CAS Casualty Loss Reserve Seminar September 13-15, 2004

1. CASCasualty Loss Reserve Seminar September 13-15, 2004 Reserving for Title Insurance and Residual Value Coverage Alan Hines, FCAS PwC LLP

2. Overview of Residual Value Coverage Insured Exposure: • Protects the owner of an asset against a severe reduction in the market value at a fixed point in time. Definitions: • Asset Expiration: Fixed Point in Time • Insured Value: fcn (Expected Residual Value) anticipates depreciation greater than expected depreciation. • Residual Value: fcn (Market Value or Book Value) defined by policy terms • Insured Loss: (Residual Value < Insured Value) at Asset Expiration • Attachment Ratio – Insured Amount / Original Value • Coverage Ratio – Insured Amount / Current Value

3. Overview of Residual Value Coverage Assets Insured • Vehicles • Real Estate • Aircraft • Commercial Equipment – special machinery, construction equipment, railroad locomotives, computers & electronics

4. Overview of Residual Value Coverage Who Purchases Coverage • Automobile Dealerships • Banks and Finance Companies • Credit Tenant Lease Arrangers (guarantying the balloon payment on the note) • Commercial Equipment Manufacturers with leasing programs

5. Overview of Residual Value Coverage Competitors in Market • Active ???: AIG, Great American, Chubb, RVI, QBE, Mitsui Sumoto, and a few small specialty insurers • Inactive???: Gulf (Travelers), St. Paul, Reliance, Philadelphia, Royal Sun Alliance (FSL), Swiss Re (North American Specialty), Hartford, ACE • Difficulty assessing since there is no annual statement line for this coverage. Usually under Aggregate Write-in or Financial Guaranty

6. Overview of Residual Value Coverage Material Risk Factors • Economic Downturn • Excess Production (supply) • Market Trends – (demand) • Innovations – Rendering Asset Obsolete

7. Overview of Residual Value Coverage Two Types of Products • Asset Value Risk – protects the residual value at lease termination. • FASB 13 Risk - This is residual value insurance to allow for the lessee and lessor to use the most favorable accounting treatment for the lease

8. FASB 13 Risk • Accounting Treatment for Leases - Finance lease accounting – lessor can smooth earnings over the term of the lease - Operating lease accounting – earnings are realized at the latter part of the lease • To Qualify for financing lease treatment: PV (Lease payments + guaranteed residual value) must be > 90% fair value of leased asset at lease inception • Lessee and Lessor need not use same treatment when 3rd party guarantees the residual value. - Lessee can use operating lease treatment with off-balance sheet financing that results in delayed expense recognition

9. FASB 13 Risk • Insured value established to meet 90% test • Low risk of loss • Do policies meet FAS 113 risk transfer requirements?

10. Establishing Insured Values Establishing Insured Values • 90% rule for FASB13 • Auto Leasing Guide - Percentage thereof • Residualized MSRP • Underwriting Models to Project Residual Value

11. Establishing Market Value at Expiration • PV – Black Book, Auction Value • RE – Appraisal Value – defined approach • CE – Green Book • Aircraft – Blue Book • Specific policy provisions regarding return conditions and which value/method to use.

12. Accounting Issues • Incurred Loss – When is a loss incurred? • At policy (asset) expiration. Accident year is asset expiration date. • Proportionally over the life of asset – when there is a reasonable expectation that the residual value of the asset will be less than the insured value at asset expiration, the expected value of the earned loss shall be recorded. Accident year of paid loss is distributed proportional to asset term. • Must match method for earning premium

13. Accounting Issues • Earned Premium – How is premium earned? • Expenses earned over policy period, remainder at policy (asset) expiration • Proportionally over the life of policy asset • Sum of digits method – (like rule of 78) sometimes used for FASB 13 risk

14. Accounting Issues • Reserves: • Limited use of Case Basis reserves. Multiple asset policies with reporting requirements and settlement lag • IBNR Reserve – To match premium recognition • Premium Deficiency Reserve Testing Required • Statutory reserves – Some states may establish statutory reserve requirements

15. Accounting Issues US GAAP Accounting: Insurance or Derivative? • FAS 133 – Accounting for derivatives and hedging activities: - When the residual value is based on an asset appraisal, or proceeds from a sale exception 10 (e) (2) is met and the contract may be treated as insurance. - When the residual value is based on reference to an asset valuation guide (Black Book, Blue Book, Green Book) instead of a specific asset appraisal, the contract does not qualify for the 10 (e) (2) exception and must be accounted for as a derivative. - When based on a combination of a multiple underlyings (ie higher of…), accounting based on contract’s predominant characteristics. Under 10(e) no exception if residual value of other underlyings is highly correlated to guide book!

16. Estimating Loss Reserves • Loss Ratio Approach • Aggregate Models – Frequency Severity Approach – Development of Coverage Ratios • Econometric Modeling – Individual Asset – Asset Classes

17. Estimating Loss ReservesEconometric Modeling Database of Insured Assets • Original Appraisal Date and Value • Most recent value and valuation date • Asset Termination Date and Insured Value • Asset Characteristics: PV - make, model, year, VIN RE – age, construction, location, use • Policy Parameters: deductibles, offset, limits, mileage/asset condition charges, settlement terms

18. Estimating Loss ReservesEconometric Modeling Projection Assumptions • Probability of reaching full term • Probability of return to lessor at end of term • Current book value • Depreciation

19. Estimating Loss ReservesEconometric Modeling Probability of Reaching Full Term Not Constant • Varies by length of lease • Varies by type of vehicle • Function of market value gain or loss

20. Estimating Loss ReservesEconometric Modeling

21. Estimating Loss ReservesEconometric Modeling Probability of Vehicle Being Returned to Lessor • Varies by length of lease • Varies by type of vehicle • Function of market value gain or loss

22. Estimating Loss ReservesEconometric Modeling

23. Estimating Loss ReservesEconometric Modeling

24. Estimating Loss ReservesEconometric Modeling PV Depreciation Data Sources • Auto Leasing Guide (ALG) • Black Book Used Vehicle Guide • Bureau of Labor Statistics (CPI) • Global Insight (DRI) economic indices • Manheim Used Vehicle Indices

25. Estimating Loss ReservesEconometric Modeling Modeling Used Vehicle Depreciation • Vehicle Attributes – Make, Segment, Body Style, Age Product cycle (age of body style) • Seasonality • Supply – Competition Index (dealer incentives), Used Vehicle Stock Index (by segment), New Vehicles Sold (lagged 3-5 years) • Demand – Consumer Confidence, Unemployment • Economic Factors – New and Used Car Price Index, New Car Auto Loan Rate, CPI

26. Estimating Loss ReservesEconometric Modeling:Estimating Depreciation

27. Estimating Loss ReservesEconometric Modeling:Estimating Depreciation

28. Estimating Loss ReservesEconometric Modeling:Estimating Depreciation

29. Estimating Loss ReservesEstimating DepreciationAverage Monthly Depreciation – 1999 Vehicles

30. Monthly Depreciation Rates ’00 to ’04 (All Segments)Weighted Average Black Book

31. Estimating Loss ReservesEconometric Modeling PV Underwriting Considerations • Who is insured, Bank or Dealer • Type of Vehicles • Mileage and Condition • Length of Lease • Market Trends • Optional Equipment • Deductibles

32. Estimating Loss ReservesEconometric Modeling Real Estate • Long Term Projections • Monitor Mark to Market Coverage Ratios • Monitor Concentration of Risk • Assess loss of stressed markets by assessing relative position of the cycle and cycle delta for historical depressions.

33. Estimating Loss ReservesEconometric Modeling Real Estate Depreciation Data Sources • National Real Estate Index - Global Real Analytics • Standard & Poors • Cushman & Wakefield and SIOR Market Reports • Property & Portfolio Research, Inc (ppr.info) • CB Richard Ellis (cbre.com) • Torto Wheaton Research (trw.com)

34. Estimating Loss ReservesEconometric Modeling Modeling Real Estate Depreciation • Property Type – Office, Retail, Industrial, Hotel/Motel, Other • Location – Standard Metropolitan Statistical Areas, State Average, National Average • Supply/Demand – Average Market Rent, New Starts, Completions, Vacancy Rates, Net Absorption, Total Occupancy • Economic Factors – Market Capitalization Rates, Interest rates, Employment

35. Estimating Loss ReservesEconometric ModelingReal Estate Depreciation

36. Estimating UPR ReservesThree NAIC Tests • Test #1 – Best estimate of the amounts refundable to contract holders. • Test #2 – Gross premium multiplied by the ratio of gross losses and expenses incurred during the unexpired term to the total gross losses and expenses under the contract (nominal basis). • Test #3 – The present value of the expected future losses and expenses.

37. Estimating UPR Reserves • Test 1: Not applicable

38. NAIC Tests 2 & 3 for UPR Reserves