Transcript Casualty Actuarial Society Improving and Protecting the Balance Sheet 2002 Spring Meeting San Diego, California.

Casualty Actuarial Society
Improving and Protecting the
Balance Sheet
2002 Spring Meeting
San Diego, California
Improving and Protecting the Balance Sheet
• Moderator:
Sean R. Devlin, Vice President
American Re-Insurance Company
• Panelists:
Michael J. Belfatti, Senior Vice President and Chief
Actuary, ACE Financial Solutions
Peter J. Doyle, Vice President, American Re-Insurance
Company
Agenda
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Environment
Capital Issues
Background of Finite Reinsurance
Accounting Issues
Case Study: Quota Share
Case Study: Adverse Loss Development Cover /
Loss Portfolio Transfer
• Questions
Environment
Environment - Recent History
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Several Years of Competitive Pricing
Under-reserved in recent accident years
Asbestos refuses to go away
Poor investment returns
September 11
Environment – Result of Recent
History
• A large percentage of balance sheets are
strained
• Many companies are in danger of rating
downgrades
Environment – Current Situation
• At long last, the hard market has recently
returned
• But, companies may not be strong enough
financially to take advantage of it
• Are there reinsurance solutions?
Capital Issues
Capital Issues
• Insurance companies need capital
– Buffer against uncertainty
– Provides comfort level for prospective
counterparties (e.g., lenders, policyholders)
– Required to run the operation and build new
strategic efforts
– Assures regulators and rating agencies that
“promise to pay” will be fulfilled.
– Avoids “run on bank” mentality.
Capital Issues
• Various Standards for Capital Need Exist
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NAIC RBC
AM Best (BCAR/ERM)
S&P
Economic Modeling
Capital Issues
• NAIC RBC
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Implemented in mid-90s
Based on statutory financials
Charges to reserves and premium by line
Adjusts for company experience relative to
industry
Capital Issues
• AM Best
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Design similar to NAIC RBC
Separate analysis of reserve inadequacy
Based on EPD calibration
Adjustment to “undo” effect of LPT
Capital Issues
• S&P
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Traditional reserve and premium charges
Also based on EPD approach (AAA)
Adjust reserves to adequate level
No explicit covariance adjustment
Capital Issues
• Modeled Capital Need
– Firms are developing their own view on capital
need
• Centralized firmwide risk modeling
• Focus on common risk drivers
• Require assets to meet designated safety standard
– For these models in particular, finite products
can reduce variability and capital need
Background of Finite Reinsurance
• History
– Pre 1992– limited risk transfer
• Restricted payment timing
– 1992 and Subsequent
• FAS 113, SAP 62 require risk transfer
• More delicate balance between risk transfer and risk finance.
– Late 1990s to today
• Development of new structures
• Integration of new exposures
• Market has reached some maturity
Background of Finite Reinsurance
• Recent Demand
– Response to increased traditional prices
• Covers that spread net lines of multiple years
– Response to reserve deterioration
• LPTs
– Need to contain impact of “black hole” exposures
• Asbestos
– Continued interest in blending traditional insurance risk
with “uninsurable” exposures
• Integrated finite covers
– Companies with need for surplus to support growth
• Quota Share
Accounting Issues
Accounting Issues
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Risk transfer
Retroactive transactions
Discounting loss reserves
Offshore carriers
Risk Transfer – FASB 113
• The reinsurer assumes significant insurance
risk under the reinsured portions of the
underlying insurance contracts.
• It is REASONABLY possible that the
reinsurer may realize a SIGNIFICANT
loss from the transaction.
Risk Transfer – Deposit Accounting
• If transaction does not pass risk transfer
test, it is booked under deposit accounting
guidelines
• No initial impact on income statement or
reserves
• No income or surplus recognition until loss
payments exceed deposit
FASB 113 – Paragraph 11 Exception
… if substantially all of the insurance risk
relating to the reinsured portions of the
underlying insurance contracts has been
assumed by the reinsurer.
Retroactive Accounting - Statutory
• Ceded entries are not posted to underwriting
accounts
• Income statement – “retroactive reinsurance
gain” in other income
• Balance sheet – “special surplus from
retroactive reinsurance” segregated from
unassigned surplus
• No adjustments to premium or limit
Retroactive Accounting - GAAP
• Gains are deferred and amortized over
anticipated settlement period
• GAAP exception when ALDC is in
conjunction with purchase – prospective
accounting treatment
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Reserve guarantee excess of existing reserves
Cost is part of purchase price
Benefit to operating company being purchased
Purchase accounting, not pooling of interests
Inception is simultaneous with sale
Discounting Loss Reserves
• In USA, no discounting of loss reserves
except for WC indemnity payments
• Pricing of finite covers often contemplates
discount in price
• Rating agencies may “discount” the
discount if it is covered elsewhere in their
formula
Cession to Offshore Carriers
• Due to discounting issue, finite covers are
often written by offshore carriers
• Federal excise tax
• Credit for Schedule F
– Trust fund
– Letters of credit
– Funds withheld
Case Study: Quota Share
Case Study: Quota Share
• Company is currently rated A minus
• It is writing close to 3:1 WP-to-PHS
• If they take advantage of hard market, ratio
will be greater than 3:1 and rating will be
jeopardized
• Quota share is a solution
Pre Q/S
Written Premium
Earned Premium
Incurred Loss
Expenses
100,000
80,000
52,000
30,000
Profit/Loss
(2,000)
Loss Ratio
Expense Ratio
Combined Ratio
65.0%
30.0%
95.0%
PHS
NPW:PHS
35,000
2.9
Quota Share Terms
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Covers all lines of business
Expected Loss Ratio is 65%
30% quota share
3% margin
1 – 1 sliding scale commission
– Maximum commission = 42% at 55% LR
– Minimum commission = 20% at 77% LR
Pre Q/S
Written Premium
Earned Premium
Incurred Loss
Expenses
100,000
80,000
52,000
30,000
Q/S
30,000
24,000
15,600
9,600
Post Q/S
70,000
56,000
36,400
20,400
Profit/Loss
(2,000)
(1,200)
(800)
Loss Ratio
Expense Ratio
Combined Ratio
65.0%
30.0%
95.0%
65.0%
32.0%
97.0%
65.0%
29.1%
94.1%
PHS
NPW:PHS
35,000
36,200
2.9
1.9
Quota Share – Other Features
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Carve out particular lines of business
Loss corridors
Loss ratio caps
Exclusion or sublimit: property cat, mold,
terrorism
• Investment credit with experience account
balance
Benefits of a Finite Quota Share
• Provides capacity for growth in core lines of
business.
• Improves premium leverage.
• Creates statutory operating income and PHS.
• Helps maintain rating / stave off a downgrade.
• Bottom Line:
Helps you manage growth
without sacrificing your rating.
Case Study: ALDC / LPT
Case Study: ALDC / LPT
• Example:
– Company writes specialty lines (e.g.,
professional liability, D&O)
– Experiencing adverse development on reserves
– Rates on new business have increased greatly
– Company hopes to capitalize on favorable
conditions.
Case Study: ALDC / LPT
• Capital Constraints:
– Most capital methods penalize reserve
inadequacy (reserve deficiency removed from
capital even if not booked).
– Premium based charges inhibit growth
– Methods don’t explicit “credit” for favorable
market conditions.
– Customers may avoid less creditworthy
companies
Case Study: ALDC / LPT
• Basic Example is straightforward
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$100 nominal reserves
$60 discounted reserves
$10 risk/profit load
Ceding company reduces $100 of booked
reserves for $70 premium
– Ceding company receives aggregate limit of
$150, and retains risk excess of $150
Case Study: ALDC / LPT
• Benefits of ALDC/LPT
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Reduce firm’s overall leverage and business risk
Can be cheaper source of financing
Can gain some tax/accounting income benefit
Can restore confidence that the problem is contained
Can obtain longer risk coverage than typically available
in capital markets or traditional markets.
Case Study: ALDC / LPT
• Some complications can arise
– Some capital adequacy methods “remove” the effect of
the LPT
• Example: AM Best
– Credit reduction in reserve risk factor for variability above
carried
– Gain is removed from surplus and treated through discounting
– Coverage from current carried to expected ultimate (deficiency)
is assumed to cost the present value of those reserves.
– Statutory accounting books LPTs through other income
and other liabilities (no reduction to gross leverage)
Case Study: ALDC / LPT
• Client Issues:
– Balancing economic cost vs. balance sheet
impact; relative to other options
– Obtaining management, regulatory, and rating
agency buy-in
– Risk transfer – how much is sought; required;
willing to be paid for
– Price expectation vs. market
Case Study: ALDC / LPT
• LPT Analysis Issues:
– Traditional Actuarial Analysis of Ultimate
– Distribution of outcomes
• Blending traditional methods w/ stochastic methods
– Claims Analysis
– Allocation of Equity
• Long Tail Risks
• Zero Sum Game? (How to value book equity)
– Risk Transfer
Case Study: ALDC / LPT
• LPT Analysis Issues:
– Moral Hazard
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Information Asymmetry
Transactions are inherently “one off”
Incentives – the “why” question
How to assess “out of sample” outcomes
– How to Value “Investment Spread”
– Financing benefits of writer
Questions
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