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CAS Ratemaking Seminar 2002

This seminar explores various techniques and frameworks for charging and managing risk in a leveraged financial institution. Topics include risk load, target return on equity, direct expenses and overhead, lessons learned from banking, RAROC, economic capital, and more.

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CAS Ratemaking Seminar 2002

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  1. CAS Ratemaking Seminar 2002 Peter Nakada Global Head of Consulting, ERisk pnakada@erisk.com March 2002

  2. Remember why we’re here Total Premium and Fees Excess Profit ROE > Target How do you charge for risk in a leveraged financial institution? Risk Load • Reflects relative cost due to variability in claim frequency and severity • Incorporates portfolio concentrations Target ROE Expected Loss • Present value of liabilities –or– • Nominal value of liabilities and include impact of investment income Direct Expense and Overhead

  3. Framing the debate HOW WHAT Technique Framework • RAROC • Value-based • Single-period • Analytical • DFA • Accounting-based • Multi-period • Simulation • How do we define risk? • VaR, TVaR • EPD • Economic Capital (Shortfall Probability) • How do we charge for risk? • RAROC • EVA, CAPM, Economic Profit • SVA • Traditional standard deviation, variance-based

  4. Lessons learned from banking Pre 1990 Post 1990 Capital Accumulation Capital Management Late ’80s Losses LDC lending Portfolio insurance Junk bonds Real estate lending Interest rate spike • Focus on earnings growth, cost efficiency • Qualitative risk measures • Seat-of-the-pants pricing • Strong pricing cycles • Focus on return on equity • Quantitative risk measures, capital linked to risk • Risk-based pricing hurdles • Dampened pricing cycles

  5. Banks used Economic Capital to drive strategic decisions . . . RATING AGNECY PERSPECTIVE SHAREHOLDER PERSPECTIVE RAROC Financial Strength C E O Risk vs. Capital Risk vs. Reward Expected Return Economic Capital Capital Structure Economic Capital

  6. Loan Pricing Tool Calculated Commitment Maturity Commitment Fee Drawn Spread Avg. Utilization Fees & Other Income $ Calculate Break- Even $ Exposure Expected Loss Expense Allocation Economic Capital Calculate based on risk yrs bp bp $ bp $ % $ VALUEADDED RAROC Sub-Portfolio Rating $ %   . . . and drove this discipline into the businesses via RAROC-based pricing tools

  7. Philosophy: Make it useful Build bridges to data Quick results and revise often Spend effort in proportion to risk Economic value-based model Single period, analytical approach Easy to incorporate management experience Capital attribution approach widely accepted in banking Philosophy: Make it accurate Analysis paralysis Spaceship building Everything’s a nail Accounting-based accrual model Multi-period, simulation approach Overall effect of micro-level dependencies obfuscated Various capital attribution approaches RAROC techniques are different from traditional DFA techniques . . . Dynamic Financial Analysis P&C RAROC . . . and provide important advantages, driven by a decade of evolution in banking

  8. -300 -200 -100 0 100 200 -125 -100 -75 -50 -25 0 -1000 -800 -600 -400 -200 0 Probability -600 -400 -200 0 200 400 600 Probability linked to solvency standard Economic Capital RAROC uses Economic Capital as the common measure of risk across all risk types CAT Risk Asset Risk Non-Cat Risk Operating Risk • Comprehensive coverage of risk types • All risks measured on a consistent basis • Time horizon harmonized across analysis • Confidence interval linked to financial strength • Forward-looking, not historical volatility • Additive across activities (business, product, customer) Enterprise-wide Risk

  9. 1 Use the right model for each risk – don’t shortchange asset risk Capital Required by the US P&C Industry by Risk Type Operating Risk Asset Risk Property Catastrophe Risk Non-Cat Liability Risk *Source: P&C RAROC: A Catalyst for Improved Capital Management in the Property and Casualty Insurance Industry, Nakada, et al., The Journal of Risk Finance, Fall 1999.

  10. 2 Value-based models allow you to define a single distribution for each risk type Probability Expected Loss Solvency standard: how strong do you want your firm to be? Economic Capital Change in value over one period

  11. Total Risk 3 Modular, analytical models are faster and more transparent A/LM Risk Market Risk Credit Risk CAT Risk Inter-risk correlations -1000 -800 -600 -400 -200 0 Value Operating Risk Non-CAT Risk AGGREGATOR Aggregate Distribution

  12. Risk Risk RiskContribution RiskContribution Policy Policy 1 1 3.0 3.0 2.2 2.2 … … … … … … n n 8.0 8.0 6.0 6.0 4 It is easier to calculate risk contributions from an analytical model Analytical 10,000 iterations, 100 policies “F9” in Excel Simulation Calculation of Contributions 10,000 iterations x 100 policies1,000,000 iterations (minutes or seconds) A few matrix multiplications (hours) Risk contributions Risk contributions

  13. Confidence Intervals around Economic Capital Estimates Model/Parameter Tested Available Capital Risk Correlation Market Index Volatility Interest Rate Volatility Confidence - Non-Cat Risk Confidence + Cat Risk Operating Risk Analogs Credit Risk TOTAL -30% -20% -10% 0% 10% 20% 30% Percent Change in Economic Capital 5 Correlation and other assumptions should be explicit – and tested

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