RCM-1 Broadening and Evolving the Ratemaking

Role in Insurance Company Management

Russ Bingham Ratemaking Seminar

Vice President Actuarial Research Atlanta, GA
Hartford Financial Services March 8-9, 2007

1
 Outline

 The Environment
 Companywide Process of Financial Discipline

 Requirements for Financial Discipline

 Standardizing Financial Valuation

 Modeling
 Financial Model Integrity

 Broadly Inclusive of All Risk and Return Variables and Metrics

 Risk-Based Pricing Principles

 Broadening the Actuarial Role – From Ratemaking to ERM

Suggestions for What Actuaries Will Need to Know / Do in the Future

 Internal versus External Perspectives

Economic and Risk-Based Orientation and Premises

2
 The Environment
Companywide Process of Financial Discipline

Financial discipline is a valuation process, supported by analytical methods

and models, intended to provide timely and meaningful assessments of
risk / return performance and trends associated with underwriting,
investment and finance operations. Sound economic, risk-based
analytics are used to support strategic and operational decision making
throughout company.

3
 The Environment
Requirements for Financial Discipline

Conditions needed to instill a financial discipline:

 Financially astute senior leadership

 A committed senior management
 A group (actuarial, accounting, finance) responsible for the
development of fundamental core “benchmark” principles and their
application
 Standardized companywide application of benchmark concepts
and models

4
 The Environment
Standardizing Financial Valuation
Standardized financial valuation throughout entire company

 Ratemaking and product pricing

 Planning
 Performance monitoring
 Profitability studies
 Incentive compensation
 Acquisition analysis
 Capital attribution
 Risk/return assessment
 ERM

Requires Integration/Utilization of Actuarial, Accounting and

Finance Concepts

Valuation must consider Economic perspective (i.e. cash flow

oriented, reflective of time value) and Risk

5
 Modeling
Financial Model Integrity
“Ideal” Financial Model for Ratemaking and Other Applications

 Fully integrated balance sheet, income and cash flow statements

 Policy / accident period and calendar period perspectives
 Nominal and economic accounting valuations
 Risk and Return Incorporated / Integrated
 Underwriting, Investment and Finance activities included

 Clearly and consistently stated parameter estimates

 Premium, loss and expense amount
 Timing of premium collection, loss and expense payment
 Investment yield rates
 Underwriting and investment tax rates
 Specification of risks included
 Amount of capital and its cost
 etc.

The same methodology (and preferably the same model) that is used for ratemaking
should, if possible, also be used for planning, performance monitoring, financial
analysis, incentive compensation, and ERM

6
 Modeling
Broadly Inclusive of All Risk and Return Variables and Metrics

 Incorporate all sources of return - Revenue and Expense

 Incorporate all sources of risk that can be “distributionalized” – Loss,

Catastrophe Loss, Investment Yield, Cash Flow, etc.

 Provide all critical performance metrics – ROE, IRR, Total Risk-Adjusted

Return, Economic Value Added, Benchmark Surplus, Embedded Value,
Probability of Ruin, EPD, TVAR, RCR, etc. in addition to the more
standard metrics (loss ratio, expense ratio, yield, etc.)

Don’t confuse models with metrics – Ideally a single model should include as
many risk and return metrics as are needed

7
 Risk-Based Pricing Principles

 Risk Pricing Objective is to insure that all operating activities (lines of

business in underwriting as well as alternative investments) conform to
a consistent risk / return relationship

 Pricing ideally sets all operating activities’ return/risk ratio to the

same benchmark standard, so that strategic opportunity decisions
can be made on a level playing field

 The corporate financial goal is distributed equitably among areas

through pricing and capital allocation, in relation to risk

 Internal Diversification and external (e.g. ratings) factors influence

this relationship

8
 Broadening the Actuarial Role - From Ratemaking to ERM
Suggestions for What Actuaries Will Need to Know / Do in the Future
 Understand the nature of risk(s) and how they relate to pricing (e.g., how is risk
reflected in pricing) – (also related to reserve range estimation)

 The internal and external costs faced by insurance companies (e.g., what is the
cost of capital and how does it affect pricing)

 Speak the same language as management (combined ratio, ROE, etc.)

 Understand and incorporate other financial metrics (e.g., economic value added,
etc.) and be an advocate for advancing the state of the art

 Understand investment and finance activities and their impact as well as

underwriting oriented ones

 Be able to connect with other financial perspectives (e.g., accounting , finance)

Actuaries need to understand a broad range of financial perspectives, integrate

those that are relevant into ratemaking activities, and be able to communicate
with a varied audience, doing whatever is necessary to become part of the
company’s financially-based decision making process

9
 Internal versus External Perspectives
Economic and Risk-Based Orientation and Premises
 Internal line of business decisions are made based on financials that reflect the “purest” view of
financial performance possible
 Accident period oriented, not Calendar period, and revised to include latest estimates of
ultimate values
 Economically based accounting, not Conventional (statutory or GAAP)

 Forward looking (includes future cash flow expectations)

 Investment risk beyond low-risk cash flow matched strategy considered as separate
investment activity, not part of underwriting
 Risk-adjustment (and capital attribution) based on independent view of risk (using
benchmark accident year, economic, cash flow, and low risk investment structure as noted
above), not the rating agency view
 Consistent with fair value accounting and economic capital principles

 Actual results will eventually emerge with retrospective lookback

 External total company “constraints” must be met based on -

 Calendar period (e.g. reported earnings), static where revised estimates can only be
included in accounting period when revisions are made
 Conventional accounting (Stat for rating agency and regulatory, GAAP for financial
reporting)
 Backward looking (reported historical financials)

 Combined underwriting and investment results

 Rating agency capital (e.g. S&P)

 Reported results that are estimations, not “actual”, since they will subsequently be revised

10