SELF INSURANCE POOL SOLVENCY TESTS

1. SELF INSURANCEPOOL SOLVENCY TESTS Conference of Consulting Actuaries October 25, 2006 Rancho Mirage, California

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3. 2 Balancing Formula Premium + inv income = losses + expenses

4. 3 Variance… Losses estimates are inherently variable Varies by coverage Excess Liability – very variable WC – indemnity less variable than medical part Auto Liability – generally more stable The greater the SIR, the greater the potential for variability

5. 4 Sources of Variation Process risk risk associated with projection of future contingencies that are inherently variable Parameter risk risk associated with selection of parameters of the model, e.g. selecting the wrong LDF Model risk Misidentifying a process model, e.g. Poisson for frequency

6. 5 Surplus is Key Measure Assets minus Liabilities = Surplus Surplus a.k.a. Net assets Pool equity Retained earnings Policyholder’s Surplus

7. 6 Major Asset and Liability Components Assets: Cash Bonds Other investments Real estate Accounts receivables Etc. Liabilities: Case reserves Case reserve development Incurred But Not Reported (IBNR) reserves ALAE ULAE Other expense payable Etc.

8. 7 No Solvency Standard for Public Sector There are no “standard tests” for public sector pools No central depository for data Pools enabled by legislation under Joint Power Authority (JPA) provisions GASB provides some common basis Financial statements now required to follow some consistent standards and format Requires supplementary schedules, similar to Schedule P Note discounting vs. non-discounting option

9. 8 Use Regulatory Tests Apply private sector IRIS tests IRIS: Insurance Regulatory Information System Easier to understand and apply – a good starting point Publicly available Not quite apples-to-apples, but apples-to-oranges Ranges are broad enough to make them meaningful Building blocks are the same, just more refinement and detail

10. 9 Other Tests Other solvency tests in use RBC: Risk-Based Capital requirements Complex, and benchmark parameters do not exist for pools Establishes amount of required capital Compares required capital to insurer’s capital and surplus Other tests exist, but overall concept is same E.g. Best’s Capital Adequacy Ratio (BCAR) E.g. S & P Capital Adequacy Ratio (CAR)

11. 10 IRIS Ratios IRIS ratios: 12 financial ratios: Range of “unusual values” 4+ flagged ratios = regulatory inquiry Public knowledge Not used to flag insolvent companies Identifies companies possibly in trouble Used to prioritize companies for further analysis by financial examiners

12. 11 IRIS Ratios,Four Categories Overall ratios: e.g., premium to surplus Profitability ratios: e.g., investment yield Liquidity ratios: e.g., liabilities to liquid assets Reserve ratios: e.g., one-year reserves development to surplus

13. 12 IRIS Tests “Unusual” Ranges

14. 13 And now for something completely different…

15. 14 Risk-Based Capital (RBC) Concept Insurance company failures in the 1980s: U.S. Congress investigates NAIC strengthens state solvency standards States set minimum capital requirements Concept not new: Introduced long ago in Wisconsin Requirements applied to banks

16. 15 NAIC Risk-Based Capital Goals of NAIC RBC Requirement: Relate capital and surplus requirements of an (re)insurer to the risks inherent in its particular operations Establish a universally recognized capital standard Provide regulators the authority to enforce compliance with more appropriate capital requirements

17. 16 Let’s Lift the Hood

18. 17 NAIC RBC Ratio

19. 18 Adjusted Surplus Components Adjust Reported Surplus by: Equity adjustments: Unearned premiums, assets Loss reserves Reinsurance Debt adjustments: e.g., surplus notes Other adjustments: e.g., potential catastrophic losses

20. 19 NAIC Risk-Based Capital Total Capital Requirement =

21. 20 RBC Results: 4 Action Levels

22. 21 RBC not readily applicable…to Pools…yet

23. 22 Focus on Key Ratios Not all IRIS tests applicable to pools e.g. Agent’s balance to Surplus Focus on 5 ratios, not necessarily IRIS Premiums – to - Surplus Reserves – to - Surplus SIR – to - Surplus Reserve Development – to - Surplus Operating Ratio These 5 ratios readily available Pool financial statements Supplementary schedules, actuarial reports Overall will provide quick and understandable metrics

24. 23 Net Premium-to-Surplus

25. 24 Net Premium-to-Surplus,Varies by LOB

26. 25 Loss Reserves-to-Surplus

27. 26 Loss Reserves-to-Surplus,Varies By LOB

28. 27 Surplus-to-SIR Surplus-to-SIR ratio of greater than 10:1 From the standard that no one risk exposes surplus of more than 10%

29. 28 Operating Ratio,As % of Premium (aka contribution)

30. 29 Operating Ratio Operating Ratio threshold is less than 100%

31. 30 Reserve Development to Surplus One-year and two-year reserve development to surplus threshold less than 20%

32. 31 Financial Statement,Supplementary Schedule

33. 32 Liquidity Some pools and entities are on a “pay-as-you-go” basis Mostly due to budget constraints Political/capital requirement considerations Is “cash” > claim payments + operating expenses GASB requirement to split liabilities into: “current liability” – amount of current outstanding liability expected to be paid out in the upcoming year “long term liability” - amount of current outstanding liability expected to be paid beyond the next year

34. 33 Review Ratios…over longer time horizon…and not in isolation but interdependently

35. 34 Ratios are Relativity Concepts Financial ratios are all relative measures Relative to other entities or aggregated insurance companies Data adjusted to common levels Discounted vs. undiscounted Other adjustments, e.g. real estate net admitted asset Absolute measures do not exist! No one right answer Use reasonable ranges Ranges broad enough to encompass meaningful results Compare to similar or peer entities

36. 35 For Peak Performance Monitor performance tests annually Explain causes for outside “usual ranges” Take gradual corrective actions Don’t wait for the steep climb … quick fall!

37. 36 Summary Losses are inherently variable Variability cushioned by surplus Set target financial measures Reserves, premium and SIR to Surplus Apply “industry” ratios judiciously Review plan periodically Details change, e.g. SIRs, membership, etc. Compare to peer groups

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39. 38 Thank You!