Asset-liability modeling for insurers: Incorporating a regime-switching process for equity returns into a Dynamic Financial Analysis model

This paper discusses a framework for asset-liability modeling of property-liability insurers. In particular, the paper has a dual purpose: (1) to describe a dynamic financial analysis (DFA) framework for insurer analysis which combines an underwriting model reflecting pricing, regulatory, and catastrophe risk with an economic and investment performance module, and which incorporates the interrelationships among these various insurance and financial processes; and (2) to evaluate the impact on projected insurer risk of incorporating into this framework a regime-switching model for the equity return process. The results suggest that, compared with a more common and simpler regression-based model of equity markets, introducing a regime-switching approach within a DFA framework can better reflect the overall risks facing an insurer. Such a model can provide a stronger basis for asset-liability management, capital allocation, and general operational and strategic planning by insurer management, as well as for regulatory supervision of the insurance industry.