1. Capital Allocation BAD Donald Mango, FCAS, MAAA American Re-Insurance CAS 2002 Ratemaking Seminar

2. Topic Du Jour • Gary Venter’s “Allocating Surplus—Not!” in the February 2002 Actuarial Review: • “…actually trying to use allocated surplus to make business decisions is a risky undertaking and can easily lead to wrong conclusions.”

3. Why BAD? • Not so much bad as backward • Philosophically unsound • Based on the wrong analytic framework co-opted from manufacturing industries

4. Philosophically Unsound • Capital is anAGGREGATE PHENOMENON that only has meaning for the Portfolio in total • Our product is Claims-paying ability in total, as a Going Concern • We CAN allocate it, but I don’t think we SHOULD

5. Wrong Framework • The old Brealey-Myers “invest capital to build widgets” • Up-front capital, known, invested as a cost of production • Future revenues are uncertain • Risk-adjusted discounting • Release (return) capital and calculate an IRR

6. Manufacturer: “Capital allocation” = current spending of a known amount Invests Capital into production of goods Knows its costs Doesn’t know it’s revenue Insurer: “Capital allocation” = completely theoretical exercise Cost of production = viable claims-paying ability + U/W staff Knows its revenue Doesn’t know its costs Wrong Framework

7. Wrong Framework • For current underwriting activities, what we are really allocating (spending) is (possibly) FUTURE CAPITAL • Current Capital is already spoken for by the reserves !! • Given this fundamental difference, should we call it the Claims Paying Reservoir™, and not allocate it?

8. Portfolio Risk is What Matters • Assess product line profitability against risk when aggregated with your own portfolio • Include as many risk sources as you can model • A Portfolio Risk Model • Call it DFA, ERM, whatever you like

9. Portfolio Risk Must Include… • Reserves = “the Wake” • “Chomp on Comp” • Ongoing Business = “the Franchise” • Contingence, Path Dependence, Real Options, Market Flexibility • Moving away from “I.I.D. samples” • Assets and Economic scenarios • Hypothesized Dependence relationships

10. Actual Recommendation • Cost of Capital is a calendar year overhead expense load as a percent of premium on ongoing product lines • Balance to a total that is tied to reality • It’s no more mismatched than any other overhead expense loading • Allocate all costs and revenues to product lines  Economic Value Added

11. Actual Recommendation • Cost of Capital loading should be proportional to “Risk” reflecting: • Accumulations in your portfolio (financial risk management) • Systemic mis-pricing risk (parameter risk, forecast volatility) • Reserve conflagration (model risk of BornFerg) • Downside, not volatility • Dependence on economic variables • Real options embedded in market decisions

12. Influence the Underwriting • “Any plan is better than no plan” – Sun Tzu • Any of these approaches can work • Reduce the fancy stuff to linear approximations = F9 • Right-size the effort – resist the temptation • Operate on at most a planning cycle • Success = impact on underwriting decisions • Focus on marketing and politics as well as science