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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

Real Options in Property-Liability Insurance

Robert P. Butsic

Fireman’s Fund Insurance

CAS Seminar on

Enterprise Risk Management

April 2-3, 2001

  • Financial options
  • Introduction to real options
  • Applications to insurance
  • Purpose: to stimulate option thinking
option basics
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
option asymmetry
Option Asymmetry




Underlying Asset Value

financial options
Traded in highly liquid markets

Based on underlying traded financial asset

Options are derivatives (futures, swaps)

Financial Options
p l insurance features with financial option characteristics
P-L Insurance Features with Financial Option Characteristics
  • Excess coverage (reinsurance)
  • Contingent commissions
  • Employee stock options
  • Insolvency put option
financial option pricing
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
reinsurance example
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
real options
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
components of firm value
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
value of renewals
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
other major insurance real options
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
net present value vs real options
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)
npv vs real options continued


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
role of uncertainty
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)
general types of real options
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)
types of real option risk
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
real options applications
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
application scope
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)
decision map



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











scope continued
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%”
scope continued22
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
implement valuation model
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
review the results
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
  • 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
  • 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
further study
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