Strategic Insurance PurchasingIn The 21st Century

ASTIN & Casualty Actuarial Society

Seminar on Reinsurance

July 12, 2001

1:15 – 2:00 PM

Deloitte & Touche

Kevin Bingham

860.543.7345

John Slusarski

860.543.7366

Introduction

• Background– Target audience– Authors

• Evolution of Insurance Purchasing Decision• Strategic Insurance Purchasing, Why Now• Convergence: Options and Insurance• Dynamic Financial Analysis and Reinsurance• Strategic Insurance Purchasing in the 21st Century• Closing Thoughts

Evolution of Insurance Purchasing Decision

Evolution

• Limited review of organization’s actual data– Purchase guaranteed cost policies– Retain risk/reflect organization’s own experience using

different insurance programs• Large deductibles

• Retrospectively rated policies

– Benchmarking• Anticipated loss rate x payroll

• Multiple of calendar payments

• Limited scenario testing (deterministic)– Captives– “What if” scenarios for insurance purchases

• Insurance exposure modeling (stochastic)– Frequency/severity modeling

• 21st Century?

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Strategic Insurance Purchasing, Why Now?

Strategic Insurance Purchasing, Why Now?

• Financial community– Value At Risk (VaR), Economic Value Added (EVATM)– BASLE Accord – Expansion of Pillar 1– CFA exams (quantitative methods, Monte Carlo simulation)

– CNBC, Bloomberg, CNNFN , Internet

• Clients (and auditors) asking for confidence levels• High profile examples/unique capital market solutions

– Bowie bonds– Arby’s securitization– Innovative insurance solutions

• Hardening market• Convergence of financial services industry• Dynamic Financial Analysis (DFA)

Convergence: Options and Insurance

Convergence: Options and Insurance

• Convergence of Financial Services Industry and terminology

Actuary CFA• Leverage the growing financial knowledge of most risk managers,

chief risk officers and corporate decision makers to explain the similarities of insurance and investment options.

OR

Convergence: Options and Insurance

A call option is the right, but not the obligation, to buy a security for a specified price (exercise price) on or before a specified date. Table 1 displays the value of a call option with a $70 exercise price (excluding transaction costs).

TABLE 1

CALL OPTION

01020304050607080

0 10 20 30 40 50 60 70 80 90 100 110 120 130 140

STOCK PRICE

OP

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N V

AL

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Convergence: Options and Insurance

• Insurance programs can be viewed as combinations of purchased and sold call options:

– The exercise price of the call option is equal to the client’s SIR, deductible or reinsurance attachment point

– For EOL and AEOL contracts, the exercise price of the sold call option is equal to the attachment point plus the insured limit

– The call options last for one year, with the expiration date equal to the last day of the accident year

Convergence: Options and Insurance

TABLE 2

0

100

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300

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500

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700

800

50 100 150 200 250 300 350 400 450 500 550 600 650 700 750

INDIVIDUAL LARGE LOSS

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GROUND UP BUY CALL @250 NET

• Table 2 displays a $250,000 SIR or large deductible using a call option with a strike price of $250,000.

Convergence: Options and Insurance

• Much easier for most investment and risk managers to understand the importance of purchasing insurance strategically using the option analogy.

• Although actual conversion is difficult, understanding insurance in terms of options is a helpful exercise for risk managers and actuaries.

KEY POINT – Just as the fundamentals underlying stock and bond investments change each year, so do the insurance risks facing an organization (e.g., hardening market, acquisitions, new exposures, etc.).

Dynamic Financial Analysis and Reinsurance

DFA and Reinsurance - Background

• The term DFA originated in the property-casualty insurance industry.

• The objective was to provide an integrated system for evaluating major risk elements affecting a company’s overall financial performance and economic value.

• Why the term DFA?– Dynamic: interaction of key variables under multiple scenarios

and management actions.– Financial: use modern financial economics to project variables– Analysis: examine impact on both the economic value and

financial statements1 of the firm.

1. Insurers prepare financials under two separate accounting methods; U.S. GAAP and

Statutory accounting principles.

DFA and Reinsurance - Background• Past v.s. Future

– Deterministic v.s. Stochastic: Expected Value100 v.s. Distribution Around Expected Value

– Fragmented v.s. Integrated Approach to Risk Analysis

– Integration of Internal and External Risk Factors– Time Horizons of Over One Year

100100

DFA and Reinsurance - Background

DeterministicDeterministic

# Policies# Policies 100100

XX Premium / PolicyPremium / Policy 2020

= = Total PremiumTotal Premium 2,0002,000

X X 1 - Operating1 - Operating Ratio Ratio .13.13

= = Operating ProfitOperating Profit 260260

DFADFA

# Policies# Policies

X Premium /X Premium / Policy PolicyX 1- Oper.X 1- Oper.

RatioRatio= Operating= Operating

Profit Profit

100100

2020

0.130.13

260260

DFA and Reinsurance - Background

Investments Underwriting

Reinsurance

BusinessStrategies

Management InterventionsManagement Interventions

DFA and Reinsurance - Background

99% Confidence Level99% Confidence Level

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Ending CapitalEnding Capital

xx FinancialFinancialForecastForecast

HistoricalHistoricalPlanPlan

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DFA and Reinsurance - Variables• In simple terms, DFA models consider a set of external

variables and a set of internal variables.• External variables - price takers:

– Interest rate levels– Inflation rates– Capital market prices and total returns– Pricing cycles and price elasticities– Natural catastrophes– Changes in loss levels from case law, jury awards, claims consciousness, etc.

• Internal Variables - management decisions:– Premium rate levels actions– Reinsurance program– Underwriting guidelines– Marketing plans and distribution mechanism– Outstanding liability reserve practices– Investment strategy– Expense management

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DFA Applications

• Reinsurance optimization– Reinsurance module from DFA model– Majority of DFA work done to date

• Asset and liability hedging strategies• Investment portfolio management• Demutualization• Credit risk modeling• Operational risk modeling• SBU operational strategies and planning• Strategic options analysis for mergers and acquisitions• Risk adjusted capital management• Rating agency management• New products and market development• Tax optimization

Strategic Insurance Purchasing in the 21st Century

Strategic Insurance Purchasing in the 21st Century

• Mathematical modeling of all risk factors (DFA)• Enterprise risk management mitigates variability in

financial results from ALL the organization’s major risks (i.e., not just insurance)– Insurance exposures– Asset returns (e.g., Intel example)– Projected sales– Production costs– Tax revenue

• Examples– Captives– Insurance companies– Unique projects

• Efficient frontier

SIP in the 21st CenturyEfficient Frontier

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RISK (S.D. OF RETURN)

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Strategic Insurance Purchasing in the 21st Century

• Answer key management questions– Insurance Specific

• What is the organization’s annual insurance cost and the confidence level feeding financial plan?

• What is the cost/benefit analysis for the insurance option selected versus other options (e.g., XOL versus AEOL, 250 SIR versus 500 SIR)?

• What is the variability of the organization’s insurance costs?

• How well is the company protected against catastrophic losses?

– Enterprise wide focus• What is the confidence level feeding financial plan for all risks?

• What circumstances may cause the company’s financial statements to be impaired (e.g., asset portfolio decline, top line revenue drop, multiple events occurring simultaneously)?

• What investment mix and reinsurance protection produces the highest return for the lowest level of risk (i.e., efficient frontier)?

Closing Thoughts

• “If it ain’t broke, don’t fix it” risk management approach no longer acceptable– Hardening market– Financial pressure from management/shareholders

• Technology– Computer processing speed– @Risk, Crystal Ball, Excel

• Ability to leverage financial “thought ware”– RiskMetrics and VaR– Investment community knowledge

• Demand for quantitative enterprise risk management • Applying and leveraging DFA research/publicity

Closing Thoughts

DFA EPD VaR EVA RAROC Ruin RBC BCAR

Insurance Manufacturing

Retail

Banking