DFA Implementation Issues

CAS Special Interest Seminar onDynamic Financial Analysis

June 6- 8, 2001

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Speakers

• Mary Wills, ACAS, MAAAUSAA

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

• Elizabeth Wiesner, FCAS, MAAAAccident Fund Company

Large Company Perspective

Mary Wills

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DFA Implementation Issues

 • Selling development of P&C DFA model internally

• Issues confronted during model developmentBuild model from scratch in-house, partner withconsultant to build new model, or purchase existingmodel?

Vendor selection process

Model design and customization/enhancement

Enterprise ALM using DFA

• Other issues that could arise when working with vendor

• How the P&C DFA model has been used

Agenda

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Selling P&C DFA Internally

• Financial services company

•  Primary Product Lines of Business (LOBs)

P&C (personal)

Life (individual)

Banking

Investment management

Overview of USAA

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Selling P&C DFA InternallyCorporate Asset Liability Management Committee

 

•     Enterprise ALM committee made up of key ALM experts from each LOB

High visibility in enterprise Tasked with identifying, measuring and recommending

actions appropriate to the management of financial risks

Monitors universe of 8 financial risks at enterprise & LOB level

Capital market volatility Interest rates

Concentration Credit

Liquidity Catastrophes

Pricing/Underwriting Reserving

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Universe of Risks

P&C Life BankMutual Funds/

Brokerage Pension EBA

Interest Rate and Stock Market Risk

Concentration and Credit Risk

Reserving Risk

Catastrophe Risk

Pricing/Underwriting Risk

Liquidity Risk

Selling P&C DFA InternallyCorporate Asset Liability Management Committee

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Selling P&C DFA InternallyApproach for Obtaining Approval to Implement

 

• Developed executive tutorial to gain buy-in on P&C DFA up front

Outlines expected uses for DFACapital management Asset allocationLiquidity management Rating agency supportPricing & reserving studies Reinsurance studiesSupport enterprise-wide DFA

Emphasis on how DFA output would be summarized into formats useful for decision making and strategy/policy

development

Includes both the capabilities of DFA as well as its limitations

• P&C DFA model seen as a natural next step to adding sophistication and integration to corporate ALM process

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Issues Confronted During Model Development

•     Considerations Lack of DFA expertise within P&C division Desired timeframe for implementation

• Decision Combined buying and building: Purchased existing vendor

model, and made significant modifications to model to reflect

company’s unique operations

• Was it the right decision? Probably the only way to get the ball rolling and implement

within reasonable timeframe Gradually building expertise in-house

 

Build Model from Scratch In-House, Partner with Consultant to Build New Model, or Purchase Existing Model?

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Issues Confronted During Model Development

Vendor Selection Process

•     Developed detailed selection criteria

Importance of DFA to firm’s strategy

Concentration of expertise in one person vs. department of experts

Broad expertise: P&C actuary, economics, investments, modeling, etc.

Open architecture of model

Flexibility of model to be changed by company staff

Model run time

Confidence in and documentation of model and underlying theories, including methodology for generating economic scenarios

 

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Issues Confronted During Model Development

•     Developed detailed selection criteria (continued)

Ability to use model to support identified needs

Ability to interface P&C model with company’s other existingALM tools

Good balance between strategic focus and level of detail

Ease of use of scenario diagnostic tools

Proactive relationships with rating agencies and regulators

Number of asset classes, P&C lines and reporting periodssupported

Ease of model maintenance (impact of new releases, ease of loading large amount of data)

Vendor Selection Process

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Issues Confronted During Model Development

Vendor Selection Process

•     Conducted phone interviews to narrow the field, and held on-site meetings and model demos with selected vendors

• Developed matrix of pros and cons by vendor, based on established selection criteria

• How well did we do in the selection process?

Good job of developing comprehensive list of questions to determine how well each vendor’s model met our needs, but should have given

more attention to ease of loading large amount of data

Devoted sufficient time and diverse group of experts; however, perhaps should have also included our IT experts in evaluation process

Decision was more difficult than we anticipated -- each vendor had strengths and weaknesses 

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Issues Confronted During Model Development

•     Level of detail

Operational versus strategic tool -- misperception that modelshould replace existing financial forecast (point estimate)planning tool

Usual checks not in place -- P&C industry’s relatively low level of experience with product & lack of IT involvement

• Parameterization

• Commitment of company resources

Grossly underestimated staff time required, as well as length of

time for project

Budget issues  

Model Design and Customization/Enhancement

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Other Issues That Could Arise When Working With Vendor

•  Very difficult to get a thorough understanding of vendor’s model and its strengths and weaknesses until committed to vendor

• Little control over resources assigned to project

• Different interpretations over what falls within or outside project scope

• Once cost and timeframe locked in, quality may get lower priority 

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Issues Confronted During Model Development

P&C Life Bank Pension EBA

Economic Simulator(Inflation, Interest Rates, Stock Market)

Enterprise

MF/Brokerage

Enterprise ALM Using DFA

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How the P&C Model Has Been Used

•     Capital management

Measure variability in net worth over planning horizon andidentify major sources of risk that cause fluctuations

Better understand the interaction of these risks Future plans

Determine if risks can/should be reduced or eliminated

Determine how much capital must be held against thoserisks

Test risk management strategies

• P&C portfolio asset allocation

• Rating agency support

• P&C reinsurance strategy analysis

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How the P&C Model Has Been Used

• Future applications

Reserve risk margin analysis

Pricing studies

Liquidity studies

• Side benefits

Utilized dynamic feature of DFA model to build new model forderiving aggregate level reserve ranges for actuarial reports

Parameter analysis for DFA model also provides benefits toother areas of actuarial work

 

Large Company / Outside Consultant

Perspective

Gerald Kirschner

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Key item to remember

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

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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

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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 – 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