The Insured's Perspective: Risk Retention as an Investment Decision

1. Friday, March 11, 2004 The Insured's Perspective:Risk Retention as an Investment Decision Insurance and Value Creation Mark Ames

2. Outline • Background to the Retention Decision • Does RM generate “value”? • Toward a quantitative approach to optimization… • Economic Capital • What is it? • Who uses it and why?

3. I. Background to Retentions • Practical applications that miss the point • Clearly differentiating risk from return • Finance Theory and Use of Capital

4. Capacity Does Not Imply Desirability • A firm’s capacity to bear risk can be thought of as a pain threshold above which the decision makers do not wish to experience. • Capacity is often found through an analysis of the firm’s financials, and application of “rules of thumb”. Wall street’s expectations often play a significant role. • By definition, capacity goes across all sources of risk, not just insurable risks. Also, as expected losses are budgeted for, expected losses do not erode capacity. • A large strong organization with many investment opportunities should not retain large amounts of fortuitous risk, as its capital base may be better employed. “Just because a company may have the capacity to bear substantial risk, does not mean that it’s in the firm’s best interest to do so.” tolerable range for maximum unexpected losses

5. Minimizing Expected ValuesA Traditional Approach that Captures Half the Picture • An often-seen approach to choosing the proper retention level is to compare the tradeoff between discounted expected losses and premium. • In the example shown at right, the decision maker might well choose to raise retentions to capture the net savings. • This approach can work for risks characterized by high-frequency low-severity losses such as Workers Compensation. • Ironically though, this approach completely ignores risk, i.e. the true risk inherent in the retentions is loss volatility or uncertainty. • Naively raising retentions on a low-frequency high severity risk such as Property could result in a bad year producing a significant hit to earnings. Expected Losses Market Premium 500,000 $135,000 $95,000 375,000 $170,000 $165,000 250,000 $240,000 $280,000 100,000 Current Retention

6. Risk Management Generates Value Foundations in Financial Theory • Modern • Modigliani & Miller’s separation theorem. • Convex tax schedules and arbitrage. • Reducing the costs of bankruptcy. • Post-Modern • Aligning the interests of stakeholders. • The under-investment model. • The Economic Capital Paradigm

7. The Under-Investment Model Increasing Future Cash-flows • The value of the firm increases with investment. • Risk Management protects liquidity and thus the ability to make value-enhancing investments. • Cash-Flow is King. Risk Management is most appropriately applied to ensure that strategic cash investments may be made from internally generated funds. Froot, Scharfstein, and Stein (HBR 11/94)

8. II. Economic Capital $$$ • provides a buffer against unexpected losses. • is a tool for management reporting and performance measurement.

9. losses Unexpected Losses Economic Capital Expected Losses Budgeted Expense 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 time Capital as Financial Buffer Distancing operations from Unexpected Losses • A retention implies the use of the Firm’s economic capital in addition to needing to fund retained losses.

10. Probability Size of Loss Unexpected Losses = Economic Capital Expected Losses Tail Estimate Defining Economic Capital As a Statistical Measure on a Loss Distribution • Expected losses can be budgeted for. • Unexpected losses pose a threat to the P&L, and is an economic measure of exposure to the firm's capital base.

11. Use of Economic Capital Measures in Financial Institutions • Management Reporting • Common language. • Setting operational limits that involve the use of capital. • Performance Measurement • Example: Rewarding traders in an investment bank. • Distinguishing between value generating and value destroying business activities.

12. When Risk is Capital Insurance Protection Reduces Economic Cost • The decision to assume risk is equated to an investment opportunity. • Investors take risks only in hopes of making a return. • Optimal insurance structure means efficient use of economic capital. • Insurance is a surrogate form of capital. • Risk management positively contributes to value generation.

13. Economic Cost ($s) Value Creation Capital Costs Premium Capital Costs Expected Losses Expected Losses Before Insurance After Insurance Value Creation Through Insurance Reducing the Economic Cost Of Risk (ECOR) • Risk imposes economic costs in the form of expected losses and capital exposure. • The modelling process allows these components to be estimated both before (gross) and after (net) of insurance. • Value is created for the policyholder when insurance reduces these costs to an extent greater than the premium.