DFA and DFCA as ALM, ERM Tools Britain Price Senior Vice President SS&C Technologies, Inc. Shawn Cowls Consultant TillinghastTowers Perrin.
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DFA and DFCA as ALM, ERM Tools Britain Price Senior Vice President SS&C Technologies, Inc.
Shawn Cowls Consultant Tillinghast Towers Perrin
Agenda
2003 Survey Results
Components of ERM
ERM Case Study (M&A)
ERM Challenges for the Industry – Results from 2003 Survey*
53% of companies are still using static, single point estimates for projections.
33% of companies have an integrated model that handles both assets and liabilities.
13% use a fixed yield to represent the expected portfolio return.
38% of companies don't forecast results within an accounting framework.
Only 25% include tax effects.
35% can drill into their assumptions and business logic.
*Results from SS&C Technologies’ Planning & Forecasting Survey, published Friday, May 30, 2003 - Volume III, Issue X
ERM Industry Favorable Result from 2003 Survey*
Functional participation in planning is good, with 47% of companies having two to four functional areas involved in the process and 53% having over five areas represented. Finance and Accounting are best represented.
*Results from SS&C Technologies’ Planning & Forecasting Survey, published Friday, May 30, 2003 - Volume III, Issue X
Model Requirements for Effective ERM
What you should have
Fully Integrated Model (Assets & Liabilities)
Risk Adjusted Assets
Sophisticated Economic Scenario Generation
Risk Adjusted Liabilities
True Decision Support Communication
Value of Enterprise Risk Management
Links your entire operations
Enhances your decision support Test alternative business strategies in advance
Underwriting Investments Accounting
Graphical Pro-forma financial statements Data drill-down
Investments, Reins., Capital Mgmt, M&A, Pricing, Tax,…
Better insight into your “realistic” business operations
Variability Interrelationships in business operations
Risk Adjusted Assets...
Actual attributes for portfolio holdings should be accounted for in an ERM model (e.g., modeled proxies or CUSIP level of detail)
If proxies are used, then they should be defined with current portfolio attributes (e.g., duration, yield, coupon, term, etc.)
Economic Scenario Generation...
Assets should be valued using a sophisticated, multi-factor economic scenario generator
Note Yield Curve Inversion
Scenario’s Effect on Assets
Risk Adjusted Liabilities...
Liabilities are “risk adjusted” when we imbed variability into our understanding of assumed values
Using probability distributions we account for various outcomes of key liability assumptions
Key assumptions to make dynamic:
Premiums Losses ALAE/UALE
Historic Held Loss Reserves Speed of Loss Payout Line Inflation (multiple of CPI)
ERM Incorporates the Compounding Effect of Business Uncertainty
Underwriting Cash Flow PPA Investment Income Net Income After Tax Auto Physical Damage (For all projection years)
A Virtual Income Statement...
Statutory Income Statement:
Net Earned Premium Net losses incurred Expenses
Net Underwriting Gain or (Loss)
100,000,000 75,000,000 26,000,000
(1,000,000)
Net investment income earned Net capital gains (losses)
Net Investment Gain or (Loss)
11,250,000 3,750,000
15,000,000 Net Income before Taxes
Federal income taxes incurred
Net Income after Taxes
14,000,000 2,520,000
11,480,000 Statutory Income Statement:
Net Earned Premium Net losses incurred Expenses
Net Underwriting Gain or (Loss)
Net investment income earned Net capital gains (losses)
Net Investment Gain or (Loss) Net Income before Taxes
Federal income taxes incurred
Net Income after Taxes
What does “simulation” mean?
Generate economic scenarios Sample business variables
Calculate liability cash-flows Calculate asset cash-flows and price investment portfolio
Rebalance the asset portfolio Pay taxes, expenses and dividends
Produce pro-forma financial statements in GAAP, STAT and Economic Valuation
Make output available for graphical representation
Repeat for thousands of iterations
Communicate Results with Graphics , NOT Statistics
Standard Deviation Stochastic Log Normal Skewness Coefficient of Variation Poisson
Graphics Ease the Understanding of Risks
Confidence Interval
MEAN 95%
ERM: Case Study on M&A
Three models created: 1. Parent Company 2. Target Company 3. Merged Company
Models populated with 2002 statutory financials from AM Best data interface
Lines modeled:
Homeowners
Private Passenger Auto Auto Physical Damage
Model Set-Up (cont.)
No change in investment allocations
Major differences between modeled lines and companies:
Premiums-earning patterns Commissions/expenses Loss ratio and premium growth distributions created from 10 year historic results (AM Best Data)
Combined
Homeowners Parent HO Target HO Private Passenger Auto Parent PPA Target PPA Auto Physical Damage Parent APD Target APD
Net Income Before Tax (2004)
RAROC (2004)
Combined Ratio (2004)
Parent Target Merged
ROE (2004)
Parent Target Merged
Net Leverage (2004)
Fail Pass
Parent Target Merged
Net Leverage Drill Down (2004)
While capital efficient on an expected basis, simulation indicates that without corrective action the likelihood of failing this Best Ratio is 29% of the time.
The acquisition improves this metric.
Absolute BCAR Projection
A++ A+ A A-
Dynamic Financial Condition Analysis and Enterprise Risk Management
Shawn Cowls, FSA, MAAA
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Dynamic Financial Condition Analysis and Enterprise Risk Management
Enterprise Risk Management (ERM)
Dynamic Financial Condition Analysis (DFCA)
Bringing ERM and DFCA Together
Enterprise Risk Management (ERM)
Defining ERM
Critical Elements of ERM
Uses of ERM
Defining Enterprise Risk Management
Assessing and addressing risks, from all sources, that represent either material threats to business objectives or opportunities to exploit for competitive advantage
An effective ERM process will:
incorporate all material risks - financial and operational
evaluate all relevant strategies - financial and operational
consider all pertinent constraints exploit natural hedges and portfolio effects among the risks, and financial and operational efficiencies among the strategies
Defining Enterprise Risk Management
Result
An optimal set of strategies that balances the need for capital and the need for return, growth, and consistency
In essence, an optimization of risk and value
Ultimately, ERM is a process composed of a number of different steps involving a range of insurance professionals
Critical Elements of Enterprise Risk Management
Assess risks
Identify risks and assess materiality
Classify and prioritize risks
Model risks
Articulate financial and operational strategies
Evaluate and refine financial and operational strategies
Monitor strategy performance and the risk environment
Uses of Enterprise Risk Management
An effective ERM process will help an insurer make sound decisions about which financial and operational strategies it should implement
What should our product mix be?
What channels should we distribute the products through, and to which markets?
What set of agency ratings should the company target? How do we most effectively achieve our target?
How much capital should we hold?
Uses of Enterprise Risk Management
An effective ERM process will help an insurer make sound decisions about which financial and operational strategies it should implement
How much and on what terms should we reinsure or hedge?
How should we invest our assets?
How much should we invest in technology?
How should resources be assigned to sales versus service and how should they be deployed across products and regions?
How much should we spend on recruiting, training, and retention?
Dynamic Financial Condition Analysis (DFCA)
Defining DFCA
Critical Elements of DFCA
Uses of DFCA
Defining Dynamic Financial Condition Analysis
Dynamic
model of the interaction of:
Economic elements
Product features
Policyholder behavior
Company behavior
Over a number of expected and unexpected scenarios
Projection of
financial
results over a near horizon
Evaluation of a company’s fitness or
condition
An
analysis
that synthesizes a company’s expected experience under various stresses
Critical Elements of Dynamic Financial Condition Analysis
A model that adequately represents a company’s business
Economic and environmental scenarios that test the financial condition
Interactivity between elements of the model and the economic and environmental scenarios
Communication of the condition and sensitivity of the company
Uses of Dynamic Financial Condition Analysis
Model financial strategies
Model the financial impact of various risks
Assess the value of various strategies in mitigating risks
Provide an analysis that communicates to management the company’s financial condition under specified strategies and scenarios
Bringing ERM and DFCA Together
Strategies
Models
Communication of Results
Bringing ERM and DFCA Together - Strategies
Making annual decisions with respect to
Distribution channel
Capital deployment
Investments
Technology
Bringing ERM and DFCA Together - Models
Environmental and Economic Scenarios
Expected environment
Unexpected environments
The interactive impact of these environments on:
Management behavior
Policyholder behavior
Policy cash flows
Portfolio manager behavior
Alternate strategies that may respond to various environments
Bringing ERM and DFCA Together - Communication of Results
Synthesis of the results organized by major risk factors
Highlights and summaries
Leave details in appendices Fewer tables and more graphics!
What did we learn?
What risks can cause the greatest harm?
What impact do various risk mitigation strategies have on the results?
Which risks can occur together? Which are mutually exclusive?
How can insights be applied to business objectives?