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Strategic Insurance Purchasing In The 21 st Century. ASTIN & Casualty Actuarial Society Seminar on Reinsurance July 12, 2001 1:15 – 2:00 PM. Kevin Bingham 860.543.7345 John Slusarski 860.543.7366. Deloitte & Touche. Introduction. Background Target audience Authors

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slide1

Strategic Insurance PurchasingIn The 21st Century

ASTIN & Casualty Actuarial Society

Seminar on Reinsurance

July 12, 2001

1:15 – 2:00 PM

Kevin Bingham

860.543.7345

John Slusarski

860.543.7366

Deloitte & Touche

slide2

Introduction

  • Background
    • Target audience
    • Authors
  • Evolution of Insurance Purchasing Decision
  • Strategic Insurance Purchasing, Why Now
  • Convergence: Options and Insurance
  • Dynamic Financial Analysis and Reinsurance
  • Strategic Insurance Purchasing in the 21st Century
  • Closing Thoughts
slide4

Evolution

  • Limited review of organization’s actual data
    • Purchase guaranteed cost policies
    • Retain risk/reflect organization’s own experience using different insurance programs
      • Large deductibles
      • Retrospectively rated policies
    • Benchmarking
      • Anticipated loss rate x payroll
      • Multiple of calendar payments
  • Limited scenario testing (deterministic)
    • Captives
    • “What if” scenarios for insurance purchases
  • Insurance exposure modeling (stochastic)
    • Frequency/severity modeling
  • 21st Century?
slide6

Strategic Insurance Purchasing, Why Now?

  • Financial community
    • Value At Risk (VaR), Economic Value Added (EVATM)
    • BASLE Accord – Expansion of Pillar 1
    • CFA exams (quantitative methods, Monte Carlo simulation)
    • CNBC, Bloomberg, CNNFN , Internet
  • Clients (and auditors) asking for confidence levels
  • High profile examples/unique capital market solutions
    • Bowie bonds
    • Arby’s securitization
    • Innovative insurance solutions
  • Hardening market
  • Convergence of financial services industry
  • Dynamic Financial Analysis (DFA)
slide8

Convergence: Options and Insurance

  • Convergence of Financial Services Industry and terminology

Actuary CFA

  • Leverage the growing financial knowledge of most risk managers, chief risk officers and corporate decision makers to explain the similarities of insurance and investment options.

OR

slide9

Convergence: Options and Insurance

A call option is the right, but not the obligation, to buy a security for a specified price (exercise price) on or before a specified date. Table 1 displays the value of a call option with a $70 exercise price (excluding transaction costs).

slide10

Convergence: Options and Insurance

  • Insurance programs can be viewed as combinations of purchased and sold call options:
    • The exercise price of the call option is equal to the client’s SIR, deductible or reinsurance attachment point
    • For EOL and AEOL contracts, the exercise price of the sold call option is equal to the attachment point plus the insured limit
    • The call options last for one year, with the expiration date equal to the last day of the accident year
slide11

Convergence: Options and Insurance

  • Table 2 displays a $250,000 SIR or large deductible using a call option with a strike price of $250,000.
slide12

Convergence: Options and Insurance

  • Much easier for most investment and risk managers to understand the importance of purchasing insurance strategically using the option analogy.
  • Although actual conversion is difficult, understanding insurance in terms of options is a helpful exercise for risk managers and actuaries.

KEY POINT – Just as the fundamentals underlying stock and bond investments change each year, so do the insurance risks facing an organization (e.g., hardening market, acquisitions, new exposures, etc.).

slide14

DFA and Reinsurance - Background

  • The term DFA originated in the property-casualty insurance industry.
  • The objective was to provide an integrated system for evaluating major risk elements affecting a company’s overall financial performance and economic value.
  • Why the term DFA?
    • Dynamic: interaction of key variables under multiple scenarios and management actions.
    • Financial: use modern financial economics to project variables
    • Analysis: examine impact on both the economic value and financial statements1 of the firm.

1. Insurers prepare financials under two separate accounting methods; U.S. GAAP and

Statutory accounting principles.

slide15

100

DFA and Reinsurance - Background

  • Past v.s. Future
    • Deterministic v.s. Stochastic: Expected Value100 v.s. Distribution Around Expected Value
    • Fragmented v.s. Integrated Approach to Risk Analysis
    • Integration of Internal and External Risk Factors
    • Time Horizons of Over One Year
slide16

Deterministic

DFA

# Policies

100

# Policies

100

Premium / Policy

20

X

X Premium / Policy

=

Total Premium

2,000

20

X

1 - Operating Ratio

X 1- Oper.Ratio

.13

0.13

=

Operating Profit

260

= Operating Profit

260

DFA and Reinsurance - Background

slide17

DFA and Reinsurance - Background

Investments

Underwriting

Management Interventions

BusinessStrategies

Reinsurance

slide18

Financial

Forecast

99% Confidence Level

Historical

Plan

DFA and Reinsurance - Background

x

x

Premiums

0

Ending Capital

slide19

DFA and Reinsurance - Variables

  • In simple terms, DFA models consider a set of external variables and a set of internal variables.
  • External variables - price takers:
    • Interest rate levels
    • Inflation rates
    • Capital market prices and total returns
    • Pricing cycles and price elasticities
    • Natural catastrophes
    • Changes in loss levels from case law, jury awards, claims consciousness, etc.
  • Internal Variables - management decisions:
    • Premium rate levels actions
    • Reinsurance program
    • Underwriting guidelines
    • Marketing plans and distribution mechanism
    • Outstanding liability reserve practices
    • Investment strategy
    • Expense management
slide20

DFA Applications

  • Reinsurance optimization
    • Reinsurance module from DFA model
    • Majority of DFA work done to date
  • Asset and liability hedging strategies
  • Investment portfolio management
  • Demutualization
  • Credit risk modeling
  • Operational risk modeling
  • SBU operational strategies and planning
  • Strategic options analysis for mergers and acquisitions
  • Risk adjusted capital management
  • Rating agency management
  • New products and market development
  • Tax optimization
slide22

Strategic Insurance Purchasing in the 21st Century

  • Mathematical modeling of all risk factors (DFA)
  • Enterprise risk management mitigates variability in financial results from ALL the organization’s major risks (i.e., not just insurance)
    • Insurance exposures
    • Asset returns (e.g., Intel example)
    • Projected sales
    • Production costs
    • Tax revenue
  • Examples
    • Captives
    • Insurance companies
    • Unique projects
  • Efficient frontier
slide24

Strategic Insurance Purchasing in the 21st Century

  • Answer key management questions
    • Insurance Specific
      • What is the organization’s annual insurance cost and the confidence level feeding financial plan?
      • What is the cost/benefit analysis for the insurance option selected versus other options (e.g., XOL versus AEOL, 250 SIR versus 500 SIR)?
      • What is the variability of the organization’s insurance costs?
      • How well is the company protected against catastrophic losses?
    • Enterprise wide focus
      • What is the confidence level feeding financial plan for all risks?
      • What circumstances may cause the company’s financial statements to be impaired (e.g., asset portfolio decline, top line revenue drop, multiple events occurring simultaneously)?
      • What investment mix and reinsurance protection produces the highest return for the lowest level of risk (i.e., efficient frontier)?
slide25

Closing Thoughts

  • “If it ain’t broke, don’t fix it” risk management approach no longer acceptable
    • Hardening market
    • Financial pressure from management/shareholders
  • Technology
    • Computer processing speed
    • @Risk, Crystal Ball, Excel
  • Ability to leverage financial “thought ware”
    • RiskMetrics and VaR
    • Investment community knowledge
  • Demand for quantitative enterprise risk management
  • Applying and leveraging DFA research/publicity
slide26

Closing Thoughts

Manufacturing

Insurance

Banking

Retail

DFA EPD VaR EVA RAROC

Ruin RBC BCAR