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lmn. Dynamic Financial Analysis: Objectives & Design Gerald S. Kirschner, FCAS, MAAA. Presented at: 1998 DFA Seminar July 13-14, 1998. Evolution of DFA Call Papers & Seminars. 1995 Call Paper: Incorporating Risk Factors in DFA Montreal, 1996: Models in Use I

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  1. lmn Dynamic Financial Analysis:Objectives & Design Gerald S. Kirschner, FCAS, MAAA Presented at: 1998 DFA Seminar July 13-14, 1998

  2. Evolution of DFA Call Papers & Seminars • 1995 Call Paper: Incorporating Risk Factors in DFA • Montreal, 1996: Models in Use I • Seattle, 1997: Models in Use II / Defining Model Variables • Boston, 1998: Applications and Uses • Chicago, 1999: Parameterizing Models • New York, 2000: Presentation of Results and Implementation of Strategies lmn

  3. Issues with DFA Acceptance • “Show me the value…” • In terms of knowledge gained • In terms of risk / reward trade-offs • In terms of implementation cost versus bottom-line payoff • Lack of objective evidence of DFA’s value • Insurance company focus • Translation of a “numbers analysis” to a big picture presentation lmn

  4. Why do DFA, then? • First one(s) to profit from the knowledge can establish better strategic directions • Accounting view of an insurance company does not help manage the organization going forward. • An approach that is looks at the organization as a going concern, subject to interactions too complex to understand individually, focusing on cash and not accounting gives fundamentally different insights than traditional planning and forecasting. • Competitive edge • Consistency of communication within an organization lmn

  5. So who’s doing DFA? • Actuaries • Strategic planners • Financial analysts • Investment professionals All are using DFA as an analytic tool to support senior management’s decisions lmn

  6. Uses of DFA • Realism of a Business Plan • Product & Market Development • Claims Management • Capital Adequacy • Capital Allocation • Liquidity Analysis • Reinsurance Structure • Asset or Investment Strategy Analysis • Rating Agency Support • Merger & Acquisition Opportunities lmn

  7. Evolution of Financial Modeling • STAGE 1: Financial Budgeting = Static modeling with one set of assumptions + Estimated Capital 0 Bankruptcy - 2000 2003 1999 2002 1998 2001 Year lmn

  8. Evolution of Financial Modeling • STAGE 2: Sensitivity or Stress Testing = Static modeling that incorporate “best case” and “worst case” scenarios along with the expected outcome + “Best Case” Estimated Capital “Worst Case” 0 Bankruptcy - 2000 2003 1999 2002 1998 2001 Year lmn

  9. Evolution of Financial Modeling • STAGE 3: Stochastic Modeling = Modeling that describes critical assumptions and their combined financial implications in terms of ranges of possible outcomes Expected Value 5% Probability 5% Probability Probability Projection Year + - 0 Estimated Capital Bankruptcy lmn

  10. Evolution of Financial Modeling • STAGE 4: Dynamic Modeling = Stochastic modeling that incorporates feedback loops and “management intervention decisions” into the model calculation flow. 2003 2002 2001 Year 2000 Probability 1999 1998 + - 0 Estimated Capital Bankruptcy lmn

  11. One Possible Flow of Logic in an “Enterprise Wide” Generalized Model Inflationary Scenario Forward Interest Rate Scenario Underwriting assumptions Equity Market Scenario Calendar Year Cash Flows Asset Mark to Market Asset Rebalancing & Reinvestment • Balance Sheets, Income Statements • Internal Results Measurements • NAIC Measurements (RBC, IRIS) • Rating Agency Measurements Federal Income Tax Calculation lmn

  12. Current State: Key Dynamic Elements • Interest rates & changes in equity market values • Inflation rates • Future premium volumes • Future loss ratios or future changes in loss frequency and severity • Reserve adequacy • Loss payout patterns • Exposure to catastrophic losses • Management decisions / model responses to changing conditions lmn

  13. Future State: More Research Is Needed • Correlations • Between lines of business • Between years within a line of business • Between asset classes • Underwriting cycles / competition • Capital markets and insurance industry • Change in rating by a rating agency • Multi-national insurance models • Multi-industry models lmn

  14. At the end of the day, what has the biggest impact on model results? • Depends on what measurement is being evaluated and on what basis (statutory, GAAP, economic, etc.) lmn

  15. $400,000 $375,000 $350,000 $325,000 $300,000 $275,000 Spread: $103 M Spread: $79 M Spread: $97 M Spread: $101 M Spread: $101 M Spread: $88 M Spread: $111 M $250,000 Everything Dynamic Static Interest Rates Static Loss Ratios No Reserve Redundancy or Deficiency Static Payout Pattern No Payout Inflation No Feedback Loops in Pricing Percentiles: 95% Mean 5% Example: Surplus After 5 Years Dollars in Millions lmn

  16. Comparison of Impact of Current State Drivers in Surplus Example lmn

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