Risk and Return - Part 1

Introduction to VaR and RAROC

• Glenn Meyers - Insurance Services Office
• Tim Freestone/Wei-Keung Tang
– Seabury Insurance Capital LLC
• Peter Nakada - eRisk, Inc.
 Risk and Return - Part 1
Introduction to VaR and RAROC
• The purpose of Part 1 is to provide an
overview of the issues involved in
determining the cost of capital for an
insurer.
• We don’t all agree on how to deal with
these issues.
• Go to Part 2 to see some different
points of view on this issue.
 Determine Capital Needs
for an Insurance Company
• The insurer's risk, as measured by its
statistical distribution of outcomes,
provides a meaningful yardstick that can
be used to set capital needs.
• A statistical measure of capital needs
can be used to evaluate insurer
operating strategies.
Volatility Determines Capital Needs
Low Volatility
Chart 3.1
Size of Loss

Random Loss
Needed Assets
Expected Loss
Volatility Determines Capital Needs
High Volatility
Chart 3.1
Size of Loss

Random Loss
Needed Assets
Expected Loss
 Define Risk
• A better question - How much money do
you need to support an insurance
operation?
• Look at total assets.
• Some of the assets can come from
unearned premium reserves and loss
reserves, the rest must come from
insurer capital.
 Coherent Measures of Risk
• Axiomatic Approach
• Use to determine insurer assets
• X is random variable for insurer loss
r(X) = Total Assets
Capital = r(X) – Reserves(X)
 Coherent Measures of Risk
• Subadditivity – For all random losses X and Y,
r(X+Y)  r(X)+r(Y)
• Monotonicity – If X  Y for each scenario, then
r(X)  r(Y)
• Positive Homogeneity – For all l  0 and random
losses X
r(lX) = lr(X)
• Translation Invariance – For all random losses X
and constants a
r(X+a) = r(X) + a
 Examples of Coherent
Measures of Risk
• Simplest – Maximum loss
r(X) = Max(X)

• Next simplest - Tail Value at Risk

r(X) = Average of top (1-a)% of losses
 Examples of Risk that are
Not Coherent
• Standard Deviation
– Violates monotonicity
– Possible for E[X] + T×Std[X] > Max(X)
• Value at Risk/Probability of Ruin
– Not subadditive
– Large X above threshold
– Large Y above threshold
– X+Y not above threshold
 Representation Theorems
• Artzner, Delbaen, Eber and Heath
r  X   sup EP  X  P 
Maximum of a bunch of generalized scenarios

• Wang, Young and Panjer


r  X    g 1  F  x   dx
0
Expected value of X with probabilities distorted by g,
where g(0)=0, g(1)=1 and g is concave down.
 Correlation
Multiple Line Parameter Uncertainty

• Select b from a distribution with E[b]

= 1 and Var[b] = b.
• For each line h, multiply each loss by
b.
• Generates correlation between lines.
 Multiple Line Parameter Uncertainty

A simple, but nontrivial example

1  1  3b ,  2  1, 3  1  3b

Pr   1  Pr   3   1/ 6 and Pr   2   2 / 3

E[b] = 1 and Var[b] = b

 Correlation and Capital
b = 0.00
Chart 3.4
Correlated Losses
7,000
Sum of Random Losses

6,000

5,000

4,000

3,000

2,000

1,000

0
1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0

Random Multiplier
 Correlation and Capital
b = 0.03
Chart 3.4
Correlated Losses
7,000
Sum of Random Losses

6,000

5,000

4,000

3,000

2,000

1,000

0
0.7 1.3 1.3 1.0 1.0 0.7 1.0 0.7 1.3 1.3 0.7 1.3 1.3 1.0 0.7 0.7 1.0 1.3 0.7 1.0 1.3 1.0 0.7 0.7 1.0

Random Multiplier
 Positive Correlation Means
More Capital
• A good insurer strategy will try to reduce
correlation between its insureds.
– Unless the price is right
• Example – Avoid geographic
concentration in catastrophe-prone
areas.
Long-Tailed Lines of Insurance
• Uncertainty in loss reserve must be
supported by capital.
• Release capital over time as uncertainty
is reduced.
 Reinsurance
• Reduces capital needs
• Reduces the cost of capital
• Adds reinsurance transaction costs
• Insurer strategy - Minimize the
combined capital and reinsurance
transaction costs.
 Allocating Capital
• Actually – Allocate the cost of capital
• In total, the cost of capital must come
from the profit provisions of individual
insurance policies.
• Allocate capital implicitly, or explicitly.
• See session C-3.
Measure Risk/Determine Capital
• Build insurer’s aggregate loss
distribution.
– Claim count distribution
– Claim severity distribution
– Dependencies/Correlation
– Catastrophes
– Reinsurance
• Hard part is to get the information.
• Should be fast as to evaluate various
line/reinsurance strategies.
Measure Risk/Determine Capital
• For various line/reinsurance strategies
– Calculate your favorite measure of
risk/needed assets/capital.
– Allocate cost of capital to business
segments.
– Compare resulting costs with market driven
premiums.
• Select the most desirable strategy
Measure Risk/Determine Capital
• Links to a comprehensive example
• “The Cost of Financing Insurance”
– CAS Ratemaking Seminar
http://www.casact.org/coneduc/ratesem/2002/handouts/meyers1.ppt
– Papers
http://www.casact.org/pubs/forum/01spforum/meyers/index.htm