How DFA Can Help the Property/Casualty Industry, Part 5
The Annual Statement Does Not Start On Page 3!
by Stephen T. Morgan with contributions by Susan T. Szkoda
Editor’s Note: This is the fifth in a series of articles on Dynamic Financial Analysis (DFA). Stephen T. Morgan, ACAS, is vice-president and actuary of the Millers Group in Fort Worth, Texas. Steve has been very active in all phases of DFA serving on a broad variety of CAS Committees. Part 1 , Part 2, Part 3, and Part 4 are available online.
For many years, like other actuaries, I concentrated only on loss liabilities. Premiums were used only to compare to incurred losses. Analyzing losses for pricing and reserving projects consumed all of my time. I did not stop to consider where cash came from to pay losses or even what the accountants did with the premiums received by the company. Since the historical purview of actuaries had always been pricing and loss reserving, it is no surprise that losses were my dominant interest.
Several external forces caused property/casualty actuaries to begin considering the asset side of the equation more carefully:
- Insurance regulators required pricing actuaries to include investment income considerations in certain rate filings.
- Investment income became important in pricing such products as paid loss retros and finite risk contracts.
- Actuaries became involved in such activities as loss commutations, loss portfolio transfers, mergers and acquisitions, and valuations. In all of these, cash flow projections and loss reserve discounting were important "pieces" of the particular financial transaction.
- The so-called underwriting cycle appeared to cease, and the industry faced a seemingly endless soft market. Investment income became increasingly important because achieving underwriting profits became increasingly rare.
- In the early 1990s, the federal government attempted to become involved in insurance regulation. State insurance departments reacted by increasing their efforts regarding solvency monitoring. Risk-Based Capital and Dynamic Solvency Testing were some of the new tools developed.
In light of these forces, and realizing life actuaries had been considering investment concepts for years, we began to consider investments. Two separate events caused me to think about the asset side of the equation: Assets = Liabilities + Surplus.
Early in my career, I was the actuary for a now defunct insurance company. It folded for several reasons, one being my assessment that the IBNR reserve needed to increase by a factor of 2. Somewhere between increasing the reserves and shutting down the company, I became acutely aware of the relationship between reserves and the cash needed to pay out those reserves. Until that time, I felt that my only responsibility was to set the reserves: Someone else would worry about paying the losses. However, I learned that I also had to assess the company’s ability to meet this financial obligation. Part of this assessment is the "how" of meeting that obligation.
The second event occurred when I was an actuary at a company purchased by a leveraged buyout (LBO) firm. The most important thing to the LBO firm in buying my company was the ongoing cash flow. Could it support the debt payoff, the insurance liability obligations, and pay dividends? The three most important considerations were cash, cash, and cash.
Before the acquisition, I headed up the loss reserving area. Since I also had a broad understanding of company operations, I got the job of establishing the asset/liability management (ALM) procedures. We used durations to estimate how well matched our assets and liabilities were. We estimated cash flows for nearly every asset and liability for both the company and the holding company. I concentrated on the company liabilities and non-invested assets while the outside asset manager concentrated on the invested assets and the holding company debt.
We began with the notion that most reserves eventually become cash. Actuaries know how to estimate loss reserves and turn factor selections from paid loss development triangles and ultimates into payout patterns. We learn how to calculate present values during the early part of our careers. So, doing durations on loss liabilities should not be difficult once we understand the concept of duration.
We then looked at invested assets. The first time I attended a staff meeting at the asset manager’s office, I found that the jargon, buzzwords, and alien concepts (CMO, PAC, Swaps, Options, Swaptions, Strips, Tigers, LYONs, arbitrage, put, call, short, long, hedge, and PIKs to name a few) were unsettling. I was extremely intimidated by the near mystical aura of INVESTMENTS.
Later, I realized that the cash flow of an asset, such as a bond, is identical in concept to the payout of losses. Once the intimidation passed, I determined the reserve (market value or cost) and the payout. Just as with losses, the risks that affect these values had to be understood.
While ALM and duration are important concepts, they represent a relatively small portion of the brave new world of Dynamic Financial Analysis (DFA). DFA is the process by which an actuary analyzes the financial condition of an insurance enterprise. Financial condition refers to the ability of the enterprise’s capital and surplus to adequately support its future operations through a currently unknown future environment. Actuaries, through their training and experiences, are uniquely qualified to perform DFA analyses.
DFA allows actuaries to take a holistic approach to insurance. We look at the interactions between assets and liabilities and their effect on surplus. We look at scenarios, we employ strategies and we model (deterministic or stochastic basis) the company operations to check sensitivities and the effects of our assumptions. We can give management more options in addition to new tools to manage and improve financial results. More importantly, we can give management additional understanding of how the company works.
In short, we become financial actuaries. We do not lose the reserving or pricing portions of our repertoire. We realize that we can now put a new spin on the concepts we already know in order to analyze investments and perform DFA exercises. The old parochial focus on reserves or pricing changes to a broader focus on the operations and interactions of the company. Reserves do not tell the "story" of a company; rather, it is told by the cash from the reserves and the interactions of assets and liabilities. The annual statement really starts on page 2.