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Research Double-Header

Don Mango, FCAS, MAAACAS Vice President of ResearchDirector of Research and Development, GE ERC

Midwest Actuarial ForumSeptember 24, 2003

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Agenda

1. CAS Research Revision: official CAS business as the VP of Research and Development

2. Capital Consumption: latest prize-winning paper

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CAS Research Revision

Don MangoCAS VP Research & Development

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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

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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

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Why Call Papers? Bottom-up, fast-track research

source. Stimulate communication,

discussion and sharing. Good in concept, in practice is

another story.

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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Not peer reviewed.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.

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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

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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 peer-

reviewed 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

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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

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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

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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

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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

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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

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Working Parties Four WPs kicked off at 2003 RCM

Seminar Reserve Variability (led by Roger

Hayne) kicked off at 2003 CLRS More to come

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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

Considering some radical surgery Maybe we join the NAAJ

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Capital Consumption

Don MangoDirector of Research and DevelopmentGE ERC

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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

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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 mirror-image in time

For these decision evaluation processes, capital allocation is sufficient but not necessary

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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

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Actually

This IS capital allocation for insurance, done right

But I needed new terminology to shake loose the old thought processes

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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.

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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.

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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

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Payoff DiagramsBet #1

-20

-10

0

10

20

30

40

50

60

Now Later

Bet #2

-60

-50

-40

-30

-20

-10

0

10

20

Now Later

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Bet #1Spend 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

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Bet #2Receive 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

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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

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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 = ???

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Allocation vs Consumption

Two different but equally valid frameworks for Treating capital Evaluating insurance business

segments Developing indicated prices for

reinsurance Nearly orthogonal

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Allocation vs Consumption Three questions:1. What do you do with the total

capital?2. How do you evaluate business

segments?3. What does it mean to be in a

portfolio?

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Allocation vs ConsumptionQuestion 1: What happens to the total capital?

Allocation Consumption Divided up among the

segments. Either by explicit

allocation, or assignment of the marginal change in the total capital requirement from adding the segment to the remaining portfolio

Left intact Each segment has the right

to “call” upon the total capital to pay its operating deficits or shortfalls

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Allocation vs ConsumptionQuestion 2: How are the segments evaluated?

Allocation Consumption Give the allocations to

each segment Evaluate each segment’s

return on their allocated capital

Must clear their hurdle rate

Give each segment “access rights” to the entire capital

Evaluate each segment’s potential calls (both likelihood and magnitude) on the total capital

Must pay for the likelihood and magnitude of their potential calls

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Allocation vs ConsumptionQuestion 3: What does being in a portfolio mean?

Allocation Consumption Being standalone with

less capital But still having access to

all the capital if necessary, although it is unclear how this is reflected

Being standalone with potential access to all the capital

But all other segments have similar access rights

The difference between having your own

kiddie pool and joining a swim club This is THE CRITICAL SLIDE!

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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

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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

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Options Beware “Options” does not imply Black-

Scholes formula For one thing, we cannot hedge

our exposure We must price it from first

principles modeled payoff distribution and internal risk charges

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Details of the Framework Scenario analysis Default-free discounting Scenario-level capital consumption Evaluation of capital consumption

using a “quasi~utility” approach

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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

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Chart 1: Capital Consumption Profile Over TimeShort versus Long Tail with 120% Loss Ratio

$-

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

$18,000

$20,000

0 1 2 3 4 5 6 7 8 9 10

Short TailLong Tail

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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.

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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.

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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

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THANK YOU!