1 Research Double-Header Don Mango, FCAS, MAAA CAS Vice President of Research Director of Research and Development, GE ERC Midwest Actuarial Forum September 24, 2003

2 Agenda 1. CAS Research Revision: official CAS business as the VP of Research and Development 2. Capital Consumption: latest prize-winning paper

3 CAS Research Revision Don Mango CAS VP Research & Development

4 Problem Statements No keepers of the state of the science Need for survey papers, syllabus material Research overload via Call Papers Role/function of the PCAS unclear

5 Proposed Solutions Rein in Call Paper programs Establish Working Paper and Model repository on the CAS Website Institute Working Parties Establish Research Corners and Working Party sessions at the major seminars

6 Why Call Papers? Bottom-up, fast-track research source. Stimulate communication, discussion and sharing. Good in concept, in practice is another story.

7 Call Paper Forum Not a top-tier professional journal Not peer reviewed. Inclusive editorial policy. Inconsistent review and prize standards. Inconsistent appearance and structure of papers. Not enough editorial oversight. Contributes to members’ filtration and overload problems.

8 Call Papers Not generating discussion Solitary practitioners produce, present No context, follow-up, formal discussion Not leading to systematic progress of the science No referencing standards, context No clear advancement of the science

9 Call Papers  Working Papers Many CPs are the equivalent of working papers within academia Posted on websites and discussion forums Works-in-progress, on their way to peer- reviewed journals We can still have bottom-up idea generation, idea sharing, and discussion by establishing a Working Paper (and Model) repository on the CAS Website

10 Working Paper Repository Categorized by research area Members can post and comment on posts (mini-reviews) Items receiving a lot of activity can be the material for the Research Corners at the major seminars

11 Call Paper Refinement Less often (~biennial) More editorial oversight Subject to the new CAS Research Paper template Impose length requirements (<30 pages) Must adhere more closely to the subjects of the Call

12 Working Parties Essentially a collective call paper task force Collective = group effort, single group work product Ideas come from the members attending major seminar Seminar has presentation of prior year’s work, selection of next year’s topics

13 Working Parties Group effort forces discussion during the production of the product Oversight by research committee Can enforce editorial standards, referencing, ensure that current state of the science is documented, as well as context and scope of new research

14 Working Parties An easy to implement answer that helps on many fronts: Solitary  Group Bottom-up + Top-down Consistency in format, referencing, etc. Member involvement Natural seminar cycle supports it

15 Working Parties Four WPs kicked off at 2003 RCM Seminar Reserve Variability (led by Roger Hayne) kicked off at 2003 CLRS More to come

16 Publications Task Force Impact and notoriety of PCAS outside the CAS is essentially NIL Forum is used / abused Large bodies of work published without formal peer review Considering some radical surgery Maybe we join the NAAJ

17 Capital Consumption Don Mango Director of Research and Development GE ERC

18 Why Even Consider This? Despite significant efforts throughout the industry, capital allocation has yet to be effectively implemented in (re)insurance This alternative method also has strong linkages to financial theory, while more accurately representing the actual capital usage of insurance

19 Problem Statements Capital allocation is a de facto paradigm  a requirement or necessity But insurance capital usage is fundamentally different than it is for manufacturing, being in fact the mirror- image in time For these decision evaluation processes, capital allocation is sufficient but not necessary

20 Problem Statements Even worse, the resulting insurance IRR framework is now completely fictional (“imputed”), since no capital is transferred or returned However, insurance capital is consumed when results are worse than planned

21 Actually  This IS capital allocation for insurance, done right  But I needed new terminology to shake loose the old thought processes

22 Core Paradox  Manufacturers need capital committed to support the operation…  …and they actually use it, spending it on materials, operations, labor…  …and it’s invested in their business, in the production of their goods.

23 Core Paradox  Insurance companies need capital committed to support the operation…  …but they can’t actually use it (or not too much of it anyway)…  …and it’s not invested in their business, but in financial instruments.

24 Two Bets Bet #1 You pay me $10 now I might pay you $50 later Bet #2 I pay you $10 now You might have to pay me $50 later

25 Payoff Diagrams

26 Bet #1 Spend then Maybe Receive You spend now, hope to receive later You spend NOW, voluntarily With the odds I give you, you can compute an expected value and decide if you want to make the bet

27 Bet #2 Receive then Maybe Spend You receive now, hope you don’t have to spend later You MAY spend LATER, contingent on something happening With the odds I give you, you can compute an expected value and decide if you want to make the bet

28 Capital? Bet #1 = $10 You spend $10 capital NOW no matter what The capital investment is current and certain – i.e., not contingent The capital is allocated = spent = consumed Natural capacity constraint = your budget

29 Capital? Bet #2 = $??? I should be sure you have $40 available LATER, but you don’t spend anything NOW If Bet #2 hits, you spend $40 capital LATER Capital expenditure (= allocation) is contingent and in the future Capacity constraints = ???

30 Allocation vs Consumption Two different but equally valid frameworks for Treating capital Evaluating insurance business segments Developing indicated prices for reinsurance Nearly orthogonal

31 Allocation vs Consumption Three questions: 1. What do you do with the total capital? 2. How do you evaluate business segments? 3. What does it mean to be in a portfolio?

32 Allocation vs Consumption

33 Allocation vs Consumption

34 Allocation vs Consumption The difference between having your own kiddie pool and joining a swim club This is THE CRITICAL SLIDE!

35 Options Framework The company capital pool is giving each reserving segment a series of options to draw upon (consume) the capital These options Expire unused if segment meets or beats Plan Are exercised if segment’s results deteriorate

36 Options Framework Similar to a Line of Credit (LOC) A contingent loan, with full expectation to be reimbursed This is a valid alternative financial analogue Much closer to the way capital actually gets used by an insurer

37 Options Beware “Options” does not imply Black- Scholes formula For one thing, we cannot hedge our exposure We must price it from first principles  modeled payoff distribution and internal risk charges

38 Details of the Framework Scenario analysis Default-free discounting Scenario-level capital consumption Evaluation of capital consumption using a “quasi~utility” approach

39 Scenario Capital Consumption Experience fund From Finite Reinsurance Fund into which goes all revenue, from which comes all payments Bakes in investment income When the fund is exhausted, but further payments still need to be made, exercise the Call Option for capital That capital gets spent  CONSUMED

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41 Capital Call Cost Function Risk-based overhead expense loading Pricing decision variable Application of utility theory Borch (1961): To introduce a utility function which the company seeks to maximize, means only that such consistency requirements (in the various subjective judgments made by an insurance company) are put into mathematical form.

42 Implicit Preferences Preferences buried in Kreps’ “Marginal Standard Deviation” risk load approach: The marginal impact on the portfolio standard deviation is our chosen functional form for transforming a given distribution of outcomes to a single risk measure. Risk is completely reflected, properly measured and valued by this transform. Upward deviations are treated the same as downward deviations.

43 Capital Call Cost Function Make the implicit explicit Express your preferences explicitly, in mathematical form, and apply them via a utility function The mythical “Risk Appetite” Enforce consistency in the many judgments being made

44 THANK YOU!