DFA Implementation Issues

CAS Risk and Capital Management Seminar

Toronto, Ontario, Canada

July 8-9, 2002

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Speakers

• Jen Ehrenfeld, ACAS, MAAAAmerican Re-Insurance Company

• Gerald Kirschner, FCAS, MAAAClassic Solutions Risk Management, Inc.

• Elizabeth Wiesner, FCAS, MAAAAccident Fund Company

Large Company Perspective

Jen Ehrenfeld

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DFA Implementation IssuesAgenda

• Lessons Learned with…– Building the Model– Parameterizing Model– Presenting Results– Corporate Structure

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Building The Model

• Right resources in-house

• Priority of DFA Model – can’t do this and your day job too

• Recognition of Investment Up Front before any Returns

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Parameterizing Model

• Company Organization vs. Risk\Line Segmentation

• Politically Sensitive Issues vs. Reality

• Highlights areas of concern\Due Diligence on own Company– If unable to model risks well, how well are

they being monitored and managed.

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Parameterizing Model - Continued

• Risk = New Planned Loss Plus Historical Reserves

• Planned Losses at least as variable as Reserves

• Reserve Modeling – Symmetric distribution or Adverse Development more likely

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Mean vs. Mode vs. Median

• Plan Loss Ratio – Where does it lie on the distribution?

• There are three measures of central tendency.

1. Mode - the most frequent observation

2. Median - the 50th percentile3. Mean - the average value of the

distribution

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Mean vs. Mode vs. Median

• Surveying Actuaries – All Three Given as Answers

• Example: – Plan Loss Ratio = 0.75– Standard Deviation around Plan = 0.30

• Clearly, Sensitive to Standard Deviation

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Median vs Mode vs Mean - 0.15 Standard Deviation

-

0.5000

1.0000

1.5000

2.0000

2.5000

3.0000

25.0% 47.5% 70.0% 92.5% 115.0% 137.5% 160.0%

Loss Ratio

f(x

)

Median

Mode

Mean

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Median vs Mode vs Mean - 0.30 Standard Deviation

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0.2000

0.4000

0.6000

0.8000

1.0000

1.2000

1.4000

1.6000

1.8000

30.0% 52.5% 75.0% 97.5% 120.0% 142.5% 165.0%

Loss Ratio

f(x

)

Median

Mode

Mean

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Mean vs. Mode vs. Median

Scenarios Mean Median Mode P(LR<=75%) P(LR>80%) P(LR>90%) P(LR>125%)

Mode = 75% 88.3% 83.6% 75.0% 37.1% 55.4% 41.2% 11.2%

Median = 75% 80.1% 75.0% 65.8% 50.0% 42.9% 30.7% 7.9%

Mean = 75% 75.0% 69.6% 60.0% 57.6% 35.9% 25.3% 6.4%

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Correlation

• Where to start?• Empirical Measures of Correlation Don’t

Result in Intuitive Answers• Initial Sensitivity Testing

– Anything below 15% - Basically Independent

– Anything above 50% - Basically Dependent

• We let intuition take over….

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Correlation Continued

• For each Line of Business Combo:– Selected Correlation Level

• Independent – 0%– Ex: PR Catastrophes with Healthcare

• Low - 15%– Ex: WC with International Lines

• Medium – 30%– Ex: Different Lines written within same Organizational Div

• High – 50%– Ex: Same Line – different types – WC Treaty & WC Fac

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Correlation Continued

• Important to do Follow-Up Sensitivity Testing• Importance of Correlation to Study

– What if all lines 100% Independent– What if all lines 100% Dependent

• Munich counterparts using an average correlation for every line combination– Not sure of implications – May be ok for Total Liability analyses, but not for

line comparisons.

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Correlation Continued

Selected Dependent IndependentExpected Value 100.00 99.96 99.91 Standard Dev 9.74 16.55 6.72

Min 83.89 82.19 86.66 Max 181.42 219.79 174.56

25% Percentile 92.99 87.36 95.61 75% Percentile 104.93 108.38 102.70

Follow-up Sensitivity Testing

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Correlation Continued

• Once Correlations are defined, if change detail of analysis, need to adjust correlations– “Answer” should stay the same no matter

what detail you review the company– Break down into more detail between

line correlations must decrease to get the same overall variance.

– Gets hairy fast

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Presenting Results

• REASONABILITY CHECK!!!• “Can’t DFA tell you that???”• Not too much at once - even for very savvy

audiences• DFA, in some respects, may be too much of a

leap from current practices• Start simple - Get buy-in – Expand Analyses

– Plan Variability– Reinsurance Analyses

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Corporate Structure

• Need Dedicated Resources– From time of building model – implementation

• Need Interaction & Coordination with All Areas of Company

• Need High Exposure & Support from Top Management

• Need to be able to have a Tangible Impact

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Success vs. Failure

• Failure - After describing a work issue or project, someone instantly is reminded of a Dilbert cartoon.

• Success - Not receiving any Dilbert cartoons for a week.

Large Company / Outside Consultant /

Software VendorPerspective

Gerald Kirschner

Classic Solutions Risk Management, Inc.

www.csrmi.com

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Key item to remember

There is no silver bullet - A DFA model can NOT do anything and everything

Large Company Perspective

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Internal Obstacles – unrealistic timelines

Implementation of a DFA model should be measured in years and not weeks or even months.

first year – figure out what you’re trying to do – usually requires a narrowing of scope

second year – improve efficiency of process

third year – start adding to the process

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Internal Obstacles – desire to cross tie with other systems• There may be other systems in the company

that are doing valuations or projections of parts of the company, and those may overlap with parts of the DFA model scope

• Expecting or demanding that the two tie out in a precise manner may be unrealistic, given the assumptions being used by the different systems

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Internal Obstacles – overly detailed modeling

• Just because data exists to allow you to model at the nth degree of detail, don’t necessarily do it.

• Where company data does not allow you to create a logical set of assumptions, don’t overwork the assumptions that you can make.

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Getting the consultants involved…company preparation• know what you want to accomplish and be

realistic as to short and long term goals• be willing to be flexible• be ready to invest significant time and

resources• have a small-scale test case that can be

used in a trial run• take advantage of your trial run to learn the

software’s strengths and weaknesses

Outside Consultant / Software Vendor

Perspective

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Getting the consultants involved…consultant preparation

• Listen first, talk second• Ask lots of questions about company:

– company expectations– desired use(s) of model– unique aspects of the company’s operations

(these will be the ones to challenge your model)

• Be honest about your model strengths and weaknesses – in the long run, an inappropriate sale is worse than no sale

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Consultant preparation continued

• Identify appropriate contact persons for the client company – these should encompass all the areas of expertise upon which the client will need help

• Be realistic as to what the client can learn on his/her own and be patient – you are the ones who know the model inside and out and the client is going up a steep learning curve

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Once you are under way…

• Company– read the user manuals– invest the time to learn the software– tell your vendor about software problems

you encounter

• Consultant / Software Vendor– check in frequently with the client– rein in “scope creep”

Small Company Perspective

Elizabeth Wiesner

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Business Needs

• Everything driven by business needs• Complete assessment• Compare alternatives for fit with

company– prioritize needs– costs– determine and include other interested

parties

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Examples

• Strategic planning

• Financial projections

• Coordination among company operations

• Loss reserving

• Management training

• Cost

• Time of delivery

• Complexity of use

• Thoroughness of model

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Implementation Issues

• Buy/build

• Transfer knowledge to internal staff

• Spread of knowledge internally

• Keeping all interested departments involved

• Keep it simple

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Issues with ‘Day to Day’ Use

• Desire to use as crystal ball

• Acceptance throughout company

• Understandable communication

• ‘Changing’ results

• Following a project process and using DFA as a tool, not the project itself