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Overview

Casualty Actuarial Society Dynamic Financial Analysis 1998 Special Interest Seminar Basic Track - Session 4 A Basic Model for DFA Stephen P. D’Arcy University of Illinois at Urbana-Champaign Charles C. Emma Miller, Rapp, Herbers & Terry, Inc. Overview. Description of Model - me

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Overview

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  1. Casualty Actuarial Society Dynamic Financial Analysis1998 Special Interest SeminarBasic Track - Session 4A Basic Model for DFAStephen P. D’ArcyUniversity of Illinois at Urbana-ChampaignCharles C. EmmaMiller, Rapp, Herbers & Terry, Inc.

  2. Overview • Description of Model - me • Demonstration of Model - Chuck • Use of Model - You (the audience)

  3. Objectives of this DFA Model Develop a financial model for a U. S. property-liability insurer that is: Realistic enough to be useable Simple enough to be understood

  4. Caveats • Any model is a simplified version of reality • This model deals with quantifiable risk only • Examples of excluded items: • A line of business being socialized • Management fraud • Devastating meteor strike

  5. Key Risks for U.S. Property-Liability Insurers • Underwriting • Aging Phenomenon • Jurisdictional Risk • Loss Development • Catastrophes • Investment • Asset Value • Investment Income

  6. Specifics Provisions of Model • Six separate, but interrelated modules Investments Catastrophes Underwriting Taxation Interest rate generator Loss reserve development • Ten lines of business • For each line of business • New business • 1st renewals • 2nd and subsequent renewals

  7. What Does This Model Do? Simulates results for the next 5 years Generates financial statements Balance sheet Operating statement IRIS results Indicates expected values and distribution of results for any value selected

  8. What Information is Required? Underwriting data Premiums and exposures, by line, state and age Renewal patterns Projected growth rates Loss development patterns Loss frequency and severity Reinsurance program Investment data Statutory and market asset values by asset class Maturity and coupon rates for bonds Beta for equity portfolio

  9. Primary Risks Reflected • Pricing • Loss reserve development • Catastrophe • Investment

  10. Components of Pricing Risk • Random variation • Loss frequency and severity • Inflation affects severity • Correlated with short term interest rates • Line of business specific • Jurisdictional risk • Underwriting cycle

  11. Jurisdictional Risk State specific Range of rate changes established Narrower range in more restrictive states Time lag for implementing rate change Longer in more restrictive states Increases take longer to implement than decreases

  12. Underwriting Cycle Four phases Immature hard Mature hard Immature soft Mature soft Each phase has different supply-demand function Probability distribution for moving to different phase next period

  13. Loss Development Risk • Initial reserve levels based on actuarial analysis, not statement values • Still subject to random variation • Inflation also affects reserve development • Initial reserves reflect specific inflation rate • Changes in inflation rate affect development

  14. Catastrophe Risk • Poisson distribution for number of catastrophes • Each catastrophe assigned to a geographic focal point • Based on focal point, size of catastrophe is determined based on a lognormal distribution • Contagion factor is used to distribute catastrophe to nearby states • Losses distributed based on market share by state

  15. Investment Risk Bonds Market values calculated based on term structure of interest rates Includes provision for default Equities - 3 step approach 1 Initial market return: Short term interest rate + market risk premium of 8.5% 2 Adjusted market return: Initial market return - 4 times change in short term rates 3 Final return includes random component (mean = 0, standard deviation = 15%)

  16. Interest Rate Generator Cox-Ingersoll-Ross one factor model

  17. How to Obtain this Model Access the Miller, Rapp, Herbers & Terry, Inc. homepage (www.mrht.com) Click on DFA Model to obtain DynaMo You need to have Excel to run this model You should have @Risk in order to run full version of the model

  18. How to Learn More about this Model CAS Limited Attendance Seminar on DFA October 1-2, 1998 Chicago, Illinois • Explanation of types and history of DFA • Discussion of common DFA issues • Hands-on workshop using DynaMo • Supervised use of model on participant provided data

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