Capital Management using DFA Tom Weidman XL America CAS - November 14, 2001

Today’s Agenda Company Case Study: Observations following 9-11 DFA Model 2000: results & critique Planning for DFA Model 2001 Observations following 9-11

What can DFA do? strategic planning operational planning valuation product development pricing reinsurance/retrocessional structure

DFA Obstacles DFA is complex each company and underwriting portfolio is unique risk/reward measures are numerous management not aware of DFA

DFA 2000 - Process Objective: determine capital requirements by major operating unit as a check on S&P’s capital model Capital requirement = probability of insolvency @ AA rating level Working team consisted of members of each operating unit for underwriting and liability modeling plus corporate investment representative for asset model assumptions Operating units met regularly from April through August to discuss and critique relevant assumptions

DFA 2000 - Process Utilized DFA software - Finesse version 3.1 Monte Carlo simulation using 5000 iterations of possible annual outcomes Simulated 5 years of future projections using 12/99 balance sheet and 5-year forecast as base case Dynamic approach allows future contingent decision options LOBs within business units not highly correlated Underwriting cycle similar for all business units

DFA 2000 - Results Major drivers of capital requirement in order of magnitude: property catastrophe aggregation including scenarios with more than 1 event per year - material affects to capital and future years’ investment income loss reserve adequacy especially for longer-tail casualty business [used 6/30/2000 view of 12/99 reserve adequacy] pricing adequacy investment strategy

DFA 2000 - Future Objectives All business units have a working model but need: (1) revisions to match product line alignment and (2) an aggregate companywide model to quantify additional capital benefit of diversification among business units Uses include budgeting and cash flow projections, capital allocation, reinsurance structure evaluation and asset strategy optimization Working team will review current model capabilities against alternative DFA approaches Continue discussions with S&P regarding value of alternative capital models for property-casualty insurance

DFA 2001 Objectives Develop RAROC approach: for all major business units & aggregate need economic return methodology especially for long-tailed businesses incorporate diversification benefit Separate investment risk and underwriting risk (investment function becomes its own profit center)

RAROC 2001 Objectives Include capital projections within business planning, reporting, and performance measurement Link RAROC to GAAP Hire consultant, revisit software Continue to discuss with rating agencies

Revisit Software: Issues Snapshot vs. multi-year VaR/risk of ruin vs. total cost of ruin stochastic DFA vs. statistical model specification Accounting vs. Economic return RAROC hurdle rate

S&P Capital Model Benefit: - Provides quantifiable, “formulaic” minimum ‘AA’ surplus standards we must maintain Shortfalls: - Not dynamic…does not measure embedded economic value, reflects point in time VaR approach rather than multi-year nature of longer-tailed business - Inadequate diversification credit - Catastrophe model is unreasonable and a ‘black box’.

Rating Agency View of DFA Complexity prohibits universal application to 3000 P&C companies very few companies using DFA DFA capital indications may be greater than rating agency models

Observations following 9-11 Extreme value theory gets a boost… http://www.risklab.ch Correlations among lines are higher insurer risk management practices can be improved

Observations following 9-11 Why are insurance industry returns on capital sub-par? Industry is overcapitalized…due to rating agencies Industry pricing is inadequate Industry structure fosters ‘excessive’ competition

Observations following 9-11 Is the insurance industry overcapitalized? Yes: very few downgrades No: new capital raised is $15 billion and growing

Observations following 9-11 Is industry pricing inadequate? Yes….Warren Buffett says so No….capital is pouring in, stock prices are higher than pre 9-11

Observations following 9-11 Buffett, in his letter to shareholders, listed three basic rules for running an insurance company. He said all three were broken at General Re during the past three years: "Only accept risks you are able to properly evaluate . . . and confine your underwriting to business that, after an evaluation of all relevant factors, including remote loss scenarios, carries the expectancy of profit." "Limit the business accepted in a manner that guarantees you will suffer no aggregation of losses from a single event or from related events that will threaten your solvency." "Avoid business involving moral risk: No matter what the rate, you can't write good contracts with bad people."

Observations following 9-11 Is the insurance industry structure sub-optimal? Yes: it traps capital, uses capital inefficiently, is not sufficiently diversified No: there will always be winners and losers, investors can diversify more efficiently

Profiting from DFA….at a professional level DFA increases demand for actuaries’ skills DFA facilitates and increases actuary’s interaction with: CUO, CIO, CFO, CRO (internal) rating analysts, investment analysts, reinsurers, investment managers (external) DFA expands the breadth of the P/C actuary’s responsibilities