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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

agenda
Agenda
  • 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

Asset

Option

Value

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
NPVNPV 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
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

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
redesign
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
summary
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
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
    • http://www.real-options.com
    • http://www.mbs.umd.edu/finance/atriantis/RealOptions.html
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