Montana State Fund

1. Montana State Fund The Role of Surplus Senate Bill 304 Study Committee September 23, 2003 Presented by: Robert F. Conger, FCAS, MAAA, FCIATillinghast – Towers Perrin200 West Madison Street Suite 3100 Chicago, IL 60606 (312) 609-9363

2. “Surplus” is an essential element in the soundmanagement of property/casualty insurance companies • Definition • The Role of Surplus • Variability • The Need for Surplus

3. Definition of Surplus • Property/casualty insurers are required to maintain assets greater than their liabilities • Sound financial management • Statutory/regulatory requirements • “Surplus” is the measure of the amount by which total assets exceed the total liabilities of the insurance company • The strength,or size,of a company’s surplus is used as an indicator of how likely an insurance company will be able to fulfill its financial and contractual obligations under changing economic, business, social, environmental, and claim conditions

4. The amount of an insurance company’ssurplus is subject to year-to-year change Sources Of Change • Current underwriting results (Premium) minus (Claims and expenses) • Investment results • Changes in loss estimates (reserves) for prior years

5. Ultimately, surplus is intended to assure that the insurer will be able to fulfillits obligations to policyholders and injured employees • Premiums are established before the number, severity, duration, or cost of claims can be known • Case reserves and actuarial reserves are established as claims occur, but the ultimate cost of those claims is not known for many years • Catastrophic and unanticipated events may occur; this possibility can not be fully funded in each year’s premiums • Assets held in support of the obligations vary in value over time • The insurer must pay the full cost of the injured workers’ claims (medical bills and wage replacement) even if costs exceed the premiums and investment income received for that year These characteristics distinguish insurance from virtually all other goods and services, where the price is established after most costs of production and delivery are known

6. MSF’s historical experience amply illustrates the potential variability and uncertainty associated with property/casualty insurance Ratio of Benefits to Premiums Collected (12/31/2002 Hindsight) ACCIDENT YEAR ENDING JUNE 30

7. MSF’s historical experience also illustrates the difficulty of quantifying workers compensation loss reserves, even after policies have expired Year-to-Year Loss Reserve Variability PERCENT DEVELOPMENT - ONE YEAR RESERVE EVALUATION DATE Note: The data for this graph was derived by comparing the best estimate reserve at an evaluation date, with the same reserve re-evaluated with hindsight twelve months later, with the benefit of one year of actual development data.

8. Surplus is not “extra” • “Surplus” is poorly named - it is not excess, un-needed funds • If insurers retained no surplus, potentially half the companies would become insolvent each year • Actual results are equally likely to be better or worse than management’s and actuaries’ best forecasts • No reasonable amount of surplus can fully guarantee against an insurance company’s failure • An infinitely large pool of surplus is neither possible, nor is it the best use of financial resources • Every insurer, regardless of financial strength, requires management intervention to stay on track

9. Insurance Company with Inadequate Surplus Insurance Company with Marginal Surplus Insurance Company with Adequate Surplus • Unable to fulfill obligations to injured workers • Supplemental funding (e.g., Old Fund Tax) • Out of business - employer must find other insurance • Wide fluctuations in premium costs to employers • Cash flow crises • Erosion of employer and injured worker confidence • Able to fulfill all obligations to employers and injured workers • Managed response to changing conditions • Stabilized costs to businesses, fostering regional economic competitiveness Potential consequences of volatilityin economic or business conditions

10. There is no one correct level of surplus Appropriate Surplus Levels Depend On … • Type and amount of business insured historically, currently, and in the future • Company strategy • Availability of outside capital • Use of reinsurance • Aversion to risk -- all stakeholders • Loss reserve adequacy • Exposure to fortuitous events • Influence of economy and other “macro” events … And Other Factors

11. MSF, as a workers compensation state fund, has several characteristics that highlight the importance of surplus to absorb adverse scenarios • Extremely long-term obligations associated with workers compensation claims • Tendency for good and bad years to run in strings • MSF writes one line of insurance • MSF writes in a single state • MSF provides a guaranteed market • Unlike a stockholder-owned insurance company, MSF cannot access additional capital to finance future growth or to cover adverse financial results • MSF’s surplus must be adequate not only to cover current and nextyear’s obligations, but also to support the long-term strategy Potentially greatervolatility of results Conclusion: MSF needs stronger than average surplus to address these issues

12. Questions ?