CAS RISK PREMIUM PROJECT

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CAS RISK PREMIUM PROJECT

• Richard A. Derrig - Moderator
• Auto Insurers Bureau of Massachusetts
• Richard D. Phillips
• Georgia State University
• Robert P. Butsic
• Firemans Fund Insurance

CAS Loss Reserve Seminar Minneapolis, MN Sept.
19, 2000
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THE RISK PREMIUM PROJECT (RPP)Phase I and II
Report

• Committee on Theory of Risk
• Discount Rate for Liabilities
• Literature Review
• Actuarial Process and Parameter Risk
• Financial Systematic Risk
• Academic Dave Cummins, Rich Phillips
• Industry Bob Butsic, Rich Derrig

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THE RISK PREMIUM PROJECT (RPP)Phase I and II
Report(www.casact.org/cotor/rpp)

• 1. Introduction
• 2. Literature Search
• 3. Theoretical Conclusion
• 4. Proposals for Phase III
• Appendix A. Risk Premium Project Bibliography
• Appendix B. Implications for Fair Value
  Accounting

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THEORETICAL CONCLUSION 1

• The opinions of financial economists and
  actuaries regarding the role of systematic vs.
  non-systematic risks in determining the
  equilibrium insurance prices are converging. Both
  see a role for non-systematic risk in pricing.

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THEORETICAL CONCLUSION 2

• A systematic risk adjustment for the duration of
  the cash flows associated with a line of
  insurance should be included in the discount rate
  used to determine the fair value of the insurance
  premium.
• The adjustment to the discount rate will be a
  function of the maturity structure of the
  liabilities.

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THEORETICAL CONCLUSION 3

• The average returns of financial assets cannot be
  adequately explained by the CAPM beta.
  Researchers have shown extensions of the CAPM
  which include additional factors significantly
  enhance the explanatory power of the models. In
  addition, although research using more
  sophisticated empirical tests has been published
  extending the CAPM, similar research focusing on
  insurance company returns does not currently
  exist.

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THEORETICAL CONCLUSION 4

• A theoretically consistent way to allocate the
  costs of holding equity capital to individual
  lines of insurance has been identified. Thus,
  the costs associated with holding capital can now
  be charged to individual lines of insurance.

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THEORETICAL CONCLUSION 5

• The risk of insurer default to the policyholder
  should be recognized in pricing the risk
  transfer.

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Fair Value Accounting Implications

• Market Value Balance Sheet
• Treatment of Insurer Default
• Franchise Value
• Accounting for the Risk Load
• Process Risk and Value Additivity
• Risk Management Costs
• Allocation of Joint Costs

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Market Value Balance Sheet

• One-period, idealized
• No default
• B/S at time policy is sold

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Default Option

• No guaranty fund, limited liability
• Fair Premium P - D
• B/S at time policy is sold

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Liability Treatment

• Liability as reduced amount L -D
• Separate liability offset (-D)

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Default Under Guaranty Fund

• Premiums as if no default
• Liability to GF offsets expected default

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Franchise Value for Ongoing Insurer

• Surplus includes value of intangibles
• Breakup value of surplus is Sf
• With no guaranty fund

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Consequences of Default with FV

• Default and franchise value are inversely related
• Effect of increasing firm risk
• Owners are worse off if (change in F) gt (change
  in D)
• Not showing F as asset creates perverse results

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Process Risk and Value Additivity

• Process risk commands a price
• Risk management costs (Stulz)
• Reinsurance, capital, diversification
• These costs dont appear in risk loads

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Types of Residual Risk

• Non-priced process risk
• Priced process risk
• Priced systematic

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Allocation of Joint Costs

• Systematic risk loads have natural value
  additivity
• Finance models such as CAPM, APM
• How does market treat cost of residual process
  risk?
• Examples cost of holding capital, risk load for
  catastrophes

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Solution Economic Allocation Methods

• Microeconomic model of joint cost allocation
• Look at marginal impact on total of separate
  (line) inputs
• Economic allocations have value additivity

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EMPIRICAL PROJECTSPhase III 1

• Full Information Beta For Insurance Lines
• If Full Information PC is 0.92 (1998), How Does
  That Distribute By Line?
• DATA CRSP and NAIC
• The FI Equity Beta With Sum Betas
  (Autocorrelation) Included And/Or Fama-French
  Model
• Industry Level And Firm Level
• Relatively Straightforward Datawise Output Will
  be Understandable

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EMPIRICAL PROJECTSPHASE III 2

• Allocation of Surplus by Line of Insurance
• Myers-Read Model Applied to Representative
  Insurer(s)
• Calculation of Covariances of Asset and Liability
  Types
• DATA CRSP and NAIC at Georgia State and More(?)
• Output Compared to Real World Data

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PHASE IIIREFERENCES

• Butsic, Robert P, (1999), Capital Allocation for
  Property-Liability Insurers A Catastrophe
  Reinsurance Application, Casualty Actuarial
  Society Forum, Spring.
• Ibbotson, Roger G, Paul D. Kaplan and James D.
  Peterson, (1997), Estimates of Small Stock Betas
  are Much Too Low, Journal of Portfolio
  Management, Summer.
• Kaplan, Paul D. and James D. Peterson, (1998),
  Full-Information Industry Betas, Financial
  Management, Summer.
• Myers, Stewart C. and James A. Read, Jr., (1999),
  Surplus Allocations for Insurance Companies, AIB
  Working Paper, July.

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APPENDIX ALITERATURE RECOMMENDATIONSTOP TEN
NON-CAS

• Campbell, John Y., Andrew W Lo, and Craig A.
  MacKinlay (1997), The Econometrics of Financial
  Markets (RPP 134)
• Campbell, John Y. (2000), Asset Pricing at the
  Millennium, NBER Working Paper (RPP238)
• Cochrane, John H. (1999), New Facts in Finance,
  NBER Working Paper (RPP188)
• Cummins, J. David, and Richard D. Phillips,
  (2000), Applications of Financial Pricing Models
  in Property-Liability Insurance, The Handbook of
  Insurance Economics (RPP130)
• Cornell, Bradford (1999), Risk, Duration and
  Capital Budgeting New Evidence on Some Old
  Questions, Journal of Business, 722 (RPP37)

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APPENDIX ALITERATURE RECOMMENDATIONSTOP TEN
NON-CAS

• Froot, Kenneth A., and Jeremy C. Stein (1999),
  Risk Management, Capital Budgeting, and Capital
  Structure Policy for Financial Institutions An
  Integrated Approach, Journal of Financial
  Economics, 471 (RPP9)
• Froot, Kenneth A., Jeremy C. Stein, and David S.
  Scharfstein (1993), Risk Management Coordinating
  Corporate Investment and Financing Policies,
  Journal of finance, 481 (RPP10)
• Merton, Robert C. and Andre F. Perold, (1993),
  Theory of Risk Capital in Financial Firms,
  Journal of Applied Corporate Finance,63 (RPP177)
• Babbel, David F. (1999), Components of Insurance
  Firm Value, and the Present Value of Liabilities,
  Investment management for Insurers (RPP225)
• Barberis, Nicholas, Ming Huang, and Tano Santos
  (1999), Prospect Theory and Asset Prices, NBER
  Working Paper (RPP218)

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EMPIRICAL PROJECTSFUTURE

• Equity Beta for Insurer via Multifactor Asset
  Pricing Models
• Campbell-Mei, Fama-French and other Multifactor
  Models Estimated for Insurers
• Alternative Factors Relating to Insurance Tested
  for Additional Explanatory Power
• DATA CRSP and NAIC at Georgia State and More
• Output Compared to Standard and Other Equity
  Betas for Insurers

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EMPIRICAL PROJECTSFUTURE

• Risk Load and Pricing via Cummins, Allen and
  Phillips Model
• Insolvency Put, Growth and Company
• Type Variables are Calculated to Estimate The
  Economic Premium Inclusive of Risk, Tax and
  Friction Loadings
• DATA CRSP and NAIC at Georgia State
• Relatively Straightforward Datawise
• Output Will be Understandable