Risk Management in Insurance

Transcription

1 University of Cologne Department of Risk Management and Insurance Risk Management in Insurance Value and risk based management with special consideration of Solvency II Salzburg University April / Friday, 21 st / 2017 Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University

2 University of Cologne Department of Risk Management and Insurance Risk Management in Insurance Part II Value Based Management Concept Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at the University of Salzburg

3 University of Cologne Department of Risk Management and Insurance 1. Risk Management and Value of the firm ( ) a. Principles of Business valuation i. Economic Value Added ii. Embedded Value iii. Appraisal Value b. Cash flow modeling c. The Concept of Cost of Capital i. Capital Requirement ii. Capital Allocation: Problem and Techniques iii. Opportunity Cost of Capital Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University

4 University of Cologne Department of Risk Management and Insurance 2. Decision Making in a Value based Management framework ( ) a. Case Study b. Evaluating the Economic Value Added i. Lines of Business in P/C Insurance ii. Reinsurance and Retention Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University

5 References English: Artzner, Ph.; F. Delbaen; J.-M. Eber; D. Heath (1999). "Coherent Measures of Risk". Mathematical Finance 9 (3): Cummins, D. J.; R. D. Philips (2005): Estimating the cost of equity capital for property-liability insurers, in: The Journal of Risk and Insurance, Vol. 72, p Denault, M. (2001): Coherent allocation of risk capital, in: The Journal of Risk, 4. Jg., H. 1, S Grant, J.L. (2003), Foundations of Economic Value Added, John Wiley & Sons. Martin, J.D.; J. W. Petty (2000): Value Based Management The corporate response to the shareholder revolution, Harvard Business School Press. SwissRe, 2001, Profitability of non-life insurance industry: it s back-to-basics time, Sigma, No. 5. 5

6 References German: Albrecht, P.; Koryciorz, S. (2004): Methoden der risikobasierten Kapitalallokation im Versicherungs- und Finanzwesen, In: Zeitschrift für die gesamte Versicherungswissenschaft, 93. Jg., S Ehrlich, K. (2009): Wertorientierte Steuerung von Versicherungsunternehmen mit Solvency II, Lohmar, Köln: Eul. Oletzky, T. (1998): Wertorientierte Steuerung von Versicherungsunternehmen, Karlsruhe: VVW. Schradin, H. R. / M. Zons (2005): Konzepte einer wertorientierten Steuerung von Versicherungsunternehmen, in: Solvency II & Risikomanagement : Umbruch in der Versicherungswirtschaft, hrsg. von Helmut Gründl u. a., Wiesbaden: Gabler, S Tillmann, M. (2005): Risikokapitalbasierte Steuerung in der Schaden- und Unfallversicherung, Frankfurt am Main u.a.: Lang. 6

7 Risk Management and Value of the firm Review Questions or: What you should know and be able to explain. Discuss strengths and weakness of alternative principles of insurance business valuation. Explain the conceptual framework of the value based management approach. Explain the basics of cash flow modeling, risk analysis and capital requirements for insurance companies. Reflect and make connections to the general risk management approach (Chapter 1-3). 7

8 University of Cologne Department of Risk Management and Insurance 1. Risk Management and Value of the firm a. Principles of Business valuation Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University

9 Basic consideration a financial perspective on Insurance Primary Insurance Company Insurance Contracts Enterprise Risk Management operatives Asset Management Premium Payment Capital Requirement Funding of Capital Financial Investments Policyholder Risk selection Strategic Asset-Allocation operative Asset-allocation Investmentpartner Claims Payment Balanced financial structure Cash- Management Recoveries payments of rents Interest, Dividends) Transfer Transformation Investment Premium Claims Payment Reinsurer 9

10 Basic considerations Insurance Company deal with specific risk / return-profiles: Underwriting Risk Investment Risk Consequences. Choose a Shareholders perspective: Investment in the whole Company, (underwriting risk, investment risk, general business risk) Choose an adequate control mechanism for running the business: Represent the overall risk / return-profile of the firm or group, Performance measurement, Value based decision making 10

11 Conceptual Framework for the VBM-Approach Determination of the relevant expected cash flow Risk analysis - management control Traditional Risk Controlling Capital Requirement/Capital Allocation Solvency II Cost Rate of Capital / Risk capital optimization Identify Economic Value Drivers VBM (Corporate Management, Performance-Measurement) 11

12 .. some more basics Value-based Management All management decisions consider primarily the interests of the companies Shareholder / owner. Efficient resource input has to focus financial risk-return ratio aspects. Risk Adjusted Performance Measurement, RAPM Economic capital / Shareholder value / market value of equity capital (EC) the difference between the market value of assets (A) and the market value of liabilities (L) EC A L where the market value of asset / liabilities reflects the present value of their future cash flows! 12

13 .. some more basics Cash flow modeling: EC E DCF t 1 E CF 1 r t t where t = time index (period), t = 1, CF t = Cash Flow* in period t E(..) = Expected Value r = discount rate (risk adjusted, risk free) DCF = Discounted Cash Flow * Cash Flow after investments, interest and taxes, before dividends In the theoretical concept the fundamental management objective is to create / increase / maximize shareholder... and in reality? future perspective (ex ante) multi period approach (sustainability?) How can we measure and control achievements? 13

14 University of Cologne Department of Risk Management and Insurance 1. Risk Management and Value of the firm a. Principles of Business valuation i. Economic Value Added Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University

15 Economic Value Added (EVA) Economic Capital (dynamic, multi-period perspective): EC = E(DCF) (different from profit / loss of the accounting period) Economic Value Added (EVA) Enterprise value (Equity capital) enhancement by period Corporate management indicator Measurement (standard notation): Residual income reduced by cost of dept and equity capital EVA = Return after Tax - (EC * COC) or EVA = EC * (ROE - COC) where EC = Equity Capital ROE = Return on Equity COC = Cost rate of (Equity) Capital (EC * COC) = Cost of Equity Capital 15

16 Economic Value Added (EVA) Measurement (common notation in the insurance literature): E CF!! t RORAC k resp. EVA E CF RAC k 0 t t t t RAC t where RAC = Risk Adjusted Capital RORAC = (expected) Return on Risk Adjusted Capital t = time index (period), CF t = Cash Flow* in period t E(..) = Expected Value k = discount rate, risk free DCF = Discounted Cash Flow * Cash Flow after investments, interest and taxes, before dividends 16

17 EVA in a non-life Insurance company Traditional management indicators for profit / loss: Technical / Actuarial: Combined Ratio Investments: Return on invested capital Extension in VBM-Context: Risk Recognition: Economic Capital (EC) requirements reflect Solvency ambition (internal view), Risk structure of balance sheet (external view), e.g.: Investment Risk, Reinsurer Credit Risk, Net Premium Risk, Loss Reserve Risk, Life Liability Risk, Operating Risk Cost Rate of Capital derived from Expected return on own investments, considering the relevant risk exposure Alternative approaches e.g. CAPM or Arbitrage Pricing Theory Investment Income (provisions and equity) 17

18 EVA in a non-life Insurance company Profit value driver EVA Profit (expected) Risk (Cost of Capital) Premium Growth Combined Ratio Investment Income Cost Rate of Capital New Policies Loss Ratio Cost Ratio Investment Performance RAC Lapse Loss Fequency Labor Costs Asset Allocation Premium Growth on average Amount of Loss on average Administration Costs CashFlow Management Commissions 18

19 EVA Strengths and Weakness STRENGTH of the EVA-Concept: is a risk adjusted corporate performance indicator, combines underwriting and investment risk with technical an non-technical outcomes in one consistently amount, reflects adjusted risk accumulation, allows to asses the profitability of scheduled strategies. 19

20 EVA Strengths and Weakness Weakness of the EVA-Concept: Any level of model complexity leads to a permanent trade-off between: - Accuracy of the quantitative model to reflect the real behavior and - the comprehensibility, implementation, communication of information. Group problems: Implementation over all organizational units Holding: often responsible for the investment management strategies Functional units: mainly focusing underwriting risk Difficult and even not free of arbitrariness by consideration special risk components like correlation, long term interest rates or extreme value statistics (model risk). Consideration by period inadequate, observation of prospective periods necessary 20

21 University of Cologne Department of Risk Management and Insurance 1. Risk Management and Value of the firm a. Principles of Business valuation i. Economic Value Added ii. iii. Embedded Value Appraisal Value Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University

22 Embedded Value Equity from balance sheet + Corrections for hidden reserves and intangible assets = Book equity = Net Asset Value (NAV) ( Market value of shareholder capital and key-date-based revenue recognition, syn.: Economic Capital) + Economic profit from existing / in force business = Embedded Value ( Market value of shareholder capital and NPV of expected future profits) 22

23 Embedded Value in Life Insurance The specific nature of life insurance business: Long duration of contracts, Cash Flow Characteristics - Net cash outflow at the starting time of the contract (because of high acquisition and administrative expenses) - Net cash inflows during the following years - Net cash outflow in the case the insured risk occurs. Economic Value Added represents just one (accounting) period but not the whole duration of the contract Embedded Value explicit multi period point of view. represents the over all / remaining periods of existing life contracts, shows the economic value added of a life contract (internal perspective), 23

24 Appraisal Value Equity from balance sheet + Corrections for hidden reserves and intangible assets + Economic profit from existing/in-force business + Present value of future/new business (starting next year) = Book equity = Net Asset Value (NAV) ( Market value of shareholder capital and key-date-based revenue recognition) = Embedded Value ( Market value of shareholder capital and NPV of expected future profits) = Appraisal Value (Market Value of shareholder capital) 24

25 Appraisal Value The future value of a life insurer can not be identified with the embedded value exclusively. Present value of future business is necessary Projection of future cash flows Appraisal Value Components: - Net Excess Assets - Value of Inforce Business - Value of future New Business 25

26 University of Cologne Department of Risk Management and Insurance 1. Risk Management and Value of the firm a. Principles of Business valuation i. Economic Value Added ii. Embedded Value iii. Appraisal Value b. Cash flow modeling Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University

27 Conceptual Framework for the VBM-Approach Determination of the relevant expected cash flow Risk analysis - management control Traditional Risk Controlling Capital Requirement/Capital Allocation Solvency II Cost Rate of Capital / Risk capital optimization Identify Economic Value Drivers VBM (Corporate Management, Performance-Measurement) 27

28 (Free) Cash Flow modeling (Free) Cash Flow (CF). cash flow available for distribution among all the shareholders of a company. Challenge: - Prospectively valuation RORAC - Stochastic and long run of cash flows t ECF t RAC t! k Cash flow (CF): - Underwriting business: Premium payment (π), Claims payment (C) - Investments: Capital investment performance (I) - Operating expenses (OE) ~ ~ ~ CF = -C + I -OE 28

29 (Free) Cash Flow modeling Conversion on valuation of the income statement to cash flows: operating income + depreciation and amortization = earnings before interests, taxes, depreciation and amortization - cash tax payments = after-tax cash flows from operations - investment (increase) in net operating working capital, which is equal to current assets less non-interest-bearing current liabilities. - investment in fixed assets (capital expenditures) and other long-term assets = (Free) Cash Flow 29

30 University of Cologne Department of Risk Management and Insurance 1. Risk Management and Value of the firm a. Principles of Business valuation i. Economic Value Added ii. Embedded Value iii. Appraisal Value b. Cash flow modeling c. The Concept of Cost of Capital i. Capital Requirement ii. Capital Allocation: Problem and Techniques Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University

31 Conceptual Framework for the VBM-Approach Determination of the relevant expected cash flow Risk analysis - management control Traditional Risk Controlling Capital Requirement/Capital Allocation Solvency II Cost Rate of Capital / Risk capital optimization Identify Economic Value Drivers VBM (Corporate Management, Performance-Measurement) 31

32 Conceptual Framework for the VBM-Approach Determination of the relevant expected cash flow Risk analysis - management control Traditional Risk Controlling Capital Requirement/Capital Allocation Solvency II Cost Rate of Capital / Risk capital optimization Identify Economic Value Drivers VBM (Corporate Management, Performance-Measurement) 32

33 Capital requirement Two different points of view: Equity base vs. risk adjusted capital Economic Capital (EC) = real available capital (market value) Risk adjusted capital (RAC) = capital necessary for internal calculation EC < RAC undercapitalization EC > RAC overcapitalization Minimum standards in particular defined by the federal supervising authority: C max {RAC,SCR} where SCR = solvency capital requirement basically similar e.g. rating models, internal models 33

34 Capital requirement Motivation limit the risk of company s collapse: Policyholder interest Shareholder interest Please mention potential conflicts of interest! Economic (risk bearing) Capital functions: Guarantee function (ex ante) Finance of investments Loss compensation (ex post) Economic (risk bearing) Capital is the bottleneck of the production of insurance coverage Defining / Restricting the risk taking capacity of an insurer 34

35 What exactly is the problem with capital allocation? Counting back diversification as a condition for to fulfill central management tasks: Creating (maximizing) shareholder value, Determination of the risk based capital (companywide), Efficient Allocation of the overall RAC to each line of business considering Risk / Return and Diversification effects, Capital allocation is a dynamic process. to create a consistent performance measurement: Risk based performance measurement (according to the allocated capital), Division managers are not bearing responsibility for companywide diversification effects, so: Allocation based performance measures have limited benefits? 35

36 What exactly is the problem with capital allocation? Measuring the line of business performance, e.g. with: where: RORAC = return on risk adjusted capital CF = cash flows RAC = risk adjusted capital k = cost rate of capital i = line of business (lob) Main problem: RORAC i E CF i RAC i! k N i 1 RAC i RAC How shall we assign the synergy advantages to the lines of business? 36

37 Requirements for a reasonable allocation method Discussed criteria for allocation techniques: see Albrecht, 1998, S Consistency with the risk based capital approach Quality of the risk measure Consideration of stochastic dependencies Axioms of coherent capital allocation: see Denault (2001, S. 5 ff.) Complete allocation. No Undercut: an undercut occurs when a portfolio s allocation is higher than the amount of risk capital it would face as an entity separate from the firm. Symmetry: A portfolio s allocation depends only on its contribution to risk within the firm, Risk less allocation A business which generates a deterministic loss c, will exactly that amount get allocated as risk capital. 37

38 Allocation Techniques Fundamental remarks: Capital allocation based on risk measures Allocate the capital via allocation factors (x) * RAC x RAC x (CF) i i i n n * i i i i 1 i 1 with x 1 RAC RAC and 0 x 1 and as risk measure (1) General determination of the allocation factors: x i CF CF i 38

39 Allocation Techniques more introduction: (2) Problem for non linear risk measures (e.g. Value at Risk, Tail Value at Risk or Expected Policyholder Deficit) n n n i i i 1 i 1 i 1 CF CF i CF CF x 1 (3) proposed solution: x i n j 1 CF i CF j 39

40 Probability theory based techniques Variance approach: x n m ik ij Var k1 j1 i n n m m n m ik ij ij i 1 k 1 j 1 k 1 i 1 j 1 Standard deviation approach: x STD i n ik k 1 j 1 ij 1/ 2 1/ 2 1/ 2 n n m m m n ik ij jk ij i 1 k 1 j 1 j 1 k 1 i 1 m Value-at-Risk approach: x i n j 1 VaR CF i VaR CF j 40

41 University of Cologne Department of Risk Management and Insurance 1. Risk Management and Value of the firm ( ) a. Principles of Business valuation i. Economic Value Added ii. Embedded Value iii. Appraisal Value b. Cash flow modeling c. The Concept of Cost of Capital i. Capital Requirement ii. Capital Allocation: Problem and Techniques iii. Opportunity Cost of Capital Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University

42 Conceptual Framework for the VBM-Approach Determination of the relevant expected cash flow Risk analysis - management control Traditional Risk Controlling Capital Requirement/Capital Allocation Solvency II Cost Rate of Capital / Risk capital optimization Identify Economic Value Drivers VBM (Corporate Management, Performance-Measurement) 42

43 What is the cost of capital? (Equity) Capital is the main bottleneck in producing insurance coverage. Investors (mainly shareholders) demand an appropriate return on the invested capital related to the riskiness of the investment. One can think about cost of capital using the idea of opportunity costs of missing an alternative investment into an asset with similar risk. A useful definition is: The cost of capital is the minimum rate of return necessary to attract capital to an investment. This is the expected rate of return prevailing in capital markets on investments of corresponding risks. (Kolbe et al. 1984) 43

44 Why does the cost of capital matter? An action creates value and is therefore profitable only when the expected future cash flow generated by this action exceeds the induced cost of capital. Thus the value of an insurance company / line of business / other reference object is highly sensitive to cost of capital estimates +40,2 Change in Value (%) - 1% point +15,9 Original cost of capital Original CAPM cost of capital Allianz: 10,1 % Zurich: 8,0 % -11,9 + 1% point Allianz -23,2 Zurich Source: McKinsey analysis 44

45 Group level vs. Line of Business Cost of Capital Group level cost of capital Idea: Investors supply capital to the enterprise as a whole and not to the single lines of business. Problem: the overall (average) cost rate of capital is not adequate to each line of business with its individual risk exposure Thus one can not see whether a line of business earns the return rate claimed by the investors and therefore creates value added, or not. 45

46 Group level vs. Line of Business Cost of Capital Line of Business Cost of Capital Idea: Anticipation of an internal capital market where the top management of the insurance group participates in the earnings and risks of the lines of business as an investor. Top Management requires a minimum return on the capital allocated to the lines of business dependent on the inherent risk of the line of business. The disaggregated cost of capital approach is appropriate to make value based decisions concerning a single lines of business, a single policyholder or even a single insurance contract. General Problem: Double consideration of risk (1 st in the risk adjusted allocated capital and 2 nd in the cost of capital). 46

47 Approaches to measure cost of capital Cost Rate of Capital Single investor Multiple investors Dependent on preferences Classical concepts of cost of capital CAPM APT 47

48 Classical concepts of cost of capital Dividends to price approach Cost of capital is calculated from the ration of the current dividends (D) to the current stock price (P 0 ) k D P 0 This approach ignores the future growth of dividends Dividends to price approach with assumption of constant growth rates of future dividends D k g P 0 48

49 Classical concepts of cost of capital Profit to price approach Cost of capital is calculated from the ration of the current profit (G) to the current stock price (P 0 ) k G P This approach ignores the future growth of profits 0 Profit to price approach with adjusted capital value Potential to growth included through the correction of the current value of the share price to the capital value of future growth opportunities k P 0 G KW 49

50 Classical concepts of cost of capital Criticism: Very rough and inaccurate estimation of the capital costs, Extrapolation of current dividends / profits by means of simple growth assumptions holds considerable uncertainties, Observed dividends / profits / share prices might be biased due to short term effects. 50

51 Capital Asset Pricing Model (CAPM) The CAPM explains the price and rate of return building process at the capital market based on the expectations that the investors have about the future probability distribution of the rates of return. k E(R ) r (E(R ) r ) i i f M f R M r risk free rate of return f M R i Cov(R i,r M) Var(R ) market rate of return corporate rate of return 51

52 Capital Asset Pricing Model (CAPM) Criticism: Lack of justification for using an equilibrium model, Unrealistic assumptions - Sufficient diversification of all investors (market porfolio) - Existence of a fully riskless commercial paper - Homogeneous expectations about future rates of return - Equilibrium model, absence of empirical validity, Risk of insolvency is not taken into account (but it is included in estimating the capital requirement), little validity of the beta coefficient in actuarial practice, Direct predictability of the cost rate of capital only possible for listed companies. 52

53 Arbitrage Pricing Theory (APT) The APT is a multi-factor-model. It explains the return rate of a commercial paper subject to the sensitivity towards various factors. J i i f ij j f j 1 k E(R ) R b (E(R ) R ) R b j f ij E(R ) Return rate of a riskless commercial paper Sensitivity of commercial paper i towards factor j Expected rate of return of a portfolio with sensitivity of 1 towards factor j and sensitivity of 0 towards all other factors 53

54 Arbitrage Pricing Theory (APT) Criticism: No information about the relevant factors for the price- and return rate building process on the capital market, Unrealistic assumptions - No arbitrage, - Existence of a fully riskless commercial paper, - etc. absence of empirical validity, Risk of insolvency is not taken into account (but it is included in estimating the capital requirement) 54

55 University of Cologne Department of Risk Management and Insurance 2. Decision Making in a Value based Management framework ( ) a. Case Study b. Evaluating the Economic Value Added i. Lines of Business in P/C Insurance ii. Reinsurance and Retention Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University

56 University of Cologne Department of Risk Management and Insurance 2. Decision Making in a Value based Management framework ( ) a. Case Study Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University

57 Case Study: VBM in an P/C insurance company We consider a P/C Insurance Company and assume the following basic data: 10 lines of business each with 50 million earned gross premiums, Estimations concerning the contribution of the claims: - Basis claims are lognormal distributed, - Sizes of major claims are pareto distributed, - Numbers of major claims are poisson distributed, Reinsurance strategy: - primary non proportional (mainly excess of loss reinsurance), - structure is following the empirically observed conditions, Asset management / allocation: - Investment volume: approx. 600 million, - bonds (50%); stocks (35%); money market (10%); real estate (5%). 57

58 Case Study: VBM in an P/C insurance company Restrictions of the model: - Only premium and asset risk are taken into account, - Non consideration of reserve risk and credit risk, - Non consideration of correlations between assets and insurance liabilities, - Correlations in claims modeling for the different lines of business (especially in fire, windstorm, homeowner insurance) are taken into account. Monte Carlo Simulation with 100,000 simulation runs Schradin, H. R. / I. Telschow / M. Zons: Kapitalallokation, in: Ergebnis- und Risikosteuerung im Versicherungskonzern: Lösungsansätze für eine wertorientierte Unternehmensführung, hrsg. von H. Maser; H. R. Schradin, Wiesbaden, 2006, S

59 Case Study: VBM in an P/C insurance company some numbers EP g E(L g ) STD(L g ) E(LR g ) V(L g ) LRE n Million Mio. Mio. % % Mio. General Liability GL 50,0 43,9 1,8 87,7 4,2 125,0 Personal Liability PL 50,0 31,6 2,0 63,2 6,5 33,3 Accident Insurance AI 50,0 36,7 3,7 73,5 10,0 25,0 Automobile Liability AML 50,0 50,8 9,4 101,6 18,6 85,7 Automobile Insurance AM 50,0 37,8 3,1 75,6 8,1 10,0 Commercial Property CP 50,0 30,7 2,3 61,5 7,5 12,5 Windstorm Insurance WS 50,0 25,3 22,0 50,6 87,0 75,0 Household Insurance HH 50,0 28,3 1,5 56,6 5,2 8,3 Homeowner Insurance HO 50,0 38,5 7,7 76,9 20,1 14,1 Fire Insurance FI 50,0 36,9 10,0 73,8 27,0 9,4 Insurance company (total) ICT 500,0 360,5 34,5 72,1 9,6 398,3 Investment volume million Asset category Anteil equity capital 120 money market 10% Equilization fund 80 Bonds with fix or variable return 50% Loss Reserves net LRE n 398,3 Stocks 35% Sum 598,3 Real estate 5% 59

60 Case Study: VBM in an P/C insurance company Capital Requirement empirical results LoB STD(CF g ) STD(CF n ) VaR g VaR n ES g ES n 1%-quantile 1%-quantile 1%-quantile 1%-quantile million million million million million million GL 1,8 1,6 19,6 19,5 20,6 20,1 PL 2,0 2,0 3,7 4,5 4,6 5,3 AI 3,7 3,5 14,2 14,3 16,2 15,8 AML 9,4 2,0 22,5 13,5 49,2 14,2 AM 3,1 3,1 10,8 11,3 12,3 12,9 CP 2,3 2,3 1,5 2,6 2,4 3,6 WS 22,0 4,6 98,1 3,2 115,8 22,8 HH 1,5 1,4-0,1 0,9 0,6 1,4 HO 7,7 2,4 37,0 6,8 44,0 12,7 FI 10,0 3,2 40,5 15,9 46,3 17,3 Subtotal I 63,5 26,2 247,6 92,4 312,0 126,1 ICT I 34,5 10,5 170,9 51,4 209,4 77,8 DE I 29,0 15,6 76,7 41,0 102,6 48,4 CI 62,6 62,6 79,3 79,3 90,4 90,4 Subtotal II 126,1 88,7 326,9 171,7 402,4 216,5 ICT II 73,4 63,4 173,7 104,9 217,4 120,5 DE II 52,6 25,3 153,2 66,8 185,0 96,0 60

61 Case Study: VBM in an P/C insurance company Capital allocation empirical results Gross SDPC ESPC VaRPC Net SDPC ESPC VaRPC LoB million million million LoB million million million RAC 173,7 173,7 173,7 RAC 104,9 104,9 104,9 GL 2,5 8,9 10,4 CGL 1,9 9,7 11,9 PL 2,8 2,0 2,0 CPL 2,4 2,6 2,8 AI 5,1 7,0 7,6 AI 4,2 7,6 8,7 AML 13,0 21,2 11,9 AML 2,4 6,9 8,2 AM 4,2 5,3 5,7 AM 3,6 6,3 6,9 CP 3,2 1,1 0,8 CP 2,7 1,7 1,6 WS 30,3 50,0 52,1 WS 5,4 11,0 1,9 HH 2,0 0,2 0,0 HC 1,7 0,7 0,5 HO 10,7 19,0 19,6 HO 2,8 6,2 4,2 FI 13,7 20,0 21,5 FI 3,8 8,4 9,7 CI 86,2 39,0 42,1 CI 73,9 43,8 48,4 sum 173,7 173,7 173,7 sum 104,9 104,9 104,9 61

62 Case Study: VBM in an P/C insurance company Expected value proportion empirical results E(Profit) without CoC Cost of Capital (CoC) E(Profit) with CoC Gross LoB E(G b ) k=0,15 E(G b,k ) RAC SDPC ESPC VaRPC SDPC ESPC VaRPC GL 6,1 0,4 1,3 1,6 5,8 4,8 4,6 PL 18,4 0,4 0,3 0,3 18,0 18,1 18,1 AI 13,3 0,8 1,0 1,1 12,5 12,2 12,1 AML -0,8 1,9 3,2 1,8-2,8-4,0-2,6 AM 12,2 0,6 0,8 0,9 11,6 11,4 11,3 CP 19,3 0,5 0,2 0,1 18,8 19,1 19,1 WS 24,7 4,5 7,5 7,8 20,1 17,2 16,9 HH 21,7 0,3 0,0 0,0 21,4 21,7 21,7 HO 11,5 1,6 2,8 2,9 9,9 8,7 8,6 FI 13,1 2,1 3,0 3,2 11,0 10,1 9,9 CI 12,9 5,9 6,3 sum 139,5 26,1 26,1 26,1 113,4 113,4 113,4 62

63 Case Study: VBM in an P/C insurance company Expected value proportion empirical results: ranking Ordered by expected value proportion without CoC with CoC 0 SDPC ESPC VaRPC HH CP PL WS AI AM FI HO GL AML 63

64 University of Cologne Department of Risk Management and Insurance 2. Decision Making in a Value based Management framework ( ) a. Case Study b. Evaluating the Economic Value Added i. Lines of Business in P/C Insurance Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University

65 Conceptual Framework for the VBM-Approach Determination of the relevant expected cash flow Risk analysis - management control Traditional Risk Controlling Capital Demand / Capital Allocation Solvency II Cost Rate of Capital / Risk capital optimization Identify Economic Value Drivers VBM (Corporate Management, Performance-Measurement) 65

66 Determination of the expected value proportion Value based key data should be forward-looking and cash flow based. The key data are derived from the discounted cash flow approach. DCF t 1 E(CF ) t t (1 k ) Target Variable: Value of the enterprise. In the special case of insurance companies one should use the equity-approach. Therefore the relevant task is to increase/maximize the market value of equity. 66

67 Determination of the expected value proportion Measurement: single-period value enhancement measures Return on risk adjusted capital (RORAC) RORAC t E(CF ) t RAC t k Economic value added (EVA) EVA E(CF ) RAC k 0 t t t The value of the company will be increased (value added), if the expected periodic Cash Flow exceeds the cost of capital. 67

68 VBM in an P/C insurance company Calculating EVA risk premium, ,5 2 0,1 Loss, L Investment, loss reserve Investment, capital (50% of lossreserve, = 0,5) Desinvestment, loss reserve Desinvestment, capital investment return, lossreserve (6%) investment return, capital (6%) Cash Flow. CF DCF, r*=10% 55,9 internal rate of return 18% without commissions, administration costs and taxes 68

69 VBM in an P/C insurance company Calculating EVA risk premium, ,5 Loss, L Investment, loss reserve Investment, capital (50% of lossreserve, = 0,5) Desinvestment, loss reserve Desinvestment, capital investment return, lossreserve (6%) investment return, capital (6%) Cash Flow. CF DCF, r*=10% 55,9 internal rate of return 18% without commissions, administration costs and taxes 69

70 VBM in an P/C insurance company Calculating EVA risk premium, ,5 2 0,1 Loss, L Investment, loss reserve Investment, capital (50% of lossreserve, = 0,5) Desinvestment, loss reserve Desinvestment, capital investment return, lossreserve (6%) investment return, capital (6%) Cash Flow. CF DCF, r*=10% 55,9 internal rate of return 18% without commissions, administration costs and taxes 70

71 VBM in an P/C insurance company Calculating EVA risk premium, ,5 2 0,1 Loss, L Investment, loss reserve Investment, capital (50% of lossreserve, = 0,5) Desinvestment, loss reserve Desinvestment, capital investment return, lossreserve (6%) investment return, capital (6%) Cash Flow. CF DCF, r*=10% 55,9 internal rate of return 18% without commissions, administration costs and taxes 71

72 VBM in an P/C insurance company Calculating EVA i i0 it EBW CF E CF E CF 1 k T t 1 Pr emium of i T line of bu sin ess, th i th c i administration cos t of i line of bu sin ess, th Li Loss of i line of business, it Lossreserve factor, mit 0 1 T Number of Regulationperiods Planinghorizon, th Solvency coefficient of i line of bu i siness, r average rate of asset return, k cos t rate of capital. t it 1 E CF E S 1 1 r 1 k i0 i i it t 1 with E CF bk E S 1 i0 i i i i t 72

73 University of Cologne Department of Risk Management and Insurance 2. Decision Making in a Value based Management framework ( ) a. Case Study b. Evaluating the Economic Value Added i. Lines of Business in P/C Insurance ii. Reinsurance and Retention Prof. Dr. Heinrich R. Schradin Chair of General Business Administration, Risk Management and Insurance, University of Cologne Visiting Professor at Salzburg University

74 Reinsurance decision making (perspective: ceding company) CF < 0 CF > 0 -C 0 E[CF] CF 74

75 Reinsurance decision making (perspective: ceding company) CF < 0 CF > 0 -C = -C n -C n 0 E[CF] E[CF n ] CF 75

76 Reinsurance decision making Evaluation of risk-instruments (a direct insurer s perspective) Calculation I: Ignoring the benefits of risk management CF n = CF g - CF RV fair reinsurance premium: E[CF g ] > E[CF n ] (expected) value of the firm decreases! Reinsurance reduces the expected Cash Flow (syn.: profit) of the project. The inherent risk reduction is not evaluated or even identified! Solution: Regarding the Change in Cost of Capital! 76

77 Reinsurance decision making Evaluation of risk-instruments (a direct insurer s perspective) Calculation II: Regarding cost of capital CF g,c = CF g - CF g C CF n,c = CF n - CF n C Cession is beneficial (the expected value of the firm increases), if: E[CF n,c ] > E[CF g,c ], thus if CF g C - CF n C Decrease in cost of capital through cession > CF RV Cost of cession 77