0. The Black Box That is Risk Quantification
The Impact of Loss Quantification in Our Business
September 11, 2013
Charlie Woodman, CPA
Risk Finance Advisory
Willis National Construction
2013 Willis Construction Risk Management Conference

1. 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”

2. 4 years of college,
3 years grad school,
four exams…for this?!
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

3. Economics of Insurance: Typical Commercial Insurance – 1st Dollar / Guaranteed Cost
Fixed (25%-35%)
Insurance Company Overhead, Taxes, Reinsurance Cost, Commission
Profits & Losses
55 -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

4. Insurance Program Risk Costs with Large Deductibles / Retentions
Incurred Losses: The Variable Stuff
65% – 90+%
Fixed
Risk Transfer
Taxes
Safety & Claims Mgmt
Loss Control
Admin & Compliance
“Fixed Costs”

5. 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)
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)

6. Life Cycle of a Claim Reserve
7/11/06
Accident reported
Claims in Transit
8/1/06
Accident entered
into records as $1,000 Formula Reserve
4/2/06
Accident occurs
Pure IBNR
8/18/07
Settlement agreed
$30,000 Case
Reserve
1/1/07
Estimate revised
$25,000 Case Reserve
10/5/06
Individual reserve
established
$10,000 Case Reserve
8/25/07
Payment sent
$30,000 Case Reserve
9/2/07
Claim draft clears
Closed

7. 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

8. Definitions
Pure 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”

9. 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)
Property A E S
Automobile Liability A E S
Workers Compensation A E S
General or Professional Liability A E S

11. 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).

12. Components of Loss Paid Paid Paid 3 months 6 months Claim Closed
Incurred but not reported (IBNR)
Incurred but not reported (IBNR)
Paid
Outstanding Case Reserves
Paid
Outstanding Case Reserves
Paid
3 months
6 months
Claim Closed
Loss Development

13. Basic Reserving Techniques: Compilation of Paid Loss Triangle
Actuarial Configuration
The losses are sorted by the year in which the accident occurred.
The losses are summed at the end of each year.
Losses paid to date are shown on the most recent diagonal.
The data is organized in this way to highlight historical patterns.

14. Basic Reserving Techniques: Compilation of Paid Loss Triangle

15. 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

16. Basic Reserving Techniques: Paid Loss Development Factors

17. Basic Reserving Techniques: Paid LDM Projections & Reserves

18. 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 18

19. 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.

20. Probability
Remote – 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. Measurability 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

22. Collateral: It All Starts Here
Dear 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

23. How Does Collateral Become A Problem?

24. The “Deductibles” Problem
Commercial Insurance Specific Excess
Risk Transfer
Total claim payments by policy year (Ultimate Loss)
Less claims paid
Plus loss forecast for upcoming renewal
= collateral requirement
$1 M
Deductible / Retention
Collateral required for
unpaid claims
Commercial
Aggregate
Protection
“Stacking” – Over time, collateral obligations
grow (usually stabilizes after 4-7 years)
Per
Occurrence
Per Year / Aggregate
Policy Year
Assume 5 policy years
$10M Loss Pick
$1 M paid per year
Annual
Collateral
Requirement
Report Year

25. Let’s Start On The Insurer Side

26. The Business of Risk Underwriting
Expected 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

27. 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

28. Insurer Collateral Emphasis and Counter-Party Risk Attitude
Paid-Loss Sensitive Programs
Large Deductible
Paid-Loss Retros
“Fronted”
Secure
Losses
Premiums, in some cases
Protection against
Statutory Penalties
Direct Obligation Default by Insureds
Sure, I’m smiling now…

29. 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?

30. The Insured Side Holy $%#%! 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

31. What Can Be Done?
Don’t Hide from the Issue

32. 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

33. 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?
$$$$

34. 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
Unrelated Risk / 3rd Party
Balance Sheet Fact Pattern / “Humana”

35. 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 , Insurance and Indemnification
FAR , 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 , Insurance and Indemnification
*Full text of FAR clauses can be found at
Full text of Cost Accounting Standards can be found at

36. 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 & Allocability
Cost accounting standards, or otherwise generally accepted accounting principles and practices appropriate to the circumstances
Terms of the contract
FAR subpart 31.2 limitations
Costs of insurance required by contract are allowable
Costs of general insurance are allowable if reasonable and measured, assigned and allocated in accordance with the requirements of CAS 416
Costs of business interruption insurance must exclude coverage for lost profits
Self-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

37. 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)

38. 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 losses
2.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 risk
3.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

39. 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.

40. And Thank-You for your Attention
Questions
And Thank-You for your Attention
Charlie Woodman, CPA
Risk Finance Advisory
Willis National Construction
2013 Willis Construction Risk Management Conference