Presented at:1998 DFA SeminarJuly 13-14, 1998

Presented at:1998 DFA SeminarJuly 13-14, 1998

Dynamic Financial Analysis:

Objectives & Design

Gerald S. Kirschner, FCAS, MAAA

Evolution of DFA Call Papers & Seminars

1995 Call Paper: Incorporating Risk Factors in DFA

Montreal, 1996: Models in Use I

Seattle, 1997: Models in Use II / Defining Model Variables

Boston, 1998: Applications and Uses

Chicago, 1999: Parameterizing Models

New York, 2000: Presentation of Results and Implementation of Strategies

Issues with DFA Acceptance

“Show me the value…”In terms of knowledge gainedIn terms of risk / reward trade-offsIn terms of implementation cost versus bottom-

line payoff

Lack of objective evidence of DFA’s value

Insurance company focus

Translation of a “numbers analysis” to a big picture presentation

Why do DFA, then?

First one(s) to profit from the knowledge can establish better strategic directionsAccounting view of an insurance company does not help

manage the organization going forward.An approach that is looks at the organization as a going

concern, subject to interactions too complex to understand individually, focusing on cash and not accounting gives fundamentally different insights than traditional planning and forecasting.

Competitive edge

Consistency of communication within an organization

So who’s doing DFA?

Actuaries

Strategic planners

Financial analysts

Investment professionals

All are using DFA as an analytic tool to support senior management’s decisions

Uses of DFA

Realism of a Business Plan

Product & Market Development

Claims Management

Capital Adequacy

Capital Allocation

Liquidity Analysis

Reinsurance Structure

Asset or Investment Strategy Analysis

Rating Agency Support

Merger & Acquisition Opportunities

Evolution of Financial Modeling

STAGE 1: Financial Budgeting = Static modeling with one set of assumptions

Year1998 1999 2000 2001 2002 2003

0

-

+

Est

imat

ed C

apit

al

Bankruptcy

Evolution of Financial Modeling

STAGE 2: Sensitivity or Stress Testing = Static modeling that incorporate “best case” and “worst case” scenarios along with the expected outcome

Year1998 1999 2000 2001 2002 2003

0

-

+

Est

imat

ed C

apit

al “Best Case”

“Worst Case”

Bankruptcy

Evolution of Financial Modeling STAGE 3: Stochastic Modeling = Modeling that describes critical

assumptions and their combined financial implications in terms of ranges of possible outcomes

Estimated Capital0+ -

5% Probability5% Probability

Expected Value

Bankruptcy

Pro

bab

ilit

y

Proje

ctio

nYea

r

Evolution of Financial Modeling STAGE 4: Dynamic Modeling = Stochastic modeling that

incorporates feedback loops and “management intervention decisions” into the model calculation flow.

Estimated Capital0+ -

Pro

bab

ilit

y

1998

Year

1999

2000

2001

2002

2003

Bankruptcy

Calendar Year Cash Flows

Asset Rebalancing & Reinvestment

Underwriting assumptions

Asset Mark

to Market

Forward Interest Rate Scenario

Federal Income Tax Calculation

Balance Sheets, Income Statements Internal Results Measurements NAIC Measurements (RBC, IRIS) Rating Agency Measurements

Inflationary Scenario

One Possible Flow of Logic in an “Enterprise Wide” Generalized Model

Equity Market Scenario

Current State: Key Dynamic Elements

Interest rates & changes in equity market values

Inflation rates

Future premium volumes

Future loss ratios or future changes in loss frequency and severity

Reserve adequacy

Loss payout patterns

Exposure to catastrophic losses

Management decisions / model responses to changing conditions

Future State: More Research Is Needed

CorrelationsBetween lines of business Between years within a line of businessBetween asset classes

Underwriting cycles / competition

Capital markets and insurance industry

Change in rating by a rating agency

Multi-national insurance models

Multi-industry models

At the end of the day, what has the biggest impact on model results?

Depends on what measurement is being evaluated and on what basis (statutory, GAAP, economic, etc.)

Example: Surplus After 5 Years

$250,000

$275,000

$300,000

$325,000

$350,000

$375,000

$400,000

EverythingDynamic

StaticInterestRates

StaticLoss

Ratios

No ReserveRedundancyor Deficiency

StaticPayoutPattern

NoPayoutInflation

NoFeedbackLoops inPricing

Spread:$103 M

Spread:$79 M

Spread:$101 M

Spread:$97 M

Spread:$101 M

Spread:$88 M

Spread:$111 M

Do

llars

in M

illio

ns

95% Mean 5%Percentiles:

Comparison of Impact of Current State Drivers in Surplus Example

(1)Observed

Mean($ millions)

(2)Spread of

Observations($ millions) (2) / (1)

Everything dynamic 328 103 31.4%Static economic scenario 325 79 24.3%Static loss ratios 335 97 29.0%Reserves are adequate 324 101 31.2%Static loss payout pattern 328 101 30.8%No inflationary impacts on loss payouts 346 88 25.4%No feedback loops in pricing 327 111 33.9%