How DFA Can Help the
by Susan T. Szkoda
from Volume 24, No. 1 edition
Editor's Note: This is the first in a series of articles on Dynamic Financial Analysis (DFA).
This series will discuss the concept of DFA and its possible uses in a number of current scenarios.
This first article will cover:
- the definition of DFA, and why it is important, and
- what the CAS is doing to further member education in this important area.
Subsequent articles will discuss pricing, reserving, reinsurance, invested assets, other assets and liabilities, the competitive environment, and rating agencies/capital issues.
DFA integrates all these topics into a holistic model of a property/casualty insurance company.
What is DFA?
DFA is a process for analyzing the financial condition of an insurance entity. Financial condition refers to the ability of the entity's capital and surplus to adequately support future operations through a currently unknown future environment. We are primarily concerned with viability (that is, the ability of the entity to not only survive but to thrive in this future environment).
The DFA concept broadens the scope of the actuary's analysis to encompass the entire balance sheet as well as the company's business plans over some future horizon. The actuary must therefore deepen his or her knowledge to include assets, liabilities other than loss and LAE reserves, off-balance sheet risks, and capital structures and requirements. The profession must deepen its understanding of the impacts of various exogenous factors (economic cycles, changes in capital markets, development of new types of risk transfer products) on our business. In a very real sense, DFA requires the actuary to evolve into a financial risk manager.
The DFA process typically involves sophisticated computer modeling techniques and multiple scenario testing. This process can help companies better understand how the "real world" impacts their financial results in a holistic manner. Armed with this knowledge, they can better plan how to maximize potential profitable business opportunities and minimize potential financial disasters.
DFA is useful in strategic business planning exercises. It helps companies deal with variance around the expected business plan outcome. DFA helps management understand the "real world" financial consequences of variances from the base scenario assumptions and expected outcomes.
Virtually every senior management team grapples with significant uncertainty on a daily basis. Should I enter a new line? How fast should I grow? How much reinsurance should I buy? Yet the tools to measure and understand the outcome of a company's many possible choices are generally simplistic. In many cases, it comes down to manager's instinct. DFA offers a better, more scientific way.
DFA is currently required in Canada at the request of the regulator. In that geographic region, DFA is known as Dynamic Capital Adequacy Testing (DCAT) and is solvency-oriented. It is generally requested when the regulator has concerns about a company or a portion of the company's business, but there is a draft Standard of Practice that, if approved, would require DCAT testing for all Canadian companies. This may become effective in early 1998 for year-end 1997 results.
In the United States, it is possible that individual states might adopt DFA requirements. Colorado, for example, already has a limited version that is required for start-up companies. In light of this, corporate managers from all types of companies may embrace DFA voluntarily. It may become increasingly beneficial for companies of all types and sizes to perform at least moderate term strategic business planning for the following reasons.
Most large companies need fairly significant amounts of lead time to adjust their businesses to changing economic conditions and operating strategies. For example, changes in distribution channels, and major changes in pricing and underwriting programs, can't be implemented overnight.
The cycles of the past have been exacerbated by many companies' poor understanding of "real" economic and business conditions and turning points in key variables underlying such conditions. When this lag in recognition is combined with the lag in operations lead time, serious strategic planning needs to look several years out to be effective.
Companies frequently try to raise capital once they're already in trouble. This practice is often difficult and expensive. Planning may lead the company to anticipate a future need when times are good and capital can be obtained relatively inexpensively.
Remember that the alternative to spotting potential risks and planning ahead to proactively address them is to close your eyes, cross your fingers and hope they go away! How many policyholders would choose to place their insurance with a company that had that as their business strategy? How many stockholders would choose to invest their money in that kind of company?
What does the CAS think about DFA?
The CAS believes that DFA will become an area of significant responsibility for the actuary and will increase actuarial involvement in key strategic business decisions. Specifically, actuaries will:
- Build DFA models;
- Develop appropriate assumptions as input to the models;
- Develop appropriate test scenarios;
- Help management interpret the results of the models;
- Help develop business plans to respond to risk factors and opportunities uncovered in the modeling process; and
- Help monitor compliance and fine-tune new strategic directives resulting from the tests.
A significant amount of research and development is necessary to discover the inter-relationships (covariances) between key variables in the models.
The CAS is committed to providing the profession with meaningful DFA education. The first-ever CAS DFA seminar was held in 1995 in Atlanta. This seminar is now an annual event and will be held this year in Seattle.
DFA tracks are held at the Casualty Loss Reserve Seminar, and the CAS Seminar on Ratemaking. In addition, DFA sessions are held at the CAS Spring and Annual Meetings.
CAS research committees have published the DFA Handbook (CAS Forum, Winter 1996 Edition), and the "White Paper on Modeling" (CAS Forum, Fall 1995 Edition). Considerable research is on-going in the areas of DFA database development, models, and scenarios. The CAS is exploring the feasibility of offering a new limited attendance seminar dealing with the hands-on workings of a "real" DFA model.
The CAS recently awarded prizes to authors of two papers about DFA:
"The Financial Modeling of Property/Casualty Insurance Companies" by Hodes, et al, and
"An Integrated Dynamic Financial Analysis and Decision Support System for a Property Catastrophe Reinsurer" by Lowe and Stanard.
Both papers are published in the CAS Forum, Spring 1996 Edition, Including the Prize and Call Papers on Dynamic Financial Models.
Susan T. Szkoda, FCAS, is a consulting actuary in Glastonbury, Connecticut. She has been active in the development of CAS activities about DFA for several years.