DFA Implementation Issues CAS Special Interest Seminar on Dynamic Financial Analysis Mary Wills Research & Financial Analysis USAA, P&C Loss Reserving June, 2001

DFA Implementation Issues Selling development of P&C DFA model internally Issues confronted during model development â Build model from scratch in-house, partner with consultant to build new model, or purchase existing model? â Vendor selection process â Model design and customization/enhancement â Enterprise ALM using DFA Other issues that could arise when working with vendor How the P&C DFA model has been used Agenda

Selling P&C DFA Internally Financial services company Primary Product Lines of Business (LOBs) â P&C (personal) â Life (individual) â Banking â Investment management Overview of USAA

Selling P&C DFA Internally Corporate Asset Liability Management Committee Enterprise ALM committee made up of key ALM experts from each LOB â High visibility in enterprise â Tasked with identifying, measuring and recommending actions appropriate to the management of financial risks â Monitors universe of 8 financial risks at enterprise and LOB level Capital market volatility Interest rates Concentration Credit LiquidityCatastrophes Pricing/UnderwritingReserving

Universe of Risks P&CLifeBank Mutual Funds/ Brokerage PensionEBA Interest Rate and Stock Market Risk Concentration and Credit Risk Reserving Risk Catastrophe Risk Pricing/Underwriting Risk Liquidity Risk Selling P&C DFA Internally Corporate Asset Liability Management Committee

Selling P&C DFA Internally Approach for Obtaining Approval to Implement Developed executive tutorial to gain buy-in on P&C DFA up front â Outlines expected uses for DFA Capital managementAsset allocation Liquidity managementRating agency support Pricing & reserving studiesReinsurance studies Support enterprise-wide DFA â Emphasis on how DFA output would be summarized into formats useful for decision making and strategy/policy development â Includes both the capabilities of DFA as well as its limitations P&C DFA model seen as a natural next step to adding sophistication and integration to corporate ALM process

Issues Confronted During Model Development Considerations â Lack of DFA expertise within P&C division â Desired timeframe for implementation Decision â Combined buying and building: Purchased existing vendor model, and made significant modifications to model to reflect company’s unique operations Was it the right decision? â Probably the only way to get the ball rolling and implement within reasonable timeframe â Gradually building expertise in-house Build Model from Scratch In-House, Partner with Consultant to Build New Model, or Purchase Existing Model?

Issues Confronted During Model Development Vendor Selection Process Developed detailed selection criteria â Importance of DFA to firm’s strategy â Concentration of expertise in one person vs. department of experts â Broad expertise: P&C actuary, economics, investments, modeling, etc. â Open architecture of model â Flexibility of model to be changed by company staff â Model run time â Confidence in and documentation of model and underlying theories, including methodology for generating economic scenarios

Issues Confronted During Model Development Developed detailed selection criteria (continued) â Ability to use model to support identified needs â Ability to interface P&C model with company’s other existing ALM tools â Good balance between strategic focus and level of detail â Ease of use of scenario diagnostic tools â Proactive relationships with rating agencies and regulators â Number of asset classes, P&C lines and reporting periods supported â Ease of model maintenance (impact of new releases, ease of loading large amount of data) Vendor Selection Process

Issues Confronted During Model Development Vendor Selection Process Conducted phone interviews to narrow the field, and held on-site meetings and model demos with selected vendors Developed matrix of pros and cons by vendor, based on established selection criteria How well did we do in the selection process? â Good job of developing comprehensive list of questions to determine how well each vendor’s model met our needs, but should have given more attention to ease of loading large amount of data â Devoted sufficient time and diverse group of experts; however, perhaps should have also included our IT experts in evaluation process â Decision was more difficult than we anticipated -- each vendor had strengths and weaknesses

Issues Confronted During Model Development Level of detail â Operational versus strategic tool -- misperception that model should replace existing financial forecast (point estimate) planning tool â Usual checks not in place -- P&C industry’s relatively low level of experience with product & lack of IT involvement Parameterization Commitment of company resources â Grossly underestimated staff time required, as well as length of time for project â Budget issues Model Design and Customization/Enhancement

Other Issues That Could Arise When Working With Vendor Very difficult to get a thorough understanding of vendor’s model and its strengths and weaknesses until committed to vendor Little control over resources assigned to project Different interpretations over what falls within or outside project scope Once cost and timeframe locked in, quality may get lower priority

Issues Confronted During Model Development Enterprise ALM Using DFA P&CLifeBank PensionEBA Economic Simulator (Inflation, Interest Rates, Stock Market) Enterprise MF/ Brokerage

How the P&C Model Has Been Used Capital management â Measure variability in net worth over planning horizon and identify major sources of risk that cause fluctuations â Better understand the interaction of these risks â Future plans  Determine if risks can/should be reduced or eliminated  Determine how much capital must be held against those risks  Test risk management strategies P&C portfolio asset allocation Rating agency support P&C reinsurance strategy analysis

How the P&C Model Has Been Used Future applications â Reserve risk margin analysis â Pricing studies â Liquidity studies Side benefits â Utilized dynamic feature of DFA model to build new model for deriving aggregate level reserve ranges for actuarial reports â Parameter analysis for DFA model also provides benefits to other areas of actuarial work