Industry Reserve Adequacy and Other Hot Topics: Financial Analyst

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Industry Reserve Adequacy and Other Hot Topics
Financial Analysts Perspectives
1999 Casualty Loss Reserve Seminar
Scottsdale, Arizona
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Presenters

• Sarah Hibler - Vice President Senior Analyst,
  Moodys Investors Service
• Jay Votta - Principal, Deloitte Touche LLP
• Bill Wilt - Vice President Senior Analyst,
  Moodys Investors Service

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Discussion Topics

• Overview of Reserve Adequacy
• Results of Moodys Top 50 Analysis
• Use of Reserves in Credit and Equity Analysis
• Reserves play critical role in gauging financial
  health
• Reserving Issues in Mergers Acquisitions
• Reserves key consideration in structuring deals

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Goals of Session

• Discuss macro-level trends in loss reserves
• Provide insight into how outsiders analyze loss
  reserves
• Demonstrate importance of reserves in different
  contexts
• Credit Analysis
• Equity Analysis
• MA Activity

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Top 50 Analysis

• Moodys Analyzed Top 50 P/C Groups
• Approx. 2/3 industry reserves and surplus
• Used annual statement data and internal reserve
  model
• Excluded AE, reinsurance, miscellaneous lines
• Tested results against independent analyses where
  available
• Despite limitations, A/S data can provide
  credible starting point

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Top 50 Analysis

• Benefits of Analysis
• Critical component of capital adequacy and credit
  analysis
• Provides greater insight in discussions with
  companies
• Independent verification of results
• Insight into developing trends quality of
  earnings, current rate adequacy
• Separate supportable facts from unsubstantiated
  rumors in market

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Top 50 Analysis

• Conclusions
• Industrywide 12.6 B redundancy at 12/98
• Represents abut 4 of Reserves and 4.5 of
  Surplus
• PPA, WC provide redundancies CMP, OL show
  deficiencies
• Trends in Reserve Margins are Major Story
• Margins thinning quickly
• Differences Between Personal and Commercial
  Insurers
• Whoever heard of a negative loss trend?

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Top 50 Analysis - Personal Lines Writers
Current Position
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Top 50 Analysis - Retrospective View of PPA
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Top 50 Analysis

• Findings - Personal Insurers
• All showed reserve redundancies
• The story then?
• Favorable loss trends early-to-mid 1990s
• Actuaries/management slow to recognize in rates
• The story now?
• Most carriers reducing rates, dividends
• Loss cost trends ticking upward again

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Top 50 Analysis - Commercial Writers Current
Position
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Top 50 Analysis - Retrospective View of Reviewed
Commercial Lines
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Top 50 Analysis

• Findings - Commercial Insurers
• More even mix of deficiencies and redundancies
• WC similarities to PPA
• legislation and rate reform benefits coupled with
  loss trends
• Competition intensifying, loss ratio climbing
  steadily
• Significant rate pressures all other commercial
  lines
• Most commercial lines show uniformly increasing
  loss ratio
• Diversified Insurers
• Redundancies outweigh deficiencies
• Favorable PPA and WC experience outweighs other
  lines

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Top 50 Analysis

• Conclusions
• Industry adequately reserved -- for now
• How actuaries can help
• Expand statement of opinion
• Include detailed footnotes in Schedule P
• Expand content of actuarial reports and
  distribution of reports
• Reserves Used in Variety of Ways by Many
  ConstituenciesThink Beyond Statement of Opinion

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Industry Reserve Adequacy -- Beyond the
Statement of Opinion

• Moodys Approach to Insurance Analysis
• Credit vs. Equity Analysis

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Moodys Approach to Insurance Analysis
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Moodys Approach to Insurance Analysis
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Moodys Approach to Insurance Analysis
Analytical Approach - Benchmark

• The lowest Secure rating has the annual
  default probability of a 500 Year event

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Moodys Approach to Insurance Analysis

• Traditional Financial Indicators
• Financial Leverage (Debt/Total Capital)
• Double Leverage (Inv in SubsGoodwill)/Equity
• Fixed Charge Coverage and Cash Flow Coverage
• In Context of Underlying Business Volatility
• In Context of Business Cycle
• Does Legal/Regulatory Structure Inhibit
  Cash/Capital Flows Across the Group?

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Moodys Approach to Insurance Analysis A
Practical Reserve Example

• Your typical property/casualty insurer

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Moodys Approach to Insurance Analysis A
Practical Reserve Example
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Credit vs. Equity AnalysisWhat
Creditors/Policyholders Want

• Absolute Repayment
• Minimize likelihood of loss of principal
  benchmark is risk-free rate
• Which translates into
• Conservative corporate governance
• Prudent capital and financial management
• Capital cushion
• Strong earnings and cash flows

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Credit vs. Equity Analysis What Shareholders Want

• Relative Return
• Maximize total return, with acceptable level of
  risk benchmark is a market index.
• Which translates into
• Assertive corporate governance
• High capital efficiency, as measured by ROE
• Active capital and financial management
• Growth in top and bottom lines
• Strong earnings and cash flows

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Credit vs. Equity Analysis Contrasting
Analytical Styles

• Basic Motivations
• Equity and credit analysts both want to be right
• Credit analysts have pressure from issuers to be
  more liberal and investors to be more
  conservative
• Equity analysts can face substantial implied
  pressure from issuers
• Inherent Bias
• Credit analysts tend to focus on the downside
  risk
• Equity analysts tend to focus on the upside
  opportunity

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Credit vs. Equity Analysis Contrasting
Analytical Styles - Example

• Trustworthys creditors/policyholders have NO
  upside

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Industry Reserve Adequacy - Beyond The Statement
of Opinion

• Reserving Issues in Mergers and Acquisitions
• Actuarial Due Diligence Process
• Sampling of Solutions to Reserve Uncertainty

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Reserving Issues in MAActuarial Due Diligence
Process

• Reserve Position
• Restatement of Reported Results
• GAAP Adjustments
• Pro Forma Analysis
• Appraisal Value

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Actuarial Due Diligence ProcessReserve Position

• Windshield Analysis
• Limited Review
• Business Units
• Access
• Time
• Comprehensive Analysis

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Actuarial Due Diligence ProcessRestatement of
Reported Results
Source Consolidated Industry Loss Ratios
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Actuarial Due Diligence ProcessGAAP Adjustments

• Assets
• DAC
• Premium Deficiencies
• Policyholder Dividends
• Contingent Commissions
• Salvage Subrogation
• Federal Income Taxes
• Other
• Present Value of Future Profits (PVFP)

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Actuarial Due Diligence ProcessPro Forma Analysis

• Assumptions
• Premium Growth
• Earnings Pattern
• Loss Ratio
• Expense Ratio
• Payout Patterns
• Investment Portfolio Mix
• Investment Yield
• Risk Adjusted Discount Rate
• Time Horizon

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Actuarial Due Diligence ProcessPro Forma Analysis

• Output
• Income
• Dividends
• Surplus
• Cash Flow From Operations
• Value
• Key Ratios, e.g. RBC

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Reserving Issues in MA

• Sampling of Solutions to
• Reserve Uncertainty

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Sampling of Solutions

• Purchase Accounting
• Retrospective Adjustments
• Reinsurance
• Carve Outs
• Other

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Purchase Accounting

• Reserves are increased by seller prior to
  transaction date
• Purchase accounting does not allow acquirer to
  book additional reserves
• Advantages
• fattens the pig before it goes to market
• Disadvantages
• depresses surplus

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Retrospective Adjustments

• Future adjustment of sales price based on
  retrospective reserve estimates
• Cash settlements
• Portion of sales price held as a note payable
• Contingent interest dividend paid to stockholders
• Advantages
• Low transaction cost
• Disadvantages
• Uncertainty

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Reinsurance

• Stop loss cover provides protection against
  adverse reserve development
• Purchased by seller
• internal
• external
• Purchased by acquirer
• Advantages
• alleviates uncertainty associated with reserve
  development
• Disadvantages
• cost

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Carve Outs

• Segregation of undesirable business segments
  and exclusion from transaction
• Prior to transaction
• Post transaction
• Strategic motives
• Advantages
• may be only way to attract buyers
• Disadvantages
• seller may retain unwanted business
• Regulatory scrutiny