1. 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. 2 WHAT IS DFA? l Management tool l Regulatory tool

3. 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. 4 OVERVIEW OF PROCESS Input Scenarios Output Select Strategy Financial Calculator

5. 5 OVERVIEW OF PROCESS Input Scenarios Output Select Strategy Financial Calculator

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

7. 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. 8 INPUT l EXPENSES u Fixed u Variable

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

10. 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. 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. 12 OVERVIEW OF PROCESS Input Scenarios Output Select Strategy Financial Calculator

13. 13 STRATEGIES l Investment l Reinsurance l Business mix l Pricing

14. 14 STRATEGIES Distribution of New Investments Among Types

15. 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. 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. 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. 18 OPTIMAL ASSET MIX TARGET RETURNS

19. 19 OVERVIEW OF PROCESS Input Scenarios Output Select Strategy Financial Calculator

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

21. 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. 22 ECONOMIC VARIABLES Note: Stock Appreciation is plotted against the axis on the right of the graph.

23. 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. 24 OVERVIEW OF PROCESS Input Scenarios Output Select Strategy Financial Calculator

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

26. 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. 27 OVERVIEW OF PROCESS Input Scenarios Output Select Strategy Financial Calculator

28. 28 CHANGE IN SURPLUS

29. 29 FINDINGS

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

31. 31 RISK/REWARD SUMMARY Average Annual Surplus Increase Probability Net Income/Surplus < 10% 2 1 45 3 1. Current 2. More Corporates 3. Stocks & Corporates 4. More Non-Taxables 5. Duration Match

32. 32 RISK/REWARD SUMMARY Average Annual Surplus Increase Standard Deviation of Surplus Increase 5 4 2 1 3 1. Current 2. More Corporates 3. Stocks & Corporates 4. More Non-Taxables 5. Duration Match

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