Capital Allocation - Casualty Actuarial Society

2003ThomasP.BowlesJr.SymposiumApril10,2003TheKeyIssuesandMissionShaunWang,Ph.D.,FCASShaunWang2TheAgendaRealityCheckWhatRiskstoMeasure?BenchmarkCapitalFairValueofLiabilitiesOurScientificProgramShaunWang3-5%0%5%10%15%20%87888990919293949596979899000102E03FUSP/CInsurersAllUSIndustriesReality:PoorROEPerformanceP/CInsurersvs.AllIndustries1987–2002Source:Dr.HartwigatInsuranceInformationInstitute;Fortune13ptsShaunWang4110.5105.0113.6119.2104.8100.8100.5114.3106.5114.4108.8115.8106.9108.5106.5105.8101.6105.6107.7110.0115.7104.9126.5162.5100110120130140150160170199119921993199419951996199719981999200020012002*ReinsuranceAllLinesCombinedRatioCombinedRatio:Reinsurancevs.P/CIndustrySource:A.M.Best,ISO,ReinsuranceAssociationofAmerica,InsuranceInformationInstituteYear2001:ReinsurersdidevenworseShaunWang5RealitySoundedAWake-upCallWhereweretheactuariesduringyearsofsevereunder-pricingandunder-reserving?Havesomeofthefinancialtheoriescontributedtomarketirrationality?Howcanwemaintainthecontinuedviabilityoftheactuarialprofession–the#1rankedprofession?ShaunWang6InSearchforAnswers,WeMust…Getoutofcomfortzone---traditionalactuarialmindsetGotothedeepwaterbyunderstandingtheriskdriversandmarketdynamicsHowcanweprojectunderwritingresultswithoutknowingthelevelofmarketcompetition?ShaunWang7WhatRiskstoMeasure?TraditionalP&CRiskAnalysisExpectedLossLossfrequency&severityCorrelationbetweenrisksConcentrationofexposureNewHorizonBusinessProcessRiskCompetitiveGameMarketcycleQualityofInformationReactiontimeIncentivemisalignmentMultiplePerspectivesShaunWang8Focuson“BusinessProcesses”LossModelingIsOnlyaPartoftheWholeStory1.“Thiscompanyhasthebrightestactuaries,soitgottobegood…”---Naïvethinking2.Onecompanyhadthestate-of-the-artactuarialpricingmodel,butintheendstilllostsomuchmoneyNeedtoquantifytheBusinessProcessRiskTop-linegrowthinasoftmarketposesamajorriskOver-crowdedcompetitivemarketposesamajorriskShaunWang9AModelofMarketCompetitionFinancialResult=Min{Quote1,…,Quotek}LosswhereQuotekNormal(k,k)1.Forlong-tailedlines,delayedinfohigherkhigherchanceofpremiumdeficiency2.morebidderskhigherchanceofpremiumdeficiencyTheWinner’sCurse:Ininsurancecompetitivepricing,thelowestpricegetsthebusiness,butmaybecursedwithfinanciallossesShaunWang10CompetitiveGameofAsset-LiabilityManagementInsurersarecompetingintwofronts:managingassetsmanagingliabilitiesProlificassetmanagementisan“offensiveplay”thatnecessarilyweakensdefenseCanscorebigduringmarketboomIntherecentmarketmeltdown,EUinsurerswerehurtthemostduetohighconcentrationinstocksShaunWang111001502002508990919293949596979899000102*USInsuredCATLosses(in$billion)andRateOnLineIndex(1989=100)Source:GuyCarpenter&*IIIEstimateROLshowedbigjumpaftermajorCATlosses,andthencamedowngradually…$7.5$2.7$4.7$22.9$5.5$16.9$8.3$7.3$2.6$10.1$8.3$4.3$28.1$5.8ShaunWang12MarketCycle&RiskPremiumsHeftyinvestmentgainsinthe1990shelpedinsurancecapitalaccumulationPre-Sept11oversupplyofcapitaltriggeredverylowriskpremiumsThedepletionofinsurancecapitalduetoSept11terroristlossesandinvestmentlossesAfterSept11,theexpectedhurricanelosseshadnotchanged,buttheinsuranceratesjumpedbymorethan30%ShaunWang13QualityofInformationPoorQualityofInformationisamajorriskfor(re)insurersInformationasymmetry--majorhurdleforsecuritization(andreinsurers)ValueofInformation?ThinkabouttheUSsearchforAlQaedaDowehaveameasurefor“qualityofinformation”?ShaunWang14ReactionTime“ReactionTime”isanimportantaspectofriskXOLreinsurancehasahigherseverityvolatilitythanproportionalreinsurance.However,thereactiontimeforrateincreaseisquickerforXOLRateincreasedelaysinsomeregulatoryjurisdictionsForlong-tailedliabilitiesorlong-termguarantees:theabilitytore-actismuchlimited.YouhaveastackofpolicieswritteninthepastToolatetore-actShaunWang15IncentiveMisalignmentMany“risks”arecreatedbymisalignmentofincentivesUnderwritersshort-termgoalv.s.long-tailedliabilitiesManagers’expansionofhis/herownkingdomCEO’scompensationlinkedtogrowthandacquisitionTrialAttorneysandtheU.S.legaldynamicsLawyerContingentFees&PunitiveDamagesshouldbeputinatrustfundforpublicgoodShaunWang16MultiplePerspectivesofRiskEntity-specificvalueversusMarketpriceMarketpricestendtoexhibitlocallinearityCatastropherisktoanentitymayincreasemorethanproportionallyVolatilityOutsiderview:stochasticandrandomwalkInsiderview:trendanddirectionRiskofbeingshort-sightedandlosingperspectiveNASDAQbubble;VariableAnnuityGuaranteesShaunWang17Thesetofmajorrisksdependsonthespecificbusiness/marketTraditionalRiskAnalysisMortality/MorbidityLapseDisintermediationNewHorizonAssetmanagementEmbeddedguarantee(VADBhedging/reserving)CompetitiveGame(distribution,expenses)…ForLifeInsurersShaunWang18RiskMeasuresforDecidingCapitalRequirementandFairValueNewBaselCapitalRequirementforInsurers(IAIS)ParalleltotheBankingBaselAccordIIMovementtowardFair-ValueAccounting(FASB)ProfoundimplicationsandheateddebatesInternally,companiesaredesperatelylookingforbetterwaysofmeasuringrisksandperformanceCompanieslaunchedcapita