcci dent years

207 March 2002

Value Dimension

2002 2003 2004 2005 2006 2007 2008 . . .<=199619971998199920002001

. . . UW Year 2002 2002

. . . UW Year 2003 2003

. . . UW Year 2004 2004

. . . UW Year 2005 2005

. . . UW Year 2006 2006

. . . UW Year 2007 2007

. . . UW Year 2008 2008. . . . . .

... b

usin

ess

in

forc

e at

31

.12.

2001

Val ue added by the . . .

Underwri ti ng Years

Accounti ng years

217 March 2002

3. Integration in a planning framework

• Other major risk factors are the(mis-)management and parameter riskDifficulty of quantifying those risks!

• Difficulties of merging two facets of risk:Solvency (extreme events, survival of the company)andVolatility (management's concern to meet the business plan)

• Make it simpleSuch a management tool can only be successful if everybody can be locked into the concept

227 March 2002

3. Integration in a planning framework

• Align the internal management tool with the communication to the external world

• NPV's of EVA®s are more easily understood as they are the natural extension of classical, well-known concepts