CONSTRUCTING AND CONSTRUCTING AND EVALUATING BUSINESS EVALUATING BUSINESS PLANSPLANS

Casualty Actuarial SocietyCasualty Actuarial Society Dynamic Financial Analysis Dynamic Financial Analysis

SeminarSeminar July 19, 1999July 19, 1999

• Debra J. Roberts, CFADebra J. Roberts, CFA• Carl J. Leo, ACAS, MAAACarl J. Leo, ACAS, MAAA

INTRODUCTIONINTRODUCTION

Meet the panelistsMeet the panelists Why business planning for Why business planning for

insurance companies is uniqueinsurance companies is unique Why Dynamic Financial Analysis Why Dynamic Financial Analysis

makes sense for insurance makes sense for insurance planningplanning

WHAT DOES A BUSINESS WHAT DOES A BUSINESS PLAN DO FOR YOU?PLAN DO FOR YOU?

Provides information for risk analysis Provides information for risk analysis and managementand management

Guides the company’s operations for a Guides the company’s operations for a specific time period, usually one to specific time period, usually one to three yearsthree years

Allows testing of assumptions for the Allows testing of assumptions for the company’s strategycompany’s strategy

Communicates clearly the expected Communicates clearly the expected financial results of the companyfinancial results of the company

THE PROCESS OF THE PROCESS OF CONSTRUCTING A BUSINESS CONSTRUCTING A BUSINESS PLANPLAN

The foundation is the existing business The foundation is the existing business and historical financial informationand historical financial information

The framework is the outline of basic The framework is the outline of basic assumptions about the future business assumptions about the future business and economic environmentand economic environment

The finished “building” is the result of The finished “building” is the result of testing the assumptions and presenting testing the assumptions and presenting the range of possible financial outcomes the range of possible financial outcomes for the futurefor the future

OBSERVATIONS ABOUT THE OBSERVATIONS ABOUT THE PROCESSPROCESS

Quality of the process determines the Quality of the process determines the quality, or usefulness, of the resultsquality, or usefulness, of the results

The planning process itself is a very The planning process itself is a very important opportunity to challenge important opportunity to challenge assumptions and re-evaluate decisionsassumptions and re-evaluate decisions

It is unrealistic to arrive at only one It is unrealistic to arrive at only one future financial result for an insurance future financial result for an insurance companycompany

PULLING TOGETHER THE PULLING TOGETHER THE PIECESPIECES

Collaborative effort, but needs Collaborative effort, but needs someone in chargesomeone in charge

Must integrate the ideas and the Must integrate the ideas and the numbersnumbers

Apply the template, or framework, of Apply the template, or framework, of the business strategy and make sure it the business strategy and make sure it fitsfits

Communication process must be clear Communication process must be clear and free of any obstructionsand free of any obstructions

EVALUATING THE PLANEVALUATING THE PLAN

Checklist of “surprises” not to be Checklist of “surprises” not to be overlooked:overlooked:• company weaknessescompany weaknesses• competitive movescompetitive moves• regulatory changesregulatory changes• accounting changesaccounting changes• natural disastersnatural disasters

EVALUATING THE PLANEVALUATING THE PLAN

Incorporate “surprises” by doing Incorporate “surprises” by doing “what if’s” in the financial models “what if’s” in the financial models by using DFA methodsby using DFA methods

Avoid the danger of excessive Avoid the danger of excessive reliance on the forecasted results by reliance on the forecasted results by including three or more financial including three or more financial scenariosscenarios

Do a “reality check” on the numbersDo a “reality check” on the numbers

What is Dynamic Financial What is Dynamic Financial Analysis?Analysis?

Methodology for evaluating the Methodology for evaluating the financial impact of various “possible” financial impact of various “possible” future eventsfuture events

Intended to capture the complex Intended to capture the complex interrelationships of the risk interrelationships of the risk components of an insurance companycomponents of an insurance company

Model-based approach designed to Model-based approach designed to answer a complex series of questions answer a complex series of questions about future outcomesabout future outcomes

How do you build the How do you build the model?model?

Decide what you are trying to Decide what you are trying to “test”“test”• Determine key questions you need to Determine key questions you need to

answeranswer• Define what goals you are trying to Define what goals you are trying to

achieveachieve• Identify the most important variables Identify the most important variables

in order to simplify the modelin order to simplify the model

Two approaches for DFA Two approaches for DFA risk analysisrisk analysis

Scenario testingScenario testing• Projects results using a defined set of Projects results using a defined set of

assumptionsassumptions Stochastic simulationStochastic simulation

• Generates a series of random events, or Generates a series of random events, or “trials”, which produces a large number of “trials”, which produces a large number of different outcomesdifferent outcomes

• The distribution of these outcomes is The distribution of these outcomes is analyzed to indicate overall financial analyzed to indicate overall financial strength of the companystrength of the company

The classifications of risk The classifications of risk covered in a modelcovered in a model

Balance SheetBalance Sheet• Asset valuation riskAsset valuation risk• Reserve adequacy riskReserve adequacy risk

Income StatementIncome Statement• Underwriting riskUnderwriting risk• Investment income riskInvestment income risk

Risks in each classification Risks in each classification operate together in complex operate together in complex relationshipsrelationships

External events can impact more External events can impact more than one class of riskthan one class of risk• example: increase in interest rates example: increase in interest rates

causes asset values to decrease, but causes asset values to decrease, but investment income to increase; may investment income to increase; may also adversely impact claims.also adversely impact claims.

Difficult to qualify the overall net Difficult to qualify the overall net outcome of a single external eventoutcome of a single external event

How are DFA models How are DFA models used?used?

To measure the financial strength of a To measure the financial strength of a company, based upon current company, based upon current operations and a given set of economic operations and a given set of economic assumptionsassumptions

To examine the financial impact of To examine the financial impact of pursuing various new strategiespursuing various new strategies

To analyze the current value of a To analyze the current value of a company based upon a variety of company based upon a variety of future financial outcomesfuture financial outcomes

How do you build the How do you build the model?model?

Decide what you are trying to Decide what you are trying to “test”“test”• Determine key questions you need to Determine key questions you need to

answeranswer• Define what goals you are trying to Define what goals you are trying to

achieveachieve• Identify the most important variables Identify the most important variables

in order to simplify the modelin order to simplify the model

Two approaches for DFA Two approaches for DFA risk analysisrisk analysis

Scenario testingScenario testing• Projects results using a defined set of Projects results using a defined set of

assumptionsassumptions Stochastic simulationStochastic simulation

• Generates a series of random events, or Generates a series of random events, or “trials”, which produces a large number of “trials”, which produces a large number of different outcomesdifferent outcomes

• The distribution of these outcomes is The distribution of these outcomes is analyzed to indicate overall financial analyzed to indicate overall financial strength of the companystrength of the company

The classifications of risk The classifications of risk covered in a modelcovered in a model

Balance SheetBalance Sheet• Asset valuation riskAsset valuation risk• Reserve adequacy riskReserve adequacy risk

Income StatementIncome Statement• Underwriting riskUnderwriting risk• Investment income riskInvestment income risk

Risks in each classification Risks in each classification operate together in complex operate together in complex relationshipsrelationships

External events can impact more External events can impact more than one class of riskthan one class of risk• example: increase in interest rates example: increase in interest rates

causes asset values to decrease, but causes asset values to decrease, but investment income to increase; may investment income to increase; may also adversely impact claims.also adversely impact claims.

Difficult to qualify the overall net Difficult to qualify the overall net outcome of a single external event outcome of a single external event without DFAwithout DFA

How are DFA models How are DFA models used?used?

To measure the financial strength of a To measure the financial strength of a company, based upon current company, based upon current operations and a given set of economic operations and a given set of economic assumptionsassumptions

To examine the financial impact of To examine the financial impact of pursuing various new strategiespursuing various new strategies

To analyze the current value of a To analyze the current value of a company based upon a variety of company based upon a variety of future financial outcomesfuture financial outcomes