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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

				
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