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How DFA Can Help the
Property/Casualty Industry,
Part 3

by Susan T. Szkoda, FCAS

Editor's Note: This is the third in a series of articles on Dynamic Financial Analysis (DFA). Click here to view Part I and Click here to view Part II.

In my previous DFA article on pricing, I noted the importance of being realistic about the fundamentals and the importance of having a "true compass" as to what your real costs are. Nowhere is this more true than in reserving.

Sound reserves form the bedrock of financial stability. In addition to being important to the balance sheet, sound reserves provide that true compass for your real costs and true pricing needs.

As we get drawn further into the current cycle we need to be careful to separate fact from wishful thinking. If we look back on the last cycle in the early-mid 1980s we will note that industry reserve adequacy deteriorated sharply - more or less in line with the deterioration in rate level adequacy.

It is possible that a component of this deterioration was due to overly optimistic assumptions about companies' ability to control costs through judicious underwriting or claims practices. Part of it may have been due to the belief that investment income would more than offset any shortfall in pricing. Part of it may have been due to management pressure.

I came upon an old Actuarial Review letter from the 1984 CAS President Carlton Honebein. I was struck by how timeless his comments were:

"Insurance results are horrendous. Reinsurance results are even worseÉWe had the forecasts and we believed them; why weren't we more forceful in demanding actions that would have avoided an unsavory situation that profoundly affects ourselves, our employers and the insuring public."

The mantra of the last cycle was that high interest rates would bulletproof all pricing and reserving decisions. The mantra of this cycle is that low inflation rates will bulletproof all pricing and reserving decisions. Time will tell.

Are we currently at the point where insurance results are horrendous? No, of course not! Reported results today are in fact extremely favorable. Could we get to this point within the next few years? It would certainly seem to be possible.

How can DFA help a company avoid or minimize a bad outcome?

Let's focus on a single line of insurance - workers compensation - and walk through some specific considerations in a DFA-style reserve analysis.

Assume the actuary has available the basic data elements of premium, exposure units, claim counts, paid losses, case reserves, type of claim (permanent total vs. permanent partial vs. temporary total) and type of loss (medical vs. indemnity vs. allocated loss adjustment expense).

What are some of the items that separate a DFA-style reserve analysis from a "traditional" reserve analysis?

Our DFA workers compensation reserve analysis for Hypothetical Company X considers the following items:

Nature of Book of Business/Premium

Exposures

Geographic/Industry Presence

Renewal Retention Rates

Expenses

Company X has slashed its expenses by $350 million over the past three years but finds the expense ratio has actually increased from 25 to 34 percent, due to lower premium levels and change in product mix of business.

Investment Income

The 30 Year Treasury yield was around 6.5 percent at year-end 1996. It now appears to be 7.0 percent. Will it head north to 8.0 percent?

The portfolio is 80 percent bonds, 10 percent stocks and 10 percent cash. The bond maturity distribution is:

30 percent 0-5 years

20 percent 5-10 years

10 percent 10-30 years

40 percent +30 years

Inflation

Mortality

Law Reforms

Claim Department Changes

Reinsurance

Cost of excess of loss and stop loss reinsurance has decreased significantly and is now widely available. In 1993 this coverage was expensive and difficult to obtain.

Summary

The precise impact of many of these variables on the final reserve need is unknowable at the time of the reserve review. Therefore it is necessary to construct scenarios using plausible ranges for these variables. Judgment comes into play. DFA helps us understand and articulate the impacts of the many judgments we routinely make as actuaries.

Our enhanced understanding of the impact of many of these variables helps us to feed back meaningful information to the marketing, underwriting, claims, reinsurance, investment and pricing areas of the company (spokes and hub concept).

CLRS Tie-In

Come see how this workers compensation DFA reserving problem is solved at the Casualty Loss Reserve Seminar, September 29-30 in Atlanta, GA. The solution will be published in the Winter Forum.