The Financial Modeling of Property-Casualty Insurance Companies

This paper describes a financial model currently being used by a major U.S. multi-line insurer. The model, which was first developed for solvency monitoring purposes, is now being employed for a variety of internal management purposes, including (i) the allocation of equity to corporate units, thereby allowing measurements of profitability by business segment and by policy year, as well as analysis of the progression of "free surplus," (ii) the analysis of major risks, such as inflation risks, interest rate risks, and reserving risks, that have heretofore been difficult to quantify, and (iii) consideration of varying scenarios on the company's financial performance, both of macro economic conditions as well as of the insurance environment. This paper begins with the genesis of the model and with its structure. It moves on to equity considerations and to performance measurement. It then discusses the major risks that have heretofore resisted actuarial analysis, such as interest rate risk (inflation risk), reserving risk, and scenario testing. The paper shows how cash flow financial models can deal with global risks that simultaneously affect various aspects of the insurer's operations, delineating the resulting changes in the company's performance.