Presentation on theme: "Sound Familiar? From your underwriter……… “Due to market conditions and your recent claims experience, we are increasing your rates by 7%” From your actuary……."— Presentation transcript:
0 The Black Box That is Risk Quantification The Impact of Loss Quantification in Our BusinessSeptember 11, 2013Charlie Woodman, CPARisk Finance AdvisoryWillis National Construction2013 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?!DiscussionLoss Quantification: Basics, esp. Loss Development MethodologyQuantification RamificationsInsurance Risk Transfer CostsCollateral CostsFinancial Reporting & GAAPTax ReportingGovernmental Contract Accountability / FAR / CAS
3 Economics of Insurance: Typical Commercial Insurance – 1st Dollar / Guaranteed Cost Fixed (25%-35%)Insurance Company Overhead, Taxes, Reinsurance Cost, CommissionProfits & Losses55 -75%Components of Traditional Insurance:Expected loss and ALAETaxes and regulatory feesOverhead and administrationInsurer selling and distribution expenseReinsurance and Intermediary chargesRisk Margins
4 Insurance Program Risk Costs with Large Deductibles / Retentions Incurred Losses: The Variable Stuff65% – 90+%FixedRisk TransferTaxesSafety & Claims MgmtLoss ControlAdmin & Compliance“Fixed Costs”
5 Losses: the 800 Pound Gorilla Sitting In The Corner Make up the vast majority of insurance cost uncertaintiesIn Guaranteed Cost: Standard Premium including Experience ModsIn ‘Loss-sensitive Programs’ : Deductibles and RetentionsLosses = 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 7/11/06Accident reportedClaims in Transit8/1/06Accident enteredinto records as $1,000 Formula Reserve4/2/06Accident occursPure IBNR8/18/07Settlement agreed$30,000 CaseReserve1/1/07Estimate revised$25,000 Case Reserve10/5/06Individual reserveestablished$10,000 Case Reserve8/25/07Payment sent$30,000 Case Reserve9/2/07Claim draft clearsClosed
7 Intro To LossesA 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 claimsCase ReservesClaim reported but not yet paidAssigned a value by a claims adjuster or by formulaIBNR reserves include: Most difficult to measure and justifyReserves for claims not yet reported (pure IBNR)Claims in transitDevelopment on known claimsReserves for reopened claims
8 DefinitionsPure LossesPaid to DateCase ReservesClaim reported but not yet paidAssigned a value by a claims adjuster or by formulaBulk + IBNR reserves include:Reserves for claims not yet reported (pure IBNR)Claims in transitDevelopment on known claimsReserves for reopened claimsLoss 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 costWithin the deductible layerFor a single policy periodOnce 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)PropertyAESAutomobile LiabilityAESWorkers CompensationAESGeneral or Professional LiabilityAES
11 Basic Loss Measurement Techniques: Definitions Sometimes solely Industry-basedComposite to Insurer ExpectationsLoss Development Method using Historical PatternsTrianglesCompiled to measure the changes in cumulative claim activity over time in order to estimate patterns of future activity.Loss Development FactorThe 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)PaidOutstanding Case ReservesPaidOutstanding Case ReservesPaid3 months6 monthsClaim ClosedLoss Development
13 Basic Reserving Techniques: Compilation of Paid Loss Triangle Actuarial ConfigurationThe 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 factorsLink Ratios
16 Basic Reserving Techniques: Paid Loss Development Factors
18 First: Financial Reporting of Losses for Contractors Financial Reporting is expense recognitionCosting is a rationalization activity which is a proactive activityFinancial reporting is the responsibility of Owners, CFOs, Management, Controllers and Independent CPAs - all share the riskReliance by various users on financial statements:SuretiesBanks and finance companiesRegulatory boards - licensingOwner and prime contractor prequalificationSuppliersStockholders (owners)Joint venture partners18
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, ANDThe 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.ImportanceA 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 eventActual payment reduces a reserve; should not effect earnings.
20 ProbabilityRemote – the chance of the future event or events occurring is slightReporting Action: Do nothing or ID as a Risk of Business, if large, in MD&AReasonably Possible – the chance of the event or events occurring is more that remote but less than likelyReporting Action: Disclose in NotesProbable – the future event or events are likely to occurReporting Action:If Measurable: Book to Financials: Disclose in NotesIf Immeasurable: Disclose in Notes under “Claims, Lawsuits and Other Contingencies”
21 Measurability Reasonable Reserves Range of Estimates Reasonable Sets of AssumptionsEvaluate Uncertainty, Risk of Material Adverse DeviationIdentify Sources of UncertaintyBook 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 InsurerStandard Indemnity Clause: Large Deductible Program
24 The “Deductibles” Problem Commercial Insurance Specific ExcessRisk TransferTotal claim payments by policy year (Ultimate Loss)Less claims paidPlus loss forecast for upcoming renewal= collateral requirement$1 MDeductible / RetentionCollateral required forunpaid claimsCommercialAggregateProtection“Stacking” – Over time, collateral obligationsgrow (usually stabilizes after 4-7 years)PerOccurrencePer Year / AggregatePolicy YearAssume 5 policy years$10M Loss Pick$1 M paid per yearAnnualCollateralRequirementReport Year
26 The Business of Risk Underwriting Expected Losses and Allocated ExpensesRisk Margin: Volatility of Loss Frequency & Loss SeverityUnallocated CostsLoss AdjustmentU/W & Acquisition CostsPremium TaxesFees, Licenses & BureausOther Operating CostsPortfolio Concentration AdjustmentsInvestment return off-setsRequired Return on Equity (Surplus) or Opportunity Cost of re-directed capitalCounter-party Risk
27 Insurance Company Dynamics Surplus is LifeLeverage Writings: i.e. 3:1 Written to SurplusDefines Single Risk Capacity: i.e. 10% of Surplus exposureSolidifies Reinsurance Treaties / RelationshipsStatutory Accounting PrinciplesAnnual Statement - Yellow Peril / Convention Blank / Yellow Book, etcLiquidation ValueDrives Statutory SurplusAdmitted Assets vs Non-Admitted Assets on SurplusSchedule FRisk Based Capital
28 Insurer Collateral Emphasis and Counter-Party Risk Attitude Paid-Loss Sensitive ProgramsLarge DeductiblePaid-Loss Retros“Fronted”SecureLossesPremiums, in some casesProtection againstStatutory PenaltiesDirect Obligation Default by InsuredsSure, I’m smiling now…
29 So What Happen with An Insured Insolvency? Primary Issue -- Does Insurer Become Responsible for all Claims Payments? - ProbablyInsured / 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 LinesOther Debt ConstraintsLiquidity IssuesTax PlanningAmount & Timing of CollateralControl of the CollateralChange of Insurer Relationships
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 lossSummary loss information by line and by policy yearLarge loss listingHistorical Exposure InformationUnderstand 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 conditionInvestigate 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 reservesDeduct fixed costs, risk transfer premiums, and only losses paid in the policy yearFuture losses deducted as paid in year paidInsurance companies can deduct loss reservesAdvantage: take current year deductions for all losses paid, loss reserves & IBNR (reduced by IRS-imposed discountSo 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 purposesInsurance RiskNuance & Common Notions (Insurance Form)Risk Shifting & Risk DistributionTax deductibility hinges on whether or not the captive is a bona fide insurance companyAlthough 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 captiveAlternatively, a captive that meets IRS requirements as a brother/sister captive (i.e., Humana structure) does not require unrelated riskUnrelated Risk / 3rd PartyBalance 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 CostsCost Accounting Standard (CAS) 403, Accounting for Home Office CostsFAR , Insurance and IndemnificationFAR , CreditsFAR 28.3, InsuranceWhen to evaluate your current accounting practices for insurance costs?Contracts will be CAS coveredContracts subject to Federal Acquisition Regulation , Insurance and Indemnification*Full text of FAR clauses can be found at https://www.acquisition.gov/far/index.htmlFull 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 & AllocabilityCost accounting standards, or otherwise generally accepted accounting principles and practices appropriate to the circumstancesTerms of the contractFAR 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 contractsSelf-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 largeIf Government reviewer considers reserve unreasonably large, may question a portion of the reserve and the related insurance costTo 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 lossActual loss experienceLoss Trending and / or InflationLoss development experience or “lag” studiesDiscounting 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 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 principlesThe 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 QuestionsAnd Thank-You for your AttentionCharlie Woodman, CPARisk Finance AdvisoryWillis National Construction2013 Willis Construction Risk Management Conference