Documents
Resources
Learning Center
Upload
Plans & pricing Sign in
Sign Out

Capital Allocation

VIEWS: 41 PAGES: 44

									Research Double-Header
Don Mango, FCAS, MAAA
CAS Vice President of Research Director of Research and Development, GE ERC

Midwest Actuarial Forum September 24, 2003
1

Agenda
1.

2.

CAS Research Revision: official CAS business as the VP of Research and Development Capital Consumption: latest prize-winning paper

2

CAS Research Revision
Don Mango CAS VP Research & Development

3

Problem Statements
   

No keepers of the state of the science Need for survey papers, syllabus material Research overload via Call Papers Role/function of the PCAS unclear

4

Proposed Solutions
   

Rein in Call Paper programs Establish Working Paper and Model repository on the CAS Website Institute Working Parties Establish Research Corners and Working Party sessions at the major seminars
5

Why Call Papers?
  

Bottom-up, fast-track research source. Stimulate communication, discussion and sharing. Good in concept, in practice is another story.

6

Call Paper Forum


Not a top-tier professional journal
  





Not peer reviewed. Inclusive editorial policy. Inconsistent review and prize standards. Inconsistent appearance and structure of papers. Not enough editorial oversight.



Contributes to members’ filtration and overload problems.
7

Call Papers


Not generating discussion
Solitary practitioners produce, present  No context, follow-up, formal discussion




Not leading to systematic progress of the science
No referencing standards, context  No clear advancement of the science

8

Call Papers  Working Papers


Many CPs are the equivalent of working papers within academia
 

Posted on websites and discussion forums Works-in-progress, on their way to peerreviewed journals



We can still have bottom-up idea generation, idea sharing, and discussion by establishing a Working Paper (and Model) repository on the CAS Website
9

Working Paper Repository
Categorized by research area  Members can post and comment on posts (mini-reviews)  Items receiving a lot of activity can be the material for the Research Corners at the major seminars


10

Call Paper Refinement
Less often (~biennial)  More editorial oversight


Subject to the new CAS Research Paper template  Impose length requirements (<30 pages)  Must adhere more closely to the subjects of the Call

11

Working Parties
 




Essentially a collective call paper task force Collective = group effort, single group work product Ideas come from the members attending major seminar Seminar has presentation of prior year’s work, selection of next year’s topics
12

Working Parties
Group effort forces discussion during the production of the product  Oversight by research committee  Can enforce editorial standards, referencing, ensure that current state of the science is documented, as well as context and scope of new research

13

Working Parties


An easy to implement answer that helps on many fronts:
Solitary  Group  Bottom-up + Top-down  Consistency in format, referencing, etc.  Member involvement  Natural seminar cycle supports it


14

Working Parties
Four WPs kicked off at 2003 RCM Seminar  Reserve Variability (led by Roger Hayne) kicked off at 2003 CLRS  More to come


15

Publications Task Force
Impact and notoriety of PCAS outside the CAS is essentially NIL  Forum is used / abused



Large bodies of work published without formal peer review Maybe we join the NAAJ



Considering some radical surgery


16

Capital Consumption
Don Mango Director of Research and Development GE ERC

17

Why Even Consider This?
Despite significant efforts throughout the industry, capital allocation has yet to be effectively implemented in (re)insurance  This alternative method also has strong linkages to financial theory, while more accurately representing the actual capital usage of insurance

18

Problem Statements
 



Capital allocation is a de facto paradigm  a requirement or necessity But insurance capital usage is fundamentally different than it is for manufacturing, being in fact the mirrorimage in time For these decision evaluation processes, capital allocation is sufficient but not necessary
19

Problem Statements
Even worse, the resulting insurance IRR framework is now completely fictional (“imputed”), since no capital is transferred or returned  However, insurance capital is consumed when results are worse than planned

20

Actually

This IS capital allocation
for insurance, done right But I needed new terminology to shake loose the old thought processes

21

Core Paradox

 Manufacturers need capital

committed to support the operation…  …and they actually use it, spending it on materials, operations, labor…  …and it’s invested in their business, in the production of their goods.
22

Core Paradox

 Insurance companies need capital
committed to support the operation…  …but they can’t actually use it (or not too much of it anyway)…  …and it’s not invested in their business, but in financial instruments.

23

Two Bets


Bet #1
You pay me $10 now  I might pay you $50 later




Bet #2
I pay you $10 now  You might have to pay me $50 later


24

Payoff Diagrams
Bet #1
60 50 40 30 20 10 0 -10 -20 Now Later

Bet #2
20 10 0 -10 -20 -30 -40 -50 -60 Now Later

25

Bet #1 Spend then Maybe Receive
You spend now, hope to receive later  You spend NOW, voluntarily  With the odds I give you, you can compute an expected value and decide if you want to make the bet


26

Bet #2 Receive then Maybe Spend
You receive now, hope you don’t have to spend later  You MAY spend LATER, contingent on something happening  With the odds I give you, you can compute an expected value and decide if you want to make the bet

27

Capital?


Bet #1 = $10
You spend $10 capital NOW no matter what  The capital investment is current and certain – i.e., not contingent  The capital is allocated = spent = consumed  Natural capacity constraint = your budget

28

Capital?


Bet #2 = $???
I should be sure you have $40 available LATER, but you don’t spend anything NOW  If Bet #2 hits, you spend $40 capital LATER  Capital expenditure (= allocation) is contingent and in the future  Capacity constraints = ???

29

Allocation vs Consumption


Two different but equally valid frameworks for
Treating capital  Evaluating insurance business segments  Developing indicated prices for reinsurance




Nearly orthogonal
30

Allocation vs Consumption
 1. 2. 3.

Three questions: What do you do with the total capital? How do you evaluate business segments? What does it mean to be in a portfolio?
31

Allocation vs Consumption
Question 1: What happens to the total capital? Allocation Consumption  Divided up among the  Left intact segments.  Each segment has the right  Either by explicit to “call” upon the total capital allocation, or assignment to pay its operating deficits of the marginal change in or shortfalls the total capital requirement from adding the segment to the remaining portfolio

32

Allocation vs Consumption
Question 2: How are the segments evaluated? Allocation Consumption  Give the allocations to  Give each segment “access each segment rights” to the entire capital  Evaluate each segment’s  Evaluate each segment’s return on their allocated potential calls (both capital likelihood and magnitude) on the total capital  Must clear their hurdle rate  Must pay for the likelihood and magnitude of their potential calls

33

Allocation vs Consumption
Question 3: What does being in a portfolio mean? Allocation Consumption  Being standalone with  Being standalone with less capital potential access to all the capital  But still having access to all the capital if  But all other segments have necessary, although it is similar access rights unclear how this is reflected

 

The difference between having your own kiddie pool and joining a swim club This is THE CRITICAL SLIDE!
34

Options Framework
The company capital pool is giving each reserving segment a series of options to draw upon (consume) the capital  These options


Expire unused if segment meets or beats Plan  Are exercised if segment’s results deteriorate

35

Options Framework
Similar to a Line of Credit (LOC)  A contingent loan, with full expectation to be reimbursed  This is a valid alternative financial analogue  Much closer to the way capital actually gets used by an insurer

36

Options Beware
“Options” does not imply BlackScholes formula  For one thing, we cannot hedge our exposure  We must price it from first principles  modeled payoff distribution and internal risk charges

37

Details of the Framework
Scenario analysis  Default-free discounting  Scenario-level capital consumption  Evaluation of capital consumption using a “quasi~utility” approach


38

Scenario Capital Consumption


Experience fund
 



From Finite Reinsurance Fund into which goes all revenue, from which comes all payments Bakes in investment income





When the fund is exhausted, but further payments still need to be made, exercise the Call Option for capital That capital gets spent  CONSUMED
39

Chart 1: Capital Consumption Profile Over Time Short versus Long Tail with 120% Loss Ratio
$20,000

$18,000

$16,000

Short Tail Long Tail
$14,000

$12,000

$10,000

$8,000

$6,000

$4,000

$2,000

$0 1 2 3 4 5 6 7 8 9 10

40

Capital Call Cost Function
   

Risk-based overhead expense loading Pricing decision variable Application of utility theory Borch (1961): To introduce a utility function which the company seeks to maximize, means only that such consistency requirements (in the various subjective judgments made by an insurance company) are put into mathematical form.
41

Implicit Preferences


Preferences buried in Kreps’ “Marginal Standard Deviation” risk load approach:






The marginal impact on the portfolio standard deviation is our chosen functional form for transforming a given distribution of outcomes to a single risk measure. Risk is completely reflected, properly measured and valued by this transform. Upward deviations are treated the same as downward deviations.
42

Capital Call Cost Function
Make the implicit explicit  Express your preferences explicitly, in mathematical form, and apply them via a utility function  The mythical “Risk Appetite”  Enforce consistency in the many judgments being made

43

THANK YOU!

44


								
To top