1. Collateral Analysis & Negotiations: An Actuary’s Perspective
Aon Global Risk Consulting
Ron Schuler FCAS, MAAA
Associate Director & Actuary

2. Overview
At a minimum, the process of estimating and evaluating collateral amounts should seek to achieve the following objectives:
Provide quantitative or qualitative information to be used for decision-making by risk management and its partners, constituents, and counter-parties.
Improve clarity, understanding, and eliminate ambiguities underlying the collateral determination process.
Provide a robust set of supportable and understood analytics and information which can be used to better understand and support the determined collateral position(s) as well as other related estimates and costs that impact the Total Cost of Risk (TCOR).

3. Overview
Understanding A Company’s Collateral Position: Why is it relevant?
Actual costs, credit capacity, and opportunity costs.
Managing expectations, effective communication, and negotiations require information (that will be provided to and used by various parties).
Defines positional arguments.
Components of Total Cost of Risk (TCOR) shouldn’t be viewed in isolation, and thus, collateral impacts other risk financing decisions.
Provides risk management perspective on performance relative to prior expectations, performance metrics, and/or benchmarks.
Quantifies statistical information which provides insight into trends, operational changes, or changes in risk profile.
Facilitates efficient audit, accounting, and risk management processes.
Provides prospective guidance for risk management and other financial purposes.
Assist with brokerage support, guidance, and recommendations.
Provide the necessary actuarial documentation which is consistent with actuarial, financial, and accounting standards of practice.

4. Overview Outputs are directly related to information provided to:
Financial Reporting
Accounting / Budget
Risk Management (General)
Benchmarking / Performance Metrics
Internal / External Audit
Insurers / Regulators
Insurance Placement (Brokerage / Captive / Other )
Loss Control / Claims Management
Other Parties (M&A+D / Vendors)

5. The Basics: Collateral Calculation
Foundation of the Collateral Calculation:
Actuarial Loss Reserve Analysis – Retrospective
Loss Forecast Analysis – Prospective
Risk Load Analysis – Retrospective & Prospective
Roll-Forward Analysis – Prospective
Financial Strength / Credit Risk Analysis – Prospective
Collateral = Ultimate Loss + Loss Forecast + Risk Load – Actual Paid – Expected Paid – Working Fund (+/ – ) Other (+/ – ) Credit Adjustment
Other: Overdue Premium, Audit Premium, Retro Adj, LCF, LBA, etc.

6. The Basics: Collateral Calculation
Collateral Calculation & Negotiation Process: The Challenge
Don’t be a spectator: Actively manage the process.
Challenge the experts.
Challenge the methods, assumptions, data, and considerations underlying the various analyses.
Challenge the status quo.
Analysis vs. Approach
Retrospective & Prospective Components
Core Assumptions: Credibility, Complement, Risk, Coverage, Characteristics , Availability of Statistics, & Other
Determination & translation of credit risk to a probability of default (or vice versa)
Other Considerations: Technical and Contractual
Other General: e.g. Funding Options
Every item underlying the collateral calculation can be quantified:
Quantify, Challenge, Understand, Communicate, Repeat.

7. Collateral Calculation – An Example

8. Collateral Calculation – An Example

9. Financial Strength / Credit Risk Analysis
Used to assess financial strength and/or creditworthiness of insured
Insurer Perspective: There are two types of risk (Reserve, Credit). Insurer is in the business of insurance (i.e. not a bank), thus primary goal is to eliminate exposure to credit risk
Utilized by insurers to determine viability of writing program and/or underwriting surcharge / discount
Generally based on insurer judgment versus a more technical evaluation of credit strength
Consideration of relevant factors such as general economic conditions and how they impact the insured, insured pro forma statements, the probability and timing of default, variance / risk in loss estimates, expected recovery rates, interest yields, and time value of money.

10. Financial Strength / Credit Risk Analysis
Type of financials and information provided impact credit evaluation (Audited, Reviewed, Compiled, & Internal)
Preferred financials to review: Latest Audited, Interim, and supplemental information
Other Information reviewed:
Public Information: S&P, Moody’s, Fitch, D&B
Company Specific Information: SEC filings, Pro Formas, Interview, etc
Industry Specific Information: Competitive, Industry, Key Economic Variables
Financial credit review results in credit “rating” which, in turn, should be converted to expected probabilities of default
Probabilities of Default similar to Rating Agencies (S&P, Moody’s, Fitch)
BBB+ and Above: Investment Grade / Superior
BBB to BBB-: Speculative / Average
B and Below: Distressed / In Default

11. Financial Strength / Credit Risk Analysis
Types of financial ratios: Liquidity, Leverage, Profitability, and Cash Flow
Liquidity Ratios: Measure ability to meet short-term obligations.
Net Working Capital = Current Assets less Current Liabilities
Current Ratio = Current Assets / Current Liabilities
Rules of Thumb:
NWC > 0 for Y year period
CR > 2
Leverage Ratios: Measure the extent to which a company is financed with debt.
Long-term debt (LTD) to Equity or LTD to Tangible Equity : Provides an indication of long-term solvency. Tangible Equity = Equity less Goodwill less Intangible Assets
Times Interest Earned (TIE) = EBIT / Interest Expense
LTD / E < 1 is acceptable; LTD / E > 2 implies a potential issue to pay interest and principle
3 < TIE < 5 is acceptable; TIE < 3 is poor and TIE > 5 is good

12. Financial Strength / Credit Risk Analysis
Profitability Ratios: Measure ability to meet short-term obligations.
Return on Sales = Net Income / Revenue; measures operating margin
Operating Margin = EBIT / Revenue; measures operating margin before interest & tax
Return on Total Assets = Net Income / Total Assets or EBIT / Total Assets; measures how effectively firm assets are used.
Return on Equity = Net Income / Equity; measure the return on invested capital
Rules of Thumb:
Need to review short- and long-term
ROE > Industry Benchmark
Cash Flow Ratios: Measure whether firm is a cash generator or user.
Net Cash Flow: CF > 0 (generator), CF < 0 (user)
CF to Revenue = CF / Revenue; measures the cash generating ability of revenues
CF to CMLTD = CF / CMLTD; measures firms ability to generate sufficient cash to meet short-term fixed obligations; CMLTD = Current maturity of LTD
CF / Revenue > 0 is acceptable