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1 The Integration of Risk and Return in Practice - From Ratemaking to ERM Russ Bingham Ratemaking Seminar Vice President Actuarial Research Salt Lake City, Utah Hartford Financial Services March 13-14, 2006

1 The Integration of Risk and Return in Practice - From Ratemaking to ERM Russ BinghamRatemaking Seminar Vice President Actuarial ResearchSalt Lake City,

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The Integration of Risk and Return in Practice- From Ratemaking to ERM

Russ Bingham Ratemaking Seminar Vice President Actuarial Research Salt Lake City, UtahHartford Financial Services March 13-14, 2006

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Outline Corporate Objective: Financial Discipline and Operational Application Risk / Return and the Risk Transfer Process Risk / Return Fundamentals Risk / Return Line Generic Risk Quantification Steps Alternative Risk Metrics Risk / Return Criteria Specifications Risk / Return Integration Risk-Based Pricing Risk Coverage Ratio Risk Metric Example of Risk-Based Pricing Translation for Operating Return to Total Return Connecting Risk and Return RAROC and RORAC Risk / Return Methodology in Practice – Scope and Attributes Appendix

Five Essential Structural Elements Economic and Risk-Based Orientation and Premises Ten Commandments of Insurance Financial Modeling

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Corporate Objective: Financial Discipline and Operational Application

Financial discipline is a valuation process, supported by analytical methods and models, intended to provide timely and meaningful assessments of risk / return performance and trends associated with underwriting, investment and finance operations. Sound economic, risk-based analytics are used to support strategic and operational decision making throughout company.

Apply benchmark standard financial valuation throughout entire company Ratemaking and product pricing Planning Performance monitoring Profitability studies Incentive compensation Acquisition analysis Capital attribution Risk/return assessment ERM

Valuation is on an Economic Basis (i.e. cash flow oriented) and Reflects Risk

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Risk / Return and the Risk Transfer Process

Risk Transfer Activities Underwriting funds flow between policyholders and company Investment funds flow between company and financial markets Finance capital funds flow between financial markets and company

Risk Transfer Characteristics Transfer of cash between two parties for a future expected benefit to both Benefits uncertain as to amount and/or timing Price for the transfer of risk based on fundamental Risk / Return tradeoff

in which higher risk requires higher price

Risk / Return Relationship Applies to all risk transfer activities Risk and Return measured from the same variable (distribution)

The same risk / return tradeoff paradigm should apply to all risk transfer activities to the extent possible

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Risk / Return Fundamentals

Insurance = underwriting, investment and financial leverage

Volatility is uncertainty of result Volatility characteristics of input and output variables are a key

component of risk assessment but volatility alone does not represent risk

Risk is exposure to loss Risk lies in the potential for adverse outcomes, which is a function

of both the level of and volatility in important variables of interest

A risk-based pricing and capital attribution methodology incorporates volatility in determining levels of outcomes in order to conform to an acceptable risk / return relationship

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Risk / Return Line

The price (premium) that satisfies the risk criterion, by reflecting the volatility in each line The price (premium) that satisfies the risk criterion, by reflecting the volatility in each line of business, places the expected total return distribution on the total risk / return line.of business, places the expected total return distribution on the total risk / return line.

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Generic Risk Quantification Steps

1. Select variable(s) of interest

2. Determine the statistical distribution of the variables(s)

3. Define and identify adverse outcomes

4. Determine the probability of an adverse outcome

5. Determine the severity of an adverse outcome

6. Calculate the risk metric

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Alternative Risk Metrics

Policyholder oriented risk metricsProbability of ruin (POR)Expected policyholder deficit (EPD)

Shareholder oriented risk metricsVariability in total return (sR)Sharpe RatioValue at risk (VAR)Tail Value at Risk (TVAR)Tail Conditional Expectation (TCE)Probability of Income Ruin (POIR)Probability of surplus drawdown deficit (PSD)Severity of surplus drawdown deficit (SSD)Expected surplus drawdown deficit (ESD)Risk Coverage Ratio (RCR)

RBC and other Rating Agency measures

Only Sharpe ratio and RCR integrate risk and return, others are an expression of risk only

In one way or another all risk measures address the likelihood and/or the severity of an adverse outcome

Metrics differ in choice of variable used and in definition of adverse event (position in distribution)

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Risk / Return Criteria Specifications in Practice

Key variable is the distribution of Total Return (ROE or “equivalently”, Operating Return) based on Accident period and Economic (cash flow based) accounting.

Adverse outcome is defined as “below breakeven” return. For ROE; Breakeven = Risk Free return For Operating Return; Breakeven = Zero

Risk metric is “Risk Coverage Ratio” (RCR) which reflects the expected return margin above breakeven in ratio to the risk as measured by the expected frequency of result below breakeven times the severity of those outcomes – this is a Reward to Risk ratio.

“All” sources of risk (cats, non-cat losses, cash flow, yield, etc.) are modeled simultaneously. Their respective contributions to overall risk and return is identified and this forms the basis for setting premium and assigning surplus.

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Risk / Return Integration in Practice

Risk measurement is a combination of the probability that returns will fall below breakeven, together with the average severity of such outcomes

“Loss” = Shortfall from breakeven return “Risk” = (Loss Frequency) x (Mean Loss Severity)

RCR (Risk Coverage Ratio) is used to integrate risk and return Risk-Based Pricing - higher price dictated when volatility and risk is

greater Establishes risk / return tradeoff whose slope is RCR Independent of surplus

Two forms of risk-adjustment can be use when translating to total return (ROE)

Risk-Adjusted Return - higher absolute total return when risk is greater, with uniform leverage (e.g. 3/1 leverage ratio in all lines) OR

Risk-Adjusted Leverage - lower leverage when risk is greater, with uniform total return (e.g. 15% ROE in all lines)

Price related to risk, leverage related to total return

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Risk-Based Pricing in Practice

Risk Pricing Objective is to insure that all operating activities (lines of business in underwriting as well as alternative investments) conform to a consistent risk / return relationship

Pricing ideally sets all operating activities’ return/risk ratio to the same benchmark standard, so that strategic opportunity decisions can be made on a level playing field

The corporate ROE goal is distributed equitably among areas through pricing and capital allocation, in proportion to risk contributed

Internal Diversification and external (e.g. ratings) factors influence this relationship

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Risk Coverage Ratio Risk Metric – Policyholder Operating Return Level

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Example of Risk-Based Pricing – Operating Level Risk

Und Return on Inv Assets Below ‘0’ Breakeven Oper Return Risk

Line Ratio Und Inv Total Oper Prob Severity Risk RCR

U r O P -T P(-T) O/{P(-T)}

Homeowners 90 11% 3% 14% 5% 14% 0.7% 20

Automobile 98 1 3 4 10 2 0.2 20

Workers Comp 104 (1) 3 2 10 1 0.1 20

Underwriting, Investment and Operating Return are shown as an annual percentage rate on invested insurance assets.

Risk is the expected average adverse outcome, the product of the probability and average severity of adverse outcomes.

Price per Unit of Risk (RCR reward to risk ratio) is the same in each line.

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Translation from Operating Return to Total Return

Operating return is converted to total return by introducing surplus and investment income on surplus as follows:

Operating Income (I) = Income from insurance (policyholder) operations, the sum of underwriting income and the investment income on policyholder asset float

Insurance Asset Float (A) = Invested assets supporting policyholder liabilities generated from insurance funds flows

Underwriting Return (U) = Underwriting Income / AInvestment Return (r) = Investment Income of Policyholder Asset Float / A Operating Return (O) = I / A = U + rInsurance Operating Leverage (L) = A / SSurplus (S) Investment Return on Surplus = r Total Return on Surplus (R) = O x L + r

All items are based on net present value across policy / accident period lifetime

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Example of Risk-Based Pricing – Total Return Level Risk

Risk-Adjusted

Return on Capital Return on Risk-Adjusted Capital

Und Oper Levg Total Levg Total Below Breakeven Total Return Risk

Line Ratio Return Ratio Return Ratio Return Prob Severity Risk RCR

O L R L R P (r-T) P(r-T) (R-r)/{P(r-T)}

Homeowners 90 14% 3.0 45% 0.86 15% 5% 12% 0.6% 20

Automobile 98 4 3.0 15 3.0 15 10 6 0.6 20

Workers Comp 104 2 3.0 9 6.0 15 10 6 0.6 20

Operating Leverage is the ratio of Insurance Assets to Surplus (Equity or Capital).

Total Return is as an annual percentage rate on Surplus.

In the RAROC perspective Risk-Adjustment is thru a varying Total Return. Operating Leverage is constant.

In the RORAC perspective Risk-Adjustment is thru a varying Operating Leverage. Total Return is constant.

Each line’s return reflects the relative risk of the line, with a uniform risk/return tradeoff across all lines.

RCR (Gain per Unit of Risk) is the same as at the Operating Level.

Under RORAC Risk (expected surplus drawdown) is a constant (% points of return) along with constant return.

Finance literature refers to risk measure as “the mean lower partial moment”.

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Risk Coverage Ratio Risk Metric – Shareholder Return Level

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Connecting Risk and Return - Risk Adjustment Alternative 1

“Step” 1: Determine Price that satisfies specified risk criteria using uniform leverage - RAROC perspective, Risk-Adjusted Return On Capital (varying return with uniform leverage)

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Connecting Risk and Return - Risk Adjustment Alternative 2

“Step” 2: Determine Leverage to achieve specified return - RORAC perspective, Return On Risk-Adjusted Capital (uniform return with varying leverage)

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Risk / Return Methodology in Practice – Scope and Attributes

Primary risk orientation is that of an on-going concern meeting return expectations in financial community

More extreme event risks (e.g. “ruin” and ratings downgrade) are indirectly addressed since they reside within the same total return distribution although farther out in the tail

Adequate product pricing based on product risk is viewed as the most important risk / return lever

Target Prices (premiums) are determined to meet specified RCR in each line of business – gain (“reward”) per unit of risk same in all lines

Leverage and capital attribution is determined and presented in the RORAC risk adjustment perspective at which time capital calibration is verified

Both policyholder (operating return level) and shareholder (total return level) subject to same risk/return tradeoff

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Risk / Return Methodology in Practice – Scope and Attributes

The Benchmark model provides a framework for economic measurement of risk-based underwriting performance, and is applied in virtually all areas

Pricing, planning, tracking, incentive compensation, ERM, etc. Supports internal line of business risk-versus-return-oriented decision-

making Accident / Calendar triangle structure demonstrates flow into

conventional calendar period reported financials

Economic and risk-based rules are used to control flow of risk capital and to distribute profits generated by the individual businesses over time internally

Incorporates all sources of risk that can be “distributionalized” – Loss, Catastrophe Loss, Investment Yield, Cash Flow, etc.

Provides all critical performance metrics – Total Risk-Adjusted Return, Economic Value Added, Benchmark Surplus, Embedded Value, etc.

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Appendix: Five Essential Structural Elements

Financial Model Completeness and Integrity: Cash Flow, Balance Sheet and Income Statements that tie to each other without adjustments

Development Triangles of Marketing / Policy / Accident Period into Calendar Period (see next slide)

Accounting Valuations: Conventional (statutory or GAAP) and Economic (present value)

Functional Delineation (Underwriting, Investment and Finance) Risk / Return Decision Framework

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Appendix: Economic and Risk-Based Orientation and Premises

Internal line of business decisions are made based on financials that reflect the “purest” view of financial performance possible

Accident period oriented, NOT Calendar period Economically based accounting, NOT Conventional (statutory or

GAAP) Forward looking (includes future cash flow expectations) Investment risk beyond ‘AA’ cash flow matched strategy considered as

separate investment activity, NOT underwriting Risk-adjustment (and capital attribution) based on independent view of

risk (using benchmark accident year, economic, cash flow, and low risk investment structure as noted above), NOT the rating agency view

External total company “constraints” must be met based on Calendar period (e.g. meet reported earnings expectations) Conventional accounting (Stat for rating agency and regulatory, GAAP

for financial reporting) Backward looking (reported historical financials) Combined underwriting and investment results Rating agency capital (e.g. S&P)

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Appendix: Ten Commandments of Insurance Financial Modeling

1. Thou shalt build only models that have an integrated set of balance sheet, income and cash flow statements

2. Thou shalt remain rooted in a policy period orientation and develop calendar period results from this base

3. Thou shalt reflect both conventional and economic accounting perspectives - guided by economics, constrained by conventions

4. Thou shalt recognize the separate contributions from each of underwriting, investment and finance activities

5. Thou shalt be guided by the risk / return relationship in all aspects6. Thou shalt include all sources of company, policyholder and shareholder

revenue and expense embodied in the insurance process7. Thou shalt reflect all risk transfer activities8. Thou shalt not separate risk from return9. Thou shalt not omit any perspective or financial metric that adds understanding10. Thou shalt allow differences in result only from clearly identified differences in

assumption, and not from model omission