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

2. 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

3. 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

4. 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!”

5. 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.

6. 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

7. 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

8. 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.333.506 5%-4.0%-8.0% 10%1.0% Indication that less capital means more ROE variability

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

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

11. 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

12. 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

13. Profitability and Capital Allocation 2. Capital Allocation Surplus Burn Example Ordered TrialPP Auto Gain/(Loss) %HO Gain/(Loss) % 1-4.0-9.0 2-5.0 35.04.0 48.09.0 510.013.0 611.015.0 712.016.0 815.018.0 919.0 1020.022.0 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.

14. 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

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

16. 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.