st
Deloitte & Touche
Kevin Bingham
860.543.7345
John Slusarski
860.543.7366

• Background
– Target audience
– Authors
• Evolution of Insurance Purchasing Decision
• Strategic Insurance Purchasing, Why Now
• Convergence: Options and Insurance
• Dynamic Financial Analysis and Reinsurance
• Strategic Insurance Purchasing in the 21 st Century
• Closing Thoughts

Evolution
• Limited review of organization’s actual data
– Purchase guaranteed cost policies
– Retain risk/reflect organization’s own experience using different insurance programs
• Large deductibles
• Retrospectively rated policies
– Benchmarking
• Anticipated loss rate x payroll
• Multiple of calendar payments
• Limited scenario testing (deterministic)
– Captives
– “What if” scenarios for insurance purchases
• Insurance exposure modeling (stochastic)
– Frequency/severity modeling
• 21 st Century?

Strategic Insurance Purchasing, Why
Now?
• Financial community
– Value At Risk (VaR), Economic Value Added (EVA TM )
– BASLE Accord – Expansion of Pillar 1
– CFA exams (quantitative methods, Monte Carlo simulation)
– CNBC, Bloomberg, CNN
FN
, Internet
• Clients (and auditors) asking for confidence levels
• High profile examples/unique capital market solutions
– Bowie bonds
– Arby’s securitization
– Innovative insurance solutions
• Hardening market
• Convergence of financial services industry
• Dynamic Financial Analysis (DFA)

Convergence: Options and Insurance

Convergence: Options and Insurance
• Convergence of Financial Services Industry and terminology
OR
Actuary CFA
• Leverage the growing financial knowledge of most risk managers, chief risk officers and corporate decision makers to explain the similarities of insurance and investment options.

Convergence: Options and Insurance
A call option is the right, but not the obligation, to buy a security for a specified price (exercise price) on or before a specified date.
Table 1 displays the value of a call option with a $70 exercise price
(excluding transaction costs).
TABLE 1
CALL OPTION
80
70
60
50
40
30
20
10
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140
STOCK PRICE

Convergence: Options and Insurance
• Insurance programs can be viewed as combinations of purchased and sold call options:
– The exercise price of the call option is equal to the client’s SIR, deductible or reinsurance attachment point
– For EOL and AEOL contracts, the exercise price of the sold call option is equal to the attachment point plus the insured limit
– The call options last for one year, with the expiration date equal to the last day of the accident year

Convergence: Options and Insurance
• Table 2 displays a $250,000 SIR or large deductible using a call option with a strike price of $250,000.
TABLE 2
GROUND UP BUY CALL @250 NET
800
700
600
500
400
300
200
100
0
50 100 150 200 250 300 350 400 450 500 550 600 650 700 750
INDIVIDUAL LARGE LOSS

Convergence: Options and Insurance
• Much easier for most investment and risk managers to understand the importance of purchasing insurance strategically using the option analogy.
• Although actual conversion is difficult, understanding insurance in terms of options is a helpful exercise for risk managers and actuaries.
KEY POINT – Just as the fundamentals underlying stock and bond investments change each year, so do the insurance risks facing an organization (e.g., hardening market, acquisitions, new exposures, etc.).

DFA and Reinsurance - Background
• The term DFA originated in the property-casualty insurance industry.
• The objective was to provide an integrated system for evaluating major risk elements affecting a company’s overall financial performance and economic value.
• Why the term DFA ?
– D ynamic: interaction of key variables under multiple scenarios and management actions.
– F inancial: use modern financial economics to project variables
– A nalysis: examine impact on both the economic value and financial statements 1 of the firm.
1. Insurers prepare financials under two separate accounting methods; U.S. GAAP and
Statutory accounting principles.

DFA and Reinsurance - Background
– Deterministic v.s. Stochastic: Expected Value
100 v.s. Distribution Around Expected Value
– Fragmented v.s. Integrated Approach to Risk Analysis
– Integration of Internal and External Risk Factors
– Time Horizons of Over One Year
100

DFA and Reinsurance - Background
Deterministic
# Policies 100
X Premium / Policy
20
= Total Premium 2,000
X 1 - Operating
Ratio .13
= Operating Profit 260
# Policies
DFA
X Premium /
Policy
X 1- Oper.
Ratio
= Operating
Profit
100
20
0.13
260

DFA and Reinsurance - Background
Investments
Underwriting
Management Interventions
Reinsurance
Business
Strategies

DFA and Reinsurance - Background x x
Financial
Forecast
Historical
Plan
0
Ending Capital
99% Confidence Level

DFA and Reinsurance - Variables
• In simple terms, DFA models consider a set of external variables and a set of internal variables.
• External variables - price takers:
– Interest rate levels
– Inflation rates
– Capital market prices and total returns
– Pricing cycles and price elasticities
– Natural catastrophes
– Changes in loss levels from case law, jury awards, claims consciousness, etc.
• Internal Variables - management decisions:
– Premium rate levels actions
–
Reinsurance program
– Underwriting guidelines
– Marketing plans and distribution mechanism
– Outstanding liability reserve practices
– Investment strategy
– Expense management

DFA Applications
• Reinsurance optimization
– Reinsurance module from DFA model
– Majority of DFA work done to date
• Asset and liability hedging strategies
• Investment portfolio management
• Demutualization
• Credit risk modeling
• Operational risk modeling
• SBU operational strategies and planning
• Strategic options analysis for mergers and acquisitions
• Risk adjusted capital management
• Rating agency management
• New products and market development
• Tax optimization

st

Strategic Insurance Purchasing in the 21 st
Century
• Mathematical modeling of all risk factors (DFA)
• Enterprise risk management mitigates variability in financial results from ALL the organization’s major risks (i.e., not just insurance)
– Insurance exposures
– Asset returns (e.g., Intel example)
– Projected sales
– Production costs
– Tax revenue
• Examples
– Captives
– Insurance companies
– Unique projects
• Efficient frontier

70
60
50
40
30
20
10
0
SIP in the 21 st Century
Efficient Frontier
RISK (S.D. OF RETURN)

Strategic Insurance Purchasing in the 21 st
Century
• Answer key management questions
– Insurance Specific
• What is the organization’s annual insurance cost and the confidence level feeding financial plan?
• What is the cost/benefit analysis for the insurance option selected versus other options (e.g., XOL versus AEOL, 250 SIR versus 500 SIR)?
• What is the variability of the organization’s insurance costs?
• How well is the company protected against catastrophic losses?
– Enterprise wide focus
• What is the confidence level feeding financial plan for all risks?
• What circumstances may cause the company’s financial statements to be impaired (e.g., asset portfolio decline, top line revenue drop, multiple events occurring simultaneously)?
• What investment mix and reinsurance protection produces the highest return for the lowest level of risk (i.e., efficient frontier)?

Closing Thoughts
• “If it ain’t broke, don’t fix it” risk management approach no longer acceptable
– Hardening market
– Financial pressure from management/shareholders
• Technology
– Computer processing speed
– @Risk, Crystal Ball, Excel
• Ability to leverage financial “thought ware”
– RiskMetrics and VaR
– Investment community knowledge
• Demand for quantitative enterprise risk management
• Applying and leveraging DFA research/publicity

Insurance
Closing Thoughts
Manufacturing
Retail
DFA EPD VaR EVA RAROC
Ruin RBC BCAR
Banking