Casualty Actuaries of New England Ratemaking & Reserving: An Enterprise Risk Management (ERM) Perspective Casualty Actuaries of New England September 26, 2006 John Kollar

CAS ERM Definition Process Holistic treatment of risk Assess Control Exploit Finance Monitor risk Holistic treatment of risk Senior management function Upside and downside

Increase the value of the entity… Objective of ERM Increase the value of the entity…

ERM “Drivers” Improved corporate governance Consolidation Sarbanes Oxley Act Consolidation Financial services convergence Globalization Basel II Solvency II Fair Value Accounting (market consistent valuations) Rating agencies – S&P, etc. Risk management evolution

Evolution Not Revolution Against the Gods: The Remarkable Story of Risk Peter L. Bernstein

Professional Societies/Associations ERM Developments COSO CAS SOA GARP PRMIA RIMS ERM-II Etc.

Holistic Treatment of Risk Economic Capital Risk Parameters Risk Allocation Reserving Risk URM Reinsurance Pricing Risk Combined Ratios Interest Rate Risk

Some ERM Pricing & Reserving Questions (Outline) What are new tools for loss reserving? Capital adequacy? Capital allocation by line, state, etc.? Reinsurance? Amount? Cost? Risk transfer? Marketing program? Underwriting guidelines? Underwriting cycle position? Predictive modeling? Adverse selection?

Overcoming Limited Data (Customized Loss Reserving Tool) Development Factors

Improving Data Quality and Stability (Customized Loss Reserving Tool)

Enhancing Estimates with Industry Information (CLRT)

Benchmarking for the Board and Senior Management (CLRT) Period 1 to Ultimate Chain Ladder with Modified Bondy Tail Factors Ratio The Sch. P data is net, includes Composite Rated Risks (CRR), and is evaluated as of 12, 24, etc. months. The ISO data is direct, excludes CRR (except as noted), and is evaluated as of 15, 27, etc. months.

Placing Loss Reserves in Confidence Intervals (CLRT)

Documenting Analysis (CLRT)

Reserve Risk: Average Size and Volatility of GL Open Claims Increases Over Time

Capital Requirements Loss Volatility } Insurer A Insurer B More Capital Less Capital } Expected costs Years Years

Correlation = More Volatility { Correlation = More Volatility Capital }Capital Low Correlation High Correlation Insurer B Insurer A Line D Total Line C Total Line A Line B

Correlation increases with volume

Aggregate Loss Distribution & Implied Economic Capital Value at Risk TVaR

Risk Measurement & (Cost of) Capital Allocation by Line, etc.

Note capital is allocated to loss reserves

Cost of Financing Risk = Cost of Capital + Net Cost of Reinsurance Cost of capital reflects: Release of capital as claims are resolved Discounted at the target rate of return on capital Rate of return on invested assets Net cost of reinsurance is the difference of the ceded premium and the expected reinsurance recovery after it has been reduced for: Discounted cash flows Federal income taxes Minimize the cost of financing risk.

Reinsurance Risk Transfer Testing Expected losses

Marketing/Underwriting Strategy Reflect Risk in Planning Change

Ratemaking/Pricing Setting Combined Ratio Targets by Line Expected losses – How adequate are the reserves? Expected expenses Investment income Cost of financing Cost of reinsurance Cost of capital (risk) – How much risk is in the pricing? Enterprise-wide risk?

Standard Ratemaking Exhibit Scroll to end –>

Cost of Financing Target Combined Ratio

Underwriting Cycle Pricing Risk Develop a number of pricing scenarios reflecting marketplace conditions (cycle): Pricing Coverage changes Policyholder selection For each pricing scenario: Adjust premiums. Calculate (projected) combined ratio. Calculate (projected) return on capital.

Confidence Interval Around the Target Combined Ratio

Predictive Modeling Risk of Adverse Selection Use of other information (beyond rating variables) to more accurately rate a policy Increased profits Reduced risk Less economic capital Inability to select better policies and compete with other insurers results in adverse selection Losses or reduced profits Increased downside risk More economic capital

Some Questions for the Reserving Actuary What are the assumptions underlying pricing – trend, loss distribution, coverage, etc.? Are marketing, underwriting and pricing seeking the same policyholders? Is policyholder retention high?

Robust Analysis of an Enterprise’s Risks (ERM) is Essential to Sound Loss Reserving and Ratemaking