DFA and DFCA as ALM, ERM Tools
Britain Price
Senior Vice President
SS&C Technologies, Inc.
Shawn Cowls
Consultant
TillinghastTowers 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, singlepoint 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
 Underwriting
 Investments
 Accounting
Enhances your decision
support
 Graphical
 Pro-forma financial
statements
 Data drill-down
Test alternative business
strategies in advance
 Better insight into your “realistic”
business operations
 Investments, Reins., Capital
Mgmt, M&A, Pricing, Tax,…
 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:
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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:
Statutory Income Statement:
Net Earned Premium
100,000,000
Net Earned Premium
Net losses incurred
75,000,000
Net losses incurred
Expenses
26,000,000
Expenses
Net Underwriting Gain or (Loss)
(1,000,000)
Net Underwriting Gain or (Loss)
Net investment income earned
11,250,000
Net investment income earned
Net capital gains (losses)
3,750,000
Net capital gains (losses)
Net Investment Gain or (Loss)
15,000,000
Net Investment Gain or (Loss)
Net Income before Taxes
14,000,000
Net Income before Taxes
Federal income taxes incurred
Net Income after Taxes
2,520,000
11,480,000
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
Coefficient of Variation
Skewness
Poisson
Graphics Ease the Understanding
of Risks
Confidence Interval
95%
MEAN
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
25
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:
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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:
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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?