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DYNAMIC FINANCIAL ANALYSIS What Does It Look Like?

Explore the concept of Dynamic Financial Analysis (DFA) as a management and regulatory tool. Learn how DFA helps estimate probabilities, identify risks, and allocate capital. Discover the process, input models, strategic scenarios, and portfolio optimization techniques involved. Gain insights into economic and financial projections using the financial calculator. Presented by Susan E. Witcraft from Milliman & Robertson, Inc.

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DYNAMIC FINANCIAL ANALYSIS What Does It Look Like?

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  1. DYNAMIC FINANCIAL ANALYSISWhat Does It Look Like? Casualty Loss Reserve Seminar September 14, 1999 Presented by: Susan E. Witcraft Milliman & Robertson, Inc.

  2. WHAT IS DFA? • Management tool • Regulatory tool

  3. USES FOR DFA • Estimate probability of attaining certain results • Identify risks to company • Capital allocation • Evaluation of alternate strategies

  4. OVERVIEW OF PROCESS Input Select Strategy Scenarios Financial Calculator Output

  5. OVERVIEW OF PROCESS Input Select Strategy Scenarios Financial Calculator Output

  6. INPUT • PREMIUM • Amount • Earning pattern • Collection pattern

  7. INPUT • LOSSES AND LAE • Loss ratio on small claims • Frequency of large claims • Severity of large claims • Catastrophes • Reserve adjustments • Payment patterns

  8. INPUT • EXPENSES • Fixed • Variable

  9. INPUT MODELS • Premium volume • Losses and LAE • Reserve development • Payment patterns • Expenses • Assets

  10. l/ri = a(l/ri-1 ) + b(inti-1 - int) + c (infi - inf) + d + ei LOSS RATIO MODEL where i is the year l/r is the undiscounted loss ratio int is the short-term yield inf is the inflation rate a, b, c, and d are constants e is a random error term

  11. EXPENSE MODEL Fixed expensesi = Fixed expensesi-1 x (1 + infi) + ei where i is the years inf is the inflation rate e is a random error term

  12. OVERVIEW OF PROCESS Input Select Strategy Scenarios Financial Calculator Output

  13. STRATEGIES • Investment • Reinsurance • Business mix • Pricing

  14. STRATEGIES Distribution of New Investments Among Types

  15. PORTFOLIO OPTIMIZER • Entire business (both assets and liabilities) viewed as a single portfolio • Considers risk from the perspective of the entire organization

  16. PORTFOLIO OPTIMIZER • Calculates line of business and asset mix that maximizes expected return for any given level of standard deviation - OR - • Calculates mix that provides lowest risk for a given level of return

  17. PORTFOLIO OPTIMIZER • Inputs • Reserve to premium ratios for each line of business • Expected underwriting and asset returns and standard deviations • Correlation matrix between underwriting returns, asset returns, and between underwriting and asset returns • Constraints • Constraints on line of business mix and percentages of asset portfolio invested in various asset classes • Reserve to surplus ratio (alternatively, premium to surplus ratio)

  18. OPTIMAL ASSET MIX TARGET RETURNS

  19. OVERVIEW OF PROCESS Input Select Strategy Scenarios Financial Calculator Output

  20. SCENARIOS • Economy • Underwriting cycle • Catastrophes • Large claims • Failure of reinsurer • Mass torts

  21. ECONOMIC SCENARIOS • GDP growth • Inflation • Interest rates • Short-term • Long-term • Stock returns • Bond default rates Produce simulated projections of:

  22. ECONOMIC VARIABLES Note: Stock Appreciation is plotted against the axis on the right of the graph.

  23. ECONOMIC SCENARIOS • Output used as inputs for income and balance sheet variables • Each scenario provides consistent set of assumptions for projection of future financial results

  24. OVERVIEW OF PROCESS Input Select Strategy Scenarios Financial Calculator Output

  25. FINANCIAL CALCULATOR-UNDERWRITING • Project net premium, losses and expenses • Income statement basis • Cash basis • Tax basis

  26. FINANCIAL CALCULATOR-ASSET MODEL • Calculate investment income • Add cash from operations, asset maturities and asset sales • Produce total funds available for investment each projection period • Invest total funds available for investment • Strategy specified by user • State end-of-year balance sheet • Carried forward to next projection period

  27. OVERVIEW OF PROCESS Input Select Strategy Scenarios Financial Calculator Output

  28. CHANGE IN SURPLUS

  29. FINDINGS

  30. E D C + + + + + + + + B + X + + + + + + + + Reward A + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + Risk RISK/REWARD ILLUSTRATION

  31. RISK/REWARD SUMMARY 3 2 Average Annual Surplus Increase 1 4 5 Probability Net Income/Surplus < 10% 1. Current 2. More Corporates 3. Stocks & Corporates 4. More Non-Taxables 5. Duration Match

  32. RISK/REWARD SUMMARY 3 4 Average Annual Surplus Increase 2 1 5 Standard Deviation of Surplus Increase 1. Current 2. More Corporates 3. Stocks & Corporates 4. More Non-Taxables 5. Duration Match

  33. DYNAMIC FINANCIAL ANALYSISWhat Does It Look Like? Casualty Loss Reserve Seminar September 14, 1999 Presented by: Susan E. Witcraft Milliman & Robertson, Inc.

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