0yd The Evolving Role of Entreprise Risk Considerations in Ratemaking FIN-13 CAS Seminar on Ratemaking March 07-08, 2002 The Tampa Marriott Waterside, Tampa, Florida Benedetto Conti Chief Actuary Winterthur Insurance P.O. Box Winterthur Switzerland

2 7 March My objective Illustrate a simple model for enhancing classical tools of financial management with the value dimension. Base such illustration on the planning process. For simplicity, illustrate the planning of one single policy. Exclude the investment risk from the example.

3 7 March What is the value dimension? “Managers today are being bombarded by an endless barrage of sophisticated new management concepts, each with fancy name and its own glossary of technical jargon.“ (Rutledge)

4 7 March What is the value dimension? In simple words, one can say that “Value Based Management” is the process of enhancing classical financial tools used for performance measurement with cost of capital.

5 7 March What is the value dimension? In classical tools used for financial management, the interests of all stakeholders in an insurance company are “modelled”, with the exception of the shareholder’s interest. Insured: incurred losses, policyholder dividends Agents, brokers,...: acquisition costs Employees: lae and other expenses State: taxx charge Shareholder: ???

6 7 March What is the value dimension?

7 7 March What is the value dimension?

8 7 March The model Asset management outsourced No explicit asset management expenses Return on investments net of management expenses Taxes paid at Required solvency capital at YYYY: x % of expected premium YYYY y % of loss reserves at YYYY Planning one policy duration one year incepting at Premium paid in one instalment at Acquisition costs paid in one instalment at Losses and LAE paid at Other management expenses paid 50% at , 50% at

9 7 March The model See enclosed workbook, worksheet "Input". The yellow fields are input-fields. See enclosed workbook, worksheet "Income Statement" See enclosed workbook, worksheet "Balance Sheet"

10 7 March 2002 Input

11 7 March 2002 Income Statement

12 7 March 2002 Balance Sheet

13 7 March The model In the given example, the combined ratio is %. Negative underwriting result in the first year, zero underwriting results in subsequent years. The model shows the following series of operating results after taxes: , 1.444, 0.825, The sum is Remark: In the first year, we allocated a "negative" tax to this specific policy, as the negative operating result before taxes of this policy will yield to tax savings.

14 7 March The model The value dimension is brought into the game by adding the line "cost of capital". The series of "Result" after cost of capital: , 1.069, 0.611, The sum is In a planning model it is common practice to discount those values to the beginning of the period at cost of capital: The obtained value is 0. Writing this policy will reward the invested capital at a "fair" cost, but will not create value for the shareholder. Creating value means creating returns in excess of the cost of capital!

15 7 March The model The "result" after cost of capital as presented here is commonly called EVA: Economic Value Added. The acronym EVA ® is a registered trademark of Stern Stewart & Co.

16 7 March The model At the bottom of the "Income Statement" sheet, we show a calculation of the free cash flows. At inception of the policy, the shareholder must provide capital of 13 to ensure the solvency. At the end of the period 2003, 2004, 2005, 2006, 5.849, 4.123, 3.504, are paid to the shareholder in form of dividends, as those amounts are not necessary to ensure the solvency in the following period. The net present value of those "free" cash-flows, discounted at cost of capital, is equal to the NPV of the EVAs.

17 7 March The model The equivalence of the NPV of the EVAs and the NPVs of the free cash-flows is a well-known fact. This theorem can be traced back to the thirties in a paper of D. Preinreich (1938). In Germany, it is also known as theorem of W. Lücke (1955). It seems that the theorem has been re-discovered by Modigliani and Miller in their well-known paper of 1961.

18 7 March Integration in a planning framework See enclosed workbook, worksheets "Classical View" and "Value Dimension". Experience in using this framework in a planning context A major valued driver is growth Growth is a major risk (new business with less own records, management capacities) Difficulty of quantifying the risk in / risk capital to be allocated to growth!

19 7 March 2002 Classical View

20 7 March 2002 Value Dimension

21 7 March Integration in a planning framework Other major risk factors are the (mis-)management and parameter risk Difficulty of quantifying those risks! Difficulties of merging two facets of risk: Solvency (extreme events, survival of the company) and Volatility (management's concern to meet the business plan) Make it simple Such a management tool can only be successful if everybody can be locked into the concept

22 7 March Integration in a planning framework Align the internal management tool with the communication to the external world NPV's of EVA ® s are more easily understood as they are the natural extension of classical, well-known concepts