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RISK AND RETURN: DEBATING ALTERNATIVE MODELING “APPROACHES”

(FIN - 10)

Russ Bingham

Vice President and Director of Corporate Research

Hartford Financial Services

Seminar on Ratemaking

Tampa, FL

March 7-8, 2002

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Outline

Value Creation / Earnings Delivery Process Risk/Return – Focus on Value or Earnings? Building Blocks Risk / Return Principles Risk / Return Decision Framework – Risk Metrics Comparison of Policyholder and Shareholder Risk Metrics Dealing With Uncertainty and Risk – Two Key Questions Comprehensive Total Risk / Total Return Model What Differences?

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The Value Creation / Earnings Delivery Process

Economic value creation begins with sound, economically based operating actions and ends with a consistent and growing distribution of earnings.

In Insurance this process embodies the following characteristics: Originating policy / accident period actions which lead to financial

results that emerge over subsequent calendar periods. Economic value creation measurements which differ from

conventional accounting with respect to the timing of income recognition.

Distinct contributions to the risk / return tradeoff from underwriting, investment and financial leverage activities.

A “complete” financial methodology should address all these aspects.

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Risk / Return – Focus on Value or Earnings?

Economic Value Creation

OR

Earnings Reported

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“Building Blocks”: Valuation Fundamentals

Balance sheet, income and cash flow statements

Development “triangles” of marketing / policy / accident period into calendar period

Accounting valuation: conventional (statutory or GAAP) and economic (present value)

plus

Risk / return decision framework which deals with separate underwriting, investment and leverage contributions

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Policy (or Accident) / Calendar PeriodDevelopment Triangles

Balance Sheet, Income, Cash Flow

Calendar Period Policy Historical Future Total Period 1999 2000 2001 2002 2003

Ultimate Prior X X X X X …... --> Sum 1999 X X X X X …... --> Sum 2000 X X X X …... --> Sum

2001 X X X …... --> Sum2002 X X …... --> Sum2003 X …... --> Sum

==== ==== ==== ==== ==== Reported Sum Sum Sum Sum Sum Calendar

Rates and Economic valuation are oriented across the policy period “row” but regulatory review and wall street focus are typically on the calendar “column” sum

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Risk / Return Principles Insurance = underwriting, investment and leverage Volatility is uncertainty of result Risk is exposure to adverse result Higher Underwriting and Investment returns are required when

volatility is greater Risk transfer pricing activities (policyholder, company &

shareholder) are based on risk parameters This can be accomplished independently of leverage

Total return is underwriting and investment return leveraged Leverage simultaneously magnifies total return and volatility

in total return, but NOT necessarily risk Diversification / covariance benefits with respect to underwriting,

investment and finance (i.e. surplus) exist in the aggregate beyond the sum of individual businesses and functions.

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Total Return, Volatility and Risk

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Risk / Return Decision Framework – Risk Metrics Policyholder oriented risk metrics

Probability of ruin Expected policyholder deficit (EPD)

Shareholder oriented risk metrics Variability in total return (R) Sharpe Ratio Value at risk (VAR) Tail Value at Risk (TVAR) Expected Shareholder Deficit Probability of surplus drawdown (PSD) Risk Coverage Ratio (RCR) Others …

RBC and other Rating Agency measuresIn one way or another all risk measures address the

likelihood and/or the severity of an adverse outcome

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Total Return Risk Schematic

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Comparison of Policyholder and Shareholder Risk Metrics

Shortcomings of Policyholder oriented risk metrics Narrow focus on loss typically does not reflect variability in loss payment,

premium amount and collection, expense amount and payment and the impact of taxes and investment income on float and surplus

Reliability of results is questionable due to basis upon extreme outcomes in tail of loss distribution

Inconsistency between measures of risk and return make management of the risk/return tradeoff difficult

Advantages of Shareholder oriented risk metrics Reflects all sources of variability Captures all relevant factors that impact bottom line Typically embodies more reliability Shareholder focus is more in tune with broader financial marketplace Should allow for diversification effects to be incorporated Addresses policyholder risks Provides an important link between price adequacy and solvency Consistency in measures of risk and return

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Dealing With Uncertainty and Risk -Two Key Questions

A critical modeling objective is to provide a framework for addressing the risk / return tradeoff, specifically addressing the following two questions:

What price should be charged (i.e. what is appropriate risk-adjusted return)?

How much capital is needed (i.e. what is appropriate risk-adjusted leverage)?

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The Answer:A Comprehensive Total Risk / Total Return Model

Fully integrated balance sheet, income and cash flow statements Calendar period financial results developed from “current and

prior” policy / accident period contributions Nominal and economic valuations Clearly and consistently stated parameter estimates

Premium, loss and expense amount Timing of premium collection, loss and expense payment Investment yield rates Underwriting and investment tax rates Leverage ratio and method (preferably risk-based) by which surplus

flows are controlled, including distribution of profits Risk-based pricing algorithm for underwriting and investment risk Risk-adjusted leverage algorithm Distributional outcomes of all key risk and return measures Quantification of underwriting, investment and leverage

risk/return relationship

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What Differences?

All methodologies are fundamentally reconcilable Comprehensive Total Risk / Total Return model encompasses

all approaches and methodologies ALL differences ultimately result from modeling CHOICES

Differences in presentation result from choices with respect to: Calendar or policy/accident period perspective Accounting focus on reported or economic basis Metrics used to measure risk and return Time frame emphasized Other . . .