- 47 Views
- Uploaded on
- Presentation posted in: General

Russ Bingham Vice President and Director of Corporate Research Hartford Financial Services

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -

RCM â€“ 4: From Enterprise Risk Management to RatemakingHow the Hartfordâ€™s Benchmark Methodology Approaches Risk, Price, Leverage and Return Across its Operations

Russ Bingham

Vice President and Director of Corporate Research

Hartford Financial Services

Seminar on Ratemaking

New Orleans, LA

March 9-11, 2005

- Basic Premises
- Background Comments
- Operating Return
- Operating Return Risk / Return Line
- Operating Return as a Basis for Risk Pricing
- Risk Coverage Ratio Risk Metric
- Total Return
- The Total Risk / Return Line
- Risk-Adjusted Return Uniform Leverage
- Risk-Adjusted Leverage Uniform Return

- Calibration of Risk Metric

- An insurance company must have a financial discipline for dealing with risk and return â€“ this requires a companywide commitment to the process and to the development and implementation of models that employ the appropriate concepts and methodologies throughout all operations
- The same concepts and methodology should be used in all areas including ratemaking, planning, performance monitoring, incentive compensation, and ERM
- The critical cornerstones are risk, price, leverage and return

- Volatility characteristics of input and output variables are a key component of risk assessment but volatility alone does not represent risk
- Risk lies in the potential for adverse outcomes, which is a function of both the level of and volatility in important variables of interest
- A risk-based pricing and capital attribution methodology incorporates volatility in determining levels of outcoumes in order to conform to an acceptable risk / return relationship
- Policyholder level risk / return relationship is based on operating return
- Shareholder level risk / return relationship is based on total return
- Where possible policyholder and shareholder risks are not intermingled
- Price is the lever that addresses policyholder sources of risk and capital attribution (i.e. leverage) the lever that addresses shareholder risk sources
- A risk metric is a statistic derived from the distribution of outcomes of a particular variable of interest related to the occurrence of an adverse event (frequency, severity, etc.)

- Operating Income is underwriting income and investment income on policyholder float (surplus and investment income on surplus is excluded).
- Operating Return (OR) is operating income expressed relative to policyholder (PH) liabilities (or their asset equivalent):
- Benchmark OR = NPV[u/w + PH inv inc] / NPV[liabilities]
- Investment return on PH funds minus cost of PH funds
- IRR of policyholder level cash flows

- OR risk / return line is set based on risk metric.
- The slope of the risk / return line is equivalent to the Sharpe ratio (z-value) in a normal distribution.
- Inherent OR volatility differs among lines of business.
- Risk-based price is determined which reflects each lineâ€™s volatility and satisfies risk metric.
- Risk can be reduced by increasing slope of risk / return line which forces an increase in price.
PRICE IS RISK-BASED

The price (premium) that reflects the volatility in each line of business and satisfies the risk criterion places the expected operating distribution on the risk / return line.

- Total Return is Operating Return Levered plus the Investment Return on Surplus:
- ROS = OR x L/S + r
- OR = (U + r L) / L
- L / S is leverage ratio
- r is after-tax, benchmark yield on investments

- ROS = OR x L/S + r
- Operating Risk / Return characteristics remain when translated to Total Return:
- Risk breakeven threshold shifts from OR=0 to ROE=r.
- L/S is a multiplier that affects return and volatility similarly without disrupting risk/return relationship.

The price (premium) that satisfies the operating return risk criterion, by reflecting the volatility in each line of business, places the expected total return distribution on the total risk / return line. The operating return profile translates to total return.

The total return RCR risk metric is the same as the operating return RCR.

The risk / return line shown assumes a uniform leverage in all lines of business (typically corporate overall average).

All lines of business are restated to a uniform 15% return with uniform volatility via altered risk-adjusted leverage.

- Two equivalent alternatives which differ in the form of presentation. At same premium & combined ratio â€“
- Maintain a fixed leverage, but vary the total return based on volatility
- This avoids varying 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

- Maintain a fixed leverage, but vary the total return based on volatility

- The risk metric is calibrated to insure that the riskâ€“adjusted leverage ratios when applied to all lines of business produce an underwriting risk equity consistent with rating and other capital requirements.
- Benchmark underwriting leverage ratios (liability / surplus) are determined which are used in numerous applications (pricing, planning, monitoring).
- Calibration considerations:
- Shift from benchmark accident year (present value of future equity needs) to a calendar perspective to support current and previous business writings;
- Incorporate investment risk equity and debt.

1. Thou shalt build only models that have an integrated set of balance sheet, income and cash flow statements

2. Thou shalt remain rooted in a policy period orientation and develop calendar period results from this base

3. Thou shalt reflect both conventional and economic accounting perspectives - guided by economics, constrained by conventions

4. Thou shalt recognize the separate contributions from each of underwriting, investment and finance activities

5. Thou shalt be guided by the risk / return relationship in all aspects

6. Thou shalt include all sources of company, policyholder and shareholder revenue and expense embodied in the insurance process

7. Thou shalt reflect all risk transfer activities

8. Thou shalt not separate risk from return

9. Thou shalt not omit any perspective or financial metric that adds understanding

10. Thou shalt allow differences in result only from clearly identified differences in assumption, and not from model omission