RCM4 Ratemaking, Capital Allocation and Risk Metrics

1
RCM-4 Ratemaking, Capital Allocation and Risk
Metrics

• Russ Bingham
• Vice President and Director of Corporate Research
• Hartford Financial Services
• Seminar on Ratemaking
• San Antonio, TX
• March 26-28, 2003

2
Outline

• Financial Model Building Blocks
• Does Your Model . . . ?
• Price, Risk, Leverage and Return
• Ten Commandments of Insurance Financial Modeling

3
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)
• Risk / return decision framework which deals with
  separate underwriting, investment and financial
  leverage contributions

4
Policy (or Accident) / Calendar
PeriodDevelopment Triangles

• Balance Sheet, Income, Cash Flow
• Calendar Period
• Policy Historical Future
  Total
• Period 2000 2001 2002 2003 2004
  Ultimate
• Prior X X X X X ...
  --gt Sum
• 2000 X X X X X ...
  --gt Sum
• 2001 X X X X ... --gt
  Sum
• 2002 X X X ... --gt
  Sum
• 2003 X X ... --gt Sum
• 2004 X ... --gt 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

5
Does Your Model . . .

• Reflect all costs?
• Reflect all risks?
• Provide all metrics?
• Apply to underwriting and investment activities?
• Facilitate the application of fundamental risk /
  return principles?

6
Talking PointsPrice, Risk, Leverage and Return

• Price for Risk, Leverage for Return
• What is Risk, and how is it reflected in the
  Price?
• What is the working Risk / Return Tradeoff?
• What determines Leverage?
• What is the Cost of Capital and how is it
  incorporated?
• What is the Economic Value Added?

7
Ten Commandments of Insurance Financial Modeling

• 1. Thou shall build only models that have an
  integrated set of balance sheet, income and cash
  flow statements
• 2. Thou shall remain rooted in a policy period
  orientation and develop calendar period results
  from this base
• 3. Thou shall reflect both conventional and
  economic accounting perspectives - guided by
  economics, constrained by conventions
• 4. Thou shall recognize the separate
  contributions from each of underwriting,
  investment and finance activities
• 5. Thou shall be guided by the risk / return
  relationship in all aspects

8
Ten Commandments of Insurance Financial Modeling

• 6. Thou shall include all sources of company,
  policyholder and shareholder revenue and expense
  embodied in the insurance process
• 7. Thou shall reflect all risk transfer
  activities
• 8. Thou shall not separate risk from return
• 9. Thou shall not omit any perspective or
  financial metric that adds understanding
• 10. Thou shall allow differences in result only
  from clearly identified differences in
  assumption, and not from model omission