1 Casualty Loss Reserve Seminar September 14, 1999 Presented by: Susan E. Witcraft Milliman & Robertson, Inc. DYNAMIC FINANCIAL ANALYSIS What Does It Look Like?

2 WHAT IS DFA? l Management tool l Regulatory tool

3 USES FOR DFA l Estimate probability of attaining certain results l Identify risks to company l Capital allocation l Evaluation of alternate strategies

4 OVERVIEW OF PROCESS Input Scenarios Output Select Strategy Financial Calculator

5 OVERVIEW OF PROCESS Input Scenarios Output Select Strategy Financial Calculator

6 INPUT l PREMIUM u Amount u Earning pattern u Collection pattern

7 INPUT l LOSSES AND LAE u Loss ratio on small claims u Frequency of large claims u Severity of large claims u Catastrophes u Reserve adjustments u Payment patterns

8 INPUT l EXPENSES u Fixed u Variable

9 INPUT MODELS l Premium volume l Losses and LAE l Reserve development l Payment patterns l Expenses l Assets

10 LOSS RATIO MODEL wherei is the year l/r is the undiscounted loss ratio int is the short-term yield inf is the inflation rate a, b, c, and d are constants e is a random error term l/r i = a(l/r i-1 ) + b(int i-1 - int) + c (inf i - inf) + d + e i

11 EXPENSE MODEL Fixed expenses i = Fixed expenses i-1 x (1 + inf i ) + e i wherei is the years inf is the inflation rate e is a random error term

12 OVERVIEW OF PROCESS Input Scenarios Output Select Strategy Financial Calculator

13 STRATEGIES l Investment l Reinsurance l Business mix l Pricing

14 STRATEGIES Distribution of New Investments Among Types

15 PORTFOLIO OPTIMIZER l Entire business (both assets and liabilities) viewed as a single portfolio l Considers risk from the perspective of the entire organization

16 PORTFOLIO OPTIMIZER l Calculates line of business and asset mix that maximizes expected return for any given level of standard deviation - OR - l Calculates mix that provides lowest risk for a given level of return

17 PORTFOLIO OPTIMIZER l Inputs u Reserve to premium ratios for each line of business u Expected underwriting and asset returns and standard deviations u Correlation matrix between underwriting returns, asset returns, and between underwriting and asset returns l Constraints u Constraints on line of business mix and percentages of asset portfolio invested in various asset classes u Reserve to surplus ratio (alternatively, premium to surplus ratio)

18 OPTIMAL ASSET MIX TARGET RETURNS

19 OVERVIEW OF PROCESS Input Scenarios Output Select Strategy Financial Calculator

20 SCENARIOS l Economy l Underwriting cycle l Catastrophes l Large claims l Failure of reinsurer l Mass torts

21 ECONOMIC SCENARIOS l GDP growth l Inflation l Interest rates u Short-term u Long-term l Stock returns l Bond default rates Produce simulated projections of:

22 ECONOMIC VARIABLES Note: Stock Appreciation is plotted against the axis on the right of the graph.

23 ECONOMIC SCENARIOS l Output used as inputs for income and balance sheet variables l Each scenario provides consistent set of assumptions for projection of future financial results

24 OVERVIEW OF PROCESS Input Scenarios Output Select Strategy Financial Calculator

25 FINANCIAL CALCULATOR- UNDERWRITING l Project net premium, losses and expenses u Income statement basis u Cash basis u Tax basis

26 FINANCIAL CALCULATOR- ASSET MODEL l Calculate investment income l Add cash from operations, asset maturities and asset sales u Produce total funds available for investment each projection period l Invest total funds available for investment u Strategy specified by user l State end-of-year balance sheet u Carried forward to next projection period

27 OVERVIEW OF PROCESS Input Scenarios Output Select Strategy Financial Calculator

28 CHANGE IN SURPLUS

29 FINDINGS

30 RISK/REWARD ILLUSTRATION A B C D E Risk Reward X

31 RISK/REWARD SUMMARY Average Annual Surplus Increase Probability Net Income/Surplus < 10% Current 2. More Corporates 3. Stocks & Corporates 4. More Non-Taxables 5. Duration Match

32 RISK/REWARD SUMMARY Average Annual Surplus Increase Standard Deviation of Surplus Increase Current 2. More Corporates 3. Stocks & Corporates 4. More Non-Taxables 5. Duration Match

33 Casualty Loss Reserve Seminar September 14, 1999 Presented by: Susan E. Witcraft Milliman & Robertson, Inc. DYNAMIC FINANCIAL ANALYSIS What Does It Look Like?