Town Hall Session/ RCM-2Town Hall Session/ RCM-2 CAS 2006 Ratemaking CAS 2006 Ratemaking

Seminar, March 13, 2006Seminar, March 13, 2006

Louise Francis, FCAS, MAAALouise Francis, FCAS, MAAAFrancis Analytics and Actuarial Data Francis Analytics and Actuarial Data

MiningMiningLouise.francis@data-mines.comLouise.francis@data-mines.com

www.data-mines.comwww.data-mines.com

How Many Risk Load How Many Risk Load Actuaries Can Dance on the Actuaries Can Dance on the

Head of a Shamrock?Head of a Shamrock?

RemarksRemarks• Risk adjusted discount rates/internal rate of Risk adjusted discount rates/internal rate of

return approaches still relevantreturn approaches still relevant• Alternative beta calculationsAlternative beta calculations• Alternative denominator for cost of equityAlternative denominator for cost of equity

• Some older approaches such as risk loads Some older approaches such as risk loads based on percentiles still make sense in some based on percentiles still make sense in some contextscontexts

• The market seems to allow for superior The market seems to allow for superior strategy returnsstrategy returns

• Should we think of Risk Load as a topic within Should we think of Risk Load as a topic within ERM?ERM?

• Should we charge a “bad data” risk load?Should we charge a “bad data” risk load?

Financial & Actuarial Financial & Actuarial Perspective Converge?Perspective Converge?

• Risk Load= Systematic + Frictional Risk Load= Systematic + Frictional CostCost

Simpler Methods are Simpler Methods are Sometimes BetterSometimes Better

• To some managements, our methods of To some managements, our methods of computing risk loads seems very computing risk loads seems very complexcomplex

• Loads based on percentiles still used Loads based on percentiles still used often for self-insurance pools and often for self-insurance pools and captivescaptives

Augmentations of BetaAugmentations of Beta

• Base on correlation with insurance Base on correlation with insurance liabilitiesliabilities

• SUMBETA – (Ibbotson, Risk SUMBETA – (Ibbotson, Risk Premium Project)Premium Project)• Take lag effects into accountTake lag effects into account• For insurance companies generally For insurance companies generally

results in larger betasresults in larger betas

Cost of Capital Cost of Capital DenominatorDenominator

• What is an appropriate denominatorWhat is an appropriate denominator• Usually GAAP surplusUsually GAAP surplus

• Smith says this is the wrong Smith says this is the wrong denominatordenominator

• Economic Value of Company = Market Economic Value of Company = Market value of assets - Discounted value of value of assets - Discounted value of liabilities + franchise value – insolvency liabilities + franchise value – insolvency putput

• Measure change in this value Measure change in this value

Return for Having an Edge: Return for Having an Edge: Geometric MaximizationGeometric Maximization

bet toallocate tocapital ofAmount

fOdds

Edgef

““Bad Data” Risk LoadBad Data” Risk Load

• Moral Hazard problemMoral Hazard problem• Customers supplying bad data may Customers supplying bad data may

be poorer risks due to poorer be poorer risks due to poorer managementmanagement

• Information has a costInformation has a cost• More uncertainty is associated with More uncertainty is associated with

pricing based on sparse or pricing based on sparse or inadequate datainadequate data