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DFA Insurance Company Case Study, Part I: - page 7 / 40

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maintains an "A" rating from A.M. Best. The company's northeast and mid-west concentrations limit their exposure to severe catastrophes2.

DFAIC's underwriting results have deteriorated recently, but the 1999 combined ratio, 105.1, was slightly better than the industry average, 107.83. DFAIC's balance sheet appears slightly leveraged versus the current industry average, but its premium-to- surplus and reserves-to-surplus ratios of 1.47 and 1.45, respectively, are low by historical standards. The company cedes a relatively small portion (8.5%) of its direct written premium to a combination of excess-of-loss (XOL), per risk excess and catastrophe reinsurance contracts.

DFAIC's invested assets are reportedly weighted toward tax-exempt municipal bonds (56%), with smaller allocations to government and corporate bonds and equities. The company's cash position is unusually large at 18% of invested assets, versus the industry average, 4.0%4. Investment income earned in 1999 was 7.0% of terminal invested assets.

Step 1: Goals and Objectives

The DFA process starts with a thorough discussion and understanding of the goals, objectives, constraints and risk tolerance of the company. This step determines the metrics that will be most important in evaluating alternative strategic initiatives. It also tends to be a valuable exercise as it helps management think through, focus on, and communicate exactly those items that are most important to them as a company. These items are stated in terms of financial statement results and, once determined, provide a common set of metrics that can be applied to all of the company's financial strategic decisions.

There is no limit to the number and types of possible objective functions that can be used for evaluating strategic initiatives. Some simple objective functions might be defined as expected surplus (policyholder surplus, shareholders' equity, or economic value) for the reward measure, and the standard deviation of the surplus for the measure of risk. Alternatively, downside risk measures can be substituted for standard deviation or company-specific risk/reward functions can be defined.

2We have assumed that DFAIC has no substantial earthquake exposure.

31999 industry excluding state funds combined ratio after policyholder dividends. "Best's Aggregates & Averages, Property-Casualty U.S.", 2000 Edition, p. 119.

4"Best's Aggregates & Averages, Property-Casualty U.S.", 2000 Edition, p. 122.

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