Issues Relating to Discounting 2007 CASE Spring Meeting March 14, 2007 Nashville, Tennessee William R. Wilkins, FCAS MAAA Senior Vice President and Chief Actuary First Acceptance Corporation

What is Reserve Discounting?  Actuarial Standard of Practice No. 20 Defines Discounted Reserve as “The present value, calculated at selected interest rate(s), of the payment of outstanding losses and/or loss adjustment expenses in the anticipated future settlement amounts.”

Why Discount Reserves?  Mandated by the IRS for Income Taxes  Makes Combined Ratio better profitability tool  Investment Income is reflected in Product Pricing  It increased Surplus underlying the balance sheets.

A general approach to discounting

Concerns arising from the Discount Rate How should the value be determined?  Risk Free Rate?  Market Rates?  A specific investment portfolio?  Interest Rate Risk adjusted? One rate for all years or multiple rates?  Should there be a range for each year?

A general approach to discounting – 4% Rate

A general approach to discounting – 2% Rate

Concerns arising from the Payout Pattern  Payout Pattern Should single or range of payout patterns be used? Actual vs. Expected Effects of  Salvage & Subrogation  Reinsurance  Claims Handling

A general approach to discounting – Payout Change

Concerns arising from the Original Estimate  While Financials are booked to a point estimate, there is generally a range around that estimate. That is due to uncertainty throughout the estimation process. Discounting lowers the held reserve. That is an explicit increase in risk. Conversely a lower reserve raises the surplus, however practice would be to increase writings for that higher surplus level, not leaving the money for the uncertainty.

A general approach to discounting – Estimate Change

Estimate Change effect of Discounting – Original Reserve

Estimate Change effect of Discounting – Revised Reserve

Estimate Change effect of Discounting – Surplus

So if you wish to discount  You need fairly predictable payouts.  Relatively stable reserve levels  Interest Rates should be on the conservative side  Growth in writings need to be tempered against possible development  Read and comply with ASOP #20

Articles on discounting  ASOP #20 Adopted April 1992  Stephen Lowe, Randall Holmberg & Wayne Upton, 1989 CLSR 4E: “Discounting Loss Reserves”  David Wasserman and Allan Kaufman, “Empirical Measure of Reserve Level Uncertainty Relative to Discounting and Financial Solvency for a Monoline Medical Professional Liability Insurer”, Casualty Actuarial Society Discussion Paper Program, Spring 1984  Stephen D’arcy, “Revisions in Reserving Techniques necessary to discount Property-Liability Loss Reserves”, Casualty Actuarial Forum Fall 1987  CAS Committee on Theory of Risk, “Risk Theoretic Issues in the Discounting of Loss Reserves”, Casualty Actuarial Forum Fall 1987