Capital Management using DFA

1. Capital Management using DFA Tom Weidman XL America CAS - November 14, 2001

2. Today’s Agenda • Company Case Study: • DFA Model 2000: results & critique • Planning for DFA Model 2001 • Observations following 9-11

3. What can DFA do? • strategic planning • operational planning • valuation • product development • pricing • reinsurance/retrocessional structure

4. DFA Obstacles • DFA is complex • each company and underwriting portfolio is unique • risk/reward measures are numerous • management not aware of DFA

5. DFA 2000 - Process • Objective: determine capital requirements by major operating unit as a check on S&P’s capital model • Capital requirement = probability of insolvency @ AA rating level • Working team consisted of members of each operating unit for underwriting and liability modeling plus corporate investment representative for asset model assumptions • Operating units met regularly from April through August to discuss and critique relevant assumptions

6. DFA 2000 - Process • Utilized DFA software - Finesse version 3.1 • Monte Carlo simulation using 5000 iterations of possible annual outcomes • Simulated 5 years of future projections using 12/99 balance sheet and 5-year forecast as base case • Dynamic approach allows future contingent decision options • LOBs within business units not highly correlated • Underwriting cycle similar for all business units

7. DFA 2000 - Results Major drivers of capital requirement in order of magnitude: • property catastrophe aggregation including scenarios with more than 1 event per year - material affects to capital and future years’ investment income • loss reserve adequacy especially for longer-tail casualty business [used 6/30/2000 view of 12/99 reserve adequacy] • pricing adequacy • investment strategy

9. DFA 2000 - Future Objectives • All business units have a working model but need: (1) revisions to match product line alignment and (2) an aggregate companywide model to quantify additional capital benefit of diversification among business units • Uses include budgeting and cash flow projections, capital allocation, reinsurance structure evaluation and asset strategy optimization • Working team will review current model capabilities against alternative DFA approaches • Continue discussions with S&P regarding value of alternative capital models for property-casualty insurance

10. DFA 2001 Objectives • Develop RAROC approach: • for all major business units & aggregate • need economic return methodology especially for long-tailed businesses • incorporate diversification benefit • Separate investment risk and underwriting risk (investment function becomes its own profit center)

11. RAROC 2001 Objectives • Include capital projections within business planning, reporting, and performance measurement • Link RAROC to GAAP • Hire consultant, revisit software • Continue to discuss with rating agencies

12. Revisit Software: Issues • Snapshot vs. multi-year • VaR/risk of ruin vs. total cost of ruin • stochastic DFA vs. statistical model specification • Accounting vs. Economic return • RAROC hurdle rate

13. S&P Capital Model • Benefit: - Provides quantifiable, “formulaic” minimum ‘AA’ surplus standards we must maintain • Shortfalls: - Not dynamic…does not measure embedded economic value, reflects point in time VaR approach rather than multi-year nature of longer-tailed business - Inadequate diversification credit - Catastrophe model is unreasonable and a ‘black box’.

14. Rating Agency View of DFA • Complexity prohibits universal application to 3000 P&C companies • very few companies using DFA • DFA capital indications may be greater than rating agency models

15. Observations following 9-11 • Extreme value theory gets a boost… http://www.risklab.ch • Correlations among lines are higher • insurer risk management practices can be improved

16. Observations following 9-11 • Why are insurance industry returns on capital sub-par? • Industry is overcapitalized…due to rating agencies • Industry pricing is inadequate • Industry structure fosters ‘excessive’ competition

17. Observations following 9-11 • Is the insurance industry overcapitalized? • Yes: very few downgrades • No: new capital raised is $15 billion and growing

18. Observations following 9-11 • Is industry pricing inadequate? • Yes….Warren Buffett says so • No….capital is pouring in, stock prices are higher than pre 9-11

19. Observations following 9-11 Buffett, in his letter to shareholders, listed three basic rules for running an insurance company. He said all three were broken at General Re during the past three years: "Only accept risks you are able to properly evaluate . . . and confine your underwriting to business that, after an evaluation of all relevant factors, including remote loss scenarios, carries the expectancy of profit." "Limit the business accepted in a manner that guarantees you will suffer no aggregation of losses from a single event or from related events that will threaten your solvency." "Avoid business involving moral risk: No matter what the rate, you can't write good contracts with bad people."

20. Observations following 9-11 • Is the insurance industry structure sub-optimal? • Yes: it traps capital, uses capital inefficiently, is not sufficiently diversified • No: there will always be winners and losers, investors can diversify more efficiently

21. Profiting from DFA….at a professional level • DFA increases demand for actuaries’ skills • DFA facilitates and increases actuary’s interaction with: • CUO, CIO, CFO, CRO (internal) • rating analysts, investment analysts, reinsurers, investment managers (external) • DFA expands the breadth of the P/C actuary’s responsibilities