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Embedding of pricing into ERM
Presented by
Thomas Guidon
11. 11. 2011
Agenda
What is pricing
Contexts & roles of pricing
Pricing within Enterprise Risk Management
Product profitability monitoring
Questions
What is pricing
Overview
Comparison of Performance of the major players within the U.K. Motor
Market for 2010 accident year (expenses are financial year)
Gross loss ratio Expense ratio Operating ratio
Mean LR Mean ER Mean OR
180.0%
In % of gross earned premium
160.0%
140.0% Gross Expense Gross
120.0% loss ratio ratio loss ratio
100.0% Mean 98.5% 20.6% 119.1%
Std div 18.6% 6.4% 19.6%
80.0%
CoV 18.9% 30.9% 16.4%
60.0%
40.0%
20.0%
0.0%
Source: Milliman Report “Driving For Profit 2010”
What is pricing
Pricing formula
Risk (Planned)
Technical Aquisition Admin.
costs profit
premium costs costs
margin
We will discuss in our seminar in detail: Risk costs & Profit margin
‒ All the summands above are economic values and calculated on underwriting
year basis
‒ Risk cost is defined as present value of sum of all claims costs, including
allocated loss adjustment expenses
‒ Profit margin is defined as additional loading to all expected costs. In our
context it constitutes “Cost of capital loading”
Retention up to 2009-02-15
What is pricing
Overview
Product pricing Actual price
(Technical price)
Technical Actual Actual
Planned profit acquisition administration Actual profit Actual
premium
Planned margin cost cost margin premium
administration
Planned cost
acquisition
cost
Planned risk Actual risk
cost cost
Implementation time passes
5
What is pricing
Example – Motor portfolio premium components
Profit margin; 5%
Acquisition costs;
25%
Risk cost; 60%
Administrative
costs; 10%
Agenda
Session 1
What is pricing
Contexts & roles of pricing
Pricing within Enterprise Risk Management
Product profitability monitoring
Questions
Contexts & role of pricing
Pricing goals
Pricing is not always about profit !
Possible company goals:
‒ Increasing profitability (margin)
‒ Increasing conversion rate or retention rate (reducing lapses)
‒ Growing in premium volume or market share
‒ Obtaining a broader spread of business (geographical, type of
customer, etc.)
An actuary must optimize several of such goals based on actuarial
sound assumptions.
– Goals can be contradicting
Contexts & role of pricing
Pricing goals
How to follow up on pricing goals decided by management:
• Build a pricing structure which is expected to reach goal
− Differentiation of prices to avoid anti-selection
− Check market/competition
− Multi team task
• Evaluation of success
− Determine up-front variables to be monitored to measure success
− Design reporting template to management
Contexts & role of pricing
Underwriting Cycle
• Insurance industry Profits
worsen
historically has cyclical
Volume
Rates
results decreased
targets
reduced
• Companies respond to hard
market by trying to expand
− Aggressive pricing across
Supply Demand
exceeds exceeds
demand supply
market (chain reaction)
• Response to low profits
− Rate increase Volume
targets
Rates
increased
increased
Profits
Ø Price monitoring is a means
improve
to track underwriting cycles
Contexts & role of pricing
Price differentiation and anti-selection
• To avoid vicious circle of Unprofitable
portfolio
anti-selection cross
subsidies need to be
Profitablilty Flat price
reduced deteriorates increase
• To reduce cross- Vicious circle of
anti-selection
subsidies price assumes existence
of at least one
differentiation is needed smart player
«Bad» risks «Good»
stay at the risks
old price subsidise
level «bad» risks
Ø Price differentiation is a «Good»
risks leave
mean to control cross (cheaper
offer)
subsidies
Contexts & role of pricing
What we have just learned
• Pricing is about risk costs, expenses and profit margin
‒ These components have different underlying behaviour and might
differ from company to company
‒ The main drivers of these components need to be understood
• Company pricing goals are not always about profit
‒ Strategic goals might overrule simple profit optimization
‒ Actuaries need to optimize across several goals
‒ Corresponding consequences should be measured
• Underwriting cycles should be monitored
‒ Allows management to strategically react
• Cross subsidies might lead to anti-selection
‒ Price differentiation is a mean to control cross subsidies
Agenda
Session 1
What is pricing
Contexts & roles of pricing
Pricing within Enterprise Risk Management
Product profitability monitoring
Questions
Pricing within Enterprise Risk Management
Enterprise Risk Management (ERM)
Management • Financial statements
defines financial • Information on company
Information to/from
goals and ERM external market
strategy.
Interpretation of financials and
company status impacts share price
Internal
information flow
Breakdown of ERM strategy and Information supporting risk appetite or
risk appetite/tolerance statements tolerance statements
into rules and constraints defining • Financial and underwriting performance
the acceptance of risk
• Other relevant portfolio information
November 11, 2011
Pricing within Enterprise Risk Management
ERM within Solvency II
• Insurance companies will have to demonstrate that they are 'in
control' firstly to the supervisor and secondly to the market as a
whole. The insurer is deemed to meet the capital requirements
and the requirements with regard to the technical insurance
provisions on a continuous basis.
• ORSA requirements will introduce new levels of risk
management
• Transparent processes from pricing to reserving are needed
• Monitoring will support efforts made and keep management
involved
Pricing within Enterprise Risk Management
ERM & ORSA
Strategy Policy
set by
management
“Own Risk and Solvency
Monitoring
Assessment (ORSA)
reports
Projections, Balance sheet, Profit-and-
Loss account
Projections on the basis of
•economic scenarios
•adverse scenarios
•management decisions
•etc
November 11, 2011
Pricing within Enterprise Risk Management
Enterprise Risk Management (ERM)
An effective ERM process maximizes a firm’s value relative to a
pre-defined appetite and tolerance for risk:
• Effectiveness needs to be measured and monitored
• Reformulation and adjustment of risk appetite or risk tolerance is part
of the process
• Maximizing a firm’s value is a trade-off between risk and return to given
constrains
• Use of compatible metrics to measure underlying risk and ERM
success links daily management decisions with ERM.
Pricing within Enterprise Risk Management
Enterprise Risk Management (ERM)
• As a principal one can state: Shareholders and share price are
external judges on a firm’s value, therefore on the effectiveness
of an ERM process.
Challenge:
− How to link a firm’s value or share price with an ERM process and
daily management?
− How to manage contradictory goals like “stability of earnings” vs
“growing gross premium”
− How to make ERM process measurable
Pricing within Enterprise Risk Management
Risk: Events resulting in financial or reputational loss and inhibiting business goals.
Underwriting Financial Business/Strategic
Operational Risk
risk risks Risk
§ Natural and § Market § Internal controls § Strategy execution
man-made § Credit § Legal § Reputation
catastrophes
§ Pricing § Regulatory § Infrastructure-
§ Employee processes-controls
§ Reserving § Human resources
safety and
§ Valuation § Business continuity § Support growth
health
§ Liquidity § M&A
§ Ratings
November 11, 2011
Agenda
Session 1
What is pricing
Contexts & roles of pricing
Pricing within Enterprise Risk Management
Product profitability monitoring
Questions
Product profitability monitoring
Reporting & monitoring concepts for pricing
• Insurance risks are fairly illiquid
− Once on a balance sheet insurance risks remain there
• Premium is paid up-front claims are paid thereafter. The only hedging
mechanisms for insurance risk is reinsurance or commutation
Ø It is important to monitor risk measure assumptions
• Challenge is to define monitoring & reporting pricing-concepts
understandable by non-actuaries, inter alia management
− Dynamics of the insured portfolio
• Underwriting year vs. calendar/financial year
• Sensitivity of risk drivers
− Link management goals with (expected) market achievements
• Provides deeper view into daily business
Product profitability monitoring
LoB pricing performance reporting
• Pricing performance reporting by line of business, an example:
Efficient Frontier
40%
30%
20%
return
10%
0%
-5% -3% -1% 1% 3% 5% 7% 9% 11% 13% 15% 17% 19% 21% 23%
-10% risk
Efficient Frontier: Motor vehicle liability Other Motor MAT
Fire General liability Credit Legal expense
Assistance Miscellaneous Portfolio TP Portfolio AP
Product profitability monitoring
LoB profitability and exposure change
• Pricing scorecard: Portfolio exposure change vs. profitability
Terminology
Non-life insurance AP vs TP − TP: technical premium
Health Motor Other Motor MAT
Fire General liability Credit Legal expense determined by pricing
Assistance Miscellaneous
− AP: actual premium of
sold product
− x-axis: (AP-TP)/AP
+
demonstrates if technical
premium is below or
exposure
above actual premium.
-15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0%
− y-axis: Exposure growth
− Upper left quadrant
-
means growing with
diluted profit
− Lower right quadrant
actual premium vs. technical premium
means shrinking with
excess profits.
Retention up to 2009-02-15
Product profitability monitoring
Example of MTPL portfolio KPIs tracking
PAID & INCURRED vs PREMIUM Explanation:
− Incurred is equal
120%
to paid plus case
Indication of change in incurred
pattern but not in paid pattern: reserves
100%
Reason?
− Corresponding
paid and incurred
80% pattern have
same length
− There are no
LOSS RATIO
60%
claims reserves
Incurred pattern for
monitored UWYs left when paid and
40%
incurred pattern
meet
20%
Paid pattern for
monitored UWYs
0%
0 6 12 18 24 30 36 42 48 54 60 66 72 78 84 90 96 102 108 114 120 126
UNDERWRITING YEAR DEVELOPMENT IN MONTHS SINCE INCEPTION
Retention up to 2009-02-15
Product profitability monitoring
Example of MTPL & Casco portfolio KPIs tracking
Loss&ALAE ratio MTPL Avg premium MTPL Loss&ALAE ratio CASCO Avg premium Casco
MTPL risk cost Pricing risk cost CASCO risk cost Pricing risk cost
100% 93% 500 80% 72% 74%
72% 500
87% 70%
83% 68% 69%
90% 79%
450 70% 64% 450
77% 63%
61%
80% 73% 72% 400 400
65% 60%
70% 62% 350 350
60% 300 50% 300
293 299 303
219 301 300
223 292
50% 201 201 200 250 40% 211 210 282 250
194 195 195 190 183 188 272
185 261
178 178 179 180
40% 200 30% 200
30% 180 150 150
169 158 20%
147 154 154
20% 131 132 100 100
110 10%
10% 50 50
0% 0 0% 0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2009 2010 2011 2009 2010 2011
Retention up to 2009-02-15
Product profitability monitoring
Example of MTPL portfolio KPIs tracking
Claims frequency Claims severity
Bodily injury Property Bodily injury Property
10% 12'000
9% 9'740
7.6% 7.4% 10'000 8'711 9'024
8% 7.4% 7.5% 7.3%
6.9% 6.8% 6.8% 7'780
7% 6.4% 7'088
8'000
6% 6'355
5'964 5'964
5% 6'000 5'183
4%
4'000
3%
2% 1529 1417 1535 1627 1709 1657 1689 1471 1159
2'000
1% 0.5% 0.5% 0.6% 0.6% 0.5% 0.6% 0.5% 0.6% 0.4%
0% 0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2009 2010 2011 2009 2010 2011
Retention up to 2009-02-15
Product profitability monitoring
Example of MTPL portfolio KPIs tracking
Lapse ratio
35%
30%
25%
% of # policies
20% Segment 1
Segment 2
15% Segment 3
Segment 4
10%
Segment 5
5%
0%
2005 2006 2007 2008 2009 2010
year
What we have just learned
• ERM under new solvency regimes will introduce new internal
reporting standards for insurance liability performance. This
might include:
‒ Overall performance of underwritten portfolio (efficient frontier)
‒ Technical vs. actual premium comparison
‒ Relative growth and corresponding profitability
‒ KPI performance by line of business
Contact
Milliman AG
Lavaterstrasse 65
CH-8002 Zürich www.milliman.ch
Dr. Thomas Guidon
Tel: + 41 91 960 0670
Mobile: + 41 79 214 8285 thomas.guidon@milliman.com
