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Real Options in Property-Liability Insurance. Robert P. Butsic Fireman’s Fund Insurance CAS Seminar on Enterprise Risk Management April 2-3, 2001. Agenda. Financial options Introduction to real options Applications to insurance Purpose: to stimulate option thinking. Option Basics.

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Real options in property liability insurance l.jpg

Real Options in Property-Liability Insurance

Robert P. Butsic

Fireman’s Fund Insurance

CAS Seminar on

Enterprise Risk Management

April 2-3, 2001


Agenda l.jpg
Agenda

  • Financial options

  • Introduction to real options

  • Applications to insurance

  • Purpose: to stimulate option thinking


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Option Basics

  • Option is a right, not an obligation

  • Characterized by asymmetric outcomes, or non-linear payoff

  • Either zero or a positive amount

    • Can be highly levered

  • Call option example

    • Buy IBM at $100 a share by May 1 for $7.20

    • Payoff is zero or (Stock Price - $100)

    • Leverage: share goes from $110 to $120


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Option Asymmetry

Asset

Option

Value

Underlying Asset Value


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Traded in highly liquid markets

Based on underlying traded financial asset

Options are derivatives (futures, swaps)

Financial Options


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P-L Insurance Features with Financial Option Characteristics

  • Excess coverage (reinsurance)

  • Contingent commissions

  • Employee stock options

  • Insolvency put option


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Financial Option Pricing

  • Option value = PV of expected outcome

  • Expectation is over all possible outcomes,adjusted for risk

    • Includes contingent decisions

  • PV is taken at risk-free interest


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Reinsurance Example

  • Reinsurer pays losses above K

  • Similar in structure to a calloption

  • Loss density is f(x) for loss x

  • Density is risk-adjusted (risk-neutral)

  • Value of reinsurance is PV of


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Real Options

  • Valuation of non-financial assets involving:

    • Contingent decisions

    • Non-linear payoff, as in financial options

  • Time element (event sequence) is important

    • Volatility of outcomes drives the option value

  • Have been used successfully in

    • Natural resource investment

    • Technology valuation


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Components of Firm Value

  • Company value = market value of equity

  • MVE = MV of (Book Assets - Book Liabilities) + Intangible Assets, or

  • MVE = Tangible Equity + Intangible Assets

  • Intangible (soft) assets = PV of future business

  • Intangible Assets are largely real options


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Value of Renewals

  • Re-pricing option

    • Multi-year policy is risky

    • Pricing flexibility is valuable

  • Non-renewal option

    • Re-underwriting advantage

    • Offset by cost of new business


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Other Major Insurance Real Options

  • Acquisition and divestiture

  • Growth

  • Capacity

    • Staffing level

    • Capital level

  • Information technology (internet)

  • All these can be valued with Real Option techniques


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Net Present Value vs. Real Options

  • Why NPV often doesn’t work: an example

  • Pay $10 million for license to sell insurance in Asia; $50 million to develop business if we go ahead

  • 20% chance favorable market with huge success; 80% chance of poor market with dismal failure

  • If favorable, gross profit is $100 million, if not, loss is $70 million

  • Under NPV (0% interest), expected profit is $-96million = -10 - 50 + 0.2(100) + 0.8(-70)


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NPV

NPV vs. Real Options, Continued

  • As a real option, the value is$15 million = -10 + 0.2(100 - 50)

  • NPV ignores conditional nature of follow-on investments


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Role of Uncertainty

  • More uncertainty increases the value of real options

  • Recall the Asian investment

    • Expected gross profit is $-36 million

    • Standard deviation is $68 million

  • Change payoff to (200 mill, -95 mill)

    • Expected gross profit remains $-36 million

    • Standard deviation rises to $118 million

    • Option value increases to $20 million = -10 + 0.2(200 - 50)


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General Types of Real Options

  • Growth (Amazon model)

  • Learning (Cisco; failure may have value)

  • Flexibility (getting ahead of competition)

  • Exit (cutting losses)

  • Waiting to invest (watch others fail)


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Types of Real Option Risk

  • Market Risk

    • Uses existing market prices of similar investments

    • Allows accurate valuation of option

  • Private Risk

    • No direct link to traded assets

    • Requires explicit probability distribution of outcomes

    • Difficult to value: uncertainty about demand, competitive responses, regulation, loss costs, interest rates and other macroeconomic conditions


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Real Options Applications

  • Process

    • Set the scope of the application

    • Implement option valuation model

    • Review results and redesign if necessary

  • Illustrate with insurance example

    • New venture:Direct marketing of Homeowners insurance


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Application Scope

  • Map the decisions

    • Incremental investments and time frames

    • Decision points

    • Residual value if abandoned

  • Include sources of uncertainty

    • Costs (combined ratio)

    • Evolution of market prices (bad timing)


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Market

OK?

2 Years

Wait 1 Year

Abandon for $5 M

Go Ahead for $100 M

Go Ahead for $100 M

Abandon for $10 M

Decision Map

Invest $30 M

No

Yes

Market

OK?

Costs

OK?

No

Yes

Yes

No


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Scope, Continued

  • Nature of the uncertainty

    • Lognormal is often used

    • Mean-reversion on market prices

  • Set the decision rules

    • “Loss ratio should be under 90% before market evaluation”

    • “Market is such that composite market/book ratio on Personal Lines insurers exceeds 120%”


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Scope, Continued

  • Choose financial market analogy

    • Portfolio of personal insurance stocks

    • Used in valuing final investment stage(when market is favorable)

  • Review for transparency and simplicity

    • Explain the scope to Homeowners managers

    • Also to disinterested managers with broad experience


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Implement Valuation Model

  • Establish inputs

    • Values of assets, cash flows, interest

    • Volatility of each source of uncertainty

    • Loss ratio (20%), Personal Lines Co. (15%)

  • Value option with proper model

    • Black-Scholes is standard

    • Others: binomial tree, simulation or dynamic programming


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Review the Results

  • Valuation numbers

    • Compare to NPV (shows embedded option values)

  • Critical values for strategic decisions

    • When to abandon vs. asset value

  • Sensitivity to inputs

    • May lead to redesign

  • Investment risk profile

    • Shows likelihood of abandonment


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Redesign

  • Expand/reduce investment alternatives

    • Additional products (auto)

    • Joint ventures

  • Add options by staging or creating modules

    • Rollout by expansion to different territory

    • Add research phase to gain market knowledge


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Summary

  • Options are a new and useful way to think about the value of insurance investments

  • Insurance applications of real options are just beginning to unfold

  • Actuaries, as risk experts, are well-positioned to use real-option methods in insurance strategies


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Further Study

  • Books

    • Amram, Martha and Nalin Kulatilaka, 1999Real Options: Managing Strategic Investment in an Uncertain WorldHarvard Business School Press

    • Trigeorgis, Lenos, 1996Managerial Flexibility And Strategy In Resource AllocationMIT Press

    • Tom Copeland, Vladimir Antikarov, 2001Real Options: A Practitioner's GuideTexere

  • Websites

    • http://www.real-options.com

    • http://www.mbs.umd.edu/finance/atriantis/RealOptions.html


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