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C O N N I N G A S S E T M A N A G E M E N T Analyzing Reinsurance with DFA Practical Examples Daniel Isaac Washington, D.C. July 28-30, 2003.

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Presentation on theme: "C O N N I N G A S S E T M A N A G E M E N T Analyzing Reinsurance with DFA Practical Examples Daniel Isaac Washington, D.C. July 28-30, 2003."— Presentation transcript:

1 C O N N I N G A S S E T M A N A G E M E N T Analyzing Reinsurance with DFA Practical Examples Daniel Isaac Washington, D.C. July 28-30, 2003

2 1 Key Considerations  Why are we changing? -Cost of current program -Rating agencies -Regulatory capital -Change in business mix/philosophy

3 2 Key Considerations  How long do we need protection? -Impacts potential reinsurers -Impacts types of covers considered  How long will benefits last? -Will that change if there is a claim?

4 3 Key Considerations  What other changes can we make? -Asset strategy -Capital structure -Business mix  How do these fit together? -Mitigate cost -Enhance benefits

5 4 General Rules  Use several different measures -We prefer Economic Value as primary  Just considers cash flows  Eliminates accounting “noise” -Also evaluate financial metrics  Statutory Surplus  GAAP Equity  RBC Ratio

6 5 Company Profile  Name:Make Believe Inc. (MBI)  Size:$150 MM Net Premium  Growth:10 - 15% per year  Mix60/40 Commercial/Personal 60/40 Liability/Property  Time Horizon:5 years

7 6 MBI Concerns  Recently went public -Very concerned about GAAP Income -Also very concerned about volatility  Wants to increase equity exposure -Very conservative asset portfolio -98% bonds -Mostly high quality (A or better) and short-term -Expect higher returns long-term

8 7 Option #1  Buy traditional coverage -10 x 70 accident year loss ratio coverage -2% of earned premium -1 year cover which is annually renewed  Increase equity allocation -Consider 10 and 20% allocations

9 8 Results Option #1

10 9

11 1010 Summary - Option #1  Reinsurance -Successfully reduces risk  25% lower standard deviation  less downside -Negatively impacts income  Equities -Further drop in GAAP Income -Little additional risk  Overall -Hit to income is too great

12 1 Option #2  Add experience account balance to Option #1 -Same coverage 10 x 70 accident year loss ratio -Increase price from 2% to 5% -5 year cover with separate limits by accident year  Experience account balance -80% of reinsurance premium added for each accident year -Positive balances earn equity returns -Any time after the end of the fifth calendar year, MBI can commute the treaty and claim the positive balance  No change in asset allocation

13 1212 Results - Option #2

14 1313

15 1414 Summary - Option #2 (cont.)

16 1515 Summary - Option #2  Achieves company’s goals -Improves average GAAP income -Increases equity exposure  Other benefits -Lock in the price and coverage for five years -Commutation provision allows company flexibility -Lower RBC charge for reinsurance recoverable than equity

17 1616 Summary - Option #2  Disadvantages - Makes stock returns currently taxable  Normally, stock returns are only taxed when realized  Changes in experience account balance flow through income  Hurts ending shareholder equity  No reduction in volatility

18 1717 Summary - Option #2  Disadvantages -In good scenarios, experience account balance would become a large (-20%) portion of assets  May concern regulators  Muted, to some extent, by commutation provision

19 1818 How Many Scenarios?  Most DFA models create large number of scenarios -Monte Carlo simulation -Allows “complete” scenarios -Other methods are available  Simulation creates the possibility of sampling error -Large samples reduce this possibility -Can be very time and resource consuming

20 1919 How Many Scenarios?  The “right” number of scenarios is based on: -Volatility of results -Metrics being used -Simulation methodology - Independent vs Dependent

21 2020 How Many Scenarios? Definitions: Reward:Average ending Economic Value Risk:Mean - 1st percentile

22 2121 How Many Scenarios? Sample Size based on: Reward:Net cost under $6 million Risk: Reduced at least $40 million

23 2 How Many Scenarios?  Different strategies are highly correlated -Same gross underwriting -Same economy  Maintaining correlation in modeling process reduces sampling error -Still have to consider parameter risk


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