Casualty Loss Reserve Seminar September 14, 1999

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
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
Produce simulated projections of

• GDP growth
• Inflation
• Interest rates
• Short-term
• Long-term
• Stock returns
• Bond default rates

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
RISK/REWARD ILLUSTRATION
31
RISK/REWARD SUMMARY
3
2
Average Annual Surplus Increase
1
4
5
Probability Net Income/Surplus lt 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.