Effect of Reinsurance on BCAR Case Study

1. Effect of Reinsurance on BCAR Case Study CARe Seminar on Reinsurance May 20, 2008 Thomas M. Mount, ACAS, MAAA A. M. Best Company

2. Outline • Quick review of BCAR • Baseline scenario • Reinsurance “Solution” • What can possibly go wrong??? • Summary

3. Economic Surplus Reported Surplus (PHS) Equity Adjustments: Unearned Premiums Loss Reserves Assets Debt Adjustments: Surplus Notes Debt Service Requirements Stress Test Adjustments: Future Operating Losses Potential Catastrophe Exp. Other Economic Surplus (APHS) Net Required Capital Gross Required Capital (GRC): (B1) Fixed Income Securities (B2) Equity Securities (B3) Interest Rate (B4) Credit (B5) Loss and LAE Reserves (B6) Net Premiums Written (B7) Off-Balance Sheet Covariance Adjustment Net Required Capital (NRC)* BCAR - Structural Overview BCAR Ratio = Economic Surplus / Net Required Capital *NRC= Ö (B1)²+(B2)²+(B3)²+(0.5*B4)² +[(0.5*B4)+B5)]²+(B6)² +B7

4. Minimum Capital Requirements Rating LevelMinimum BCAR A++ 175 A+ 160 A 145 A- 130 B++ 115 B+ 100 B/B- 80 C++/C+ 60

5. Baseline Scenario • Monoline liability insurer • Writes in 3 states • 20+ year history • $2M per occurrence net retention • Softening market conditions • Current rating = A- • Historical BCARs 145, 140, 135 (prior yr end) • Selected minimum required BCAR = 135

6. Baseline Scenario

7. What to do? • Eliminate bad risks (re-underwrite)? • File new (higher) rates? • Diversify into more states? • Diversify into more lines? • Raise capital? But I need help NOW !!!!!!

8. How About a Reinsurance Solution? • Prospective Aggregate Stop Loss • Coverage begins 1/1/08 • Reduces NPW risk • $50M of limit in risk layer = 17% of NPW • Attaches 10 points over the ELR of 80% • Low cost • Increases BCAR now

9. Benefit of ASL

10. NPW Risk

11. Origin of NWP Risk Capital Factors Capital factor

12. NPW Risk

13. 3 More Yrs Status Quo

14. What could possibly go wrong???

15. Adverse Reserve Development Scenario • Limit used up on prior AY’s in CY 2010 • $50M each for 2008, 2009, 2010 • Recoverables increase $150M • Compounded by reinsurance dependence factor • Reserve risk analyzed pre ASL • Revised assessment of Expected Loss for NPW • Reduces credit to capital factor

16. Adverse Development Scenario

17. Credit Risk

18. Credit Risk

19. Reserve Risk

20. Baseline Industry Reserve Capital Factor Calc. 2.5 2 1% in tail 1.5 1 0.5 0 -60% -40% -20% 0% 30% 60% 90% 120% (Favorable)/Adverse Reserve Development % of Original Reserves capital factor zero 99% defic. Reserve Risk

21. Revised NPW Risk ELR=107% ELR=80%

22. Prospective Stop LossRating/Capitalization Issues • BCAR score initially improves due to the transfer of risk to the reinsurer • Distorts true picture of risk when utilized • Exposure bases understated (NWP & Reserves) • BCAR distorted/understated • Adds reinsurance recoverable credit risk • Protects volatility but increases reins dependence • Short term solution to a long term problem

23. Summary • Understand what the contract is trying to do • Understand the accounting of the contract • Understand the impact of that acctg on BCAR • Make the appropriate BCAR adjustments • Need to update adjustments each year • Any adjustments to assuming company? • Commutation of these contracts also requires adjustments to BCAR • Never allow rating to be more than 1 rating level above true picture before credit for risk transfer

24. Effect of Reinsurance on BCAR

25. Questions/Comments?