The Evolving Role of Entreprise Risk

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The Evolving Role of Entreprise Risk

• Considerations in Ratemaking
• FIN-13 CAS Seminar on Ratemaking
• March 07-08, 2002
• The Tampa Marriott Waterside, Tampa, Florida
• Benedetto Conti
• Chief Actuary
• Winterthur Insurance
• P.O. Box 286
• 8401 Winterthur
• Switzerland
• Benedetto.Conti_at_winterthur.ch

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0. My objective

• Illustrate a simple model for enhancing classical
  tools of financial management with the value
  dimension.
• Base such illustration on the planning process.
• For simplicity, illustrate the planning of one
  single policy.
• Exclude the investment risk from the example.

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1. What is the value dimension?

• Managers today are
• being bombarded by
• an endless barrage of
• sophisticated new
• management concepts,
• each with fancy name
• and its own glossary of
• technical jargon.
• (Rutledge)

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1. What is the value dimension?

• In simple words, one can
• say that Value Based
• Management is the
• process of enhancing
• classical financial tools
• used for performance
• measurement with
• cost of capital.

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1. What is the value dimension?

• In classical tools used for
• financial management,
• the interests of all
• stakeholders in an
• insurance company are
• modelled, with the
• exception of the
• shareholders interest.

• Insuredincurred losses,policyholder dividends
• Agents, brokers, ...acquisition costs
• Employeeslae and other expenses
• Statetaxx charge
• Shareholder???

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1. What is the value dimension?
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1. What is the value dimension?
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2. The model

• Asset management outsourcedNo explicit asset
  management expensesReturn on investments net of
  management expenses
• Taxes paid at 31.12.
• Required solvency capital at 01.01.YYYYx of
  expected premium YYYYy of loss reserves at
  01.01.YYYY

• Planning one policyduration one yearincepting
  at 01.01.2003
• Premium paid in one instalmentat 01.01.2003
• Acquisition costs paid in one instalment at
  01.01.2003
• Losses and LAE paid at 31.12.
• Other management expensespaid 50 at
  01.01.2003,50 at 31.12.2003

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2. The model

• See enclosed workbook, worksheet "Input".The
  yellow fields are input-fields.
• See enclosed workbook, worksheet "Income
  Statement"
• See enclosed workbook, worksheet "Balance Sheet"

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Input
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Income Statement
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Balance Sheet
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2. The model

• In the given example, the combined ratio is 104.3
  .Negative underwriting result in the first
  year, zero underwriting results in subsequent
  years.
• The model shows the following series ofoperating
  results after taxes-0.900, 1.444, 0.825, 0.206.
  The sum is 1.575.Remark In the first year, we
  allocated a "negative" tax to this specific
  policy, as the negative operating result before
  taxes of this policy will yield to tax savings.

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2. The model

• The value dimension is brought into the game
  byadding the line "cost of capital".The series
  of "Result" after cost of capital-1.680, 1.069,
  0.611, 0.153. The sum is 0.152.In a planning
  model it is common practice to discount those
  values to the beginning of the period at cost of
  capitalThe obtained value is 0. Writing this
  policy will reward the invested capital at a
  "fair" cost, but will not create value for the
  shareholder. Creating value means creating
  returns in excess of the cost of capital!

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2. The model

• The "result" after cost of capital as presented
  here is commonly called EVA Economic Value
  Added.
• The acronym EVA is a registered trademark of
  Stern Stewart Co.

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2. The model

• At the bottom of the "Income Statement" sheet, we
  show a calculation of the free cash flows.
• At inception of the policy, the shareholder must
  provide capital of 13 to ensure the solvency.
• At the end of the period 2003, 2004, 2005,
  2006,5.849, 4.123, 3.504, 1.099 are paid to the
  shareholder in form of dividends, as those
  amounts are not necessary to ensure the solvency
  in the following period.
• The net present value of those "free" cash-flows,
  discounted at cost of capital, is equal to the
  NPV of the EVAs.

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2. The model

• The equivalence of the NPV of the EVAs and the
  NPVs of the free cash-flows is a well-known fact.
  This theorem can be traced back to the thirties
  in a paper of D. Preinreich (1938).In Germany,
  it is also known as theorem of W. Lücke (1955).
• It seems that the theorem has been re-discovered
  by Modigliani and Miller in their well-known
  paper of 1961.

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3. Integration in a planning framework

• See enclosed workbook, worksheets "Classical
  View" and "Value Dimension".
• Experience in using this framework in a planning
  context
• A major valued driver is growthGrowth is a
  major risk (new business with less own records,
  management capacities)Difficulty of quantifying
  therisk in / risk capital to be allocated to
  growth!

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Classical View
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Value Dimension
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3. Integration in a planning framework

• Other major risk factors are the(mis-)management
  and parameter riskDifficulty of quantifying
  those risks!
• Difficulties of merging two facets of
  riskSolvency (extreme events, survival of the
  company)andVolatility (management's concern to
  meet the business plan)
• Make it simpleSuch a management tool can only be
  successful if everybody can be locked into the
  concept

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3. Integration in a planning framework

• Align the internal management tool with the
  communication to the external world
• NPV's of EVAs are more easily understood as they
  are the natural extension of classical,
  well-known concepts