Identification and Quantification of Incremental Market Risk
The Black Box That is Risk Quantification The Impact of Loss Quantification in Our Business...
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Transcript of The Black Box That is Risk Quantification The Impact of Loss Quantification in Our Business...
The Black Box That is Risk Quantification
The Impact of Loss Quantification in Our Business
September 11, 2013
Charlie Woodman, CPARisk Finance Advisory
Willis National Construction
2013 Willis Construction Risk
Management Conference
Sound Familiar?From your underwriter………
“Due to market conditions and your recent claims experience, we are increasing your rates by 7%”
From your actuary…….
“Total unpaid losses increased by approximately $900,000 due to adverse loss development and an increase in claim frequency”
From your broker…….
“The carrier has increased your collateral requirement by $2 million and the LOC needs to be in place in 30 days”
From the IRS…….
“This is to inform you of the initiation of an issue regarding the valuation of unpaid loss reserves deductions under IRC Sec 482…the following must be provided regarding ABC Captive Insurance Company…”
From your DCAA auditor…..
“Your charge for self insurance is disallowed as it is not based on Projected Average Loss as defined under CAS 416”
Discussion
Loss Quantification: Basics, esp. Loss Development Methodology
Quantification Ramifications Insurance Risk Transfer Costs Collateral Costs Financial Reporting & GAAP Tax Reporting Governmental Contract
Accountability / FAR / CAS
4 years of college, 3 years grad school, four exams…for this?!
Economics of Insurance: Typical Commercial Insurance – 1st Dollar / Guaranteed Cost
Fixed (25%-35%) Insurance Company
Overhead, Taxes,Reinsurance Cost, Commission
Profits & Losses55 -75%• Components of Traditional
Insurance:• Expected loss and
ALAE• Taxes and regulatory
fees• Overhead and
administration• Insurer selling and
distribution expense• Reinsurance and
Intermediary charges• Risk Margins
Insurance Program Risk Costs with Large Deductibles / Retentions
Fixed• Risk Transfer• Taxes• Safety & Claims Mgmt• Loss Control• Admin & Compliance
“Fixed Costs”
Incurred Losses: The Variable Stuff65% – 90+%
Losses: the 800 Pound Gorilla Sitting In The Corner
Make up the vast majority of insurance cost uncertainties
In Guaranteed Cost: Standard Premium including Experience Mods
In ‘Loss-sensitive Programs’ : Deductibles and Retentions
Losses = Pure Loss (claimant satisfaction costs) + Loss Adjustment Expense (loss reconciliation activity costs)
6
Losses and their uncertainty broken down into two (2) types:
• Frequency / Burning Losses (Predictable)
• Severity / Adverse / Catastrophic Losses: Tougher to Predict - PL / Comp Op / SDI (Risk Margin)
Life Cycle of a Claim Reserve
8/1/06Accident entered into records as $1,000 Formula Reserve
7/11/06 Accident reportedClaims in Transit
10/5/06Individual reserveestablished $10,000 Case Reserve
1/1/07Estimate revised$25,000 Case Reserve
8/18/07Settlement agreed $30,000 Case Reserve
8/25/07Payment sent$30,000 Case Reserve
9/2/07Claim draft clears
Closed
4/2/06Accident occursPure IBNR
Intro To Losses A Loss is the Paid (to date) + Claim (Case) Reserve + Incurred-
But-Not-Reported (IBNR) Certain exposures will have many losses in a given policy year
which may take many years to ultimately reconcile and close. What is a Loss Reserve?
Amount necessary to settle unpaid claims Case Reserves
· Claim reported but not yet paid· Assigned a value by a claims adjuster or by formula
IBNR reserves include: Most difficult to measure and justify· Reserves for claims not yet reported (pure IBNR)· Claims in transit· Development on known claims· Reserves for reopened claims
DefinitionsPure Losses Paid to Date Case Reserves
· Claim reported but not yet paid· Assigned a value by a claims adjuster or by formula
Bulk + IBNR reserves include:· Reserves for claims not yet reported (pure IBNR)· Claims in transit· Development on known claims· Reserves for reopened claims
Loss Adjustment Expenses (LAE) are sum of:· Defense & Cost Containment (DCC) Expense (including
adjusting)
The Sum of These is referred to as “expected to ultimate” losses or “projected ultimate losses”
Projected Ultimate Loss
An estimate of total claims cost· Within the deductible layer· For a single policy period· Once all claims are settled, paid and closed.
For first party coverage (Property or Builders Risk), losses are directly measured based on property valuation whether actual cash value or replacement cost. (Short tail)
For casualty lines (AL, GL and WC), due to the lengthy period of time between the occurrence of a claim and final settlement, estimation of ultimate loss is required.
10
Considerations:Emergence/Settlement
Emergence (E) vs. settlement (S)
A E S
A E S
General or Professional Liability
Workers Compensation
Automobile Liability
A
A E S
E S
Property
Basic Loss Measurement Techniques:Definitions
Sometimes solely Industry-based
Composite to Insurer Expectations
Loss Development Method using Historical Patterns
Triangles‒ Compiled to measure the changes in cumulative claim activity
over time in order to estimate patterns of future activity.‒ Loss Development Factor‒ The ratio of losses at successive evaluations for a defined
group of claims (e.g. accident year).
Components of Loss
Paid
Paid
PaidOutstanding Case
Reserves
Incurred but not reported (IBNR) Outstanding Case
Reserves
Incurred but not reported (IBNR)
3 months 6 months Claim Closed
Loss Development
Basic Reserving Techniques:Compilation of Paid Loss Triangle
Actuarial ConfigurationCumulative Paid Losses ($000 Omitted)Accident Development Stage in Months
Year 12 24 36 48 60 72
1995 3,780 6,671 8,156 9,205 9,990 10,508 1996 4,212 7,541 9,351 10,639 11,536 1997 4,901 8,864 10,987 12,458 1998 5,708 10,268 12,699 1999 6,093 11,172 2000 6,962
1. The losses are sorted by the year in which the accident occurred.
2. The losses are summed at the end of each year.
3. Losses paid to date are shown on the most recent diagonal.
4. The data is organized in this way to highlight historical patterns.
Basic Reserving Techniques:Compilation of Paid Loss Triangle
Cumulative Paid Losses ($000 Omitted) Final Accident Development Stage in Months Total
Year 12 24 36 48 60 72 Cost
1995 3,780 6,671 8,156 9,205 9,990 10,508 ???1996 4,212 7,541 9,351 10,639 11,536 ???1997 4,901 8,864 10,987 12,458 ???1998 5,708 10,268 12,699 ???1999 6,093 11,172 ???2000 6,962 ???
Basic Reserving Techniques: Paid Loss Development Factors
From the end of the accident year (at 12 months) to the end of the following year (at 24 months), paid losses for 1996 grew 79%. During the next year (from 24 to 36 months), paid losses experienced an additional 24% growth (or development) and so forth.
Loss Development Factors (LDFs) are also known as:
Age-to-Age factors
Link Ratios
Evaluation Interval in MonthsAccident 72 to
Year 12-24 24-36 36-48 48-60 60-72 Ultimate1995 1.765 1.223 1.129 1.085 1.052 ???1996 1.790 1.240 1.138 1.084 1997 1.809 1.240 1.134 1998 1.799 1.237 1999 1.834 2000
Sample Calculation for Accident Year 1996:
12-to-24 Months 1.790 = 7,541 / 4,212
Basic Reserving Techniques:Paid Loss Development Factors
Evaluation Interval in MonthsAccident 72 to
Year 12-24 24-36 36-48 48-60 60-72 Ultimate1995 1.765 1.223 1.129 1.085 1.052 ???1996 1.790 1.240 1.138 1.084 1997 1.809 1.240 1.134 1998 1.799 1.237 1999 1.834 2000
Simple Average - All Years1.799 1.235 1.134 1.085 1.052
Simple Average - Latest 3 Years1.814 1.239 1.134 XXX XXX
Simple Average - Excluding High & Low1.799 1.239 1.134 XXX XXX
Weighted Average - All Years1.803 1.235 1.134 1.085 1.052
Selected Loss Development Factors1.800 1.235 1.134 1.085 1.052 1.070
Basic Reserving Techniques:Paid LDM Projections & Reserves
Actual Cumulative Estimated Actual EstimatedPaid Development Ultimate Paid Loss
Accident Losses Selected Factors to Losses Losses ReservesYear @ 12/31/00 LDFs Ultimate [(2) x (4)] @ 12/31/00 {(5) - (6)}(1) (2) (3) (4) (5) (6) (7)
1995 10,508 1.070 1.070 11,244 10,508 736 1996 11,536 1.052 1.126 12,985 11,536 1,449 1997 12,458 1.085 1.221 15,215 12,458 2,757 1998 12,699 1.134 1.385 17,588 12,699 4,889 1999 11,172 1.235 1.710 19,109 11,172 7,937 2000 6,962 1.800 3.079 21,435 6,962 14,473
Total 65,335 97,576 65,335 32,241
First: Financial Reporting of Losses for Contractors
Financial Reporting is expense recognition Costing is a rationalization activity which is a proactive activity Financial reporting is the responsibility of Owners, CFOs,
Management, Controllers and Independent CPAs - all share the risk
Reliance by various users on financial statements:· Sureties· Banks and finance companies· Regulatory boards - licensing· Owner and prime contractor prequalification· Suppliers· Stockholders (owners)· Joint venture partners
19
20
Recognition of Losses: Rule
A loss or group of losses is recorded only when (old FAS 5):· The likelihood of actual loss is probable, AND· The amount of the loss is reasonably subject to estimation.
If reasonable estimates of loss or losses produces a range of equally likely outcomes – (FIN 14) book the minimum.
Importance• A company cannot set aside reserves for a loss it believes might occur
before it actually happens.• If a loss occurs, a company must recognize the full value of the loss as an
expense on its financials in the accounting period in which it knows of the event
• Actual payment reduces a reserve; should not effect earnings.
ProbabilityRemote – the chance of the future
event or events occurring is slight Reporting Action: Do nothing or ID as a
Risk of Business, if large, in MD&A
Reasonably Possible – the chance of the event or events occurring is more that remote but less than likely
Reporting Action: Disclose in Notes
Probable – the future event or events are likely to occur
Reporting Action: · If Measurable: Book to Financials:
Disclose in Notes· If Immeasurable: Disclose in Notes
under “Claims, Lawsuits and Other Contingencies”
21
Reasonable Reserves
Range of Estimates
Reasonable Sets of Assumptions
Evaluate Uncertainty, Risk of Material Adverse Deviation
Identify Sources of Uncertainty
Book Management’s Best Estimate
Measurability
Collateral: It All Starts HereDear Insured
“We will pay benefits and damages that are covered under this policy. We will only seek reimbursement for those amounts that are within the applicable deductible shown above. You will reimburse us promptly for any deductible amounts and all Allocated Loss Adjustment Expenses that we have addressed.”
Sincerely yours,
The Insurer
Standard Indemnity Clause: Large Deductible Program
How Does Collateral Become A Problem?
The “Deductibles” Problem
Deductible / Retention
Collateral required for unpaid claims
Commercial Insurance Specific Excess
Risk Transfer
$1 M
CommercialAggregateProtection
Per Year / Aggregate
Per Occurrenc
e
Total claim payments by policy year (Ultimate Loss)
Less claims paidPlus loss forecast for upcoming
renewal= collateral requirement
“Stacking” – Over time, collateral obligations grow (usually stabilizes after 4-7 years)
Assume 5 policy years$10M Loss Pick
$1 M paid per year
Policy Year
Rep
ort
Yea
r
AnnualCollateral
Requirement
Let’s Start On The Insurer Side
The Business of Risk UnderwritingExpected Losses and Allocated Expenses
Risk Margin: Volatility of Loss Frequency & Loss Severity
Unallocated Costs
Loss Adjustment
U/W & Acquisition Costs
Premium Taxes
Fees, Licenses & Bureaus
Other Operating Costs
Portfolio Concentration Adjustments
Investment return off-sets
Required Return on Equity (Surplus) or Opportunity Cost of re-directed capital
Counter-party Risk
Insurance Company Dynamics
Surplus is Life
Leverage Writings: i.e. 3:1 Written to Surplus
Defines Single Risk Capacity: i.e. 10% of Surplus exposure
Solidifies Reinsurance Treaties / Relationships
Statutory Accounting Principles
Annual Statement - Yellow Peril / Convention Blank / Yellow Book, etc Liquidation Value Drives Statutory Surplus
· Admitted Assets vs Non-Admitted Assets on Surplus· Schedule F· Risk Based Capital
Insurer Collateral Emphasis and Counter-Party Risk Attitude
Paid-Loss Sensitive ProgramsLarge Deductible
Paid-Loss Retros
“Fronted”
SecureLosses
Premiums, in some cases
Protection againstStatutory Penalties
Direct Obligation Default by Insureds
Sure, I’m smiling now…
So What Happen with An Insured Insolvency?
• Primary Issue -- Does Insurer Become Responsible for all Claims Payments? - Probably
• Insured / Employer Must Keep Coverage in Place.
• Insurer May Not Be Permitted to Cancel Policy.
• In Liquidation, Insurer Will Most Likely Have to Pay All Claims and File Claim for Deductible Amounts.
Crap. Now what?
The Insured Side
Issues:
Type of Security
Draw on Credit Lines
Other Debt Constraints
Liquidity Issues
Tax Planning
Amount & Timing of Collateral
Control of the Collateral
Change of Insurer Relationships
Holy $
%#%!
What Can Be Done?
Don’t Hide from the Issue
Navigating Collateral & Finding Common Ground
• Review insured’s payment agreement with their insurance company.• Defines the rights and obligations of both parties, timing of adjustments (generally at
renewal)
• Quantitative analytics / Actuarial calculation of ultimate loss• Summary loss information by line and by policy year
• Large loss listing
• Historical Exposure Information
• Understand insurance program design (i.e. ALAE treatment)
• Challenge Insurer assumptions (loss development factors, renewal forecasts)
• Request “paid loss credit” based on the insured’s historical payout patterns and financial condition
• Investigate alternative forms (LOC, Cash/asset backed, Insurance Trusts, etc)
• Claim reviews / claim closure projects – effect of collateral is intensified when losses are developed
Insurance Taxation: Basic
Non-Insurance Companies deduct loss reserves
• Deduct fixed costs, risk transfer premiums, and only losses paid in the policy year
• Future losses deducted as paid in year paid
Insurance companies can deduct loss reserves
• Advantage: take current year deductions for all losses paid, loss reserves & IBNR (reduced by IRS-imposed discount
So what about the Reserves?
$$$$
I’m not an insurance company, so what?What if I own a captive? And…
The captive must qualify as insurance company for tax purposes
• Insurance Risk• Nuance & Common Notions (Insurance
Form)• Risk Shifting & Risk Distribution
Tax deductibility hinges on whether or not the captive is a bona fide insurance company
• Although there is no “bright line” test, case law suggests that at least 30% of the captives risk must be “unrelated” to the employer in order for the employer to take a deduction for premiums paid to the captive
• Alternatively, a captive that meets IRS requirements as a brother/sister captive (i.e., Humana structure) does not require unrelated risk
Third Party Writings Approach
Captive
Parent
Sub Sub Sub Sub Sub Sub
Deductible
Outside Business
Unrelated Risk / 3rd Party
Brother-Sister Approach
Captive
Parent
Sub
Not Deductible
Deductible
Sub SubSubSubSub Sub
Balance Sheet Fact Pattern / “Humana”
36
Federal Contracts and Loss Reimbursement
Key regulation* for accounting for insurance costs:
Cost Accounting Standard (CAS) 416, Accounting for Insurance Costs
Cost Accounting Standard (CAS) 403, Accounting for Home Office Costs
FAR 31.205-19, Insurance and Indemnification
FAR 31.201-5, Credits
FAR 28.3, Insurance
When to evaluate your current accounting practices for insurance costs?
Contracts will be CAS covered
Contracts subject to Federal Acquisition Regulation 31.205-19, Insurance and Indemnification
*Full text of FAR clauses can be found at https://www.acquisition.gov/far/index.html
Full text of Cost Accounting Standards can be found at http://www.access.gpo.gov/nara/cfr/waisidx_01/48cfr9904_01.html
37
FAR Part 31, Cost Principles Allowability
Factors for determining allowability :“A cost is allowable only when the cost complies with all of the following requirements”Reasonableness & AllocabilityCost accounting standards, or otherwise generally accepted accounting
principles and practices appropriate to the circumstancesTerms of the contract
FAR subpart 31.2 limitationsCosts of insurance required by contract are allowableCosts of general insurance are allowable if reasonable and measured,
assigned and allocated in accordance with the requirements of CAS 416Costs of business interruption insurance must exclude coverage for lost
profitsSelf-insurance program approval is required when:
50% or > of the self-insurance costs allocable to negotiated government contracts Self-insurance costs for the fiscal year are anticipated >$200k
38
Insurance Reserves
IBNR (Incurred But Not Reported)
• While generally understood by Government reviewers to be a common feature, may be concern that reserves are too large
• If Government reviewer considers reserve unreasonably large, may question a portion of the reserve and the related insurance cost
• To lessen risk of issues with purchased insurance reserves, contractors and insurance carriers should be prepared to demonstrate that reserves are reasonable based on:
· Exposure to loss· Actual loss experience· Loss Trending and / or Inflation· Loss development experience or “lag” studies
Discounting reserves not expressly required by CAS 416, but DCAA guidance suggests reserves may be subject to present value discounting (prompt payment rate)
39
Measurement of Self-insurance Charges and Reserves
With significant self-insurance, typical practices for recovering insurance costs are establishing methods for:1.Estimating annual projected average losses2.Allocating self-insurance charges to segments and cost objectives
(jobs)
Under CAS 416, three ways to measure projected average loss (PAL)1.Actual Losses: actual amount of losses (where actual losses not
expected to differ significantly from PAL)2.Comparable Purchased Insurance: Estimate of the PAL based on the
cost of insurance that could be purchased for the self-insured risk3.Actuarial Measurement: self-insurance charge based on the
contractor’s or industry experience and anticipated conditions in accordance with generally accepted actuarial principles
The total of self-insured charges plus insurance charges must not exceed guaranteed cost insurance for the same exposures
Warranty (and CYA Statement)
These discussions were meant to be general in nature. We at Willis, as
risk management professionals, do have a layman’s working knowledge
of the tax and accounting issues associated with many risk financing arrangements. However, we do not
provide legal, tax or financial reporting advice. Therefore, none of
our comments in this area may be relied upon to be either accurate or
indicative of probable outcomes when applied to specific facts and
circumstances. Hear no evil, see no evil, do no evil.
I Am Not Here.
Questions
And Thank-You for your Attention
Charlie Woodman, CPARisk Finance Advisory
Willis National Construction
2013 Willis Construction Risk
Management Conference