DFA Implementation Issues

1. DFA Implementation Issues CAS Special Interest Seminar onDynamic Financial Analysis June 6- 8, 2001

2. Speakers • Mary Wills, ACAS, MAAA USAA • Gerald Kirschner, FCAS, MAAA Classic Solutions Risk Management, Inc. • Elizabeth Wiesner, FCAS, MAAA Accident Fund Company

3. Large Company Perspective Mary Wills

4. DFA Implementation Issues Agenda • Selling development of P&C DFA model internally • Issues confronted during model development • Build model from scratch in-house, partner with consultant to build new model, or purchase existing model? • Vendor selection process • Model design and customization/enhancement • Enterprise ALM using DFA • Other issues that could arise when working with vendor • How the P&C DFA model has been used

5. Selling P&C DFA Internally Overview of USAA • Financial services company •  Primary Product Lines of Business (LOBs) • P&C (personal) • Life (individual) • Banking • Investment management

6. Selling P&C DFA Internally • Corporate Asset Liability Management Committee • • Enterprise ALM committee made up of key ALM experts from each LOB • High visibility in enterprise • Tasked with identifying, measuring and recommending actions appropriate to the management of financial risks • Monitors universe of 8 financial risks at enterprise & LOB level • Capital market volatility Interest rates • Concentration Credit • Liquidity Catastrophes • Pricing/Underwriting Reserving

7. Selling P&C DFA Internally Universe of Risks Corporate Asset Liability Management Committee Mutual Funds/ Brokerage P&C Life Bank Pension EBA Interest Rate and Stock Market Risk Concentration and Credit Risk Liquidity Risk Pricing/Underwriting Risk Reserving Risk Catastrophe Risk

8. Selling P&C DFA Internally • Approach for Obtaining Approval to Implement • Developed executive tutorial to gain buy-in on P&C DFA up front • Outlines expected uses for DFA Capital management Asset allocation Liquidity management Rating agency support Pricing & reserving studies Reinsurance studies Support enterprise-wide DFA • Emphasis on how DFA output would be summarized into formats useful for decision making and strategy/policy development • Includes both the capabilities of DFA as well as its limitations • P&C DFA model seen as a natural next step to adding sophistication and integration to corporate ALM process

9. Issues Confronted During Model Development Build Model from Scratch In-House, Partner with Consultant to Build New Model, or Purchase Existing Model? • • Considerations • Lack of DFA expertise within P&C division • Desired timeframe for implementation • Decision • Combined buying and building: Purchased existing vendor model, and made significant modifications to model to reflect company’s unique operations • Was it the right decision? • Probably the only way to get the ball rolling and implement within reasonable timeframe • Gradually building expertise in-house

10. Issues Confronted During Model Development • Vendor Selection Process • • Developed detailed selection criteria • Importance of DFA to firm’s strategy • Concentration of expertise in one person vs. department of experts • Broad expertise: P&C actuary, economics, investments, modeling, etc. • Open architecture of model • Flexibility of model to be changed by company staff • Model run time • Confidence in and documentation of model and underlying theories, including methodology for generating economic scenarios

11. Issues Confronted During Model Development Vendor Selection Process • • Developed detailed selection criteria(continued) • Ability to use model to support identified needs • Ability to interface P&C model with company’s other existing ALM tools • Good balance between strategic focus and level of detail • Ease of use of scenario diagnostic tools • Proactive relationships with rating agencies and regulators • Number of asset classes, P&C lines and reporting periods supported • Ease of model maintenance (impact of new releases, ease of loading large amount of data)

12. Issues Confronted During Model Development • Vendor Selection Process • • Conducted phone interviews to narrow the field, and held on-site meetings and model demos with selected vendors • Developed matrix of pros and cons by vendor, based on established selection criteria • How well did we do in the selection process? • Good job of developing comprehensive list of questions to determine how well each vendor’s model met our needs, but should have given more attention to ease of loading large amount of data • Devoted sufficient time and diverse group of experts; however, perhaps should have also included our IT experts in evaluation process • Decision was more difficult than we anticipated -- each vendor had strengths and weaknesses

13. Issues Confronted During Model Development Model Design and Customization/Enhancement • • Level of detail • Operational versus strategic tool -- misperception that model should replace existing financial forecast (point estimate) planning tool • Usual checks not in place -- P&C industry’s relatively low level of experience with product & lack of IT involvement • Parameterization • Commitment of company resources • Grossly underestimated staff time required, as well as length of time for project • Budget issues

14. Other Issues That Could Arise When Working With Vendor • •  Very difficult to get a thorough understanding of vendor’s model and its strengths and weaknesses until committed to vendor • Little control over resources assigned to project • Different interpretations over what falls within or outside project scope • Once cost and timeframe locked in, quality may get lower priority 

15. Issues Confronted During Model Development Enterprise ALM Using DFA Economic Simulator (Inflation, Interest Rates, Stock Market) P&C Life Bank MF/ Brokerage Pension EBA Enterprise

16. How the P&C Model Has Been Used • • Capital management • Measure variability in net worth over planning horizon and identify major sources of risk that cause fluctuations • Better understand the interaction of these risks • Future plans • Determine if risks can/should be reduced or eliminated • Determine how much capital must be held against those risks • Test risk management strategies • P&C portfolio asset allocation • Rating agency support • P&C reinsurance strategy analysis

17. How the P&C Model Has Been Used • Future applications • Reserve risk margin analysis • Pricing studies • Liquidity studies • Side benefits • Utilized dynamic feature of DFA model to build new model for deriving aggregate level reserve ranges for actuarial reports • Parameter analysis for DFA model also provides benefits to other areas of actuarial work

18. Large Company / Outside Consultant Perspective Gerald Kirschner

19. Key item to remember There is no silver bullet - A DFA model can NOT do anything and everything

20. Internal Obstacles – unrealistic timelines Implementation of a DFA model should be measured in years and not weeks or even months. • first year – figure out what you’re trying to do – usually requires a narrowing of scope • second year – improve efficiency of process • third year – start adding to the process

21. Internal Obstacles – desire to cross tie with other systems • There may be other systems in the company that are doing valuations or projections of parts of the company, and those may overlap with parts of the DFA model scope • Expecting or demanding that the two tie out in a precise manner may be unrealistic, given the assumptions being used by the different systems

22. Internal Obstacles – overly detailed modeling • Just because data exists to allow you to model at the nth degree of detail, don’t necessarily do it. • Where company data does not allow you to create a logical set of assumptions, don’t overwork the assumptions that you can make.

23. Getting the consultants involved…company preparation • know what you want to accomplish and be realistic as to short and long term goals • be willing to be flexible • be ready to invest significant time and resources • have a small-scale test case that can be used in a trial run • take advantage of your trial run to learn the software’s strengths and weaknesses

24. Getting the consultants involved…consultant preparation • Listen first, talk second • Ask lots of questions about company: • company expectations • desired use(s) of model • unique aspects of the company’s operations (these will be the ones to challenge your model) • Be honest about your model strengths and weaknesses – in the long run, an inappropriate sale is worse than no sale

25. Consultant preparation continued • Identify appropriate contact persons for the client company – these should encompass all the areas of expertise upon which the client will need help • Be realistic as to what the client can learn on his/her own and be patient – you are the ones who know the model inside and out and the client is going up a steep learning curve

26. Once you are under way… • Company • read the user manuals • invest the time to learn the software • tell your vendor about software problems you encounter • Consultant • check in frequently with the client • rein in “scope creep”

27. Small Company Perspective Elizabeth Wiesner

28. Business Needs • Everything driven by business needs • Complete assessment • Compare alternatives for fit with company • prioritize needs • costs • determine and include other interested parties

29. Examples • Strategic planning • Financial projections • Coordination among company operations • Loss reserving • Management training • Cost • Time of delivery • Complexity of use • Thoroughness of model

30. Implementation Issues • Buy/build • Transfer knowledge to internal staff • Spread of knowledge internally • Keeping all interested departments involved • Keep it simple

31. Issues with ‘Day to Day’ Use • Desire to use as crystal ball • Acceptance throughout company • Understandable communication • ‘Changing’ results • Following a project process and using DFA as a tool, not the project itself