10 Questions You Should Ask About DFA
Whether you’re reviewing your DFA platform or considering the risk model that best meets your needs, there are 10 questions you should ask.
1. What is dynamic financial analysis — DFA?
DFA is an analysis of the financial results of a company under a large number — hundreds of thousands — of possible outcomes simulated by fast computers. Each simulated outcome produces the values of all unknowns of the company: insured losses, investment returns, defaults of counterparties, and others.
2. More and more insurers and reinsurers are using financial modeling software. What are the key drivers behind this?
Human desire for knowledge is the main driver. Financial modeling means better knowledge about what can happen to the company and how to make it safer and more profitable. Regulators and rating agencies have become one of the most important drivers recently. For them, a company that is seriously implementing financial modeling is a company that is better aware of its risks and ultimately a better managed company. Explosive growth of computer technologies over the last couple of decades, both hardware and software, certainly is one of the most important drivers. Dynamic financial analysis is only possible on fast, modern computers using the latest accomplishments of software engineering.
3. What about the growth in popularity of enterprise risk management (ERM) and how dynamic financial analysis fits into this?
Discussions about ERM began in the mid-1990s. At the beginning, it was more of a theoretical exercise, but as computers grew faster and senior management of the companies became more aware of the benefits of DFA, overall acceptance of the concept within the insurance/reinsurance industry grew rapidly. Regulatory pressure to adopt financial modeling began with FSA in the UK and continued with regulators in Europe, the US, South Africa, Australia, and other parts of the world. Rating agencies followed. The result was an environment where companies that are still skeptical about DFA are viewed more as the ones lagging behind the industry.
4. How can financial modeling software help insurers and reinsurers in Europe prepare for the new Solvency II regime that is due to be effective in 2016?
Solvency II explicitly requires companies to implement internal ERM models. Financial modeling software helps companies comply with that requirement much faster. Without the ready-to-use software, companies would have to write such software themselves. Most of them do not have the resources or desire to do so.
5. What lessons with regard to modeling and risk management can the insurance industry learn from the banking crisis that escalated in September, 2008?
First, companies should look more carefully at where they invest. Second, companies need to be able to evaluate the overall impact of economic downturns, whether from the banking crisis or other developments that could impact their business.
6. How does Risk Explorer™ help with strategic decision making?
Risk Explorer™ allows companies to create their risk portfolios quickly and efficiently, including insurance risks, assets and counterparties (reinsurers). Risk Explorer™ also allows companies to evaluate the impact of economic changes on the portfolio. Once all the risks are included in the portfolio, you can quickly run large numbers of simulations to produce a spectrum of outcomes for financial results. Then, various strategic decisions, such as reinsurance purchase, asset allocation, portfolio composition, and business growth, can be applied to all simulated scenarios This enables management to determine the best business strategy.
7. Most insurers and reinsurers are very conservative investors who prefer to take risk on the liability side of their balance sheets. How can financial modeling software help them manage the underwriting risk and prepare for the next Hurricane Katrina or asbestos?
In a good portfolio model, some of the simulated scenarios will produce large losses such as those from the hurricanes or from asbestos. Financial modeling software can help companies design efficient strategies to deal with such adverse loss scenarios; for example, through purchasing reinsurance or through financial risk transfers.
8. Consolidation and globalization mean that many of today’s insurance and reinsurance companies are large multinational businesses. How can DFA help coordinate and manage risks across such organizations?
DFA can help companies manage the risks of each subsidiary and then combine those risks to create a global portfolio. This will enable them to evaluate various global strategies that may benefit the large multi-national organization but would not be possible to evaluate at the subsidiary level. Also, large multi-nationals are exposed to exchange rate risk. A good DFA model for companies of this type should include exchange rate risk.
9. The insurance industry has sometimes been slow to embrace new technology and paperless ways of doing business. Have you witnessed a change in the industry culture in recent years?
As dynamic financial analysis has become more and more sophisticated over the last decade, the culture is changing and companies are embracing new technology.
10. Where do you see the insurance and reinsurance industry in five years’ time, and how prevalent will DFA modeling be at that point?
DFA models will become “must haves” in all insurance and reinsurance companies. DFA modeling will likely expand into asset-liability management where assets and liabilities have historically been managed separately. Business decisions in most insurance companies will be made with the results of a good DFA model as one of the inputs.