The Financial Modeling of Property-Casualty Insurance Companies

Abstract

This paper describes a financial model currently being used by a major U.S. multiline property-casualty insurer. The model, which was first developed for solvency monitoring purposes, is now being employed for a variety of internal management purposes as well, including (1) the allocation of equity to corporate units, thereby allowing measurements of profitability by business segment and policy year, as well as analysis of the progression of “free surplus,” (2) the analysis of major risks–such as inflation risks, interest rate risks, and reserving risks–that have heretofore been difficult to quantify, and (3) consideration of varying scenarios on the company’s financial performance, both of macroeconomic conditions as well as of the insurance environment. Many aspects of financial modeling do not differ significantly between life and property-casualty insurers, and these are not discussed in the paper. Rather, the paper focuses on the following topics: 1. Surplus allocation and profitability: how economic surplus and the returns on this surplus are determined by line of business, separately for new business and for the runoff of existing business, and how the progression of free surplus is viewed. 2. Multifaceted risks: how to model risks that affect multiple components of the insurer’s operations, such as economic risks and financial risks. The multiple effects of macroeconomic conditions and changing inflation rates on workers’ compensation claim frequencies and severities complicate the basic interest rate path modeling of life insurance products and annuity contracts. 3. Scenario building: how to construct scenarios of macroeconomic conditions or industry cyclical movements to test the resilience of the company to changing external conditions.