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

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

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

4. 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

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

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

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

8. 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?

9. Overcoming Limited Data (Customized Loss Reserving Tool)
Development Factors

10. Improving Data Quality and Stability (Customized Loss Reserving Tool)

11. Enhancing Estimates with Industry Information (CLRT)

12. 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.

13. Placing Loss Reserves in Confidence Intervals (CLRT)

14. Documenting Analysis (CLRT)

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

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

17. 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

18. Correlation increases with volume

19. Aggregate Loss Distribution & Implied Economic Capital
Value at Risk
TVaR

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

21. Note capital is
allocated to
loss reserves

22. 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.

23. Reinsurance Risk Transfer Testing
Expected losses

24. Marketing/Underwriting Strategy Reflect Risk in Planning Change

25. 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?

26. Standard Ratemaking
Exhibit
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27. Cost of
Financing
Target
Combined
Ratio

28. 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.

29. Confidence Interval Around the Target Combined Ratio

30. 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

31. 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?

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