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CAJPA 2006 Fall Conference and Training Seminar September 20 – 22, 2006 South Lake Tahoe

Interpreting Financial Ratios and Using Financial Ratios for Decision Making on Retention Levels, Setting Target Equity Levels and Dividend Reimbursements. CAJPA 2006 Fall Conference and Training Seminar September 20 – 22, 2006 South Lake Tahoe. Presented by: Mujtaba Datoo, ACAS, MAAA

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CAJPA 2006 Fall Conference and Training Seminar September 20 – 22, 2006 South Lake Tahoe

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  1. Interpreting Financial Ratios and Using Financial Ratios for Decision Making on Retention Levels, Setting Target Equity Levels and Dividend Reimbursements CAJPA 2006 Fall Conference and Training Seminar September 20 – 22, 2006 South Lake Tahoe Presented by: Mujtaba Datoo, ACAS, MAAA Actuarial Practice Leader ARM Tech 23701 Birtcher Drive, Lake Forest, CA 92630 (949) 470-4343 • FAX (949) 470-4340 • www.armtech.com

  2. Discussion Points • Conceptual framework • Variability • Need for surplus • Confidence level, contingency margin • Target surplus level • Equity position • Dividend release • Summary

  3. So how do you get to your goal? Different people get there differently, or not…

  4. The English Plan Depending on the wind, the striker’s position may vary…

  5. The German Plan Radical, efficient, unstoppable… (ball’s speed may reach 180 mph)

  6. Pooling and Self-Insurance,Insurance mechanism • Essentially the business is an insurance enterprise Pay generally fixed premium up front for a promise to pay claims later Claims will not be known for a while and are subject to variation

  7. Balancing Formula Premium + inv income = losses + expenses fixed minimal variable fixed

  8. Variance… • Losses estimates are inherently variable • Confidence Level is a statistical measure • 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

  9. Surplus provides primary protection against adverse deviation 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

  10. Surplus is key measure • Assets minus Liabilities = Surplus • Surplus a.k.a. • Net assets • Pool equity • Retained earnings • Policyholder’s Surplus

  11. What are your assets • Cash • Bonds • Other investments • Real estate • Accounts receivables • Etc.

  12. Outstanding Losses are the largest component of liabilities What are your liabilities • Claims payable • Case reserves • Case reserve development • Incurred But Not Reported (IBNR) reserves • Allocated loss adjustment expense (ALAE) • Unallocated loss adjustment expense (ULAE) • Other expense payable • Etc.

  13. Reasons for Surplus • Absorb adverse loss development – KEY reason • Reinsurers may become insolvent • Contingent liabilities • Use for rate stabilization • Rating agencies • Make pool more attractive to • Prospective members • Reinsurers • Required by state regulators (private sector)

  14. Determining Surplus Adequacy,the considerations • Lines of coverage • Long tail, short tail • Amount of reserves • Retention level, i.e. SIR • Annual contribution (premium) volume • Strategic plan • Competitive environment • Target levels

  15. Financial Measures • Used by private sector to determine • Financial solidity • Developed to weed out financially troubled companies • Many measures from simple to complex • IRIS ratios: Premium to Surplus (3:1), etc. • Risk Based Capital (RBC) requirements • Basic building blocks are the same

  16. How much Surplus? • Set key financial measure targets • Premiums Contributions to Surplus • Reserves to Surplus • SIR to Surplus • Financial ratios based on private sector experience • Applies to public entities – same risk measure concept • Not quite apples to apples, say apples to oranges! • Benchmark range is still a good guide

  17. Premium-to-Surplus AM Bests – Workers Comp • Premium-to-surplus ratio well within usual range of less than 3:1 Able to: Increase retention, Return dividends, Increase membership

  18. Loss Reserves-to-Surplus AM Bests – Workers Comp • Reserve-to-surplus ratio well within usual range for WC of 3 (to 4):1 Able to withstand adverse development

  19. Retention Levels Depends on: • Amount of Surplus • Subjective willingness to bear risks • The “flinch test” • Excess insurance pricing • Market availability • Other benchmarks, measures

  20. Freakonomics Risk = hazard + outrage

  21. SIR-to-surplus ratio well above 10:1 SIR-to-Surplus Able to withstand more large claims (up to retention levels)

  22. Ratios are relativity concepts • Financial ratios are all relative measures • Relative to other companies • Data adjusted to common levels • Discounted vs. undiscounted • Market value of investments • Absolute measures do not exist! • No one right answer • Use reasonable ranges • Compare to your similar entities

  23. The Italian Plan Iron defense, small ideas in midfield, passes to striker..and…Penalty

  24. The Brazilian Plan … no comments!

  25. The Australian Plan They manage to lose the game by themselves, no help needed.

  26. The Dividend Decision • How much income is available for release? • Relate to Surplus target levels • Use confidence level measures • Accumulate surplus gradually to target levels • Release in staggered amounts • Wait for claims to close or sufficient period to minimize variability

  27. Equity, conceptually Premium Contribution FY 2004/05 Plus Investment income earned 2004/05 Less Program expenses 2004/05 Losses paid in 2004/05 Loss reserves Other adjustments/dividend payable

  28. Equity calculation, Funds available

  29. Equity calculation, Equity above Confidence Level

  30. Equity calculation, Target Equity Release

  31. Equity release • Use Fund Year Accounting • Relates to members who participated in the same years • Accumulate gradually • Through rate additions • Assessments • Release in staggered stages • When all claims are closed, or • Longer waiting and release time for long-tail lines • Ensure overall financial targets are met

  32. The French Plan In their plan, they try all possible hypotheses. Oh No! Oui, Oui …they forgot the goal

  33. Mujtaba’s Plan Survey the field, build advancing strategies, and strike…..

  34. The Big Picture…

  35. Projected Financial PositionAs of June 30, 2005 Program at about 75% confidence level Surplus $4 M

  36. What are your goals? Understand underlying concepts, assumptions Surplus is cushion for adverse deviation, etc. Set reasonable targets Make gradual, incremental changes Compare to peer group or entity Monitor regularly, adjust if necessary For a long-term, financially solid win…

  37. Summary • Losses are inherently variable • Variability cushioned by surplus • Set target financial measures • Reserves, premium and SIR to Surplus • Establish dividend release formula • Calculate equity position by Fund Year • Accumulate surplus gradually, release slowly • Review plan periodically • Details change, e.g. SIRs, membership, etc. • Does it work and achieve equity?

  38. Questions? Thank you. Mujtaba Datoo, ACAS, MAAA Actuarial Practice Leader ARM Tech (949) 470-4342 mujtaba_datoo@armtech.com

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