Funding Framework for Maturing Public Entity PoolsAssociation of Governmental Risk Pools2012 Institute for Management & Leadership

www.pwc.com

PwC 2

Financial Expectations of Pools Have Matured

20+ Years Ago

• Functioning program addressing availability and affordability crisis

• Adequacy of funding levels was a secondary concern

Current Environment

• External and internal scrutiny of funding levels

• Pools expected to deliver stable and competitive rates

- Surplus required to support this strategy

• Members have their own financial demands

– Want rate relief/dividends

• Reassessments not a viable funding option

PwC 3

Funding Minimums versus Funding Targets

Funding Minimum

•Regulatory Threshold

– IRIS Ratios

– Risk Based Capital (RBC)

•Runoff/Liquidation Perspective

Funding Target

• Capital requirement to support program risk

– All financial risks

– Current and prospective

• Ongoing concern perspective

Regulation developed in

context of having sufficient resources left in a troubled company to rehabilitate or

liquidate

PwC

Illustrative Funding Framework for Pools

2000

2002

2004

2006

2008

2010

$0

$5,000,000

$10,000,000

$15,000,000

$20,000,000

$25,000,000

$30,000,000

Year End

4

1

4

2

3

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Regulatory Minimum (Point of Failure)

2000

2002

2004

2006

2008

2010

$0

$5,000,000

$10,000,000

$15,000,000

$20,000,000

$25,000,000

$30,000,000

Year End

5

1

1

Three Situations

1.Regulation exists

– Point of failure defined

2.No regulation

– Surplus becoming negative may indicate failure

3. Cash call is a viable and accepted business strategy

– Point of failure does not exist

PwC

Target Funding Range

2000

2002

2004

2006

2008

2010

$0

$5,000,000

$10,000,000

$15,000,000

$20,000,000

$25,000,000

$30,000,000

Year End

6

2

2

Target operating range for surplus

• Minimum and maximum

– Based on risk and risk tolerance

Why a range versus singular point?

• Core goal is rate stability• In delivering stable rates,

costs fluctuate and so surplus fluctuates

• Range allows fluctuation so core goal can be met

PwC

Above or Below Target Funding Range

2000

2002

2004

2006

2008

2010

$0

$5,000,000

$10,000,000

$15,000,000

$20,000,000

$25,000,000

$30,000,000

Year End

7

3

3Surplus above target range

• Rate relief, distributions, etc.

Surplus below target range

• Adopt rate strategies to increase surplus

• Reduce risk of program (lower SIR)

4

4

PwC 8

Current Situation with Pools

• Need to assess funding adequacy

• Look to insurance industry for perspective

• Find regulatory thresholds

Result is a perception of excess surplus which leads to:

1. Inappropriate funding decisions

2. Inability to respond to scrutiny

2000

2002

2004

2006

2008

2010

$0

$5,000,000

$10,000,000

$15,000,000

$20,000,000

$25,000,000

$30,000,000

SurplusRegulatory Minimum

Year End

PwC 9

Common Pool Solvency MeasuresThe “Confidence Level”

• Incomplete measurement of program risk

– Historical unpaid claims only

• Misleading

- Percentage scale

- Generally misunderstood by stakeholders

• Not used in broader insurance marketplace

• Made sense in the context of pooling when use started

• More of a “minimum” than a “target”

PwC 10

Common Pool Solvency MeasuresRisk-Based Capital

• Regulatory Tool

– Developed for a specific context

– Not “capital based on risk”

• Formula approach

– Assumes risk categories are similar across industry

• Surplus levels 10 times RBC levels are common“…will not compute the precise amount of capital an

insurer needs to maintain in a competitive, dynamic and uncertain marketplace.”

PwC 11

Common Pool Solvency MeasuresBenchmark Financial Ratios

• Dependent on benchmark values

• Issues

– Variation in business models

– “Cash call” viability

– Risk differences

– Excess versus primary

– Tort capsThe concept of a “one size fits all” set of pool financial ratios

to define funding targets is flawed as it is not an “apples

to apples” comparison.

PwC 12

Use of Capital Modeling to Develop Funding Targets

Profile Case Study Example

Annual Contribution $11 million

Liability Retention $1.5 million

Property Retention $250 thousand

Number of Members 25

Primary Exposure Auto liability

PwC 13

Process

1. Target Funding Statement

2. Review ALL major risks facing the pool

3. Review the pool’s own risk profile

• coverage, retention, risk management program, etc

• in contrast to formula approach

4. Risk Aggregation

• reflecting correlation

Business Model

Risk

Capital Requirements

PwC

Target Funding Statement

“We would like to have enough fund to protect our members from a 1-in-100 to 1-in-200 year event in the next year, under the current retention or the $5m liability retention”

Indicator

What are we measuring? (all

options eventually come back to fund

level)

Severity

What is the tolerable level of

this selected “indicator”?

Frequency

What is the tolerable frequency

that the selected indicator hits the selected severity

Time Horizon

What time horizon is the fund supposed

to protect?

Extremity

14

PwC

Major Risk Categories

What could deteriorate the current fund level?

Most of the asset and liability items are variable, as well as the profitability of the next year’s business, putting the total fund value at risk.

Asset Liability + Fund

County Investment Pool

$27.5m Unpaid Reserves $10.9m

Reinsurance recoverable

$0.7m Other Liabilities $0.3m

Other current assets $0.3m TOTAL LIABILITIES

$11.2m

Non-current assets $0.4m

Equity in reinsurer $1.2m TOTAL FUND $18.9m

TOTAL ASSET $30.1m

15

PwC

Major Risk Categories

Underwriting

Risk that the next year’s business

result may deviate from plan

• Catastrophic events

• Systemic losses

• Reinsurance cost

• Market cycle

• Price inadequacy, etc.

Reserving

Risk that the eventual loss &

expense may exceed booked reserves

• Excessive inflation

• Judicial environment on certain claim types

• Latent claims, etc.

Asset & Credit

Risk that the value of investment asset and receivables may

decrease

• County Investment Pool – exposed to interest rate risk and default risk

• Reinsurer failure

Operational

Any other unplanned expense that may arise from

operation

• External events such as an earthquake

• People related (turn over, fraud, reputational)

• System and process failure, etc.

Simulation based approach using historical data

Simulation based approach using historical data

Stress scenario test approach based on

discussions

Stress scenario test approach based on

discussions

16

PwC

Underwriting Risk – Auto Liability Example

Observations:

• Reinsurance program reduces the volatility greatly.

• The result is validated through the pool’s historical experience.

17

PwC

Reserving Risk – Auto Liability Example

18

Observations:

• The familiar concept of “Confidence Level” in reserve variability

• Reviewed reserve variability from known (reported) claims vs. unknown (pure IBNR) claims separately

PwC

Asset Risk

County investment pool is with governmental and municipal bonds, which are subject to interest rate risk.

• Given the history of the treasury rates, the year-on-year interest rate increases were:

• Based on the bond asset amount, reserve amount and net asset duration, loss of value at the following scenarios is estimated at:

Treasury Bond 1-in-10 1-in-20 1-in-50 1-in-100 1-in-200*

3 year bond

1.48% 1.79%

1.93%

2.47%

2.74%

1-in-10 1-in-20 1-in-50 1-in-100 1-in-200

Loss of Bond Value $1.1m $1.4m $1.6m $1.9m $2.1m

19

PwC

Credit Risk

The reinsurer relationship has risk, from various aspects.

If the financial strength of reinsurer weakens, the following elements are at risk.

1. Reinsurance recoverable: $0.7M2. Current year transferred risk provision: $1.2M3. The equity investment: $1.2M4. Need to purchase reinsurance from another reinsurer in stressed

situation: $2.2M for full year

Using the default probability distribution by insurer’s rating [based on AM Best publications], the distribution of the fund need related to the reinsurer relationship is estimated to be:

1-in-10 1-in-20 1-in-50 1-in-100 1-in-200

Reinsurer Risk $0.8m $1.0m $1.4m $1.6m $1.8m

Observation:• All reinsurance relationships have some element of risk, but the risk

will vary depending on the financial strength.

20

PwC

Operational RiskTypically something not intended or budgeted for and hard to quantify due to lack of historical data.

Low Frequency / High Impact:

MANAGE or PROTECT WITH

SURPLUS

High Frequency / High Impact:

ACTIVELY MITIGATE & MANAGE

Low Frequency / Low Impact:

Pay as it happens

High Frequency / Low Impact:

Budget for it

Imp

act

Frequency

21

PwC

Operational Risk

Focused on high impact & low frequency items

•People related: Fraud, turnover•System: Failure of software vendor, hacking leading to impaired privacy • External events: Natural disaster leading to power outage, damage to the

office building and infra-structure

Category Stress Scenarios $ Impact

People Fraud by accountant, taking balance of the account out [1-in-50?] Fraud by claimant [1-in-10?]

$250k

$100k

System Software vendor failure leading to purchase of new software, extensive conversion work, and training [1-in-20?] Privacy impaired, needing to send out notice [1-in-20?]

$500k

$250 per record

External Events

Magnitude 7 earthquake, causing damages to the pool property and business interruption [1-in-50]

$250k

22

PwC

Risk Aggregation

Once all the individual risks are quantified,

• We don’t simply sum across these numbers to get overall funding need, because this assumes that all those events are occurring at the same time (100% correlated), which is an unduly pessimistic assumption.

• Developed a correlation structure (between lines of business, and between risk categories, etc.) to reflect diversification and aggregated the funding level across those components.

AL GL

APD

Underwriting Reserving Asset & Credit Operational

Int. rate

Counter-

partyEquity

External

SystemPeopl

e

Total Funding Need

PR

AL GL

APD

PR

23

PwC

High Level Study Result – Target Funding Range

Baseline ($1.5m liab/$250k prop)

$5m Retention $1.5m liab/$500k prop

$0

$5,000,000

$10,000,000

$15,000,000

$20,000,000

$25,000,000

$30,000,000

Target (1-in-100 to 1-in-200 year event)

Current Funding

Reinsurance Arrangement

24

PwC

Issues Addressed

• Capital Requirements– Proper perspective for

board– Target to manage program

• Better decision making– Can we entertain a higher

SIR? Which coverage?– Is the Pool in a position to

add members or a coverage?

– Investment mix change? • Respond to Potential Scrutiny

– Internal– External

25

PwC 26

What should pools do?Step 1: Clarity on your business model

Risk

Cash

Call

Cash

Call

Risk

Su

rplu

s

Cash

Call

Risk

Su

rplu

s

Su

rplu

s

or or

Pooling industry timeline

“Mutual Insurance Company” model – Adequate surplus is

critical

“Group Self-Insurance” model – Surplus level is

not that important

PwC 27

What should pools do?Step 2: Evaluate your financial metrics

• Is your funding policy:

– Consistent with the business model?

– Regularly updated or validated?

• Funding targets defined?

• Prepared to provide an effective response to inquiries over funding levels?

PwC 28

What should pools do?Step 3: Adopt a risk-based decision framework

• Rate level decisions consistent with funding objectives?

• Appropriate levels of reinsurance?

• Impact of change in investment mix?

• Cost/benefit of “A rated” reinsurer versus “B rated” option?

• Is the pool operating efficiently?

Informed decisions require information

Funding Framework for Maturing Public Entity Pools

Whitepaper on pool solvency metrics available at: http://www.pwc.com/us/en/insurance/publications/insurance-pool-solvency-measures.jhtml

For further discussion regarding pool solvency measures and framework, please contact:

Kevin L. Wick, FCAS, MAAA Hyeji Kang, FCAS Martin Ménard, FCAS, MAAAManaging Director Director Director+1 (206) 398 3518 +1 (312) 298 4167 +1 (802) 876 7109kevin.l.wick@us.pwc.com hyeji.kang@us.pwc.com martin.menard@us.pwc.com

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© 2012 PricewaterhouseCoopers LLP. All rights reserved. In this document, “PwC” refers to PricewaterhouseCoopers LLP which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.