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DFA Insurance Company Case Study, Part I: - page 14 / 40





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Asset Class

Expected Annual Return

Annual Std Dev

Annualized Compound Return

Annualized Compound Std Dev

Cash Equivalents





US Gov't Bonds (1-5) US Gov't Bonds (5-10) US Gov't Bonds (10-30)

6.5% 6.9% 7.4%

3.5% 6.7% 10.7%

6.5% 6.7% 6.9%

0.8% 1.8% 3.3%

US Corporate Bonds (1-5) US Corporate Bonds (5-10) US Corporate Bonds (10-30)

7.2% 7.6% 8.0%

3.6% 6.8% 10.8%

7.2% 7.4% 7.5%

0.9% 1.9% 3.3%

US Municipal Bonds (1-5) US Municipal Bonds (5-10) US Municipal Bonds (10-30)

4.9% 6.1% 7.0%

3.2% 7.8% 11.8%

4.8% 5.8% 6.4%

0.7% 2.0% 3.2%

US Stock Preferred Stock

10.8% 8.3%

20.0% 12.6%

9.3% 7.7%

7.6% 4.2%

Table 2: Simulated Five-Year Return StatlsUcs '3

The operations of insurance companies differ from other industries for a number of reasons. Prominent among these is the receipt of payment for a product before the magnitude or timing of the product's costs are known to the company (insurer). A reserve must be established to account for this contingent obligation. The importance of liabilities to the operations of an insurance company implies a similarly important role to an appropriate insurance company DFA model. Such items as payment patterns, loss ratios and reserves, expense ratios, and premiums are examples of obvious inputs to a DFA model. Further, one must apply these and other inputs within the context of other considerations such as line of business, whether we are generating results gross or net of reinsurance, or whether these parameters are applied to business already written or business to be written at some future time. This section will not focus on the details but rather present a general overview of the parameterization process for losses and liabilities as well as some of the more interesting particulars.

Our study of DFAIC's current reinsurance program and how it compares to alternative programs does not include loss portfolio transfers or other retrospective coverage. Hence existing business, with its attendant loss and unearned premium reserves, is modeled on a net of reinsurance basis. New business, however, is modeled on a gross basis. This allows us to vary prospective reinsurance strategies and compare the consequences of differing strategies. Since a principle focus of our paper is the current reinsurance program and its possible alternatives, we begin with a brief discussion of

'3 Expected annual return statistics are arithmetic averages and are indicative of risk and return expectations over a one-year holding period. Annuahzedcompound return statistics are geometric averages and reflect the impact of time dwersification over the five-year holding period.


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