presentation Capital Allocation Fundamental Analysis by mikeholy


									2003 Thomas P. Bowles Jr. Symposium

          The Key Issues
           and Mission

         Shaun Wang, Ph.D., FCAS

                             April 10, 2003
The Agenda

   Reality Check

   What Risks to Measure?

   Benchmark Capital

   Fair Value of Liabilities

   Our Scientific Program

                                Shaun Wang

          Reality: Poor ROE Performance
          P/C Insurers vs. All Industries 1987–2002





           87   88   89   90    91   92   93   94   95   96   97   98    99   00   01   02E 03F

                               US P/C Insurers           All US Industries

Source: Dr. Hartwig at Insurance Information Institute; Fortune
                                                                        Shaun Wang

  Source: A.M. Best, ISO, Reinsurance Association of America, Insurance Information Institute

      Combined Ratio:
      Reinsurance vs. P/C Industry
                                   Reinsurance                             All Lines Combined Ratio


160                                    Year 2001: Reinsurers did
                                       even worse













110                                                                                    101.6

100                                                                                              100.5
      1991       1992           1993       1994         1995              1996       1997      1998         1999          2000        2001 2002*
                                                                                                            Shaun Wang

Reality Sounded A Wake-up Call

   Where were the actuaries during years of severe
    under-pricing and under-reserving?

   Have some of the financial theories contributed
    to market irrationality?

   How can we maintain the continued viability of
    the actuarial profession – the #1 ranked

                                    Shaun Wang

In Search for Answers, We Must …

   Get out of comfort zone --- traditional actuarial

   Go to the deep water by understanding the risk
    drivers and market dynamics
       How can we project underwriting results without
        knowing the level of market competition?

                                         Shaun Wang

What Risks to Measure?

      Traditional P&C           New Horizon
                                   Business Process Risk
       Risk Analysis
                                   Competitive Game
   Expected Loss
                                   Market cycle
   Loss frequency & severity
                                   Quality of Information
   Correlation between risks
                                   Reaction time
   Concentration of exposure
                                   Incentive misalignment

                                   Multiple Perspectives

                                           Shaun Wang

Focus on “Business Processes”

   Loss Modeling Is Only a Part of the Whole Story
    1. “This company has the brightest actuaries, so it got to be
       good …” --- Naïve thinking

    2. One company had the state-of-the-art actuarial pricing model,
       but in the end still lost so much money

   Need to quantify the Business Process Risk
       Top-line growth in a soft market poses a major risk

       Over-crowded competitive market poses a major risk

                                               Shaun Wang

A Model of Market Competition

   Financial Result = Min{Quote1, …, Quotek}  Loss

              where Quotek  Normal(k, k)
    1. For long-tailed lines, delayed info  higher k 
       higher chance of premium deficiency

    2. more bidders k  higher chance of premium deficiency

   The Winner’s Curse: In insurance competitive pricing,
    the lowest price gets the business, but may be cursed
    with financial losses

                                          Shaun Wang

Competitive Game of Asset-Liability
   Insurers are competing in two fronts:
       managing assets
       managing liabilities

   Prolific asset management is an “offensive
    play” that necessarily weakens defense
       Can score big during market boom
       In the recent market meltdown, EU insurers were hurt
        the most due to high concentration in stocks

                                           Shaun Wang

        US Insured CAT Losses (in $billion)
        and Rate On Line Index (1989=100)
      Source: Guy Carpenter & *III Estimate            ROL showed big jump after
250                                                    major CAT losses, and then
                                                       came down gradually …

200                        $22.9


150                                                                  $10.1
      $7.5                                        $8.3 $7.3                  $8.3
                                   $5.5                                                            $5.8
                    $4.7                                                            $4.3
             $2.7                                             $2.6

      89     90     91      92     93      94     95    96    97      98      99    00      01     02*
                                                                           Shaun Wang

Market Cycle & Risk Premiums

   Hefty investment gains in the 1990s helped
    insurance capital accumulation

   Pre-Sept 11 oversupply of capital triggered very low
    risk premiums

   The depletion of insurance capital due to Sept 11
    terrorist losses and investment losses
       After Sept 11, the expected hurricane losses had not
        changed, but the insurance rates jumped by more
        than 30%

                                         Shaun Wang

Quality of Information

   Poor Quality of Information is a major risk for

   Information asymmetry -- major hurdle for
    securitization (and reinsurers)

   Value of Information?
     Think about the US search for Al Qaeda

   Do we have a measure for “quality of information”?

                                        Shaun Wang

Reaction Time

   “Reaction Time” is an important aspect of risk
         XOL reinsurance has a higher severity volatility than
          proportional reinsurance. However, the reaction time
          for rate increase is quicker for XOL

         Rate increase delays in some regulatory jurisdictions

   For long-tailed liabilities or long-term guarantees:
    the ability to re-act is much limited.
         You have a stack of policies written in the past

         Too late to re-act

                                              Shaun Wang

Incentive Misalignment

   Many “risks” are created by misalignment of
       Underwriters short-term goal v.s. long-tailed liabilities

       Managers’ expansion of his/her own kingdom

       CEO’s compensation linked to growth and acquisition

   Trial Attorneys and the U.S. legal dynamics
       Lawyer Contingent Fees & Punitive Damages should be
        put in a trust fund for public good

                                             Shaun Wang

Multiple Perspectives of Risk

   Entity-specific value versus Market price
        Market prices tend to exhibit local linearity

        Catastrophe risk to an entity may increase more than

   Volatility
        Outsider view: stochastic and random walk

        Insider view: trend and direction

   Risk of being short-sighted and losing perspective
        NASDAQ bubble;              Variable Annuity Guarantees

                                                   Shaun Wang

The set of major risks depends on the
specific business /market

                  For Life Insurers

Traditional Risk            New Horizon
                               Asset management
   Mortality/Morbidity
                               Embedded guarantee
   Lapse                       (VADB hedging/reserving)

   Disintermediation          Competitive Game
                                (distribution, expenses)

                               …

                                        Shaun Wang

Risk Measures for Deciding
Capital Requirement and Fair Value
   New Basel Capital Requirement for Insurers (IAIS)
        Parallel to the Banking Basel Accord II

   Movement toward Fair-Value Accounting (FASB)
        Profound implications and heated debates

   Internally, companies are desperately looking for better
    ways of measuring risks and performance
        Companies launched capital Allocation projects
        Lot of confusion, misconception & practical difficulties

                                                   Shaun Wang

Capital Allocation, or really
Capital Consumption?
   For high-risk low-return business, we want to allocate
    less capital to it, but the capital consumption is high!

   The capital consumption increases more than linearly
    for correlated risks and high-impact losses

   Knowing the capital consumption by business units can
    help manage the business!

   Many allocation methods rely heavily on superficial
    assumptions about diversification between LOBs

                                          Shaun Wang

Superficial Diversification Is Dangerous!

   The pure loss generating process may show a low
    correlation and high diversification benefit

   From business standpoint, playing two different games
    is much harder than playing just one competitive game

   The contagion (or drag) effect may overwhelm any

   Over-diversification increases the risk of losing touch
    of reality for executives (and making bad decisions)

                                          Shaun Wang

Right and Wrong Diversifications

   Years of under-pricing were partially caused by the “low
    correlation” argument by some multi-line players

   Diversification needs to match with areas of expertise
        Renaissance Re, a mono-line CAT-writer, achieves
         diversification by geographic region and by peril

   Expanding to a new line of business is very risky

   Citigroup spun-off Travelers; GE selling ERC

                                             Shaun Wang

Benchmark Capital

   Other players’ capital allocation can affect you!

   To avoid artificial effects of diversification, industry
    benchmark capital charge is badly needed

   Parameters are more important than the model

   Benchmarks should reflect the inherent risks of the
    business, regardless of risk portfolio
   It will take a lot of fundamental analysis, expert opinion,
    and timely updates

                                            Shaun Wang

Did “U.S. Risk Based Capital” Help?

   U.S. Benchmark RBC has only limited success:

       Factor based reserve charges ignored the bigger issue of
        reserve adequacy

       Incentives for putting up inadequate reserves

       Same capital charge factor for premium written in a hard
        market versus in a soft market

   Limitations due to a point-in-time measure, without
    reference to future direction and sensitivity over time

                                              Shaun Wang

It Is Coming! -- Fair Value of Liabilities

   Actuarial Standards Setters are pushing for fair value of

   Motivated by consistent accounting treatment of assets
    and liabilities

   For actively traded assets, market values are readily

   For insurance liabilities, there is no “active traded
    market” --- “fair value” creates big challenges and
                                           Shaun Wang

Challenges of Fair Value Accounting

   Fair value will introduce more volatilities on paper
        Are we prepared for the “consequences”?

        Is it better to enlarge or dampen the underwriting cycle?

   Heated debate on the credit standing of the liability
        There seems to be a conflict between “financial theory”
         and “public interest”

        We will learn a lot more today from the speakers!

                                              Shaun Wang

Financial Theories for Fair Value

   “CAPM with Zero beta” does not reflect reality

   The Link between Insurance Stock Price and
    Individual Loss Distribution is WEAK!

   Insurance equity prices tend to reflect more of the
    quality of company management
        Renaissance Re --- mono-line writer for catastrophe
         insurance, but very stable stock price appreciation

                                             Shaun Wang

Fair Value: Arbitrage-free versus
Actuarial Models

   Two different models, how do we reconcile them?

   Frictional costs are the missing link
    1. Actuarial models should be modified to reflect
       available hedging in the capital market

    2. Arbitrage-free models assumed complete market and
       zero transaction cost (which are often not the case)

                                          Shaun Wang

Reserve Deficiency for Long-tailed
   Before tackling the fair-value question, we have a more
    fundamental problem of reserve deficiency
   As of 2002, P&C Industry reserve deficiency is estimated
    at $120 billion – Morgan Stanley
         Recently a flurry of billion$ reserve increases
   In 2002, the top 300 EU companies have unfunded
    pension liability > $267 billion -- WSJ
   Reserve uncertainty for Long-Term-Care & Annuity
                                             Shaun Wang

Cycle Nature of Reserve Estimates

   The adequacy of reserve estimates showed a
    clear cycle over the years, coupled with the
    pricing UW cycle
        Pressure on short-term performance
        Following the competitors
        Tax smoother for some players
        A slow-death sentence for many companies

                                         Shaun Wang

Recent Dramas in Actuarial Reserve
   Mechanical actuarial methods can produce a wide range
    of reserve estimates
   In the past the lowest reserve estimates were often being
   Recently we saw large increases in reserve estimates
        Trigged by lawsuit against professional actuaries
        Dramatic increases in reserve estimates may push struggling
         companies off the cliff

   Nowadays actuarial consulting fee is rated on the
    potential legal liability of the project
                                                  Shaun Wang

Fair Value and Benchmark Capital Are
Intimately linked
   The fair value of reserve liability necessarily contains a
    risk margin --- (see Steve Philbrick 1994 paper)

   These risk margins should be reflected in the capital
    charge for reserve uncertainty risk

   Otherwise, we create disincentives that would distort the
    fair value calculation

                                            Shaun Wang

Our Scientific Program

   The Bowles Symposium Call Paper Program:

        An overwhelming response of 25+ paper proposals

        We selected 15+ proposals, which were subsequently
         developed to papers

   This Symposium

        Joint efforts of Georgia State University, the CAS, and the
         Actuarial Foundation

        International event: participants from 9 countries

        Industry-Academic Partnership: 5 universities

                                                   Shaun Wang

We Need Your Participation!

   In this meeting room we have many bright minds with
    deep research and industry experience

   Interactive discussion is a key feature of this Symposium

   It is important that you share your insights and

   Please try to be concise and clear in making your points

   Have fun!

                                           Shaun Wang


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