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securities in profitable years. The model also determines whether the alternative minimum tax (AMT) is required and factors the AMT penalty into the analysis accordingly.

As a result, a prospective model of DFAIC's tax liabilities under many possible scenarios was evaluated. The optimization model found the allocation to tax-exempt securities that maximizes DFAIC's reward objective within the bounds of the company's risk tolerance. Based on our model of DFAIC and the assumed future business plans, the probabilities of negative taxable income for each of the next five years under the current asset investment strategy are indicated in Table 8.

Table 8: DFAIC's Taxable Income

Mean (000s)

Probability of Negative

47,791

30%

128,251

21%

196,870

18%

227,064

13%

264,481

10%

Year I

Year 2

Year 3

Year 4

Year 5

The above table is consistent with the loss ratio improvements built into Falcon's business plan assumptions for DFAIC. The increasing expected income levels combined with the decreasing probability of negative income results suggests that tax- exempt investments should very well have a role in the investment strategy for DFAIC over the five-year planning horizon.

Now, assuming that Falcon management is happy with DFAIC's current risk tolerance level, the investment strategy can be adjusted to that indicated by Strategy D (see Exhibit 5). This would suggest increasing the equity allocation from 11.2% to 17.3%, reducing the fixed-income duration from 4.9 to 3.2 and allocating 10% of the fixed- income portfolio into tax-exempt securities.

The move to Strategy D results in a $67.8M increase in economic reward over the five- year horizon without any additional increase in economic risk. The next step is to examine the statutory implications of such a strategy. Exhibit 7 shows the impact to DFAIC's statutory surplus under both the current asset strategy and Strategy D.

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