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

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

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

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

5. DFA Process
Objective: determine capital requirements by major operating unit as a check on S&P’s capital model
Capital requirement = probability of 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

6. 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

7. DFA 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

9. 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

10. 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)

11. 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

12. 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

13. 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’.

14. 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

15. Observations following 9-11
Extreme value theory gets a boost…
Correlations among lines are higher
insurer risk management practices can be improved

16. 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

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

18. 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

19. 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."

20. 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

21. 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