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C O N N I N G A S S E T M A N A G E M E N T Analyzing Reinsurance with DFA Practical Examples

C O N N I N G A S S E T M A N A G E M E N T Analyzing Reinsurance with DFA Practical Examples Daniel Isaac Washington, D.C. July 28-30, 2003. Key Considerations. Why are we changing? - Cost of current program - Rating agencies - Regulatory capital

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C O N N I N G A S S E T M A N A G E M E N T Analyzing Reinsurance with DFA Practical Examples

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  1. C O N N I N G A S S E T M A N A G E M E N T Analyzing Reinsurance with DFA Practical Examples Daniel Isaac Washington, D.C. July 28-30, 2003

  2. Key Considerations • Why are we changing? - Cost of current program - Rating agencies -Regulatory capital - Change in business mix/philosophy

  3. Key Considerations • How long do we need protection? - Impacts potential reinsurers - Impacts types of covers considered • How long will benefits last? - Will that change if there is a claim?

  4. Key Considerations • What other changes can we make? - Asset strategy - Capital structure - Business mix • How do these fit together? - Mitigate cost - Enhance benefits

  5. General Rules • Use several different measures - We prefer Economic Value as primary • Just considers cash flows • Eliminates accounting “noise” - Also evaluate financial metrics • Statutory Surplus • GAAP Equity • RBC Ratio

  6. Company Profile • Name: Make Believe Inc. (MBI) • Size: $150 MM Net Premium • Growth: 10 - 15% per year • Mix 60/40 Commercial/Personal 60/40 Liability/Property • Time Horizon: 5 years

  7. MBI Concerns • Recently went public - Very concerned about GAAP Income - Also very concerned about volatility • Wants to increase equity exposure - Very conservative asset portfolio - 98% bonds - Mostly high quality (A or better) and short-term - Expect higher returns long-term

  8. Option #1 • Buy traditional coverage - 10 x 70 accident year loss ratio coverage - 2% of earned premium - 1 year cover which is annually renewed • Increase equity allocation - Consider 10 and 20% allocations

  9. Results Option #1

  10. Results Option #1

  11. Summary - Option #1 • Reinsurance - Successfully reduces risk • 25% lower standard deviation • less downside - Negatively impacts income • Equities - Further drop in GAAP Income - Little additional risk • Overall - Hit to income is too great

  12. Option #2 • Add experience account balance to Option #1 - Same coverage 10 x 70 accident year loss ratio - Increase price from 2% to 5% - 5 year cover with separate limits by accident year • Experience account balance - 80% of reinsurance premium added for each accident year - Positive balances earn equity returns - Any time after the end of the fifth calendar year, MBI can commute the treaty and claim the positive balance • No change in asset allocation

  13. Results - Option #2

  14. Results - Option #2

  15. Summary - Option #2 (cont.)

  16. Summary - Option #2 • Achieves company’s goals - Improves average GAAP income - Increases equity exposure • Other benefits - Lock in the price and coverage for five years - Commutation provision allows company flexibility - Lower RBC charge for reinsurance recoverable than equity

  17. Summary - Option #2 • Disadvantages - Makes stock returns currently taxable • Normally, stock returns are only taxed when realized • Changes in experience account balance flow through income • Hurts ending shareholder equity • No reduction in volatility

  18. Summary - Option #2 • Disadvantages - In good scenarios, experience account balance would become a large (-20%) portion of assets • May concern regulators • Muted, to some extent, by commutation provision

  19. How Many Scenarios? • Most DFA models create large number of scenarios - Monte Carlo simulation - Allows “complete” scenarios - Other methods are available • Simulation creates the possibility of sampling error - Large samples reduce this possibility - Can be very time and resource consuming

  20. How Many Scenarios? • The “right” number of scenarios is based on: - Volatility of results - Metrics being used - Simulation methodology - Independent vs Dependent

  21. How Many Scenarios? Definitions: Reward: Average ending Economic Value Risk: Mean - 1st percentile

  22. How Many Scenarios? Sample Size based on: Reward: Net cost under $6 million Risk: Reduced at least $40 million

  23. How Many Scenarios? • Different strategies are highly correlated - Same gross underwriting - Same economy • Maintaining correlation in modeling process reduces sampling error - Still have to consider parameter risk

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