Thursday March 9, 2000 Ted Dew Emerging Risks (COM-45) CAS 2000 Seminar on Ratemaking - San Diego

2 Agenda Traditional versus “Emerging Risk” ratemaking Example #1 Example #2 Important Points Conclusions

3 Traditional Ratemaking Profit & Contingencies Development Historical Ins. Data Projected Ultimates Trended Loss Cost Trending Acquisition General & Admin T,L,&F +Others Categories

4 “Emerging Risks” Ratemaking Typically multi-year deals Loss funding Fewer Regulatory Hurdles Use computer models to produce a distribution of potential outcomes (loss & expense) Little historical INSURANCE data

5 Key Rating Components 1.Loss distribution (outcome) component: Reflects Premium Features; Loss & Expense expenditures; Timing risk. 2.Capital allocation component 3.Target rates or key ratios: Return on capital, return on premium; Ratios of expected estimate to worst case.

6 Example 1 - Financial Loss from Weather Exposure A Hydro-Electric Plant wants to buy a 5-year policy to provide coverage for financial loss due to low precipitation. Contracts exists obliging them to provide power: Produce power through their own plant  “Current” precipitation  Deplete reservoir levels Buy power on open market and re-sell to clients Annual premium payments plus a return premium feature for good claim experience.

7 Example 1 - Cascade Model for Weather Exposure Fixed Costs Reservoir Level Precipitation Open Mkt Price Electricity PurchasedElectricity Produced Total Operating Cost Electricity Sold Variable Operating Cost Profit/(Loss) Revenue

8 Example 1 - Cashflow for Weather Model

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10 Example 1 - Sample Output

11 Example 2 - Income from Lease Payments Manufacturer wants to insure the income stream from payments of leased equipment. Multi-year policy. Losses can result from: Lease payments being less than expected:  Lessee default;  Reduction in market lease rates;  Extended downtime; Higher than expected costs:  Refurbishment;  Marketing;  Transaction costs (repossession, …).

12 Example 2 - Loss Modeling Lease Payments Loss modeling of the lease payments is very complex. Model each individual equipment lease contracts from inception through expiration (or default). Then model the process of subsequent leases for each item of equipment (turnaround costs & downtime). Model incorporates economic factors affecting the manufacturer and the lessees (GDP, inflation, creditworthiness of lessees, interest rates, …).

13 Example 2 - Lease Payments Capital Allocation Capital on Stand Alone Basis Capital All Except Contract i Contract Diversification Benefit A B C D (New) Total 40.0All Contracts Notional Total Marginal Diversification Benefit Allocated Diversification Benefit Capital Required

14 Important Points Time - Typically must respond in a relatively short time frame and in competition with other markets. Expertise - Learn about other fields to model the process; don’t try to become an expert. Know when to seek additional advice. Sensitivity Test Models - Know how models will react to variation of inputs. Over-reliance - Don’t become married to the model. Over-Parameterization - Don’t create a “Black Box”; Assumptions and structure should be explicit.

15 Conclusions Little historical insurance data exists - typically will end up modeling the process that may occur during the policy period. Premium features, expenses (brokerage, FET), and claims are all part of the modeled process. Capital needs to be allocated to each deal. Develop profitability metrics to assess each deal. Results must be put in the proper context: Contrast with traditional methods; Rationalize the results; Understand the limitations.

Thursday March 9, 2000 Ted Dew Emerging Risks (COM-45) CAS 2000 Seminar on Ratemaking - San Diego