The Value Proposition of DFA

1. The Value Proposition of DFA Basic Applications for Real World Decision Making Bob Mueller ACAS Executive Vice President Middlesex Mutual / Country Companies Group

2. Perspectives ... • CFO, Chief Actuary, Corporate Strategist • Small to Mid - sized Company

3. Illustrations ... 1) Asset Allocation Decision 2) Strategic Partnering Decision

4. Anatomy of an Asset Allocation Decision • Year: 1988

5. Anatomy of an Asset Allocation Decision • Historic Financial Profile: Low leverage, high equity investment

6. Anatomy of an Asset Allocation Decision • Emerging Issues • Premium growth 15 - 25% per year • Significant new investment in Real Estate • Pressure from A.M.Best

7. Anatomy of an Asset Allocation Decision Board Finance Committee: • University president with investment background • Regional bank president • Two president/owners of boutique investment management firms • CFO of a national investment management firm • Key Decision Makers

8. Approach • Direct, intuitive • Focus on concept and principal • Quick

9. “Back of the Napkin” Model Total Return = Investment + Underwriting Return T / S = I/S + U/S = I/A x A/S + U/P x P/S = I/A x (1 + L/PxP/S) + U/P x P/S S= Surplus, A= Assets, L=Liabilities, P=premium

10. “Back of the Napkin” Model Total Return = Investment + Underwriting Return T / S = I/S + U/S = I/A x A/S + U/P x P/S = I/A x (1 + L/PxP/S) + U/P x P/S “constant” leverage factors

11. “Back of the Napkin” Model Total Return = Investment + Underwriting Return T / S = I/S + U/S = I/A x A/S + U/P x P/S = I/A x (1 + L/PxP/S) + U/P x P/S random variables

12. Model Results 100% stocks 50% stocks No stocks

13. Model Results

14. Business Conclusions • Risks too high , returns too low at any level of equities • Need to focus on core business issues rather than asset allocation

15. In Summary ... • Advantages • not a “black box” approach • clear linkage of investment and underwriting • gets management acquainted with DFA • Disadvantages • one year projection • not good for “fine tuning” asset allocation or underwriting strategy

16. Strategic Partnering Decision • Year: 1996

17. Strategic Partnering Decision • Business Situation: • $80MM PL in Connecticut and Maine • Good auto results, volatile and unprofitable property results • 100 year return time wind loss = 1.5 x Surplus • Catastrophe insurance ROL approaching 4% • Depressed returns from large real estate investment • Ratings pressure

18. Alternatives • Open Market Reinsurance Product • Contingent Surplus notes etc. • Demutualization and Sale • Merger • Reinsurance Pooling Arrangement

19. Pooling Arrangement • All premiums, losses and expenses pooled with member companies • Retrospective reinsurance treatment of prior loss reserves • Pool results redistributed based on “economic value” surplus • Companies maintain separate surplus and investments

20. DFA Modeling Approach • Focus on the underwriting side of the model • underwriting volatility changes • investment projections left deterministic • State conclusions in terms of relative rather than absolute returns • eliminate need for economic scenarios etc. • Custom built model to accommodate pooling transaction accounting

21. Underwriting model • Accident year loss ratios by line • decomposed historical to cycle + randomness • No reserve uncertainties • Separate catastrophe loss modeling • Distributions from IRAS model before and after pooling • Catastrophe reinsurance modeling

22. Model Results • Parameter Assumption sets • Forecast (expected )underwriting results • Better than past average results • $100MM catastrophe loss • Model outputs • Probability that surplus in 5 years would be X% better under pooling than stand-alone

23. DFA Benefits • Demonstrated significant risk reduction benefit to transaction • Helped achieve regulatory approval • Kept all “stakeholders” focused on the real issues

24. Summary • Avoid the “model in search of a problem” • Avoid “black box” modeling • Understand the people you’re influencing • Focus on relative performance