Financial Risk Management of Insurance EnterprisesOverviewDynamic, Financial, AnalysisDefinition of Dynamic Financial Analysis (DFA)A Broader ConceptDefinitionsAnalytic vs. SimulationPrior TechniquesThe Impetus Behind DFAThe “Seeds” of DFAThe DFA ApproachTwo Approaches to DFA: (1) Scenario TestingTwo Approaches to DFA: (2) Stochastic SimulationUses of Stochastic SimulationCategories of Insurer RiskBuilding a DFA ModelVariables in a DFA ModelDFA for Life InsurersNY 126 Interest Rate ScenariosDynamic Financial Analysis ModelBasics of DFA ModelUnderwriting ModuleAging PhenomenonSlide 24Catastrophe ModuleFinancial ModuleShort-Term Interest RateSlide 28InflationTax ModuleReinsurance ModuleUsing the DFA OutputObjective of Optional Growth PaperMarket Value of P-L Insurance CompanyMultiple Regression ApproachMean-Variance illustrationSlide 37Slide 38Operating ConstraintsConstraining Premium-to-Surplus RatiosThe Future of DFAFinancial Risk Management of Insurance EnterprisesDynamic Financial Analysis1. D’Arcy, Gorvett, Herbers, and Hettinger - Contingencies2. D’Arcy and Gorvett - JRIOverview•What is DFA?•How is it different from other modeling procedures?•How did DFA evolve?•What are the basic approaches in DFA modeling?Dynamic, Financial, Analysis•Dynamic–“Energy, continuous activity, intensity, interactive”–Insurer variables are not fixed, but stochastic•Financial–“Related to management of money or investments”–Evaluate insurer activities, both liabilities and assets•Analysis–“Examination of an interrelated system and its elements”Definition of Dynamic Financial Analysis (DFA)•Casualty Actuarial Society definition:–Analyze the financial condition of an insurance enterprise–Financial condition refers to ability of capital and surplus to meet future obligations of insurer in “unknown future environment”–For life insurers, similar modeling procedures are known as dynamic solvency testing or dynamic financial condition analysisA Broader Concept•DFA does not need to focus only on solvency issues•Other uses:–Model ongoing operations over time instead of concentrating on the current position–Determining the sensitivity of financial results to various environmental factors–Identify specific scenarios where the insurer is exposed to significant risk of loss–Valuation of a line of business or entire insurerDefinitions•Appointed actuary–A “qualified” actuary that is appointed by the Board of Directors of an insurer–Files actuarial opinion with the states stating that all reserves are appropriate and assets are adequate to meet liabilitiesAnalytic vs. Simulation•Analytic model provides exact solution based on precise relationships•Simulation models can be used if exact mathematical representations do not exist–Can accommodate complex relationships•The “answer” in a simulation model is not just one number–It is a range or distribution of plausible resultsPrior Techniques•Previous models evaluated insurer strategies under certain assumptions with respect to:–Asset returns–Underwriting results–Economic environment (recession, expansion)•Typically, these models ignored interaction of assets and liabilities•The future was assumed to be essentially the same as the present–Regardless of lifetime of policy/projectThe Impetus Behind DFA•Interest rate fluctuations in the 1970s–Life insurers are sensitive to interest rate changes–Disintermediation resulted from high interest rates•Rating agencies began to consider effect of interest rate swings on surplus/solvencyThe “Seeds” of DFA•RBC is first attempt at linking capital to risk of insurers–The various RBC factors are the same for all insurers•RBC has short term focus•DFA customizes the analysis by accounting for specific insurer business plan both now and in the futureThe DFA Approach•Model variability of all important variables–Claims, catastrophes–Asset returns–Premium income•Account for correlation among all factors within each scenario–When modeling the entire insurer, include correlation among lines of business•Project cash flows under the assumptions•Determine the insurer’s financial positionTwo Approaches to DFA:(1) Scenario Testing•Select several assumptions for all variables–e.g., optimistic, pessimistic, and average•A scenario is a set of assumptions about the future environment•Determine financial position•Better than point estimate but does not provide any likelihood information•Range of outcomes is frequently too wide to make decisionsTwo Approaches to DFA:(2) Stochastic Simulation•Select distributions for and correlations among all variables•Draw randomly from each distribution•Determine the aggregate financial outcome for each iteration–Incorporate any variable interactions•Analyze distribution of outcomesUses of Stochastic Simulation•Stochastic simulation provides more information than scenario testing•Use of information depends on objectives–How often does insurer go insolvent?–Which assumptions are the most critical?–What accounts for good/bad scenarios?•If possible, select hedges to protect against bad scenariosCategories of Insurer Risk•Balance sheet risk–Changes in value of assets and liabilities•Operating risk–Investment and underwriting activities •Actuaries have traditionally looked at liabilities and underwriting•Balance sheet and operating risks are interrelatedBuilding a DFA Model•Determine the objective–Evaluating solvency, valuation of a block of business or insurer•Include only the most relevant factors–Only model general asset classes such as bonds, equities, and mortgages–Reserves should reflect economic value and incorporate discounting•Model only the factors that are measurableVariables in a DFA Model•Claim distributions are a result of frequency and severity•Frequency of claims is affected by:–Catastrophe–Society trends (e.g., smoking, speed limit)•Severity of claims is affected by inflationDFA for Life Insurers•Life insurer products are long term and are interest rate sensitive–Option of policyholder to withdraw is very important•Cash flow testing is a primitive form of DFA–Test adequacy of assets vs. liabilities under a few scenarios–NY Regulation 126 specifies seven scenariosNY 126 Interest Rate Scenarios•Remain level for 10 years •Increase ½ % per year for 10 years•Increase 1% for 5 years,