How DFA Can Help theby Susan T. Szkoda
from Volume 24, No. 2 Edition
Editors Note: This is the second in a series of articles on Dynamic Financial Analysis (DFA).
Click here to view Part I
Part 1 of this series covered the definition of DFA, why it is important, and what the CAS is doing to further member education in this important area.
This article will focus on DFA as related to pricing.
Articles in the trade press (National Underwriter and Best's Review) have noted that, during 1996, rate levels deteriorated significantly as competition continued to heat up. Alan Greenspan's phrase "irrational exuberance" may be applicable to current and future property/casualty pricing activities.
It appears that liability and package rates have been soft for several years and that workers compensation rates softened significantly during 1996. Competitive pressures are likely to continue these trends for the next several years. This does not imply that every company's rates are inadequate. However, on average, it does imply that liability rates are inadequate and that workers compensation rates may soon be.
If you add to this mix the consideration that medical inflation rates may turn sharply upward over the next few years and that most companies can't cut expenses fast enough to offset stagnant or declining premium volumes, you have the fundamentals aligning to create a hostile operating environment.
This suggests that the commercial property/casualty industry is heading toward a 1984-style debacle. DFA can help avert a crisis.
In the "old days," when the cycle was three years up and three years down, management could simply hunker down and ride out the rough times. In today's environment, where the cycle seems to run roughly three years up and seven years down, that strategy doesn't seem prudent. Rating agencies probably aren't going to give many points for that approach. Points will be awarded to those companies who can not only survive, but thrive, in this challenging environment.
This is where actuaries can apply DFA to perform a valuable role.
There are (at least) five broad classes of pricing-related activities that can help the industry:
Trim the Sails - Now is the time to critically analyze the existing book of business. Have you taken on risks during good times that may not look as good when rates are lean? Rate and underwriting reviews geared toward identifying, fixing or shedding unprofitable (or likely to become unprofitable) lines, classes, geographical regions, or target market subsidiaries may be prudent. Development of specific strategies to maximize renewal retention of desirable business is also prudent.
Share the Risk - Programs that make rate credits more loss-sensitive and less automatic may also be prudent. Examples include greater use of retro rating, loss sensitive dividends and loss sensitive contingent commissions. Cost effective use of reinsurance may also be a key element of this strategy.
Identify Pockets of Opportunity in New Areas - Many of the largest and most successful insurers became so when they spotted opportunity in the "cast-offs of the traditional insurance industry. Such opportunities still exist.
Another opportunity is to build a better, more desirable product within mainstream lines of business. When was the last time you asked your customers what features they would like to see in your products?
Another opportunity is to look at new subdivisions of data and new data elements. One thousand companies looking at the same data elements will typically draw the same conclusions as to the desirability of a certain class or subline of business. Successful companies frequently look at new and different data to acquire fresh perspectives.
The main point is that it's tough to shrink your way to greatness. A little creativity can go a long way in opening up new business opportunities.
Create Pockets of Opportunity via Operational Changes - Examine new distribution channels with desirable allies, identify new market segments based on demographic and income characteristics. Look at where the economy is growing in desired target industry groups and geographic regions and strive to offer competitive prices and good service to these niches.
Look at your claims operations and strive to maximize efficiencies and best practices to reduce claim cost trends and identify and reduce fraud.
Take a hard look at managed care. Many of the big HMO/PPO plans in Connecticut recently raised rates by 6 percent to 10 percent after several years of little or no rate increases. This trend appears likely to become national. HMO's have been absorbing rising underlying claim costs for several years but haven't passed them along to customers due to strong competitive pressures. This cannot last. Therefore, trends in medical costs appear to be headed north again. A good managed care plan is necessary to restrain these costs.
Be Realistic About the Fundamentals - Regardless of what competitive pressures may do to the actual prices charged, you need a true compass as to what your actual costs are.
Many of the large national companies that foundered during the last cycle were overly optimistic about their ability to underwrite and control costs. Prices and reserves were also too optimistic. These companies have not survived as independents.
I believe that the current cycle will similarly create a few spectacular winners and a few spectacular losers. Most companies will simply tread water. The ability to spot turning points in the cycle before the crowd brings opportunities for tremendous profits. The opposite brings opportunities for tremendous losses. Realistic assessments of the fundamentals and appropriate strategic business decisions make all the difference.
Last, it's important to take a hard look at the prices being paid for acquisitions. Irrational exuberance can saddle the acquirer with a heavy financial burden for years to come.
The activities listed above require significant actuarial analysis. Sound actuarial analysis is the foundation for developing appropriate business strategies. These strategies and associated relevant data may then be loaded into the DFA model. Typical DFA model output would include income statements (GAAP and Statutory), balance sheets, capital ratios (such as RBC and IRIS) and cash flow statements. The results of all the relevant output exhibits need to be considered in the selection of appropriate strategies. Statutory and GAAP accounting rules and proposed changes to such rules also need to be considered.
DFA actuaries have prime roles in helping management find suitable strategic paths. The next few years will present a challenging environment. DFA scenario testing can be a positive factor in helping your company thrive in this environment.