Thoughts on DFA Modeling

Avoid complexity for the sake of complexity.

Our modeling approach is to aim for the least complicated model possible without sacrificing any accuracy of results. Too many model providers seem to have gotten caught up in creating overly complex models in an attempt to be as close to “perfect” as possible.

Perfection, unfortunately, is never possible with financial modeling. The accuracy of underlying assumptions constrains robust results for any model — and both capital market and liability assumptions are imperfect at best.

No investment professional would make the significant-figure mistake of carrying calculations to greater accuracy than the original data. Yet ALM / DFA models too often try to deliver results with four or more significant figures based on underlying capital market and liability assumptions with only one or two.

The more serious concern is that this pursuit of model perfection comes at a substantial cost in terms of complexity, significantly increasing the opportunity for error: both model miss-specification and user error.

There are multiple models currently available to insurers. Most suffer from the same limitations: They are complex for the sake of complexity, opaque, unnecessarily time-consuming to use, and expensive. Perhaps the overly complex models can command higher prices, but they don’t better serve the client.

A better approach offers the advantages of transparency and ease-of-use without any real sacrifice in the robustness of results.

We believe DFA/ALM models should be user-friendly, transparent, easily vetted, available to clients with all assumptions challenged, tested, and fully disclosed.

Finally, we recommend a DFA/ALM Peer Company Risk Analysis (the same stochastic analysis of individual peer companies) to describe the client’s asset, liability and surplus, net income, and Risk-Based-Capital, risk trade-offs in context with those same risk positions of individual peer companies. This perspective adds insight into how much short-term surplus loss clients can comfortably withstand while pursuing maximum surplus growth over time.

 

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