DRAFT #1 DFA DFA Applications in Profit and Capital Allocation Presented at the Casualty Actuarial Society 2000 Ratemaking Seminar San Diego.

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Presentation transcript:

DRAFT #1 DFA DFA Applications in Profit and Capital Allocation Presented at the Casualty Actuarial Society 2000 Ratemaking Seminar San Diego

DRAFT #1 Panelists & Topics... Chuck Emma Chuck Emma ( Miller, Herbers, Lehmann, & Associates, Inc.) Profitability and Capital Allocation Overview Kevin Olsen Kevin Olsen (GuideOne Insurance) Capital Allocation Example Manny Almagro Manny Almagro (Tillinghast - Towers Perrin) Asset & Reinsurance Strategies Example

Profitability and Capital Allocation What I’m Going to Talk About... â Ratemaking and DFA: The Link â Technical Discussion 1.Individual Company Capital Standard 2.Capital Allocation: A DFA Approach 3.Profitability Analysis 4.The Profit Provision: A DFA Approach

Profitability and Capital Allocation Ratemaking and DFA: The Link? â “Ratemaking is a longstanding set of actuarial methods and principles” â “DFA is this new set of computer models which projects financials.” â “SO, STOP CONFUSING US!”

Profitability and Capital Allocation Ratemaking and DFA: The Link Capital DFA Ratemaking Capital is the link. DFA is the leading methodology for defining it. Ratemaking conclusions are incomplete without it.

Profitability and Capital Allocation Ratemaking and DFA: The Link “OK, but what does this mean, practically…” â Total company profitability can be measured â DFA provides a rigorous basis for measuring required capital â More “holistic” rate of return standards can be developed on company and line specific bases â A rate’s profit provision can be calculated

Profitability and Capital Allocation 1. Individual Company Capital Standard The Method â Define Critical Metrics –ROE (maximize subject to risk constraints) –Risk Adjusted ROE (maximize) â Analyze Variability of this Measure by Stochastic Process â Arrive at Optimal Capitalization Level

Profitability and Capital Allocation 1. Individual Company Capital Standard The Analysis Statistic Base Case Strategy Dividend - Up Strategy Mean15.0%17.0% Standard Deviation5.0%8.6% CV %-4.0%-8.0% 10%1.0% Indication that less capital means more ROE variability

Profitability and Capital Allocation 1. Individual Company Capital Standard The Decision Graph ROE 0.0% 15.0% 17.0% Base Case Dividend Up ProbabilityProbability

Profitability and Capital Allocation 2. Capital Allocation Motivations â Performance Measures of Return on Surplus by Line / Business Unit â Financial Reporting â Ratemaking

Profitability and Capital Allocation 2. Capital Allocation Basic Notions â Capital is needed to absorb potential operating losses â By line profitability requires allocating investment income

Profitability and Capital Allocation 2. Capital Allocation Methods â Relative Variability â Downside Measures –“surplus burn” at defined confidence levels â Most formula processes require re-balancing

Profitability and Capital Allocation 2. Capital Allocation Surplus Burn Example Ordered TrialPP Auto Gain/(Loss) %HO Gain/(Loss) % Each line devours capital, ordering the trials. Only loss outcomes are considered until total capital is gone or no more losses. At 10% confidence level, Homeowners requires 9/13 or 69.2% of the company’s capital.

Profitability and Capital Allocation 3. Return Analysis Basic Notion â Analyze net profitability by line using allocated capital to calculate line ROE â Distribution gives rise to efficient frontier

Profitability and Capital Allocation 3. Return Analysis The Analysis Risk ReturnReturn PP Auto Homeowners New Line

Profitability and Capital Allocation 4. The Profit Provision: A DFA Approach Basic Notion â Profit provision, “U” is part of total line profitability equation using target ROE â Use concepts in Mahler Part VI Note (1985 CAS Proceedings): U i = 1 – (t + (L i +E i )/P i ) â Analyze various provided U’s for each line using total company ROE concept. Refine as necessary.