1. Effect of Reinsurance on BCAR Case Study CARe Seminar on Reinsurance May 20, 2008 Thomas M. Mount, ACAS, MAAA A. M. Best Company

2. Outline Quick review of BCAR Quick review of BCAR Baseline scenario Baseline scenario Reinsurance “Solution” Reinsurance “Solution” What can possibly go wrong??? What can possibly go wrong??? Summary Summary

3. Economic Surplus Reported Surplus (PHS) Equity Adjustments: Unearned Premiums Loss Reserves Assets Debt Adjustments: Surplus Notes Debt Service Requirements Stress Test Adjustments: Future Operating Losses Potential Catastrophe Exp. Other Economic Surplus (APHS) Net Required Capital Gross Required Capital (GRC): (B1) Fixed Income Securities (B2) Equity Securities (B3) Interest Rate (B4) Credit (B5) Loss and LAE Reserves (B6) Net Premiums Written (B7) Off-Balance Sheet Covariance Adjustment Net Required Capital (NRC)* BCAR Ratio = Economic Surplus / Net Required Capital *NRC=  (B1)²+(B2)²+(B3)²+(0.5*B4)² +[(0.5*B4)+B5)]²+(B6)² +B7 BCAR - Structural Overview

4. Minimum Capital Requirements Rating LevelMinimum BCAR A++175 A+160 A145 A-130 B++115 B+100 B/B- 80 C++/C+ 60

5. Baseline Scenario Monoline liability insurer Monoline liability insurer Writes in 3 states Writes in 3 states 20+ year history 20+ year history $2M per occurrence net retention $2M per occurrence net retention Softening market conditions Softening market conditions Current rating = A- Current rating = A- Historical BCARs 145, 140, 135 (prior yr end) Historical BCARs 145, 140, 135 (prior yr end) Selected minimum required BCAR = 135 Selected minimum required BCAR = 135

6. Baseline Scenario

7. What to do? Eliminate bad risks (re-underwrite)? Eliminate bad risks (re-underwrite)? File new (higher) rates? File new (higher) rates? Diversify into more states? Diversify into more states? Diversify into more lines? Diversify into more lines? Raise capital? Raise capital? But I need help NOW !!!!!!

8. How About a Reinsurance Solution? Prospective Aggregate Stop Loss Prospective Aggregate Stop Loss Coverage begins 1/1/08 Coverage begins 1/1/08 Reduces NPW risk Reduces NPW risk $50M of limit in risk layer = 17% of NPW $50M of limit in risk layer = 17% of NPW Attaches 10 points over the ELR of 80% Attaches 10 points over the ELR of 80% Low cost Low cost Increases BCAR now Increases BCAR now

9. Benefit of ASL

10. NPW Risk

11. Origin of NWP Risk Capital Factors Capital factor

12. NPW Risk

13. 3 More Yrs Status Quo

14. What could possibly go wrong???

15. Adverse Reserve Development Scenario Limit used up on prior AY’s in CY 2010 Limit used up on prior AY’s in CY 2010 $50M each for 2008, 2009, 2010 $50M each for 2008, 2009, 2010 Recoverables increase $150M Recoverables increase $150M Compounded by reinsurance dependence factor Compounded by reinsurance dependence factor Reserve risk analyzed pre ASL Reserve risk analyzed pre ASL Revised assessment of Expected Loss for NPW Revised assessment of Expected Loss for NPW Reduces credit to capital factor Reduces credit to capital factor

16. Adverse Development Scenario

17. Credit Risk

19. Reserve Risk

20. Baseline Industry Reserve Capital Factor Calc. 0 0.5 1 1.5 2 2.5 -60%-40%-20%0%30%60%90%120% (Favorable)/Adverse Reserve Development % of Original Reserves 1% in tail zero defic. 99% capital factor

21. Revised NPW Risk ELR=80% ELR=107%

22. Prospective Stop Loss Rating/Capitalization Issues BCAR score initially improves due to the transfer of risk to the reinsurer BCAR score initially improves due to the transfer of risk to the reinsurer Distorts true picture of risk when utilized Distorts true picture of risk when utilized Exposure bases understated (NWP & Reserves) Exposure bases understated (NWP & Reserves) BCAR distorted/understated BCAR distorted/understated Adds reinsurance recoverable credit risk Adds reinsurance recoverable credit risk Protects volatility but increases reins dependence Protects volatility but increases reins dependence Short term solution to a long term problem Short term solution to a long term problem

23. Summary Understand what the contract is trying to do Understand what the contract is trying to do Understand the accounting of the contract Understand the accounting of the contract Understand the impact of that acctg on BCAR Understand the impact of that acctg on BCAR Make the appropriate BCAR adjustments Make the appropriate BCAR adjustments Need to update adjustments each year Need to update adjustments each year Any adjustments to assuming company? Any adjustments to assuming company? Commutation of these contracts also requires adjustments to BCAR Commutation of these contracts also requires adjustments to BCAR Never allow rating to be more than 1 rating level above true picture before credit for risk transfer Never allow rating to be more than 1 rating level above true picture before credit for risk transfer

24. Effect of Reinsurance on BCAR

25. Questions/Comments?