Asset and Liability Dynamics Dynamic Financial Analysis CAS Special Interest Seminar July , 1999 Elissa M. Sirovatka, FCAS, MAAA Tillinghast - Towers Perrin

2 Overview Asset modeling process Existing assets Future assets Investment strategies Interrelation of asset and liability dynamics Real life uses

3 Asset Modeling Process Existing Assets Future Assets Liability Cash Flows Economic Scenarios Investment Strategies Asset/Liability Cash Flows Dynamic Model

4 Existing Assets - PC Industry Bonds % Equities % Cash - 5.0% Real Estate, Mortgages, and CMOs - 5.0%

5 Existing Assets - Bond Types Fixed rate coupon - rate fixed through maturity Adjustable rate coupon - rate periodically reset based on market rates Zero coupon - no coupon, sold at deep discount Sinking fund - par value repaid according to fund schedule Tax status - all or part of coupon payment tax exempt ? Callable - borrower may prepay principal at specified premium Putable - investor has option to demand discounted prepayment

6 Existing Assets - Bond Characteristics Quality - Treasury, AAA, AA, junk Maturity date Value - book, par, and market Coupon - rate and frequency Issue year Planned date of sale Call/Put info - year, premium/discount Sinking fund info Tax status Investment expenses

7 Existing Assets - Equity Characteristics Sector - Large cap, small cap, international Market value Actual cost Relationship of market value to market value index Relationship of dividend yield to dividend yield index Dividend frequency Investment expenses

8 Existing Assets - Cash Account Establish at start of model Select a relationship to point on yield curve

9 Relationship of Asset Yields to Economic Scenarios (Yield x M) + S Yield = Scenario generated yield rate for a point on yield curve M = Multiplier S = Spread

10 Future Assets - Asset Groups Select asset groups for future investment with common characteristics: Quality - affects relationship of asset returns to scenario generated yield curve and default rates Types - sinking fund bonds, common stock, callable bonds, etc. Duration - for purchasing and selling Assign to existing assets as well

11 Investment Strategy Uses asset groups Purchase/sell assets Determine allocation between asset groups –Cash based –Book value based Apply different strategies in different situations

12 Investment Strategy - Calendar Period Strategy applies for a given period of time Allows you to change asset mix over time Example: –Beginning asset mix: 80% bonds, 5% equities, and 15% cash –Move towards industry: 65% bonds, 25% equities, 5% other invested, and 5% cash –Strategy varies by year over first four years and then stabilizes at desired allocation

13 Investment Strategy - Calendar Period

14 Investment Strategy - Special Situation Overrides calendar period strategy if a special situation occurs –High interest rates Allocate a greater portion of total assets to bonds Invest in long-term bonds to lock in higher coupon rates –Low interest rates Allocate a greater portion of total assets to equities Invest in short-term bonds rather than long-term –Inverted yield curve Invest in short-term bonds to get high rate with lower risk

15 Investment Strategy - Negative Cash Flow Reduce cash to minimum amount Alternatives : –Borrow funds can borrow up to a maximum amount interest rate is based on 90-day yield rate, plus spread –Purchase negative assets can purchase up to a maximum amount proxy for borrowing assets from another asset segment of the company –Sell assets according to sales classification/priority assigned at model start

16 Interrelation of Asset and Liability Dynamics Economic conditions directly affect asset results through –varying asset default rates, floating interest rates, and changing market values –exercise of call, put and prepayment options

17 Interrelation of Asset and Liability Dynamics Economic conditions directly affect liability results through –inflation affects amount of loss and ALAE future written premium affected by inflation fixed expenses –if discounting loss reserves, discount rate may be affected by scenario generated yield curve

18 Real Life Uses Deterministic Scenarios –Used to investigate the behavior of results during specific assumed future economic conditions Stochastic Scenarios –Used to investigate the range of possible future economic conditions which cannot be predicted with certainty

19 Real Life Uses Cash Flow Testing –Measures adequacy of asset held for a company or a block of business. Can set existing assets equal to initial liabilities Distribution of Results –Range of asset/liability results using stochastic scenarios can show the volatility and risks involved in a company or block of business. Can test alternative investment portfolios, underwriting strategies and reinsurance programs