Using the Public-Access DFA Model: A Case Study

1. Using the Public-Access DFA Model: A Case Study Richard Gorvett, FCAS, Ph.D. The College of Insurance Thomas Hettinger, ACAS Miller, Rapp, Herbers & Terry, Inc. Robert Walling, ACAS Miller, Rapp, Herbers & Terry, Inc. CAS Seminar on Dynamic Financial Analysis July, 1998

2. Outline of Our Case Study • Description of the MRH&T Public-Access DFA Model • Description of the Company • Information Requested From the Company • Initial Findings • Presentation to Company Management • Reaction of Company Management: Their Concerns and Our Responses • Future Model Enhancements • Conclusions

3. DynaMo:The Public-Access DFA Model • Developed by Miller, Rapp, Herbers & Terry, Inc. (with Academic Assistance) • Freely Available -- Encourages Industry Input • www.mrht.com • Excel and @Risk • Stochastic Simulation • Specify Inputs • Select Outputs

4. DynaMo Catastrophe Generator U/W Inputs U/W Cashflows U/W Generator Payment Patterns U/W Cycle Tax Investment Cashflows Interest Rate Generator Investment & Economic Inputs Investment Generator Outputs & Simulation Results

5. Risks ModeledUnderwriting • Pricing • Claim Frequency and Severity (Non-Cat.) • Inflation • Aging Phenomenon • Jurisdictional • Underwriting Cycle • New Business Penalty • Loss Reserve Development • Catastrophes

6. Risks ModeledFinancial • Interest Rates • Cox-Ingersoll-Ross • dr = a(b-r)dt + sr0.5dz • Mean-Reverting; Rate-Sensitive Volatility • Inflation • General (CPI): Function of Simulated Interest Rate • Line of Business: Function of Simulated CPI • Equity Market Performance

7. Outputs Available • 5-year Projections • Balance Sheets • Income Statements • Loss Ratio Reports • IRIS Tests • Others as Needed • Select Any Cell of Spreadsheet • Graphs and Histograms

8. Internal Strategic Planning Ratemaking Reinsurance Valuation / M&A Market Simulation and Competitive Analysis Asset / Liability Management External External Ratings Communication with Financial Markets Regulatory / Risk-Based Capital Capital Planning / Securitization Model Uses

9. Description of Case Company We applied DynaMo to an actual insurance company having the following attributes: • Mid-size Property-Liability Insurer • Writes Nationally • In Business for More than Twenty Years • Multi-line

10. Lines of Business • Private Passenger Auto • Homeowners • Commercial Auto • Commercial Multiple Peril • Workers Compensation • Others

11. Reinsurance Contracts • Excess-of-Loss • Quota Share • Catastrophe • Aggregate Stop Loss

12. Data Requested From Company • Annual Statements • Expense Data • IEE • Future Plans • Historical Loss Data • Actuarial Analysis • Direct, Ceded, and Net • Historical Premium Data • By Renewal Category Where Possible • Reinsurance Program

13. Data Requested From Company • Underwriting Data -- by Line of Business • New and Renewal Exposures Written • Renewal Ratios • Projected Growth Rates • Exposure Distribution • Policy Limit Profile • Asset data • Statutory and Market Values, by Asset Type • Coupon and Dividend Rates • Equity Betas

14. The DFA Process • Review Company • Gather Data • Modify Base Model to Best Reflect ABC’s Structure • Group and Ungroup Lines of Business • Unique Reinsurance? • Unique Assets? • Other

15. The DFA Process (cont.) • Enter Data • Run Model • How Many Simulations? • Review Results • Graphs • Exhibits

16. The DFA Process (cont.) • Check for Reasonableness • Premiums • Losses • Asset Values • Compare Modeled Latest Two Years to Actual • Loss Ratios • ...

17. The DFA Process (cont.) • Re-parameterize Model • Frequencies • Severities • Interest Rates • Other • Accept or Reject • What Criteria?

18. The DFA Process (Cont.) • Modify and Rerun Model • Sensitivity Test By Changing Parameters • Determine Plan of Attack

19. A Second Look at Parameters • New Business Penalty • Frequencies • Severities • Interest Rates • Long Term Mean • Volatility • Underwriting Cycle • Trends in WC and HMP Results

20. Initial Findings - Areas to Review • Dispersion of Results • Probability of Undesirable Results • Maximum and Minimum

21. Initial Findings • Surplus Steadily Decreased Over the 5 Year Period • Great Variability in Year 2002 Results • Probability of Negative Surplus

22. Year 2002 Surplus DistributionOriginal Assumptions

23. Initial Findings - Possible Reasons Large Growth Objectives Surplus Drain Renewal Ratio New Business Penalty

24. Initial Findings - Additional Complications Growth Objectives Loss Ratio Deterioration Adverse Reserve Development Unacceptable Surplus Drain Devaluation of Assets Unusual Catastrophes

25. What Now? • Leave As Is • Make Adjustments and Rerun • Critical Variables • Parameters

26. Critical Variables • Exposure Changes • Expense Provisions • Frequencies and Severities • Initial Selections • New Business Penalty • Growth Rates • Interest Rates • Current • Long-Run

27. Critical Variables (cont.) • Parameter Adjustments • Inflation • U/W Cycle (Probability of Turning) • U/W Cycle (Supply and Demand Curves) • Jurisdictional Risk • Renewal Ratios • Reinvestment Allocations • Stock Betas • U/W Cycle (Current Position)

28. Critical Variables (cont.) • Reinsurance Arrangements • Q/S • XOL • CAT • Stop Loss • Retention • Cost • Commission • Ceding %

29. Presentation of Initial Findings • Initial Report to Management • Information about DynaMo and DFA • Results/Simulations for 2 Initial Scenarios • Meeting With ABC and Authors • Actuarial • Investments • Reinsurance • CFO • Interactive Session • Q & A • Laptops for Training and Variation

30. Suggested Changes • Our Original Suggestion • Temper Growth Rate • ABC’s Suggestion • Adjusting Growth Unsatisfactory • Renewal Ratio • New Business Penalty (Tighten U/W) • Exposure Distributions • Our Additional Recommendation • Changing Reinsurance Provisions

31. Other Changes • Change Long Term Interest Rate • Tendency of Interest Rates Climbing (Mean Reverting Property of C-I-R Model) • Higher Investment Return • Lower Future Value of Current Bonds • Higher General Inflation • Higher Claims Inflation • Greater Than Expected Losses

32. Year 2002 Surplus DistributionConstrained Growth Assumptions

33. Year 2002 Surplus Distribution Different Reinsurance AssumptionsIncreased Stop Loss Max Ceding Amount

34. Year 2002 Surplus Distribution Different Reinsurance AssumptionsLowered Stop Loss Attachment Point

35. Year 2002 Surplus DistributionSlightly Constrained Growth, Tightened Underwriting, and Increased New Business Retention

36. ABC’s First Impressions • Excel/@Risk Platform • Understandability • Ability to Modify

37. ABC’s View on Using the Model • Strategic Planning • Capital Allocation • Reinsurance Contract Negotiations • Internal Communications • External Communications • Regulators • Rating Agencies • Investment Community • Other Company Assessment

38. ABC’s Concerns • Usability With Other Software • Catastrophe Models • Fixed Income Security Software • Presenting Results to Senior Management • Comparing Expected vs. Actual • Project Last Year and Look at Differences • Enhanced Assets • Callable Bonds • CMO’s

39. Future Enhancements • Expand Enterprise-Wide Modeling Capabilities • Enhancements to Assets • Callable Bonds • Other Options Embedded in Bonds • CMO’s • Foreign Currency Risk • More Sophisticated Reinvestment Abilities • Add State and/or Regional Detail in U/W Module

40. Future Enhancements (cont.) • Enhancement of U/W Cycle Module • Supply/Demand Curves • Impact on Retention Rates • Impact on Jurisdictional Risk • Additional Correlations Between LoB’s • Add Tax Carry-Forwards and Carry-Backs • Additional Outputs • RBC • BCAR • Others

41. Summary and Conclusions • The MRH&T Public-Access Model • Publicly Available • Use Encouraged; Comments Welcome • Evolving • Application of DFA Model to Companies • Model Flexibility is Important • Test the Results; Make Adjustments if Necessary • Listen to the Company