>>> "Meyers, Glenn G." <GMeyers@iso.com> 07/01/98 11:17am >>>
Izzy:
I must disagree with you and reaffirm my belief that duration plays an
integral part of risk load. If you view risk load as the marginal cost
of capital, as I do, the longer an insurance contract ties up capital,
the greater the dollar risk load you have to put in the premium.
Duration provides a first approximation to this part of the risk load.
It is only an approximation. A more complete answer would take into
account that the larger claims tend to settle later.
One question that I have ducked - do you need capital now to account
for risk in the future?
Actually I presented a fairly complete explanation of all this at two
different Casualty Loss Reserve Seminar - I think they were 93 and 95.
I was fairly hostile to the allocating surplus concept at the time and I
did not discuss it. The current connection might not have been made.
Glenn Meyers
Insurance Services Office, Inc.
Internet: gmeyers@iso.com
Voice:(212) 898-5938
Fax: (212) 898-6060
----------
From: Israel Krakowski [SMTP:IKRA0@allstate.com]
Sent: Wednesday, July 01, 1998 12:58 PM
To: casnet@lists.casact.org
Subject: RE: Allocating Surplus and Risk Loads -Reply
I think some of the discussion here is at cross purposes. If you
will recall
Glenn's first comment suggested that surplus allocation was
interchangeable with calculating a risk load--that is, it is
primarily a pricing
function. Now this may not be its only function, but for that
particular
function it strikes me that a lot of the considerations below
are not
germane, since pricing is done before the policy is issued.
Unfortunately Glenn himself, I believe, had conflated the
issues. Thus
from the risk load/pricing angle I don't see what relevance the
duration is.
It happens to be true that books of (P&C) business with longer
duration
tend to be more risky, but there is no necessary connection
here. It may
seem intuitive that a "longer" policy should have more surplus
associated
with it, but this is only form the "accounting" perspective
where you're
attempting to actually connect surplus with a particular
policy/line or
whatever.
Are there other uses for surplus allocation. Well there's
monitoring profit,
but it seems to me that the correct surplus to allocate here is
what was
originally allocated for pricing purposes. The allocation
described below,
where surplus is released over time, I would call an accounting
use. It
would be helpful e.g. if a regulator wanted the surplus
allocated to
his/her state and such and such a line. On the other hand it
vulnerable to
the "all the surplus is available to pay the losses for each
policy"
argument.
>>> "Blanchard, Ralph S" <ralph.s.blanchard@travelers.com>
07/01/98
07:13am >>>
I agree with David Ruhm's analysis of this situation. The
discussion
to-date seems to have confused two items, the surplus assigned
to a
policy, which is a flow, and the surplus associated with a line
at a point
in time, which is a stock amount.
The amount assigned to a policy should be a function of the risk
associated with writing the policy, and will change over time as
the risk
changes. At first, the risk will include event risk. Examples
of event risk
include:
. Catastrophe risk
. Large loss risk (such as a fire at a major resort
leading to a
large number of suits and injured parties)
. High frequency risk as was seen in 1984 for WC, when
an
expanding economy led to an increased use of inexperienced
workers
and higher WC accident rate.
After the policy has "expired", the event risk will be
essentially over, but
the estimation risk is still there. Therefore the surplus
requirement should
drop but not go away once the losses move from the Unearned
Premium
Reserve to the loss reserve. There is still some "event" type
risk in the
IBNR reserve, as the events have occurred for policy trigger
purposes
but the details are not available for estimation purposes. Once
the claim
is reported, the estimation risk should decrease. Hence there
is more
risk in the IBNR reserve than in the case plus Bulk reserve.
(NOTE: This
line of reasoning can be found in an earlier paper by Bob
Butsic, which
dealt with profitability pricing loads.)
Given the above conceptual framework, surplus supporting a
policy
should start out at its highest at inception, and should
gradually decrease
as risk disapates.
Note that the above framework would NOT necessarily give you
the
same surplus loads by line. A WC policy for which losses take
10 years
to pay out may have the same paid loss duration as a GL policy,
but the
risks could be totally different. The WC policy may have risk
similar to an
annuity, while the GL policy may incorporate the far greater
risks of the
tort system. The statement that surplus should strictly be a
function of
duration breaks down most obviously when life insurance
products
are
considered. The surplus needed to support most life insurance
reserves
is typically much less than the surplus needed to support
casualty
reserves, even if the durations are similar.
After surplus is notionally assigned to a policy, the amounts
assigned to
historic policies can be stacked up to get the total assigned to
the line at
a point in time (i.e., the stock value). The faster the payout
(or duration
of reserve) the smaller the stock value will be in relation to
the initial
amount. This also implies that a start-up may have small
initial capital
requirements inherent in its balance sheet risks, but the
capital
requirements will steadily grow until it reaches a "steady
state" or going
concern level.
One useful concept for capital management is the velocity of
capital. If
the writer of a long tail line can eliminate the risk sooner
after policy
expiration, then that writer can release the supporting capital
sooner,
increasing capital velocity. If this could be done, then the
overall capital
requirements (surplus stock) would be much lower. The faster
the
capital velocity, the more flexible a company can be, and the
slower the
capital velocity, the more locked-in the company will be.
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