September 22, 2004 Maine Event 2004 Thinking about Decision Making Rich Clement:Underwriting Decisions Rick Leavitt: Actuarial Decisions - Issues - Simulation - Game Theory

September 22, 2004 Maine Event 2004 Underwriting Decisions

September 22, 2004 Maine Event 2004 Difficulties In Underwriting Limited to poor information Quick turnaround time Competition – Acquisition/Irrational Pricing Multiple Products Tenure of underwriters – size of accounts Economic conditions Evaluation periods are too short Most volatile time period

September 22, 2004 Maine Event 2004 Difficulties In Underwriting Limited Tools/Consistently Changing Tools Changing plan designs – move to employee contributions New sales and underwriting territories Aging workforce Obesity – co-morbid conditions Pressure on underwriting gain from poor investment income Limitations to Home Office Partners

September 22, 2004 Maine Event 2004 Difficulties In Underwriting Mind space for LTD Increasing medical costs Churning business Employers attitude towards employees Regulatory issues Internal meetings Profitable Growth Goals

September 22, 2004 Maine Event 2004 Traditional U/W Response

September 22, 2004 Maine Event 2004 Traditional U/W Response Risk Analysis Read and Understand the RFP Why is case out to bid? Who is the broker? Partner with sales on strategy. Who is employer? – Financial Underwriting Manual rates SIC, OCC, Area factors

September 22, 2004 Maine Event 2004 Traditional U/W Response Risk Analysis (continued) Plan design features Experience evaluation Cause and effect Most recent period is volatile Credibility Other perspectives Claims, actuarial, similar customers trust yourself

September 22, 2004 Maine Event 2004 New Approaches Track Decisions Competitive advantage Learn from your mistakes Evaluate # of claims Strategic direction Understand where you make money Maintain underwriting discipline – mistakes sell Hit them were they aint – Ty Cobb

September 22, 2004 Maine Event 2004 Actuarial Decisions …. Harder than I thought All you need in this life is ignorance and confidence; then success is sure - Mark Twain The greatest obstacle to discovery is not ignorance - it is the illusion of knowledge - Daniel Boorstein

September 22, 2004 Maine Event 2004 Actuarial Decision Making 1980s actuary: Conduct an experience study and recommend rate modifications 21 st Century Actuary: ??? Actuaries are professionals who provide expert advice and relevant solutions for business and societal problems that involve economic risk ….SOA Promotional Material Given difficult business environment, it is not enough just to get the pricing right.

September 22, 2004 Maine Event Disability Product Strategy 1.Slow and Steady Wins the Race -Develop Appropriate Pricing and Stay the Course -You might need investor and management education *** Strategy Options *** 2.Decisive and Aggressive -Identify Target Markets and Attack Aggressively -Fix Mistakes as you Go

September 22, 2004 Maine Event Disability Product Strategy *** Strategy Options *** 3. Market Intelligence: Hit em where they aint -Exploit Undeveloped Market Niches 4. Execution, execution, execution -Improve Distribution Efficiency/UW Decision Making -Reduce Administrative Expenses and Cost of Capital -Risk Evaluation Tools = Smart Decision Making

September 22, 2004 Maine Event 2004 Actuarial Decisions: LTD Why is it so hard to get the pricing right? 1. Volatility of Loss

September 22, 2004 Maine Event 2004 Loss Volatility

September 22, 2004 Maine Event 2004 Actuarial Decisions: LTD Why is it so hard to get the pricing right? 1.Volatility of Loss – Random versus external impacts 2.Loss takes a long-time to develop

September 22, 2004 Maine Event 2004 LTD Components of Loss

September 22, 2004 Maine Event 2004 Actuarial Decisions: LTD Why is it so hard to get the pricing right? 1.Volatility of Loss – Random versus external impacts 2.Loss takes a long-time to develop 3.Product Complexity

September 22, 2004 Maine Event 2004 LTD Product Complexity Risk Drivers are Correlated (Isolation of Risk is Impossible)

September 22, 2004 Maine Event 2004 Example of Risk Dependence

September 22, 2004 Maine Event 2004 Actual Manual Rates

September 22, 2004 Maine Event 2004 Actual Manual Rates (Cont)

September 22, 2004 Maine Event 2004 Actual Manual Rates (Cont)

September 22, 2004 Maine Event 2004 Manual Rate Volatility

September 22, 2004 Maine Event 2004 Actuarial Decision Making So Lets see…. Disability Rates are all over the place Trends are hard to predict and hard to track Some Carriers are buying Market share Some Carriers are behaving, uh, irrationally Investors want short-term results on a long-term product What is an actuary to do??

September 22, 2004 Maine Event 2004 One Approach: Simulation Simulate Reality and Test Various Strategies But…. Need to simplify may eliminate key dynamics Be careful not to assume your outcomes Test outcomes and relationships for Reasonability (Need Reality Check)

September 22, 2004 Maine Event 2004 Example: Sales/Profit Model Assumptions: All Carriers have identical expertise Average Rate = Best Estimate of Cost Sale depends on Rate (5% Threshold) Incumbent has rate advantage on renewal Some Cases will take almost any rate increase Some Cases will leave regardless of renewal action

September 22, 2004 Maine Event 2004 New Sales Price Elasticity

September 22, 2004 Maine Event 2004 Persistency Model

September 22, 2004 Maine Event 2004 Scenario 1: On Target Pricing No Rate Increase on Renewal

September 22, 2004 Maine Event 2004 Scenario 2: Modest Acquisition: Break-even Pricing, 10% Increase on Renewal

September 22, 2004 Maine Event 2004 Scenario 3: Aggressive Acquisition: Priced at a Loss, 20% Increase on Renewal

September 22, 2004 Maine Event 2004 Scenario 4: Light Acquisition: Two Renewal Increases limited to 5%

September 22, 2004 Maine Event 2004 Scenario 5: Classic Underwriting Cycle

September 22, 2004 Maine Event 2004 Scenario Outcomes

September 22, 2004 Maine Event 2004 Scenario Outcomes (Years 6-10)

September 22, 2004 Maine Event 2004 Other Approaches? Can Game Theory Help?? The theory of games is a theory of decision making in complex situations… when the outcome is uncertain (chance) and there are competing goals (other players) 1944, John Von Neumann – Theory of Games and Economic Behavior 1948, John Nash – Nashs Equilibrium – identifies existence of optimal Strategy

September 22, 2004 Maine Event 2004 Game Theory Categories Zero-Sum versus Non Zero-Sum 2 Person versus Multi-person Cooperative versus Non-Cooperative

September 22, 2004 Maine Event 2004 Optimal Strategies?? Equilibrium Strategy Defined as a strategy in which you will have no regrets regardless of what the other players do Nash Equilibrium – 1948 An equilibrium strategy exists for all two-person games zero-sum and non-zero sum

September 22, 2004 Maine Event 2004 Prisoners Dilemma Question: What is the equilibrium strategy?

September 22, 2004 Maine Event 2004 Prisoners Dilemma You and your partner are caught leaving the scene of a crime with no other evidence. You are placed in separate rooms and pressured to testify. What should you do?

September 22, 2004 Maine Event 2004 Prisoners Dilemma Best Possible Payoff: Keep Silent If you keep silent and your partner testifies, you will regret decision If you testify: Partner keeps silent: You go free (Good decision) Partner Testifies: Lesser charge (Good decision) Both Partners testify = Nash Equilibrium

September 22, 2004 Maine Event 2004 Prisoners Dilemma Nash Equilibrium minimizes expected payout. Is this really the optimal strategy? What strategy would you use over multiple games?

September 22, 2004 Maine Event 2004 Multi-player Games Complicated by Possibility of Alliances Start-up company offers the following bonuses 24K ActuaryUnderwriter 20K 16K Claims 27K if all three join Who should join? How much should each get?

September 22, 2004 Maine Event 2004 Multi player Games Option 1: All three join and get $9K each Option 2: Actuary and Underwriter get $12K each … but wait, Claims person offers the underwriter $13 (keeping $3) Actuary offers the claims person $4 (keep $16) Underwriter offers the claims person $5 (keeping $11) … where will the negotiation end up?

September 22, 2004 Maine Event 2004 Multi-player Games Any solution is unstable. There can always be an alliance with another player that works better for one member of the alliance. No Optimal Solution: Too often all parties end up with nothing

September 22, 2004 Maine Event 2004 Game Theory Interesting, but… N-player, non-zero sum, cooperative games are poorly understood. Game Theory can characterize optimal solutions, but does not do well at identifying actual solutions Defining player utility in real life is difficult Games are more fun to play than they are to study…