Contractual Liability for Warranty Business – More than Meets the Eye Regulatory Perspective

1. Contractual Liability for Warranty Business – More than Meets the Eye Regulatory Perspective Leslie M. Jones Executive Assistant/Consulting Actuary South Carolina Department of Insurance

2. Overview • Evolution of the use of Risk Retention Groups (“RRGs”) to provide Coverage for Warranty Business (“Warranty Coverage”) • Typical Structure of an RRG used to Provide Warranty Coverage • Typical Coverage Provided by “Warranty RRG’s” • Regulatory Concerns • National Warranty RRG • Regulatory Response • NAIC – CATF – Warranty Subgroup • Regulatory Guidance Document

3. Evolution of the Use of RRGs to Provide “Warranty Coverage” • Federal Liability Risk Retention Act of 1986 • Permitted the formation of insurance companies (called “RRGs”) by • “persons” engaged in businesses or activities similar or related with respect to the liability of which such “persons” are exposed by virtue of any related, similar, or common business, trade, product, services, premises, or operations; and • which has as its owners only persons who comprise the membership of the risk retention group and who are provided insurance by such group (or a similar sole owner) • The RRG may only offer liability coverage to owner/insureds. • The RRG must be licensed in one state and then may, in general, engage in business in any other state by “registering” in that state.

4. Evolution of the Use of RRGs to Provide “Warranty Coverage” • Regulation of Service Contract Providers (SCPs) • Most states do not require SCPs to be licensed as insurance companies and therefore states do not generally regulate the reserves or investments of the SCP. • NAIC Model Act • Differentiates between “warranties” and “service contracts” • Requires evidence of “financial responsibility” for SCP

5. Evolution of the Use of RRGs to Provide “Warranty Coverage” • SCPs faced with availability/affordability issues turned to the “alternative markets” and formed RRGs to provide “liability” coverage for the risks under the service contracts they offered.

6. Typical Structure of an RRG used to Provide “Warranty Coverage” • Owners of the RRG are the SCPs (also known as Administrator Obligors (AOs)) • The SCPs are also the insureds • The RRG provides “liability” coverage to the SCPs with respect to the service contracts which they offer (typically vehicle service contracts (VSCs) but also may include service contracts on appliances or “brown and white products”) • The SCPs covered by a single RRG are often related entities

7. Typical “Liability” Coverage Provided by the RRG • First Dollar (aka “Ground Up”) • RRG is responsible for reimbursing the SCP for the entire amount of any claim incurred under the covered service contracts. • Excess of Loss • RRG is responsible for reimbursing the SCP for claims incurred in excess of the SCPs loss reserve fund (generally based upon an agreed upon loss ratio) for covered service contracts. • Contractual Liability • RRG is responsible for all claims made under covered service contracts in the event that the SCP fails to fulfill its obligation. These policies are generally issued on a “one-year claims made basis.”

8. Regulatory Concerns • Concerns primarily relate to Contractual Liability Coverage • Example: RRG provides one-year claims made contractual liability coverage for underlying service contracts written by SCP. • Projected Future Liability for underlying service contracts written by SCP = $41M • Assets available to SCP to pay claims on underlying service contracts - $30.5M • i.e., the “underlying deficit” is $10.5M • Capital and Surplus of RRG is $7M

9. Regulatory Concerns • For the example, what responsibility does the opining actuary for RRG have in forming his/her opinion to: • assess the underlying reserve liability? • examine the underlying assets to ensure that the assets of the SCP that are presumably “available to pay claims” are actually set aside for the purpose of paying claims, provide sufficient liquidity to pay claims, are invested in a reasonable manner re: quality/diversification, etc? • Assess the financial condition of the SCPs? • What reserves, if any, should RRG establish? • What, if anything, should the actuary disclose in his/her opinion for RRG regarding the underlying deficit and/or the ability of the SCP to continue to meet its obligations under the covered service contracts? • Should the underlying deficit be considered a “single risk” for purposes of the “10 to 1” rule (i.e., the maximum retained loss on any one risk should not exceed 10% of surplus)?

10. National Warranty RRG • Major insolvency of an RRG covering SCPs writing vehicle service contracts • Domiciled Offshore but entered through the state of Nebraska • Left many consumers without coverage for their vehicle service contracts • Consumers were not covered by state guaranty funds

11. Regulatory Response • GAO Report (published August 2005) Recommended • Consistent regulatory standards for RRGs among states • With partial preemption granted only to states that adopt those standards • Strengthening Corporate Governance Standards

12. Regulatory Response • NAIC Activities • RRG (E) Task Force • Reviewing accreditation standards to determine applicability to RRGs • The standards will likely include a requirement for RRGs to report on the NAIC P&C statement blank and to provide the related Statement of Actuarial Opinion (SAO) • The Task Force is considering the applicability of the “10 to 1” rule to RRGs • RRG (C) Task Force • Reviewing recommendations of GAO report • Requested assistance from the Casualty Actuarial Task Force (CATF) with respect to “warranty reserves” • Will consider whether contractual liability coverage is truly “liability” coverage as provided for in the Federal Risk Retention Act

13. NAIC CATF – Warranty Subgroup • Letter from Director Wagner • Requested CATF to “give consideration to supporting a modification in the standards that apply to the actuarial certification of reserves held by insurers that underwrite service contracts.” • The request was based on the ‘absence of any indication of financial stress in the certified financial statements or the actuarial opinions of several insurers that engaged in this business and failed.”

14. NAIC CATF – Warranty Subgroup • Letter from Director Wagner –cont. • Director Wagner states that he has concluded that to protect the public from the failure of service contract insurers • The reserves must be “ground up” and must be reviewed and opined on by a qualified independent actuary. • The “reserves” must be subject to a regulated investment code. • However, he concedes that this is politically difficult to achieve and that the only way to create a national solution is by strengthening the standards upon which an actuary opines on the reserves held by a service contract insurer and the financial reporting and oversight process. • He concludes by stating that “This is an issue that should be addressed by the actuarial community as part of its responsibility rather than through a statute or regulation.”

15. NAIC CATF – Warranty Subgroup • CATF Response Letter indicates that it intends to pursue the following: • Include an alert in the annual Regulatory Guidance Document requesting that the actuary disclose in the SAO what the actuary believes to be the financial condition of the obligor for the service contracts and/or the adequacy of any reserve funds the obligor holds for payment of claims under the service contracts covered by the insurer • Provide educational sessions at the CLRS and the opinion writers’ workshop • Ask the CAS Research Committee to prepare an educational “primer” to address issues related to pricing and reserves for warranty and service contract reimbursement insurance exposures. Roger Hayne, Milliman, is preparing the primer. A draft will be available at www.naic.org/committees_c_catf.htm

16. NAIC CATF – Warranty Subgroup • CATF response letter further indicates • That there are other initiatives that could be pursued by other NAIC groups (e.g., SC requires a semi-annual review of the loss reserves and an annual submission of financial statements for the underlying SCPs). • The Blanks committee is considering making warranty business a stand-alone statutory line of business. As part of this review Blanks could consider requiring insurers to report this on the “Financial Guarantee” line rather than “Other Liability”. This would raise the mandatory surplus requirements and reduce the distortion of Schedule P that results from reporting this as “Other Liability.”

17. Regulatory Guidance Document (draft available at www.naic.org/ committees_c_catf.htm) • Paragraph 4: Scope Coverage for Service Contracts. Regulators in several states have recently encountered threats to solvency involving companies that provide coverage for service contracts (automobiles, appliances, etc). Due to wide variation in state laws, this type of product may or may not be insurance. Insurance may only come into play as excess coverage for contractual liability. The insurer and the Appointed Actuary often have no underlying data on loss experience absorbed by the policyholder. When losses break through the retention, they can be catastrophic for the insurer, particularly a specialty writer or a risk retention group with concentration in this exposure. ASOP #36, Section 3.5, the CAS Statement of Principles on Loss and Loss Adjustment Expense Reserves, and other actuarial literature address the relevance of exposure to the reserve actuary’s work. The CATF expects the actuary to understand the exposure associated with the Opinion to be issued.

18. Questions? Thank You!