Reserving for Catastrophes
Kay Cleary
Catastrophe Risk Management Seminar October 7, 2002
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Current Catastrophe Reserve Funding (Problem)
After tax
Timing of establishment of a loss reserve
Recognition of catastrophe premiums
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Other Countries
Equalization reserves
Catastrophe reserve
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Two Components of Catastrophe Reserve (Solution)
NAIC mechanism
Internal Revenue Code change
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Internal Revenue Code Change
Deduction from taxable income for loss reserves
HR785
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NAIC Catastrophe Reserve
Definitions
Design overview
Accounting treatment
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Definitions
Qualifying lines of business
Qualifying catastrophe events
Qualifying losses
Reserve cap
Catastrophe reserve cap factors
Reserve drawdowns/thresholds
Catastrophe year
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Qualifying Lines of BusinessFire & allied linesFarmowners multiple-perilHomeowners multiple-perilCommercial multiple-peril (non-liability portion)EarthquakePrivate passenger & commercial auto physical damageInland marine Non-proportional reinsurance for the qualified lines of business.
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Qualifying Catastrophe Events
Wind & hail
Earthquake and fire following
Winter catastrophes such as snow, ice, freezing
Fire
Tsunami
Flood
Volcanic eruption (including lahar)
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Design Overview
Pre-event reserves
Voluntary
Company specific
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Reserve Additions
Portion of net written premium
Sum of $$ for qualifying lines
Contribution subtracted from taxable income
Individual company vs. group
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Reserve Cap Factors
$40B industry-wide reserve
Data
Methodology
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Data
Both historical experience and modeling
AM Best – 1967 through 1999
Judgment
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Methodology1. Industry direct incurred loss ratios2. Mean and standard deviation of loss ratio for
each line3. Cap each loss ratio at mean plus one standard
deviation4. Recalculate means and standard deviations using
capped loss ratios5. Threshold loss ratio for each line of adjusted
mean plus two adjusted standard deviations
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Methodology, continued
6. Calculate loss ratios excess of threshold by line and by year
7. Calculate loss dollars excess of threshold by line for all years, using 1999 direct written premium
8. Prorate loss dollars from historical experience to be 2/3 of $40 B
9. Modeled losses by line, prorated to 1/3
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Methodology, continued
10. Add historical losses and modeled losses for each line.
11. To get initial factors, divide summed losses by 1999 net written premium.
12. Auto physical damage set to 1%
13. Recalculate
14. Round to 5%
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Adjustments
See Appendix C
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Reserve Cap Factors
Fire 25%
Allied lines 85%
Farmowners 10%
Homeowners 60%
CMP 30% (non-liab)
Inland marine20%
Earthquake 1630%
Auto PD 1%
Reinsurance 45%
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Example - Accumulation
(1) (2) (3) (4)
Line Prem Factor (2) x (3)
Home 100,000 .60 60,000
Auto liab 150,000 na 0
Auto PD 80,000 .01 800
Total 330,000 60,800
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When are $$ in Reserve Used?
Declaration of a catastrophe
Allowable drawdown amounts & qualifying losses
Federally taxed when taken out
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Declaration of a Catastrophe
Property Claims Service
President
Chief executive official of a state, territory or possession of the United States or the District of Columbia
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Qualifying Losses
Gross qualifying losses Used in calculations of allowable amounts
Net qualifying losses Maximum amount that can be draw down
Track by catastrophe year
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Amount of Drawdown Allowed
Amount is larger of:Excess of gross qualifying loss above 30% prior year’s surplus
OR
Excess of gross qualifying loss above 100% prior year’s reserve cap
Up to net qualifying loss
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Example - Drawdown
Gross qualifying losses 1,350
Salvage, subro & other recoveries 800
Net qualifying losses 550
30% of prior ye surplus 1,853
Prior year reserve cap 584
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Excess of gross qualifying loss above 30% prior year’s surplus
(1350 minus 1583) = negative
OR
Excess of gross qualifying loss above 100% prior year’s reserve cap
(1350 minus 584) = 766
Amount is Larger of:
766
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Up to Net Qualifying Loss
Larger amount = 766
Net qualifying loss = 550
Allowable drawdown is
550
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Other Drawdowns Allowed
Amounts in excess of cap
Insolvency
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Accounting Treatment
Single separate reserve
Additions to annual statement blanksBalance sheet
Statement of income
Notes to financial statements
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State Catastrophe Programs
Florida Hurricane Catastrophe Fund
California Earthquake Authority
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Considerations during Development
Voluntary or mandatory
Lines of business
Perils
Net written premiums
Factors by state as well as by line
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Additional NAIC Activities
Review and update
Accounting and blanks
RBC treatment
Demonstrating financial responsibility framework
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Accounting and Blanks
Need effective date
Need to reconcile voluntary reserve with mandatory reporting
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RBC Treatment
Additional liability;“paid for” from surplus
Increased reserving risk charge?
Catastrophe risk in RBC formula
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Demonstrating Financial Responsibility Framework
Proposed when reserve became voluntary
How company will manage net PML
NAIC status
Considerations
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Reserve as Part of Catastrophe Management Program
Funds immediately availableStability in resultsNo credit riskVisible to regulators, investors, policyholdersBetter tracking of catastrophe premium
Potential future tax liability
No transfer of risk
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Questions ???
850-413-5254
217-524-5376
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