Financial Modeling of Risk Transfer - AIRROC · Agenda ! Reason for performing financial modeling for LPT’s ! Overall approach to financial modeling ! Economic uncertainty ! Claims

Financial Modeling of Risk Transfer AIRROC

AIRROC Education Session by Sandra Santomenno, ACAS, MAAA October 20, 2014

© 2014 Towers Watson. All rights reserved.

Agenda

l  Reason for performing financial modeling for LPT’s

l  Overall approach to financial modeling

l  Economic uncertainty l  Claims uncertainty

towerswatson.com © 2014 Towers Watson. All rights reserved.

Why Perform Financial Modeling for LPT’s?


Why Perform Financial Modeling For LPT’s?

A tool to help measure the % of failure scenarios of the loss portfolio transfer (the risk margin) which would include l  Uncertainty of investment returns – Asset Risk

l  Mix of investments l  Strategy to meet cash flow requirements l  Probability of defaults

l  Uncertainty of reserve estimates – Reserve Risk l  Impact of various inflationary scenarios l  Nominal payment uncertainty

l  Uncertainty of payment patterns – Timing Risk l  Changes in future claim handling l  Compressed payments due to large settlements, commutations


Why Perform Financial Modeling For LPT’s?

A tool to help measure the amount of capital necessary to fund the reserve run-off. l  Regulatory surplus requirements l  Capital management - allocation to support discontinued business

l  Measure expected shortfall in failure scenarios

l  Implications to balance sheet and income statement in stress scenarios


Approach to Financial Modeling



Goal: Determine the probability that the run-off portfolio is properly funded across most possible economic conditions Measure: What is the probability that the opening assets will be sufficient to meet future loss and loss adjustment expense payments?


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l  Start with beginning balance sheet l  Beginning assets l  Beginning liabilities

l  Perform 10,000 or another large number of simulations of the run-off of the claims and asset returns

l  Using the results of the simulations to determine the following:

l  Number of failure scenarios (where assets are not sufficient to meet loss payments) will determine the probability that the run-off portfolio is not properly funded by the assets across all forecasted economic conditions

l  Causes of failure scenarios –  Poor asset returns – re-consider investment capital and strategy –  Claims inflation – re-consider portfolio pricing and claim settlement practice –  Lines of business generating the most volatility – consider exclusions, an

adverse development cover or other reinsurance


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Inflated Gross Losses

Asset Model

ESG

Apply Reinsurance

Projected Cash Flows

Asset Re-balancing Tax

The following flow chart summarizes the major components of a typical cash flow financial model:

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ESG = Economic Scenario Generator

Approach to Financial Modeling ESG


Economic Scenario Generator (ESG)


About the ESG l  Towers Watson’s proprietary ESG is an example of what can be used

to produce future economic scenarios typically consisting of: l  Interest rates l  Credit spreads l  Equity returns l  Default rates l  Wage and price inflation

l  These economic variables are then used to determine the full distribution of returns at various time horizons for a wide range of assets (at both an aggregate level and individual-security level)

l  Variables can also be used on the future liabilities (impact of inflation and potentially discounting)

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What is an Economic Scenario Generator?

A scenario is “a story of what happened in the future”1

1 Jon Scott Armstrong, “The forecasting dictionary”, Principles of forecasting: a handbook for researchers and practitioners

Approach to Financial Modeling Asset Modeling



l  Invested assets are divided into portfolio categories such as treasuries, corporate bonds, securities on deposit and equities

Asset Re-balancing l  At each point in time, and for each scenario, apply rules regarding which

assets should be sold to pay losses and expenses. In the scenarios where cash outflows are higher than the cash inflows and an asset sale is required, determine the order of the asset disposal based on pre-determined investment strategy

l  Determine when portfolios are to be held to maturity or are to be rebalanced annually - which dictates the valuation approach that is to be used

l  Cash flow matching of assets to either a mean scenario cash flow or a

high scenario cash flow

Asset Modeling

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Approach to Financial Modeling Combining Sources of Claims Uncertainty


Gross and Ceded Loss Payouts

l  Volatility in timing (timing risk) and amounts (reserve risk) l  Reserve risk modeled in two categories:

l  Uncertainty with respect to future claims inflation l  All other sources of uncertainty

l  Projections can be performed either gross or net of all reinsurance l  If performed gross, then reinsurance needs to be applied

l  Reinsurance collections can also be modeled considering counter-party risk

l  Timing risk factors can also be modeled – for example changes in settlement or claim handling philosophy


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Modeling of uncertainty


l  Claims Inflation Uncertainty l  Price and wage inflation are generated directly by the ESG l  Claims inflation for each line is projected based on a combination of the

following: –  price inflation –  wage inflation –  medical inflation –  superimposed inflation

l  Non-inflationary Uncertainty

l  Reserve variability l  Variability of the timing of loss payments

l  Model the relationship between the risks - dependencies

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Model Output



Goal: Determine the probability that the run-off portfolio is properly funded across most possible economic conditions Measure: What is the probability that the assets will be sufficient to meet future loss payments under every possible economic scenario?

l  % of failure scenarios (where assets are not sufficient to meet loss payments) l  Causes of failure scenarios

–  Poor asset returns – re-consider investment strategy –  Claims inflation – re-consider portfolio pricing and claim settlement practice –  Lines of business generating the most volatility – consider exclusions

l  Size or severity of failure scenarios

l  Consider alternative LPT structures to lower the % of failure scenarios or their severity

Financial Modeling - Output

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Thank you!

Sandra Santomenno, ACAS, MAAA Towers Watson [email protected] +1 908 879 9254

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Financial Modeling of Risk Transfer - AIRROC · Agenda ! Reason for performing financial modeling for LPT’s ! Overall approach to financial modeling ! Economic uncertainty ! Claims

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