MANAGING ASSET/LIABILITY RISK WITH REINSURANCE AND ASSET STRATEGIES - A P/C Insurance Company Application Casualty Actuarial Society Casualty Loss Reserve Seminar September 13-14, 1999 Manuel Almagro, Tillinghast-Towers Perrin Stephen W. Philbrick, Swiss Re Investors - Falcon Asset/Liability Management

Today’s Agenda Company’s Objectives Approach to Asset/Liability Risk Management Profile of Company Analysis of Current Strategy Design and Evaluation of Alternate Strategies Conclusions

ALMCO’s GOALS AND OBJECTIVES ALMCo is concerned about: Expected value and volatility of operating income Specific focus is on GAAP income Exposure to insolvency risk Absolute level and variability of Statutory Surplus Cost effectiveness of its reinsurance purchase Measured by impact on Economic Value of ALMCo Constituents include: Owners Policyholders Rating Agencies & Regulators

ALMCO’s GOALS AND OBJECTIVES ALMCo’s goal is to better manage its risk/return profile Alternatives include: Re-underwrite/shift type of business Change rates/terms of coverages provided Restructure its ceded reinsurance for existing and future liabilities Revise its asset allocation profile and investment style ALMCo has chosen to evaluate alternative reinsurance and asset strategies Alternative reinsurance structures for prospective business were considered in conjunction with Alternative asset allocation strategies

APPROACH TO ASSET/LIABILITY RISK MANAGEMENT Build financial model of ALMCo Identify drivers of financial risk Decomposition of financial statement variability Design potential alternate Reinsurance/Asset strategies Analyze distributions of: GAAP Income, Economic Value, and Statutory Surplus Modify alternative covers to achieve desired objectives

APPROACH TO ASSET/LIABILITY RISK MANAGEMENT Build model of ALMCo to reflect The financial risks to which ALMCo is exposed The risks are multi-period and integrated The impact of each strategy on financial results Therefore the model of ALMCo should: Simulate Gross loss experience Able to evaluate alternative reinsurance structures Include candidate asset categories being considered Including only asset classes acceptable to ALMCo Cover a three year projection period Reflects ALMCo’s planning horizon and existing business plan

APPROACH TO ASSET/LIABILITY RISK MANAGEMENT Model organization is important for accurate reflection of risks ALMCo Investment Strategy Capital Markets Economy ALMCo Assets ALMCo Financials Insurance Market ALMCo Liabilities ALMCo Reinsurance Strategy Liability Cashflows

APPROACH TO ASSET/LIABILITY RISK MANAGEMENT Each simulation component produces 500 - 20,000 scenarios Each scenario represents a single path through time for all variables A cascade structure allows dependency between selected variables Simulation Components Capital Markets Economy ALMCo Assets Insurance Market ALMCo Liabilities Liability Cashflows

APPROACH TO ASSET/LIABILITY RISK MANAGEMENT The financial component transforms scenario results into financial statements Economic, GAAP and Statutory bases are produced Earnings, cashflows, surplus, etc. - based on the particular characteristics of ALMCo (tax laws, accounting rules….) Simulation Components Capital Markets Economy ALMCo Assets ALMCo Financials Insurance Market ALMCo Liabilities Liability Cashflows

APPROACH TO ASSET/LIABILITY RISK MANAGEMENT The strategy components apply management decisions to scenario results Alternate strategies can be evaluated using desired reward/risk measures Searching a range of strategies for the best reward/risk combinations produces an efficient frontier ALMCo Investment Strategy Capital Markets Economy ALMCo Assets ALMCo Financials Insurance Market ALMCo Liabilities Liability Cashflows ALMCo Reinsurance Strategy

APPROACH TO ASSET/LIABILITY RISK MANAGEMENT Different strategies are compared using the company’s selected measures for reward and risk Ideal strategies have higher reward and lower risk

APPROACH TO ASSET/LIABILITY RISK MANAGEMENT The “efficient frontier” is the set of possible strategies that either maximizes reward for a given level of risk or minimizes risk for a given level of reward

APPROACH TO ASSET/LIABILITY RISK MANAGEMENT This framework can be used to evaluate the current strategy and find others that reduce risk or increase reward

APPROACH TO ASSET/LIABILITY RISK MANAGEMENT In order to decide which of the efficient strategies to choose, we need to analyze the entire distribution of results

OBJECTIVES & APPROACH - Recap ALMCo has completed three steps in Asset/Liability Risk Management: Identified goals and objectives Developed an approach to a stochastic model which accurately represents the risks from assets, liabilities, and their interaction; and their impact on financial results Laid out a framework for analyzing these risks and strategies for modifying them in light of the expressed objectives Now ALMCo can proceed to applying this process to their specific circumstances

Today’s Agenda Company’s Objectives Approach to Asset/Liability Risk Management Profile of Company Analysis of Current Strategy Design and Evaluation of Alternate Strategies Conclusions

PROFILE OF COMPANY - Premium & Expenses Expected Loss & LAE Ratio: Gross: 54% Net: 58% Expenses (to Net Prem): Commissions: 16% Taxes, Lic & Fees: 4% General Expense: 26% Expected Combined Ratio: Net: 104%

PROFILE OF COMPANY - Loss & LAE Liabilities Characteristics: Duration: Liquidation Basis: 2.3 Ongoing Basis: 3.3 Note: For this analysis the reinsurance on balance sheet liabilities was not restructured

PROFILE OF COMPANY - Expected Liability Cashflow

PROFILE OF COMPANY - Current Reinsurance Program Liability Lines of Business Net Retention of $1.0 Million 25% Quota Share on Net Miscellaneous covers reduce certain lines to a $500 K Net Cost: 40% of Direct WP Property Lines of Business Net Retention of $100K per risk Cat protection of $140 Million Excess of $10 Million Cost: 55% of Direct WP

PROFILE OF COMPANY - Assets Characteristics: Duration: 4.3 Expected Return: 5.2% Current Investment Style: Buy and hold Assets marked as available for sale High quality - Investment grade Conservative - very low risk of loss of principal

PROFILE OF COMPANY - Historical Experience Actual historical experience provides evidence of volatility and relatively low returns Ten year average Return On Equity = 8.9%

CURRENT STRATEGY - Projection of GAAP Income Current strategy reduces income volatility, but Significant probability of low/negative income in any given year

CURRENT STRATEGY - Statutory Surplus Projection In any given year there is a significant potential of decline in statutory surplus

CURRENT STRATEGY - Decomposition of Risk Total variance before reinsurance = 46.4 Billion 45.1 from Liabilities, 2.1 from Assets, (0.8) Covariance Total variance after current reinsurance = 12.5 Billion 11.6 from Liabilities, 1.3 from Assets, (0.4) Covariance

CURRENT STRATEGY - Reinsurance Strategy Efficiency Reinsurance in Current Strategy: Approximate $105 Million reduction in Standard Deviation, but Economic cost of $80 million over three year period

CURRENT STRATEGY - Efficiency of Asset Allocation

PROFILE & CURRENT STRATEGY - Recap Mid-sized Company with Property and Liability Exposures Risk Exposure is Virtually all Underwriting Significant Reinsurance Provides protection but at a healthy cost Conservative Asset Mix - But not Efficient Yet, results are still volatile Conservative Reinsurance coupled with Conservative Assets is not enough to eliminate volatility

Today’s Agenda Company’s Objectives Approach to Asset/Liability Risk Management Profile of Company Analysis of Current Strategy Design and Evaluation of Alternate Strategies Conclusions

ALTERNATE STRATEGY 1 - Design Reinsurance Structure: Aggregate Excess of Loss Attachment at 50% Loss Ratio Limit of 100 Loss Ratio Points Cost: 27.5% of Direct WP Asset Allocation: Shift to longer duration Fixed Income Increase Equity Allocation

ALTERNATE STRATEGY 1 - Economic Value Modest total risk reduction, with increase in value of $45 million Must also look at GAAP income and Statutory Surplus

ALTERNATE STRATEGY 1 - GAAP Income Downside risk is dramatically reduced Increases upside potential Lower expected income due to shift towards unrealized income

ALTERNATE STRATEGY 1 - Statutory Surplus Significantly improves downside and upside potential

ALTERNATE STRATEGY 2 - Design Alternate 2 - Integrated Aggregate Excess of Loss Reinsurance: Attachment at 50% Loss Ratio Limit of 100 Loss Ratio Points Attachment point adjusted downward for Equity returns below 10% Adjustment rate is one-for-one Cost: 32.5% of Direct WP Asset Allocation: Use allocation derived for Strategy 1

ALTERNATE STRATEGY 2 - Economic Value Very small economic cost with dramatic risk reduction But again, we must look at GAAP income and Statutory Surplus

ALTERNATE STRATEGY 2 - GAAP Income Downside risk is comparable or better than Alternative 1 Improvement in expected income and upside potential

ALTERNATE STRATEGY 2 - Statutory Surplus Further reduction in downside risk over Alternative 1, and Modest improvement in upside potential

ALTERNATE STRATEGY 2 - Decomposition of Risk Alternate Strategy 2 takes best advantage of Covariance Better diversification of risk between Assets and Liabilities

DESIGN & EVALUATION OF STRATEGIES - Recap ALMCo has identified a reinsurance/asset strategy that addresses its concerns: The strategy reduces the variability of GAAP income from

DESIGN & EVALUATION OF STRATEGIES - Recap ALMCo has identified a reinsurance/asset strategy that addresses its concerns: The strategy improves the downside risk to Statutory Surplus

DESIGN & EVALUATION OF STRATEGIES - Recap ALMCo has identified a reinsurance/asset strategy that addresses its concerns: The strategy improves Economic Value

Conclusions A Financial Integrated Risk Management approach is an effective way to evaluate reinsurance and asset strategies Analysis of strategies should simultaneously examine reinsurance and assets A stochastic approach is necessary to get a full appreciation of the impact of strategies