Management Strategies and Dynamic Financial Analysis Martin Eling, University of Ulm CAS Spring Meeting Thomas Parnitzke, Baloise Holding San Diego, May 23-26, 2010 Hato Schmeiser, University of St. Gallen

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Eling, Parnitzke, Schmeiser| Management Strategies and Dynamic Financial Analysis

Outline

1. Motivation 2. Model Framework 3. Management Strategies 4. Performance Measurement 5 Simulation 5. Si l ti Study St d 6. Role of Non-linear Dependencies 7. Conclusion and Outlook

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Eling, Parnitzke, Schmeiser| Management Strategies and Dynamic Financial Analysis

1. Motivation: Three pillars of Solvency II

Solvency II First pillar: Quantitative regulations for capital requirements

Second pillar: Qualitative elements of supervision

Third pillar: Market transparency and disclosure requirements

→ Technical provisions provisions, minimum capital, target capital → Use of standard models and internal models (Dynamic Financial Analysis)

→ Appropriate processes and decisions in the context of a risk management system → Principles for internal risk management and control

→ A transparent process will require less regulation as market participants themselves force appropriate insurer behavior → Harmonization with IFRS

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Eling, Parnitzke, Schmeiser| Management Strategies and Dynamic Financial Analysis

1. Motivation: Dynamic Financial Analysis (DFA) • Projects results under a variety of possible scenarios, showing how outcomes might g be affected byy changing g g internal and external conditions • Used in practice for

Assets

Liabilities

cash flow projection and decision support

Risk Management

Competition

• Aim Ai off this thi paper:

Insurance Company

Capital Market

Regulation

1. Implement management strategies in a DFA framework 2 Study the effects on the insurer 2. insurer’s s risk and return position 3. Give helpful insights for the development of DFA tools

Environment

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Eling, Parnitzke, Schmeiser| Management Strategies and Dynamic Financial Analysis

2. Model Framework



Simplified model of a property-liability insurer



Balance sheet (t=0):

Assets

Investments Equity (stocks, bonds, Reserves etc.) (Premiums)

Investment Result



Statement of Income (t=1):

Liabilities

Underwriting g Result Premiums - Claims - Costs (Upfront, Claim Settlement) = Underwriting Result + Investment Result = Earnings

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Eling, Parnitzke, Schmeiser| Management Strategies and Dynamic Financial Analysis

2. Model Framework: Earnings

(1) ECt  ECt 1  Et

Assets

Competition

Et : Earnings E i I t : Investment Result U t : Underwriting Result tr : Tax rate

Insurance Company

Risk Management

(2) Et  I t  U t  max(tr  ( I t  U t ),0) ) 0)

ECt : Equity Capital at the end of period t

Liabilities

Capital Market

Regulation

Environment

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Eling, Parnitzke, Schmeiser| Management Strategies and Dynamic Financial Analysis

2. Model Framework: Investment result

(3) I t  rpt  ( ECt 1  Pt 1  ExtP1 )

Assets

Competition

Pt 1 : Premiums ExtP1: Upfront costs (depending on premiums)

 t 1 : Portion invested in high-risk investments r1t : Return Ret rn of high-risk high risk in investment estment (e.g., (e g stocks) r2t : Return of low-risk investment (e.g., bonds)

Insurance Company

Risk Management

(4) rpt   t 1  r1t  1   t 1   r2t

rpt : Return of investment portfolio

Liabilities

Capital Market

Regulation

Environment

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Eling, Parnitzke, Schmeiser| Management Strategies and Dynamic Financial Analysis

2. Model Framework: Underwriting result

(5) U t  Pt 1  Ct  ExtP1  ExtC (6) Pt 1  crt 1

ECt 1

Assets

Liabilities

Insurance Company

Risk Management

  t 1   t 1  MV Competition

Capital Market

Regulation

Environment

• Consumer response (cr) to changes in solvency

cr  1, if ECt  MCR cr  1, 1 if ECt  MCR • Underwriting cycle (π): Markov chain with different states • Claims: Ct  Ccat t  Cncat t

ExtC : Claim settlement costs cr

: Consumer response

t

: Underwriting cycle

MCR : Minimum capital required (Solvency I)

t 1

: Portion in the underwriting market

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Eling, Parnitzke, Schmeiser| Management Strategies and Dynamic Financial Analysis

2. Model: Implementation in R (simplified one period example) E=0 EC=15 MV 200 MV=200 β=0.2 P=MV*β ExP