PROFIT AND CONTINGENCIES IN RATEMAKING (FIN - 12)

1. PROFIT AND CONTINGENCIES IN RATEMAKING (FIN - 12) Russ Bingham Vice President and Director of Corporate Research Hartford Financial Services Seminar on Ratemaking Las Vegas, NV March 11-13, 2001

2. Profit and Contingencies in Ratemaking - Outline • Value Creation / Earnings Delivery Process • The Reported Earnings Dilemma • Building Blocks • Risk / Return Decision Framework • Integration of Pricing and Solvency Control • Risk-Adjusted Return vs Risk-Adjusted Leverage • Financial Integrity • Risk / Return Graphic and Sample Exhibit

3. The Value Creation / Earnings Delivery Process Economic value creation begins with sound, economically based operating actions and ends with consistent and growing earnings. In Insurance this process embodies the following characteristics: • Originating policy / accident period actions create financial results that emerge over subsequent calendar periods. • Economic value creation measurement differs 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 aspects.

4. The Reported Earnings Dilemma • The value creating actions (including ratemaking) that begin at the line of business level by individual policy / accident periods subsequently “deliver” reported company wide earnings that are clouded by the following: • Actual (???) Results • Delayed reporting of reality since calendar period results aggregate the financial activity of current and prior policy / accident periods as they emerge over time • Substantial portion is estimation, to be restated in later calendar periods • Co-mingling of results across originating policy / accident periods • GAAP/Stat accounting rules that specify the timing of income recognition and define how “income” emerges • Other Income items (reserve adjustments, realized gains,etc.) • Historical rather than prospective view

5. “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

6. Policy (or Accident) / Calendar PeriodDevelopment Triangles Balance Sheet, Income, Cash Flow Calendar Period Policy Historical Future Total Period19971998199920002001Ultimate Prior X X X X X …... --> Sum 1997 X X X X X …... --> Sum 1998 X X X X …... --> Sum 1999 X X X …... --> Sum 2000 X X …... --> Sum 2001 X …... --> Sum ==== ==== ==== ==== ==== Reported Sum Sum Sum Sum Sum Calendar Rates are set across the policy period “row” but regulatory review is often based on the calendar “column” sum

7. Risk / Return Decision Framework – Basic Principles • Basic principles • Insurance = underwriting, investment and leverage • Volatility is uncertainty of result • Risk is exposure to loss • Policyholder, company & shareholder risk transfer pricing activities are a function of risk, and can be accomplished independently of leverage • Return is a function of volatility (greater uncertainty, greater required return and vice versa) • Leverage simultaneously magnifies return and volatility in return, but NOT necessarily risk

8. Underwriting vs Investment Risk / Return • Underwriting and Investment each contribute to risk and return • While higher risk investments can be used in ratemaking, the risk transfer pricing principles that apply to this added investment risk must still be reflected • Properly separated and priced underwriting and investment risk largely eliminates the disagreement as to what investment strategy should be built into premium rates. Offsetting occurs since • Higher investment risk requires higher price (yield) OR • Higher investment risk requires increased surplus

9. Integration of Pricing and Solvency Control • Simultaneous determination of price and control of risk • Risk controlled using selected risk metric(s) • Price determined which generates return along a tradeoff line that meets risk / return criteria • Adequate risk-adjusted price IS the way that solvency is maintained • Threats to solvency are driven more by inadequate risk-adjusted price than by shortages in surplus • Ideally, any rate filed should also be supported by • the total return that is implied by it and • the risk criteria upon which it is based

10. Risk-Adjusted Return vs Risk-Adjusted Leverage • Two equivalent alternatives which differ in the form of presentation At same premium & combined ratio - • Maintain a fixed leverage, but vary the total return based on volatility • This avoids allocation of surplus to lines of business • Maintain a fixed total return, but vary leverage to adjust for volatility • This makes regulatory environment less contentious • Introduction of surplus into ratemaking (via the application of a varying leverage ratio) is optional (but helps communication). A leverage ratio (and thus surplus) serves a similar purpose in application as do IBNR factors, yields, expense ratios and tax rates. While they do not exist at the individual policy level, their necessary consideration in ratemaking requires introduction by formula.

11. Financial Integrity Ideal Ratemaking Financial Documentation Support • Fully integrated balance sheet, income and cash flow statements • Reconciliation of policy / accident period with calendar period • 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

12. Financial Integrity(Continued) • All ratemaking models can be reconciled with this documentation • Ratemaking focus should be on parameter assumptions and inputs and not be distracted by a particular model structure • Differing and often incomplete forms of presentation make it nearly impossible to understand and compare “opposing” approaches. • Inconsistent parameter estimation to bias outcomes is all too common and not challenged effectively. • Ratemaking is a key component of financial management • It is the actuary’s responsibility to see that ratemaking and related activities are part of a disciplined financial process. • Actuaries risk being marginalized unless they adopt a bottom line, ownership orientation. Total return is relevant, return on premium by itself is not.

13. Figure 1

14. Figure 2