Risk and Return: Underwriting, Investment and Leverage Probability of Surplus Drawdown and Pricing for Underwriting and Investment Risk

The basic components of the risk/return model applicable to insurance consist of underwriting return, investment return and leverage. A pricing approach is presented to deal with underwriting and investment risk, guided by basic risk/return principles, which addresses the policyholder and shareholder perspectives in a consistent manner. A methodology to determine leverage is also presented, but as a distinct and separate element, enabling the pricing approach to be applied either with or without allocation of surplus to lines of business. Since the leverage is also developed within a total risk/return framework, the approach provides a means to integrate what are often disjointed rate and solvency regulatory activities. Risk is controlled by a focus on the likelihood that total return falls short of the target “fair” return by an amount which results in a specified drawdown of surplus. Thus rate adequacy and solvency are dealt with simultaneously. A shift away from probability of ruin and expected policyholder deficit approaches to solvency and ratings is proposed and explained. An “Operating Rate of Return” is defined and suggested as the appropriate rate of return measure that should be used for measuring the charge for risk transfer from the policyholder to the company, rather than other measures such as profit margin, return on premium, etc.