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DYNAMIC FINANCIAL ANALYSIS What Does It Look Like?

DYNAMIC FINANCIAL ANALYSIS What Does It Look Like?. Casualty Loss Reserve Seminar September 14, 1999 Presented by: Susan E. Witcraft Milliman & Robertson, Inc. WHAT IS DFA?. Management tool Regulatory tool. USES FOR DFA. Estimate probability of attaining certain results

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DYNAMIC FINANCIAL ANALYSIS What Does It Look Like?

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  1. DYNAMIC FINANCIAL ANALYSISWhat Does It Look Like? Casualty Loss Reserve Seminar September 14, 1999 Presented by: Susan E. Witcraft Milliman & Robertson, Inc.

  2. WHAT IS DFA? • Management tool • Regulatory tool

  3. USES FOR DFA • Estimate probability of attaining certain results • Identify risks to company • Capital allocation • Evaluation of alternate strategies

  4. OVERVIEW OF PROCESS Input Select Strategy Scenarios Financial Calculator Output

  5. OVERVIEW OF PROCESS Input Select Strategy Scenarios Financial Calculator Output

  6. INPUT • PREMIUM • Amount • Earning pattern • Collection pattern

  7. INPUT • LOSSES AND LAE • Loss ratio on small claims • Frequency of large claims • Severity of large claims • Catastrophes • Reserve adjustments • Payment patterns

  8. INPUT • EXPENSES • Fixed • Variable

  9. INPUT MODELS • Premium volume • Losses and LAE • Reserve development • Payment patterns • Expenses • Assets

  10. l/ri = a(l/ri-1 ) + b(inti-1 - int) + c (infi - inf) + d + ei LOSS RATIO MODEL where i is the year l/r is the undiscounted loss ratio int is the short-term yield inf is the inflation rate a, b, c, and d are constants e is a random error term

  11. EXPENSE MODEL Fixed expensesi = Fixed expensesi-1 x (1 + infi) + ei where i is the years inf is the inflation rate e is a random error term

  12. OVERVIEW OF PROCESS Input Select Strategy Scenarios Financial Calculator Output

  13. STRATEGIES • Investment • Reinsurance • Business mix • Pricing

  14. STRATEGIES Distribution of New Investments Among Types

  15. PORTFOLIO OPTIMIZER • Entire business (both assets and liabilities) viewed as a single portfolio • Considers risk from the perspective of the entire organization

  16. PORTFOLIO OPTIMIZER • Calculates line of business and asset mix that maximizes expected return for any given level of standard deviation - OR - • Calculates mix that provides lowest risk for a given level of return

  17. PORTFOLIO OPTIMIZER • Inputs • Reserve to premium ratios for each line of business • Expected underwriting and asset returns and standard deviations • Correlation matrix between underwriting returns, asset returns, and between underwriting and asset returns • Constraints • Constraints on line of business mix and percentages of asset portfolio invested in various asset classes • Reserve to surplus ratio (alternatively, premium to surplus ratio)

  18. OPTIMAL ASSET MIX TARGET RETURNS

  19. OVERVIEW OF PROCESS Input Select Strategy Scenarios Financial Calculator Output

  20. SCENARIOS • Economy • Underwriting cycle • Catastrophes • Large claims • Failure of reinsurer • Mass torts

  21. ECONOMIC SCENARIOS • GDP growth • Inflation • Interest rates • Short-term • Long-term • Stock returns • Bond default rates Produce simulated projections of:

  22. ECONOMIC VARIABLES Note: Stock Appreciation is plotted against the axis on the right of the graph.

  23. ECONOMIC SCENARIOS • Output used as inputs for income and balance sheet variables • Each scenario provides consistent set of assumptions for projection of future financial results

  24. OVERVIEW OF PROCESS Input Select Strategy Scenarios Financial Calculator Output

  25. FINANCIAL CALCULATOR-UNDERWRITING • Project net premium, losses and expenses • Income statement basis • Cash basis • Tax basis

  26. FINANCIAL CALCULATOR-ASSET MODEL • Calculate investment income • Add cash from operations, asset maturities and asset sales • Produce total funds available for investment each projection period • Invest total funds available for investment • Strategy specified by user • State end-of-year balance sheet • Carried forward to next projection period

  27. OVERVIEW OF PROCESS Input Select Strategy Scenarios Financial Calculator Output

  28. CHANGE IN SURPLUS

  29. FINDINGS

  30. E D C + + + + + + + + B + X + + + + + + + + Reward A + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + Risk RISK/REWARD ILLUSTRATION

  31. RISK/REWARD SUMMARY 3 2 Average Annual Surplus Increase 1 4 5 Probability Net Income/Surplus < 10% 1. Current 2. More Corporates 3. Stocks & Corporates 4. More Non-Taxables 5. Duration Match

  32. RISK/REWARD SUMMARY 3 4 Average Annual Surplus Increase 2 1 5 Standard Deviation of Surplus Increase 1. Current 2. More Corporates 3. Stocks & Corporates 4. More Non-Taxables 5. Duration Match

  33. DYNAMIC FINANCIAL ANALYSISWhat Does It Look Like? Casualty Loss Reserve Seminar September 14, 1999 Presented by: Susan E. Witcraft Milliman & Robertson, Inc.

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