Presented at: 1998 DFA Seminar July 13-14, 1998 Presented at: 1998 DFA Seminar July 13-14, 1998 lmn 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 lmn

Issues with DFA Acceptance “Show me the value…” FIn terms of knowledge gained FIn terms of risk / reward trade-offs FIn 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 lmn

Why do DFA, then? First one(s) to profit from the knowledge can establish better strategic directions FAccounting view of an insurance company does not help manage the organization going forward. FAn 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 lmn

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 lmn

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 lmn

Evolution of Financial Modeling STAGE 1: Financial Budgeting = Static modeling with one set of assumptions Year Estimated Capital lmn 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 Year Estimated Capital “Best Case” “Worst Case” lmn 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 Capital % Probability Expected Value Bankruptcy Probability Projection Year lmn

Evolution of Financial Modeling STAGE 4: Dynamic Modeling = Stochastic modeling that incorporates feedback loops and “management intervention decisions” into the model calculation flow. Estimated Capital 0 +- Probability 1998 Year Bankruptcy lmn

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 lmn

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 lmn

Future State: More Research Is Needed Correlations FBetween lines of business FBetween years within a line of business FBetween asset classes Underwriting cycles / competition Capital markets and insurance industry Change in rating by a rating agency Multi-national insurance models Multi-industry models lmn

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.) lmn

Example: Surplus After 5 Years $250,000 $275,000 $300,000 $325,000 $350,000 $375,000 $400,000 Everything Dynamic Static Interest Rates Static Loss Ratios No Reserve Redundancy or Deficiency Static Payout Pattern No Payout Inflation No Feedback Loops in Pricing Spread: $103 M Spread: $79 M Spread: $101 M Spread: $97 M Spread: $101 M Spread: $88 M Spread: $111 M Dollars in Millions 95%Mean5%Percentiles: lmn

Comparison of Impact of Current State Drivers in Surplus Example lmn