1. MANAGING ASSET/LIABILITY RISK WITH REINSURANCE AND ASSET STRATEGIES - A P/C Insurance Company Application
Casualty Actuarial Society
Casualty Loss Reserve Seminar
September 13-14, 1999
Manuel Almagro, Tillinghast-Towers Perrin
Stephen W. Philbrick, Swiss Re Investors - Falcon Asset/Liability Management

2. Today’s Agenda
Company’s Objectives
Approach to Asset/Liability Risk Management
Profile of Company
Analysis of Current Strategy
Design and Evaluation of Alternate Strategies
Conclusions

3. ALMCO’s GOALS AND OBJECTIVES
ALMCo is concerned about:
Expected value and volatility of operating income
Specific focus is on GAAP income
Exposure to insolvency risk
Absolute level and variability of Statutory Surplus
Cost effectiveness of its reinsurance purchase
Measured by impact on Economic Value of ALMCo
Constituents include:
Owners
Policyholders
Rating Agencies & Regulators

4. ALMCO’s GOALS AND OBJECTIVES
ALMCo’s goal is to better manage its risk/return profile
Alternatives include:
Re-underwrite/shift type of business
Change rates/terms of coverages provided
Restructure its ceded reinsurance for existing and future liabilities
Revise its asset allocation profile and investment style
ALMCo has chosen to evaluate alternative reinsurance and asset strategies
Alternative reinsurance structures for prospective business were considered in conjunction with
Alternative asset allocation strategies

5. APPROACH TO ASSET/LIABILITY RISK MANAGEMENT
Build financial model of ALMCo
Identify drivers of financial risk
Decomposition of financial statement variability
Design potential alternate Reinsurance/Asset strategies
Analyze distributions of:
GAAP Income, Economic Value, and Statutory Surplus
Modify alternative covers to achieve desired objectives

6. APPROACH TO ASSET/LIABILITY RISK MANAGEMENT
Build model of ALMCo to reflect
The financial risks to which ALMCo is exposed
The risks are multi-period and integrated
The impact of each strategy on financial results
Therefore the model of ALMCo should:
Simulate Gross loss experience
Able to evaluate alternative reinsurance structures
Include candidate asset categories being considered
Including only asset classes acceptable to ALMCo
Cover a three year projection period
Reflects ALMCo’s planning horizon and existing business plan

7. APPROACH TO ASSET/LIABILITY RISK MANAGEMENT
Model organization is important for accurate reflection of risks
ALMCo
Investment
Strategy
Capital
Markets
Economy
ALMCo
Assets
ALMCo
Financials
Insurance
Market
ALMCo
Liabilities
ALMCo
Reinsurance
Strategy
Liability
Cashflows

8. APPROACH TO ASSET/LIABILITY RISK MANAGEMENT
Each simulation component produces ,000 scenarios
Each scenario represents a single path through time for all variables
A cascade structure allows dependency between selected variables
Simulation Components
Capital
Markets
Economy
ALMCo
Assets
Insurance
Market
ALMCo
Liabilities
Liability
Cashflows

9. APPROACH TO ASSET/LIABILITY RISK MANAGEMENT
The financial component transforms scenario results into financial statements
Economic, GAAP and Statutory bases are produced
Earnings, cashflows, surplus, etc. - based on the particular characteristics of ALMCo (tax laws, accounting rules….)
Simulation Components
Capital
Markets
Economy
ALMCo
Assets
ALMCo
Financials
Insurance
Market
ALMCo
Liabilities
Liability
Cashflows

10. APPROACH TO ASSET/LIABILITY RISK MANAGEMENT
The strategy components apply management decisions to scenario results
Alternate strategies can be evaluated using desired reward/risk measures
Searching a range of strategies for the best reward/risk combinations produces an
efficient frontier
ALMCo
Investment
Strategy
Capital
Markets
Economy
ALMCo
Assets
ALMCo
Financials
Insurance
Market
ALMCo
Liabilities
Liability
Cashflows
ALMCo
Reinsurance
Strategy

11. APPROACH TO ASSET/LIABILITY RISK MANAGEMENT
Different strategies are compared using the company’s selected measures for reward and risk
Ideal strategies have higher reward and lower risk

12. APPROACH TO ASSET/LIABILITY RISK MANAGEMENT
The “efficient frontier” is the set of possible strategies that either maximizes reward for a given level of risk or minimizes risk for a given level of reward

13. APPROACH TO ASSET/LIABILITY RISK MANAGEMENT
This framework can be used to evaluate the current strategy and find others that reduce risk or increase reward

14. APPROACH TO ASSET/LIABILITY RISK MANAGEMENT
In order to decide which of the efficient strategies to choose, we need to analyze the entire distribution of results

15. OBJECTIVES & APPROACH - Recap
ALMCo has completed three steps in Asset/Liability Risk Management:
Identified goals and objectives
Developed an approach to a stochastic model which accurately represents the risks from assets, liabilities, and their interaction; and their impact on financial results
Laid out a framework for analyzing these risks and strategies for modifying them in light of the expressed objectives
Now ALMCo can proceed to applying this process to their specific circumstances

16. Today’s Agenda
Company’s Objectives
Approach to Asset/Liability Risk Management
Profile of Company
Analysis of Current Strategy
Design and Evaluation of Alternate Strategies
Conclusions

17. PROFILE OF COMPANY - Premium & Expenses
Expected Loss & LAE Ratio:
Gross: 54%
Net: 58%
Expenses (to Net Prem):
Commissions: 16%
Taxes, Lic & Fees: 4%
General Expense: 26%
Expected Combined Ratio:
Net: %

18. PROFILE OF COMPANY - Loss & LAE Liabilities
Characteristics:
Duration:
Liquidation Basis: 2.3
Ongoing Basis: 3.3
Note:
For this analysis the reinsurance on balance sheet liabilities was not restructured

19. PROFILE OF COMPANY - Expected Liability Cashflow

20. PROFILE OF COMPANY - Current Reinsurance Program
Liability Lines of Business
Net Retention of $1.0 Million
25% Quota Share on Net
Miscellaneous covers reduce certain lines to a $500 K Net
Cost: 40% of Direct WP
Property Lines of Business
Net Retention of $100K per risk
Cat protection of $140 Million Excess of $10 Million
Cost: 55% of Direct WP

21. PROFILE OF COMPANY - Assets
Characteristics:
Duration:
Expected Return: 5.2%
Current Investment Style:
Buy and hold
Assets marked as available for sale
High quality - Investment grade
Conservative - very low risk of loss of principal

22. PROFILE OF COMPANY - Historical Experience
Actual historical experience provides evidence of volatility and relatively low returns
Ten year average Return On Equity = 8.9%

23. CURRENT STRATEGY - Projection of GAAP Income
Current strategy reduces income volatility, but
Significant probability of low/negative income in any given year

24. CURRENT STRATEGY - Statutory Surplus Projection
In any given year there is a significant potential of decline in statutory surplus

25. CURRENT STRATEGY - Decomposition of Risk
Total variance before reinsurance = 46.4 Billion
45.1 from Liabilities, 2.1 from Assets, (0.8) Covariance
Total variance after current reinsurance = 12.5 Billion
11.6 from Liabilities, 1.3 from Assets, (0.4) Covariance

26. CURRENT STRATEGY - Reinsurance Strategy Efficiency
Reinsurance in Current Strategy:
Approximate $105 Million reduction in Standard Deviation, but
Economic cost of $80 million over three year period

27. CURRENT STRATEGY - Efficiency of Asset Allocation

28. PROFILE & CURRENT STRATEGY - Recap
Mid-sized Company with Property and Liability Exposures
Risk Exposure is Virtually all Underwriting
Significant Reinsurance
Provides protection but at a healthy cost
Conservative Asset Mix - But not Efficient
Yet, results are still volatile
Conservative Reinsurance coupled with Conservative Assets is not enough to eliminate volatility

29. Today’s Agenda
Company’s Objectives
Approach to Asset/Liability Risk Management
Profile of Company
Analysis of Current Strategy
Design and Evaluation of Alternate Strategies
Conclusions

30. ALTERNATE STRATEGY 1 - Design
Reinsurance Structure: Aggregate Excess of Loss
Attachment at 50% Loss Ratio
Limit of 100 Loss Ratio Points
Cost: 27.5% of Direct WP
Asset Allocation:
Shift to longer duration Fixed Income
Increase Equity Allocation

31. ALTERNATE STRATEGY 1 - Economic Value
Modest total risk reduction, with increase in value of $45 million
Must also look at GAAP income and Statutory Surplus

32. ALTERNATE STRATEGY 1 - GAAP Income
Downside risk is dramatically reduced
Increases upside potential
Lower expected income due to shift towards unrealized income

33. ALTERNATE STRATEGY 1 - Statutory Surplus
Significantly improves downside and upside potential

34. ALTERNATE STRATEGY 2 - Design
Alternate 2 - Integrated Aggregate Excess of Loss
Reinsurance:
Attachment at 50% Loss Ratio
Limit of 100 Loss Ratio Points
Attachment point adjusted downward for Equity returns below 10%
Adjustment rate is one-for-one
Cost: 32.5% of Direct WP
Asset Allocation:
Use allocation derived for Strategy 1

35. ALTERNATE STRATEGY 2 - Economic Value
Very small economic cost with dramatic risk reduction
But again, we must look at GAAP income and Statutory Surplus

36. ALTERNATE STRATEGY 2 - GAAP Income
Downside risk is comparable or better than Alternative 1
Improvement in expected income and upside potential

37. ALTERNATE STRATEGY 2 - Statutory Surplus
Further reduction in downside risk over Alternative 1, and
Modest improvement in upside potential

38. ALTERNATE STRATEGY 2 - Decomposition of Risk
Alternate Strategy 2 takes best advantage of Covariance
Better diversification of risk between Assets and Liabilities

39. DESIGN & EVALUATION OF STRATEGIES - Recap
ALMCo has identified a reinsurance/asset strategy that addresses its concerns:
The strategy reduces the variability of GAAP income from

40. DESIGN & EVALUATION OF STRATEGIES - Recap
ALMCo has identified a reinsurance/asset strategy that addresses its concerns:
The strategy improves the downside risk to Statutory Surplus

41. DESIGN & EVALUATION OF STRATEGIES - Recap
ALMCo has identified a reinsurance/asset strategy that addresses its concerns:
The strategy improves Economic Value

42. Conclusions
A Financial Integrated Risk Management approach is an effective way to evaluate reinsurance and asset strategies
Analysis of strategies should simultaneously examine reinsurance and assets
A stochastic approach is necessary to get a full appreciation of the impact of strategies