Actuarial Issues: Pricing and Risk Transfer Considerations

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Actuarial Issues Pricing and Risk Transfer
Considerations

• September 20, 2006

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Pricing 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

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Captive Pricing

• Ann M. Conway, Consulting Actuary, Towers Perrin

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Captive Pricing

• Ratemaking Issues
• Ratemaking Examples
• Captive Metrics

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Ratemaking Issues Cash Flow
The following chart shows simplified captive cash
flows.
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Ratemaking Issues - Data

• Exposures without losses
• No closed claims data
• Combined coverage information
• Incomplete/inconsistent exposures
• Missing claim counts
• Partial loss data

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Ratemaking Issues Industry Statistics

• Loss development data
• Size of loss curves
• Trend
• Loss costs
• Statutory changes

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Example 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
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Example One Adding A Coverage to a Captive
CONTINUED
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Example 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
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Example One Adding A Coverage to a Captive
CONTINUED
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Example One Adding A Coverage to a Captive
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Example Two Allocating Premiums for a New RRG

• Four physician groups consider establishing a
  captive to react to increases in premium and
  retentions

CONTINUED
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Example 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
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Example Two Allocating Premiums for a New RRG
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Example 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

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Example Two Allocating Premiums for a New RRG
CONTINUED
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Example Two Allocating Premiums for a New RRG
CONTINUED
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Example 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
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Example Three Develop PremiumEstimates for
Non-Traditional Exposures
CONTINUED
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Example 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
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Example Three Develop PremiumEstimates for
Non-Traditional Exposures
CONTINUED
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Example Three Develop PremiumEstimates for
Non-Traditional Exposures
CONTINUED
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Captive 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
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Captive 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

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Transfer Pricing Tax Perspective

• Catherine Sheridan-Moore, Partner, KPMG Bermuda

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Risk Transfer Analysis

• Karl Goring, Consulting Actuary, Milliman Inc

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Risk 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.

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Finite 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

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Accounting 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

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Common 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.

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Contracts 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

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Risk-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

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Presentation of Results
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Risk 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

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10-10 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.

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10-10 Rule Counter Example 2

• Quota Share Reinsurance Agreement with 25 ceding
  commission, and 75 Reinsurer break-even loss
  ratio.
• On-Level Loss Ratio Experience

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Pricing 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

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Risk 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.

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Risk 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

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Suggested 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.

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Case StudyAlberto-Culver Company

• Karl Zimmel, Director, Risk Management,
  Alberto-Culver Company

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First Two Years of Captive

• Premium Actuarially Projected Ultimate Losses
• Adverse loss experience
• Premium allocation formula based on units
  individual loss experience and headcounts

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Year 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

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Year 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