Collateral Analysis & Negotiations: An Actuary’s Perspective Aon Global Risk Consulting Ron Schuler FCAS, MAAA Associate Director & Actuary ron.schuler@aon.com

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).

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.

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)

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.

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.

Collateral Calculation – An Example

Collateral Calculation – An Example

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.

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

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

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