The Black Box T hat is Risk Quantification

1. The Black Box That is Risk Quantification The Impact of Loss Quantification in Our Business September 11, 2013 Charlie Woodman, CPA Risk Finance Advisory Willis National Construction 2013 Willis Construction Risk Management Conference

2. Sound Familiar? • From your underwriter……… • “Due to market conditions and your recent claims experience, we are increasing your rates by 7%” • From your actuary……. • “Total unpaid losses increased by approximately $900,000 due to adverse loss development and an increase in claim frequency” • From your broker……. • “The carrier has increased your collateral requirement by $2 million and the LOC needs to be in place in 30 days” • From the IRS……. • “This is to inform you of the initiation of an issue regarding the valuation of unpaid loss reserves deductions under IRC Sec 482…the following must be provided regarding ABC Captive Insurance Company…” • From your DCAA auditor….. • “Your charge for self insurance is disallowed as it is not based on Projected Average Loss as defined under CAS 416”

3. 4 years of college, 3 years grad school, four exams…for this?! Discussion • Loss Quantification: Basics, esp. Loss Development Methodology • Quantification Ramifications • Insurance Risk Transfer Costs • Collateral Costs • Financial Reporting & GAAP • Tax Reporting • Governmental Contract Accountability / FAR / CAS

4. Economics of Insurance: Typical Commercial Insurance – 1st Dollar / Guaranteed Cost Profits & Losses 55 -75% • Fixed (25%-35%) • Insurance CompanyOverhead, Taxes,Reinsurance Cost, Commission • Components of Traditional Insurance: • Expected loss and ALAE • Taxes and regulatory fees • Overhead and administration • Insurer selling and distribution expense • Reinsurance and Intermediary charges • Risk Margins

5. “Fixed Costs” • Fixed • Risk Transfer • Taxes • Safety & Claims Mgmt • Loss Control • Admin & Compliance Insurance Program Risk Costs with Large Deductibles / Retentions Incurred Losses: The Variable Stuff 65% – 90+%

6. Losses: the 800 Pound Gorilla Sitting In The Corner • Make up the vast majority of insurance cost uncertainties • In Guaranteed Cost: Standard Premium including Experience Mods • In ‘Loss-sensitive Programs’ : Deductibles and Retentions • Losses = Pure Loss (claimant satisfaction costs) + Loss Adjustment Expense (loss reconciliation activity costs) • Losses and their uncertainty broken down into two (2) types: • Frequency / Burning Losses (Predictable) • Severity / Adverse / Catastrophic Losses: Tougher to Predict - PL / Comp Op / SDI (Risk Margin)

7. Life Cycle of a Claim Reserve 7/11/06 Accident reported Claims in Transit 8/1/06 Accident entered into records as $1,000 Formula Reserve 4/2/06 Accident occurs Pure IBNR 1/1/07 Estimate revised $25,000 Case Reserve 10/5/06 Individual reserve established $10,000 Case Reserve 8/18/07 Settlement agreed $30,000 Case Reserve 9/2/07 Claim draft clears Closed 8/25/07 Payment sent $30,000 Case Reserve

8. Intro To Losses • A Loss is the Paid (to date) + Claim (Case) Reserve + Incurred-But-Not-Reported (IBNR) • Certain exposures will have many losses in a given policy year which may take many years to ultimately reconcile and close. • What is a Loss Reserve? • Amount necessary to settle unpaid claims • Case Reserves • Claim reported but not yet paid • Assigned a value by a claims adjuster or by formula • IBNR reserves include: Most difficult to measure and justify • Reserves for claims not yet reported (pure IBNR) • Claims in transit • Development on known claims • Reserves for reopened claims

9. Definitions • Pure Losses • Paid to Date • Case Reserves • Claim reported but not yet paid • Assigned a value by a claims adjuster or by formula • Bulk + IBNR reserves include: • Reserves for claims not yet reported (pure IBNR) • Claims in transit • Development on known claims • Reserves for reopened claims • Loss Adjustment Expenses (LAE) are sum of: • Defense & Cost Containment (DCC) Expense (including adjusting) • The Sum of These is referred to as “expected to ultimate” losses or “projected ultimate losses”

10. Projected Ultimate Loss • An estimate of total claims cost • Within the deductible layer • For a single policy period • Once all claims are settled, paid and closed. • For first party coverage (Property or Builders Risk), losses are directly measured based on property valuation whether actual cash value or replacement cost. (Short tail) • For casualty lines (AL, GL and WC), due to the lengthy period of time between the occurrence of a claim and final settlement, estimation of ultimate loss is required.

11. Considerations:Emergence/Settlement • Emergence (E) vs. settlement (S) Property S A E Automobile Liability S A E Workers Compensation A S E General or Professional Liability S A E

12. Basic Loss Measurement Techniques:Definitions • Sometimes solely Industry-based • Composite to Insurer Expectations • Loss Development Method using Historical Patterns • Triangles • Compiled to measure the changes in cumulative claim activity over time in order to estimate patterns of future activity. • Loss Development Factor • The ratio of losses at successive evaluations for a defined group of claims (e.g. accident year).

13. Components of Loss Incurred but not reported (IBNR) • Incurred but not reported (IBNR) • Paid • Outstanding Case Reserves Paid Outstanding Case Reserves Paid 6 months 3 months Claim Closed • Loss Development

14. Basic Reserving Techniques:Compilation of Paid Loss Triangle • Actuarial Configuration • The losses are sorted by the year in which the accident occurred. • The losses are summed at the end of each year. • Losses paid to date are shown on the most recent diagonal. • The data is organized in this way to highlight historical patterns.

15. Basic Reserving Techniques:Compilation of Paid Loss Triangle

16. Basic Reserving Techniques: Paid Loss Development Factors From the end of the accident year (at 12 months) to the end of the following year (at 24 months), paid losses for 1996 grew 79%. During the next year (from 24 to 36 months), paid losses experienced an additional 24% growth (or development) and so forth. Loss Development Factors (LDFs) are also known as: Age-to-Age factors Link Ratios

17. Basic Reserving Techniques:Paid Loss Development Factors

18. Basic Reserving Techniques:Paid LDM Projections & Reserves

19. First: Financial Reporting of Losses for Contractors • Financial Reporting is expense recognition • Costing is a rationalization activity which is a proactive activity • Financial reporting is the responsibility of Owners, CFOs, Management, Controllers and Independent CPAs - all share the risk • Reliance by various users on financial statements: • Sureties • Banks and finance companies • Regulatory boards - licensing • Owner and prime contractor prequalification • Suppliers • Stockholders (owners) • Joint venture partners

20. Recognition of Losses: Rule • A loss or group of losses is recorded only when (old FAS 5): • The likelihood of actual loss is probable, AND • The amount of the loss is reasonably subject to estimation. • If reasonable estimates of loss or losses produces a range of equally likely outcomes – (FIN 14) book the minimum. • Importance • A company cannot set aside reserves for a loss it believes might occur before it actually happens. • If a loss occurs, a company must recognize the full value of the loss as an expense on its financials in the accounting period in which it knows of the event • Actual payment reduces a reserve; should not effect earnings.

21. Remote – the chance of the future event or events occurring is slight Reporting Action: Do nothing or ID as a Risk of Business, if large, in MD&A Reasonably Possible – the chance of the event or events occurring is more that remote but less than likely Reporting Action: Disclose in Notes Probable – the future event or events are likely to occur Reporting Action: If Measurable: Book to Financials: Disclose in Notes If Immeasurable: Disclose in Notes under “Claims, Lawsuits and Other Contingencies” Probability

22. Measurability Reasonable Reserves Range of Estimates Reasonable Sets of Assumptions Evaluate Uncertainty, Risk of Material Adverse Deviation Identify Sources of Uncertainty Book Management’s Best Estimate

23. Collateral: It All Starts Here Dear Insured “We will pay benefits and damages that are covered under this policy. We will only seek reimbursement for those amounts that are within the applicable deductible shown above. You will reimburse us promptly for any deductible amounts and all Allocated Loss Adjustment Expenses that we have addressed.” Sincerely yours, The Insurer Standard Indemnity Clause: Large Deductible Program

24. How Does Collateral Become A Problem?

25. The “Deductibles” Problem Commercial Insurance Specific Excess Risk Transfer • Total claim payments by policy year (Ultimate Loss) • Less claims paid • Plus loss forecast for upcoming renewal • = collateral requirement $1 M Deductible / Retention Collateral required for unpaid claims Commercial Aggregate Protection “Stacking” – Over time, collateral obligations grow (usually stabilizes after 4-7 years) Per Occurrence Per Year / Aggregate Policy Year Assume 5 policy years $10M Loss Pick $1 M paid per year Annual Collateral Requirement Report Year

26. Let’s Start On The Insurer Side

27. The Business of Risk Underwriting • Expected Losses and Allocated Expenses • Risk Margin: Volatility of Loss Frequency & Loss Severity • Unallocated Costs • Loss Adjustment • U/W & Acquisition Costs • Premium Taxes • Fees, Licenses & Bureaus • Other Operating Costs • Portfolio Concentration Adjustments • Investment return off-sets • Required Return on Equity (Surplus) or Opportunity Cost of re-directed capital • Counter-party Risk

28. Insurance Company Dynamics • Surplus is Life • Leverage Writings: i.e. 3:1 Written to Surplus • Defines Single Risk Capacity: i.e. 10% of Surplus exposure • Solidifies Reinsurance Treaties / Relationships • Statutory Accounting Principles • Annual Statement - Yellow Peril / Convention Blank / Yellow Book, etc • Liquidation Value • Drives Statutory Surplus • Admitted Assets vs Non-Admitted Assets on Surplus • Schedule F • Risk Based Capital

29. Sure, I’m smiling now… Insurer Collateral Emphasis and Counter-Party Risk Attitude • Paid-Loss Sensitive Programs • Large Deductible • Paid-Loss Retros • “Fronted” • Secure • Losses • Premiums, in some cases • Protection against • Statutory Penalties • Direct Obligation Default by Insureds

30. Primary Issue -- Does Insurer Become Responsible for all Claims Payments? - Probably Insured / Employer Must Keep Coverage in Place. Insurer May Not Be Permitted to Cancel Policy. In Liquidation, Insurer Will Most Likely Have to Pay All Claims and File Claim for Deductible Amounts. So What Happen with An Insured Insolvency? Crap. Now what?

31. The Insured Side Holy $%#%! • Issues: • Type of Security • Draw on Credit Lines • Other Debt Constraints • Liquidity Issues • Tax Planning • Amount & Timing of Collateral • Control of the Collateral • Change of Insurer Relationships

32. What Can Be Done? Don’t Hide from the Issue

33. Navigating Collateral & Finding Common Ground • Review insured’s payment agreement with their insurance company. • Defines the rights and obligations of both parties, timing of adjustments (generally at renewal) • Quantitative analytics / Actuarial calculation of ultimate loss • Summary loss information by line and by policy year • Large loss listing • Historical Exposure Information • Understand insurance program design (i.e. ALAE treatment) • Challenge Insurer assumptions (loss development factors, renewal forecasts) • Request “paid loss credit” based on the insured’s historical payout patterns and financial condition • Investigate alternative forms (LOC, Cash/asset backed, Insurance Trusts, etc) • Claim reviews / claim closure projects – effect of collateral is intensified when losses are developed

34. Insurance Taxation: Basic • Non-Insurance Companies deduct loss reserves • Deduct fixed costs, risk transfer premiums, and only losses paid in the policy year • Future losses deducted as paid in year paid • Insurance companies can deduct loss reserves • Advantage: take current year deductions for all losses paid, loss reserves & IBNR (reduced by IRS-imposed discount • So what about the Reserves? • $$$$

35. Unrelated Risk / 3rd Party Balance Sheet Fact Pattern / “Humana” I’m not an insurance company, so what? • What if I own a captive? And… • The captive must qualify as insurance company for tax purposes • Insurance Risk • Nuance & Common Notions (Insurance Form) • Risk Shifting & Risk Distribution • Tax deductibility hinges on whether or not the captive is a bona fide insurance company • Although there is no “bright line” test, case law suggests that at least 30% of the captives risk must be “unrelated” to the employer in order for the employer to take a deduction for premiums paid to the captive • Alternatively, a captive that meets IRS requirements as a brother/sister captive (i.e., Humana structure) does not require unrelated risk

36. Federal Contracts and Loss Reimbursement • Key regulation* for accounting for insurance costs: • Cost Accounting Standard (CAS) 416, Accounting for Insurance Costs • Cost Accounting Standard (CAS) 403, Accounting for Home Office Costs • FAR 31.205-19, Insurance and Indemnification • FAR 31.201-5, Credits • FAR 28.3, Insurance • When to evaluate your current accounting practices for insurance costs? • Contracts will be CAS covered • Contracts subject to Federal Acquisition Regulation 31.205-19, Insurance and Indemnification *Full text of FAR clauses can be found at https://www.acquisition.gov/far/index.html Full text of Cost Accounting Standards can be found at http://www.access.gpo.gov/nara/cfr/waisidx_01/48cfr9904_01.html

37. FAR Part 31, Cost Principles Allowability • Factors for determining allowability :“A cost is allowable only when the cost complies with all of the following requirements” • Reasonableness & Allocability • Cost accounting standards, or otherwise generally accepted accounting principles and practices appropriate to the circumstances • Terms of the contract • FAR subpart 31.2 limitations • Costs of insurance required by contract are allowable • Costs of general insurance are allowable if reasonable and measured, assigned and allocated in accordance with the requirements of CAS 416 • Costs of business interruption insurance must exclude coverage for lost profits • Self-insurance program approval is required when: • 50% or > of the self-insurance costs allocable to negotiated government contracts • Self-insurance costs for the fiscal year are anticipated >$200k

38. Insurance Reserves • IBNR (Incurred But Not Reported) • While generally understood by Government reviewers to be a common feature, may be concern that reserves are too large • If Government reviewer considers reserve unreasonably large, may question a portion of the reserve and the related insurance cost • To lessen risk of issues with purchased insurance reserves, contractors and insurance carriers should be prepared to demonstrate that reserves are reasonable based on: • Exposure to loss • Actual loss experience • Loss Trending and / or Inflation • Loss development experience or “lag” studies • Discounting reserves not expressly required by CAS 416, but DCAA guidance suggests reserves may be subject to present value discounting (prompt payment rate)

39. Measurement of Self-insurance Charges and Reserves • With significant self-insurance, typical practices for recovering insurance costs are establishing methods for: • 1.Estimating annual projected average losses • 2.Allocating self-insurance charges to segments and cost objectives (jobs) • Under CAS 416, three ways to measure projected average loss (PAL) 1.Actual Losses: actual amount of losses (where actual losses not expected to differ significantly from PAL) 2.Comparable Purchased Insurance: Estimate of the PAL based on the cost of insurance that could be purchased for the self-insured risk 3.Actuarial Measurement: self-insurance charge based on the contractor’s or industry experience and anticipated conditions in accordance with generally accepted actuarial principles • The total of self-insured charges plus insurance charges must not exceed guaranteed cost insurance for the same exposures

40. These discussions were meant to be general in nature. We at Willis, as risk management professionals, do have a layman’s working knowledge of the tax and accounting issues associated with many risk financing arrangements. However, we do not provide legal, tax or financial reporting advice. Therefore, none of our comments in this area may be relied upon to be either accurate or indicative of probable outcomes when applied to specific facts and circumstances. Warranty (and CYA Statement) Hear no evil, see no evil, do no evil. I Am Not Here.

41. Questions And Thank-You for your Attention Charlie Woodman, CPA Risk Finance Advisory Willis National Construction 2013 Willis Construction Risk Management Conference