Capital Management using DFA

Tom Weidman

XL America

CAS - November 14, 2001

Today’s Agenda

• Company Case Study:– DFA Model 2000: results & critique– Planning for DFA Model 2001

• Observations following 9-11

What can DFA do?

• strategic planning

• operational planning

• valuation

• product development

• pricing

• reinsurance/retrocessional structure

DFA Obstacles

• DFA is complex

• each company and underwriting portfolio is unique

• risk/reward measures are numerous

• management not aware of DFA

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

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

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

GAAP EquitySBU #1

$778,711

$91,375

$36,047-$4,747

$21,138

$118,470

$667,442

$575,709

$513,134$483,388

$585,582

$1,201,925

$1,003,912

$859,618

$738,032

$653,729

-$200,000

$0

$200,000

$400,000

$600,000

$800,000

$1,000,000

$1,200,000

$1,400,000

1999 2000 2001 2002 2003 2004

0.01

Mean

0.99

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

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)

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

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

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’.

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

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

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

Observations following 9-11

• Is the insurance industry overcapitalized?– Yes: very few downgrades– No: new capital raised is $15 billion and

growing

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

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."

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

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