DFA- The Value of Risk

This paper describes the use of a Dynamic Financial Analysis (DFA) model to answer questions on capitalization, business and asset strategy in the case of a US P&C insurer, in the framework of maximizing stockholder wealth. We measure this wealth by applying a risk measure on the individual stochastic cash flows from the DFA model, in preference to more conventional approaches based, for example, on historic betas The risk translates into value by two mechanisms: 1. For systematic risk, we use a multiple-factor arbitrage-free pricing approach. This is calibrated to be consistent with the prices that our stochastic macroeconomic model generates. We implement these ideas using explicit deflator processes. 2. Both systematic and non-systematic risks generate frictional costs, which we model explicitly. These costs are o f vital importance to insurance, yet are often overlooked in DFA analysis. We allocate these frictional costs back to each simulation so as to produce realistic, rather than idealistic, financial statements which then enable us to look at capitalization issues as well as valuation ones. Our approach to risk definition is consistent with the recent findings of the CAS Risk Premium Project - see Butsic et al (2000) KEYWORDS Dynamic Financial Analysis; Capital, Risk, Return; Financial Economics, Reinsurance; Catastrophe Exposure; Investment Strategy; Systematic Risk, Non-Systematic Risk; Frictional Costs; Operational Risk; Capital Allocation;