Title: Actuarial Issues: Pricing and Risk Transfer Considerations
1Actuarial Issues Pricing and Risk Transfer
Considerations
2Pricing and Risk Transfer Considerations
- ModeratorAndre Perez, CEO, Horseshoe Group
- PanelistsAnn M. Conway, Consulting Actuary,
Towers Perrin - Catherine Sheridan-Moore, Partner, KPMG Bermuda
- Karl Goring, Consulting Actuary, Milliman Inc
- Karl Zimmel, Director, Risk Management,
Alberto-Culver Company
3Captive Pricing
- Ann M. Conway, Consulting Actuary, Towers Perrin
4Captive Pricing
- Ratemaking Issues
- Ratemaking Examples
- Captive Metrics
5Ratemaking Issues Cash Flow
The following chart shows simplified captive cash
flows.
6Ratemaking Issues - Data
- Exposures without losses
- No closed claims data
- Combined coverage information
- Incomplete/inconsistent exposures
- Missing claim counts
- Partial loss data
7Ratemaking Issues Industry Statistics
- Loss development data
- Size of loss curves
- Trend
- Loss costs
- Statutory changes
8Example One Adding A Coverage to a Captive
- An indemnification policy for a self-insured
workers compensation program where the
self-insurer retains the first 500,000 of any
occurrence. The company has an existing captive. - Analysis Approach
- Calculate losses limited to 100,000 and develop
a limited pure premium - Compare large loss experience to industry
- Incorporate risk margins, expenses and
discounting
CONTINUED
9Example One Adding A Coverage to a Captive
CONTINUED
10Example One Adding A Coverage to a Captive
- Typical captive expenses can include
- Captive management
- Excess or reinsurance
- Claims handling
- Actuarial, audit, legal fees
- Taxes
- Investment expenses
- LOC costs
- Other, including travel and domicile charges
- In the example the new coverage is assigned a
pro-rata amount of expense - Discounting
- Approach varies by domicile
- Investment yield should consider captive asset
structure
CONTINUED
11Example One Adding A Coverage to a Captive
CONTINUED
12Example One Adding A Coverage to a Captive
13Example Two Allocating Premiums for a New RRG
- Four physician groups consider establishing a
captive to react to increases in premium and
retentions
CONTINUED
14Example Two Allocating Premiums for a New RRG
- Analysis approach
- Data review
- Estimate retained losses based on physician and
industry data - Adjust for policy form, retention level,
discounting, risk margins and expenses
CONTINUED
15Example Two Allocating Premiums for a New RRG
16Example Two Allocating Premiums for a New RRG
- Experience Mod Approach
- Determine at what loss limit data is credible
- Compare actual loss costs with expected loss
costs to determine experience modification factor
(experience mod) - Incorporate credibility, and select experience
mod - Apply selected experience mod to industry
expected loss cost - Multiply experience-modified loss cost and
projected exposures to estimate losses - Allocate results by practice
17Example Two Allocating Premiums for a New RRG
CONTINUED
18Example Two Allocating Premiums for a New RRG
CONTINUED
19Example Three Develop PremiumEstimates for
Non-Traditional Exposures
- Analyze process to generate an insured event
- Develop frequency and severity estimates
- Assume two ways in which a claim could arise
- A vaccinated worker contracted smallpox (direct
exposure) or - A vaccinated worker infected a co-worker
(indirect exposure) - Estimate claim frequencies for both exposures and
combine. Key variables include - Percentage of workers vaccinated
- Estimated percentage of non-vaccinated workers
exposed to vaccinated workers - Estimated percentage of workers contracting
smallpox
CONTINUED
20Example Three Develop PremiumEstimates for
Non-Traditional Exposures
CONTINUED
21Example Three Develop PremiumEstimates for
Non-Traditional Exposures
- Assume one of three outcomes
- Outcome A - fatal claim
- Outcome B - permanent total claim
- Outcome C - temporary total claim
- Assign percentage probabilities to each outcome
and develop estimated severities for each
scenario - Calculate an overall estimated severity
- Combine the frequency and severity assumptions to
calculate expected losses - Consider timing of cash flows, expenses and risk
margins
CONTINUED
22Example Three Develop PremiumEstimates for
Non-Traditional Exposures
CONTINUED
23Example Three Develop PremiumEstimates for
Non-Traditional Exposures
CONTINUED
24Captive Metrics
- Surplus adequacy is the critical standard
- Needs to consider the type of risk and the type
of captive - Surplus can reside in the surplus account or
the loss reserve account - Loss reserve adequacy is key for captives, they
typically represent 90 or more of the
liabilities - Premiums need to at least cover expenses and the
present value of losses many captives price with
a risk margin
CONTINUED
25Captive Metrics
- There are long-term advantages to prudent pricing
- Flexibility with respect to program structure
- Increasing the ability to add new members to a
group captive or provide additional coverage - Respond to unusual adverse situation
- Solvency requirements
- Some key financial ratios are
- The premium to surplus ratio, which reflects a
companys exposure to pricing errors a range of
normal leverage ratios for captives is shown
below
26Transfer Pricing Tax Perspective
- Catherine Sheridan-Moore, Partner, KPMG Bermuda
27Risk Transfer Analysis
- Karl Goring, Consulting Actuary, Milliman Inc
28Risk Transfer - Why All The Hype?
- Heightened scrutiny from supervisors, media and
industry participants. - Major market participants have had internal and
external investigations of accounting practices. - Restated prior year earnings to remove or reduce
impact of certain finite reinsurance agreements. - Minimal intent to transfer risk at policy
inception. - Certain required accruals were not made on a
timely basis. - Separate side agreements were not considered when
assessing risk transfer.
29Finite Reinsurance
- Reinsurance arrangements that transfer limited
risk for limited premium. - Insurance risk involves both uncertainty in
ultimate payments (Underwriting Risk) and
uncertainty with timing of payments (Timing
Risk). - Finite Reinsurance Contracts usually contain one
or more of the following characteristics - Risk transfer and risk financing combined
- Assumption of limited risk by reinsurer
- Transfer of volatility
- Inclusion of future investment income in price
- Potential profit sharing
- Pricing determined by ceding companys results
30Accounting Standards
- US GAAP Accounting FASB 113
- One of two conditions must be met
- Reinsurer has assumed substantially all of the
underlying reinsurance risk (Paragraph 11), or - Reinsurer has assumed significant insurance
risk and it must be reasonably possible that
the reinsurer may realize a significant loss
from the transaction. (Paragraph 9) - US Statutory Accounting SSAP 62
31Common Safe Harbors
- Since adoption of current accounting rules,
common practice that risk transfer analyses be
completed for contracts considered to be Finite
or Structured as opposed to traditional. - Introducing the term Reasonably Self-Evident
- Risk transfer is reasonably self-evident in he
following cases - A straight quota share with no risk limiting
features - Single year property catastrophe and casualty
clash contracts - Most facultative or treaty per-risk excess of
loss arrangements with rates on line well below
the present value of the limit of the coverage.
32Contracts Not Reasonably Self-Evident
- Aggregate Excess of Loss Contracts
- Contracts with experience accounts, experience
rated refunds, or similar features. - Multiple year contracts
- Quota share contracts w/ features such as
- Loss corridors
- Sliding scale commissions
- Loss ratio caps
- Sub-limits
33Risk-Transfer Testing Quantitative
- Understand the Substance of the Agreement
- Develop Cash Flow/Scenario Testing of Subject
Losses - ignore brokerage and internal reinsurers
expenses - Overlay Contractual Terms
- Interest Rate Used to Present-Value Cash Flows
- Summary of Ceded Cash Flows
34Presentation of Results
35Risk Transfer Testing - Quantitative
- 10-10 Rule
- Arose as an informal test for testing whether
reinsurance contracts contained sufficient risk
transfer. - not intended to be a universally applicable risk
transfer test. - A 10 chance of a 10 Loss
- Value at Risk Analysis
- Counter Example 1 Catastrophe Reinsurance
- Counter Example 2 Quota Share Reinsurance
3610-10 Rule Counter Example 1
- Property catastrophe reinsurance contract paying
a premium equal to 10 of the limit is typically
priced to a loss ratio of around 50.
3710-10 Rule Counter Example 2
- Quota Share Reinsurance Agreement with 25 ceding
commission, and 75 Reinsurer break-even loss
ratio. - On-Level Loss Ratio Experience
38Pricing Versus Risk Transfer Analysis
- Pricing/Risk Transfer Similarities
- Adjusting historical experience for development,
trend, premium on-leveling, changes in exposure,
and presence or absence of large losses or
catastrophic events. - Selecting payout pattern
- Expenses
- Pricing/Risk Transfer Differences
- Mean versus tail of distribution
- Types of Risk
- Process
- Parameter
- Model
39Risk Transfer Testing
- Types of Analyses
- 10-10 Rule or Variation
- Particular emphasis on outlying values
- Expected Reinsurer Deficit (ERD)
- Other Methods
- Document all assumptions
- The more transparent an analyses the easier to
prove risk transfer - Regulators or SEC never had any problems with
well documented risk transfer analyses.
40Risk Transfer Testing - Qualitative
- What is your motivation for the deal?
- What is the business intent?
- What is the economic benefit you expect to
achieve? - Document
41Suggested Documentation
- Relevant Correspondence between the ceding and
assuming entities. - A copy of each draft of the reinsurance slip and
cover. - A memorandum from management describing the
business purpose and the economic intent. - A statement regarding risk transfer
- Reasonably self-evident
- Copy of analysis that displays outcomes, their
likelihood, and economic impact. - Signoff from management.
- Signoff from external auditor.
42Case StudyAlberto-Culver Company
- Karl Zimmel, Director, Risk Management,
Alberto-Culver Company
43First Two Years of Captive
- Premium Actuarially Projected Ultimate Losses
- Adverse loss experience
- Premium allocation formula based on units
individual loss experience and headcounts
44Year Three and Four
- Premium Actuarially Projected Ultimate Losses
_at_80 confidence level 20 for Administrative
Expenses - Aggressive safety and claims management programs
- Favorable loss ratio
- Year 3 proposed allocation to units based 100 on
individual loss experience. Implementation in
Year 4 - Year 4 implemented monthly WC loss experience
report
45Year Five
- Budgeted premium allocation based on proportional
share of past 1.5 years of loss experience - PremiumActuarially Projected Ultimate Losses
_at_80 confidence level - 11 months YTD Incurred Losses 35 less than
previous year at same point in time