2003 Thomas P. Bowles Jr. Symposium

April 10, 2003

The Key Issues

and Mission

Shaun Wang, Ph.D., FCAS

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Shaun Wang

The Agenda

Reality Check

What Risks to Measure?

Benchmark Capital

Fair Value of Liabilities

Our Scientific Program

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Shaun Wang

-5%

0%

5%

10%

15%

20%

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

US P/C Insurers All US Industries

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

Source: Dr. Hartwig at Insurance Information Institute; Fortune

13 pts

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Shaun Wang

110.

5

105.

0 113.

6 119.

2

104.

8

100.

8

100.

5

114.

3

106.

5 114.

4

108.

8 115.

8

106.

9

108.

5

106.

5

105.

8

101.

6

105.

6

107.

7

110.

0 115.

7

104.

9

126.

5

162.

5

100

110

120

130

140

150

160

170

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002*

Reinsurance All Lines Combined Ratio

Combined Ratio:Reinsurance vs. P/C Industry

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

Year 2001: Reinsurers did even worse

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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 profession?

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Shaun Wang

In Search for Answers, We Must …

Get out of comfort zone --- traditional actuarial

mindset

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?

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Shaun Wang

What Risks to Measure?

Traditional P&C

Risk Analysis

Expected Loss

Loss frequency & severity

Correlation between risks

Concentration of exposure

New Horizon

Business Process Risk

Competitive Game

Market cycle

Quality of Information

Reaction time

Incentive misalignment

Multiple Perspectives

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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

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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

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Shaun Wang

Competitive Game of Asset-Liability Management

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

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Shaun Wang

100

150

200

250

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

US Insured CAT Losses (in $billion) and Rate On Line Index (1989=100)

Source: Guy Carpenter & *III Estimate ROL showed big jump after

major CAT losses, and then came down gradually …

$7.5

$2.7$4.7

$22.9

$5.5

$16.9

$8.3 $7.3

$2.6

$10.1$8.3

$4.3

$28.1

$5.8

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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%

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Shaun Wang

Quality of Information

Poor Quality of Information is a major risk for (re)insurers

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”?

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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

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Shaun Wang

Incentive Misalignment

Many “risks” are created by misalignment of incentives

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

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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 proportionally

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

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Shaun Wang

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

Traditional Risk Analysis

Mortality/Morbidity

Lapse

Disintermediation

New Horizon

Asset management

Embedded guarantee (VADB hedging/reserving)

Competitive Game (distribution, expenses)

…

For Life Insurers

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Shaun Wang

Risk Measures for DecidingCapital 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

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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

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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 diversification

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

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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

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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

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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

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Shaun Wang

It Is Coming! -- Fair Value of Liabilities

Actuarial Standards Setters are pushing for fair value of liabilities

Motivated by consistent accounting treatment of assets and liabilities

For actively traded assets, market values are readily available

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

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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 holder:

There seems to be a conflict between “financial theory” and “public interest”

We will learn a lot more today from the speakers!

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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

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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)

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Shaun Wang

Reserve Deficiency for Long-tailed Liabilities

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 Guarantees?

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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

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Shaun Wang

Recent Dramas in Actuarial Reserve Opinions

Mechanical actuarial methods can produce a wide range of reserve estimates

In the past the lowest reserve estimates were often being used

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

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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

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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

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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 perspectives

Please try to be concise and clear in making your points

Have fun!