DFA is a manner of viewing the world; it is not a specific model or procedure rather it is a perspective. Stochastic simulation, scenario testing, financial modeling, risk covariance, sensitivity estimation- all the terms that are associated with dynamic financial analysis — are handmaidens to the central perspective. To see the power of dynamic financial analysis and the variety of issues that it addresses — let us compare dynamic analysis with static analysis.
Static loss reserve analyses are straight forward and they suffice for most purposes. Dynamic analyses are more complex, but they are essential in turbulent economic times. Workers compensation insurers have large and volatile loss reserves, whose expected value depends both on medical inflations and on the likelihood of disabled workers return to work depends on how many jobs are there, and how eager employers are to hire more workers.
That is, it depends on the rate of unemployment and the rate of economic expansion. The static loss reserve analysis assumes no future changes in inflation and no future changes in unemployment. The static analysis procedure a “best-estimate “reserve indication. It informs the company of the expected benefit costs as long as inflation and unemployment do not change.
However, these values do change, sometimes slowly, sometimes abruptly. When medical inflation rises, medical benefits cost rise as well. When unemployment rises indemnity loss reserves rise in tandem. Dynamic analysis supplements static analysis; it does not replace it. The static analysis remains the bedrock of loss reserves. It shows the average of future results and it is readily understood by others.
Yet this average, this best estimate, tells only a small portion of the story. It tells nothing about the uncertainty in the reserve estimate, or about the sensitivity of the reserve estimate to other variables. Dynamic analysis fills in the rest of the loss reserve story, giving us a better view of the change that the future may hold.
With the Static analysis, each component of the insurance company’s operations was examined separately, Reserving actuaries produced reserve indications, and the financial analysts estimated investment returns. In monitoring the company’s overall performance, in setting business plans, and in formulating corporate strategy, each component was treated separately. Rising inflation would raise the reserve indications; rising interest rates would depress the values of fixed income securities, such as bonds, mortgages, and CMOS. Interest rates and inflation rates often move in tandem; that is, reserving risks and investment risks are interlinked
But companies do not ask: ”how are reserving risk and investment risk interlinked?” They think in terms of economic and business reality.
In scenario testing, the infiltration of basic business terminology into actuarial analysis is clear. A typical scenario testing dynamic financial analysis might take the following form
Scenario building: — It comprises realistic scenarios, covering a variety of economic, financial, and business conditions and emphasizing those attributes that have the greatest effect on insurance performance
Relationships: — The insurance correlates of these economic attributes are formulated. Some of these relationships are obvious to most insurance personnel. Other relationships seem surprising at first, though they are well known to astute observers of the insurance industry
Sensitivity: — The magnitude of the insurance correlates is quantified, either by analytic studies or by business judgment, such as “A 1% drop in the unemployment rate leads to a 1.5% rise in the workers’ compensation claim frequency”
The static analysis may predict a 12% return on equity. The dynamic analysis now asks:” What is the chance that this product will indeed give a 12@ return on equity?” So actuaries have learned to simulate. For Static analysis actuaries predict, for dynamic analysis, the actuary simulates. In a dynamic financial analysis, the actuary does not predict next year’s inflation rate. Rather, the actuary simulates the possible inflation rates in the coming year. Prediction is difficult, but simulation is twice as hard.
The dynamic analysis may produce ten thousand simulations, in seven thousand of which the product produces 12% or better return on equity, but in 500 of which the product actually loses money. The results provide better information. They not only produce the distribution of the likely returns, but they also show the sensitivity of the return to the various factors affecting the company
The output of the dynamic financial analysis is not a specific number; it is a future performance of the insurance enterprise. This future performance may be presented as Pro-forma financial statements, cash flows of assets and liabilities, or present values of future earnings. The output may be geared to the audience: accountants may prefer the financial statements and investment officers may prefer the cash flows. The dynamic financial analysis extends the actuarial analysis to address practical problems in business strategy.