Effect of Reinsurance on Effect of Reinsurance on BCAR BCAR

Case StudyCase StudyCARe Seminar on ReinsuranceCARe Seminar on ReinsuranceMay 20, 2008May 20, 2008

Thomas M. Mount, ACAS, MAAAThomas M. Mount, ACAS, MAAAA. M. Best CompanyA. M. Best Company

OutlineOutline

Quick review of BCARQuick review of BCAR Baseline scenarioBaseline scenario Reinsurance “Solution”Reinsurance “Solution” What can possibly go wrong???What can possibly go wrong??? SummarySummary

Economic SurplusEconomic SurplusReported Surplus (PHS)Reported Surplus (PHS)Equity Adjustments:Equity Adjustments:

Unearned PremiumsUnearned PremiumsLoss ReservesLoss ReservesAssetsAssets

Debt Adjustments:Debt Adjustments:Surplus NotesSurplus NotesDebt Service Debt Service

RequirementsRequirementsStress Test Adjustments:Stress Test Adjustments:

Future Operating LossesFuture Operating LossesPotential Catastrophe Potential Catastrophe

Exp.Exp. OtherOther

Economic Surplus (APHS)Economic Surplus (APHS)

Net Required CapitalNet Required CapitalGross Required Capital (GRC):Gross Required Capital (GRC):

(B1) Fixed Income Securities(B1) Fixed Income Securities(B2) Equity Securities(B2) Equity Securities(B3) Interest Rate(B3) Interest Rate(B4) Credit(B4) Credit(B5) Loss and LAE Reserves(B5) Loss and LAE Reserves(B6) Net Premiums Written(B6) Net Premiums Written(B7) Off-Balance Sheet(B7) Off-Balance Sheet

Covariance AdjustmentCovariance Adjustment

Net Required Capital (NRC)*Net Required Capital (NRC)*

BCAR Ratio = Economic Surplus / Net Required Capital

*NRC= (B1)²+(B2)²+(B3)²+(0.5*B4)² +[(0.5*B4)+B5)]²+(B6)² +B7

BCAR - BCAR - Structural Structural

OverviewOverview

Minimum Minimum Capital Capital

RequirementsRequirementsRating LevelRating Level

Minimum BCARMinimum BCARA++A++ 175175A+A+ 160160AA 145145A-A- 130130B++B++ 115115B+B+ 100100B/B-B/B- 80 80C++/C+C++/C+ 60 60

Baseline Baseline ScenarioScenario

Monoline liability insurerMonoline liability insurer Writes in 3 statesWrites in 3 states 20+ year history20+ year history $2M per occurrence net retention $2M per occurrence net retention Softening market conditionsSoftening market conditions Current rating = A-Current rating = A- Historical BCARs 145, 140, 135 (prior Historical BCARs 145, 140, 135 (prior

yr end)yr end) Selected minimum required BCAR = Selected minimum required BCAR =

135135

Baseline Baseline ScenarioScenario

2007 YEw/o ASL

Reported Surplus 300,000Net Loss Reserves 600,000NPW 300,000

(B1) Fixed Income Risk 3,500(B2) Equities Risk 0(B3) Interest Rate Risk 6,000(B4) Credit Risk 2,700(B5) Reserve Risk 230,931(B6) Premium Risk 112,036(B7) Business Risk 0Gross Required Capital 355,167

Net Required Capital 257,986

APHS 330,042

BCAR 128

What to do?What to do?

Eliminate bad risks (re-underwrite)?Eliminate bad risks (re-underwrite)? File new (higher) rates?File new (higher) rates? Diversify into more states?Diversify into more states? Diversify into more lines?Diversify into more lines? Raise capital?Raise capital?

But I need help NOW !!!!!!

How About a How About a Reinsurance Reinsurance

Solution?Solution? Prospective Aggregate Stop LossProspective Aggregate Stop Loss

Coverage begins 1/1/08Coverage begins 1/1/08 Reduces NPW riskReduces NPW risk

$50M of limit in risk layer = 17% of $50M of limit in risk layer = 17% of NPWNPW

Attaches 10 points over the ELR of 80%Attaches 10 points over the ELR of 80% Low costLow cost

Increases BCAR Increases BCAR nownow

Benefit of ASLBenefit of ASL2007 YE 2007 YEw/o ASL w/ ASL

Reported Surplus 300,000 300,000Net Loss Reserves 600,000 600,000NPW 300,000 300,000

(B1) Fixed Income Risk 3,500 3,500(B2) Equities Risk 0 0(B3) Interest Rate Risk 6,000 6,000(B4) Credit Risk 2,700 2,700(B5) Reserve Risk 230,931 230,931(B6) Premium Risk 112,036 61,036(B7) Business Risk 0 0Gross Required Capital 355,167 304,167

Net Required Capital 257,986 240,271

APHS 330,042 330,042

BCAR 128 137

NPW RiskNPW RiskBEFORE ASL Adjustment

Capital RequiredLine NPW Factor Capital

Other Liability 300,000 0.373 112,036 1.00 Diversification Factor1.00 Growth Factor

112,036 Adjusted Required Capital

AFTER ASL AdjustmentCapital Required

Line NPW Factor Capital

Other Liability 300,000 0.203 61,036 1.00 Diversification Factor1.00 Growth Factor

61,036 Adjusted Required Capital

Origin of NWP Origin of NWP Risk Risk

Capital FactorsCapital FactorsLognorm(1.9607, 0.11756) Shift=-2.0183

0

1

2

3

4

5

6

-0.5 -0.4 -0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4

(Profit)/Loss % (All years)

1% in tail

breakeven

99%industry mean

Capital factor

NPW RiskNPW Risk

80% 80%

10%

17%

10%

37%

0%

20%

40%

60%

80%

100%

120%

140%

Before ASL After ASL

as of 12/31/07

Lo

ss &

LA

E R

atio

Retained Risk

Ceded Risk Layer

Retained Expected Losses

3 More Yrs Status 3 More Yrs Status QuoQuo

2007 YE 2008 YE 2009 YE 2010 YEw/ ASL w/ ASL w/ ASL w/ ASL

Reported Surplus 300,000 300,000 300,000 300,000Net Loss Reserves 600,000 600,000 600,000 600,000NPW 300,000 300,000 300,000 300,000

(B1) Fixed Income Risk 3,500 3,500 3,500 3,500(B2) Equities Risk 0 0 0 0(B3) Interest Rate Risk 6,000 6,000 6,000 6,000(B4) Credit Risk 2,700 2,700 2,700 2,700(B5) Reserve Risk 230,931 230,931 230,931 230,931(B6) Premium Risk 61,036 61,036 61,036 61,036(B7) Business Risk 0 0 0 0Gross Required Capital 304,167 304,167 304,167 304,167

Net Required Capital 240,271 240,271 240,271 240,271

APHS 330,042 330,042 330,042 330,042

BCAR 137 137 137 137

What could possibly go What could possibly go wrong???wrong???

Adverse Reserve Adverse Reserve Development Development

ScenarioScenario Limit used up on prior AY’s in CY 2010Limit used up on prior AY’s in CY 2010

$50M each for 2008, 2009, 2010$50M each for 2008, 2009, 2010 Recoverables increase $150M Recoverables increase $150M

Compounded by reinsurance dependence Compounded by reinsurance dependence factorfactor

Reserve risk analyzed pre ASLReserve risk analyzed pre ASL Revised assessment of Expected Loss for Revised assessment of Expected Loss for

NPWNPW Reduces credit to capital factorReduces credit to capital factor

Adverse Adverse Development Development

ScenarioScenarioStatus Quo Adverse2010 YE 2010 YEw/ ASL w/ ASL Change

Reported Surplus 300,000 300,000 0Net Loss Reserves 600,000 600,000 0NPW 300,000 300,000 0

(B1) Fixed Income Risk 3,500 3,500 0(B2) Equities Risk 0 0 0(B3) Interest Rate Risk 6,000 6,000 0(B4) Credit Risk 2,700 9,046 6,346(B5) Reserve Risk 230,931 288,508 57,577(B6) Premium Risk 61,036 112,036 51,000(B7) Business Risk 0 0 0Gross Required Capital 304,167 419,090 114,923

Net Required Capital 240,271 313,828 73,557

APHS 330,042 330,042 0

BCAR 137 105 (32)

Credit RiskCredit Risk

Asset AdjustedCredit Risk Statement Adjusted Risk Required

Value Adjustment Amount Factor (%) CapitalAgents' Balances

In Course of Collection 30,000 0 30,000 5.0 1,500

Reinsurance Recoverables (A)All Other Insurers 30,000 0 30,000 4.0 1,200Less: Funds Held By Company 0 0 0 4.0 0

Net Reinsurance Recoverables 30,000 0 30,000 4.0 1,200

Multiply: Reinsurance Dependence Factor (B) 1.00Adjusted Net Reinsurance Recoverables 30,000 0 30,000 4.0 1,200

Company Total 60,000 0 60,000 4.5 2,700

Notes:(A) - Includes ceded paid, case, IBNR, and unearned premium recoverables.(B) - Excessive Reinsurance Dependence:

Non-Affiliated Reinsurance Recoverables / PHSCompany 0.1Industry Expected 0.4

Excess 0.0

BEFORE Ceding Adverse Development to ASL

Credit RiskCredit RiskAsset Adjusted

Credit Risk Statement Adjusted Risk RequiredValue Adjustment Amount Factor (%) Capital

Agents' BalancesIn Course of Collection 30,000 0 30,000 5.0 1,500

Reinsurance Recoverables (A)All Other Insurers 30,000 150,000 180,000 4.0 7,200Less: Schedule F Provision 0 0 0 10.0 0

Net Reinsurance Recoverables 30,000 150,000 180,000 4.0 7,200

Multiply: Reinsurance Dependence Factor (B) 1.05Adjusted Net Reinsurance Recoverables 30,000 150,000 180,000 4.2 7,546

Company Total 60,000 150,000 210,000 4.3 9,046

Notes:(A) - Includes ceded paid, unpaid, IBNR, and unearned premium recoverables.(B) - Excessive Reinsurance Dependence:

Non-Affiliated Reinsurance Recoverables / PHSCompany 0.60Industry Expected 0.40

Excess 0.20

AFTER Ceding Adverse Development to ASL

Reserve RiskReserve Risk

600,000 600,000

90,000

112,500230,931

288,508

150,000

Before ASL Adjustment After ASL Adjustment

as of 12/31/2010

Do

llars

(0

00

s) Capital Charge

Deficiency

Ceded Layer

Booked Reserves

Reserve RiskReserve Risk Baseline Industry Reserve Capital Factor Calc.

0

0.5

1

1.5

2

2.5

-60% -40% -20% 0% 30% 60% 90% 120% (Favorable)/Adverse Reserve Development % of Original Reserves

1% in tail

zerodefic.

99%capital factor

Revised NPW Revised NPW RiskRisk

80%90%

37%

10%

17%17%

10%

0%

20%

40%

60%

80%

100%

120%

140%

160%

Prior View of ASL Credit Revised View of ASL Credit

Lo

ss &

LA

E R

ati

o

Retained Risk

Ceded RiskLayer

RetainedExpectedLosses

ELR=80%

ELR=107%

Prospective Stop LossProspective Stop LossRating/Capitalization Rating/Capitalization

IssuesIssues BCAR score initially improves due to the BCAR score initially improves due to the

transfer of risk to the reinsurertransfer of risk to the reinsurer Distorts true picture of risk when utilizedDistorts true picture of risk when utilized

Exposure bases understated (NWP & Reserves)Exposure bases understated (NWP & Reserves) BCAR distorted/understatedBCAR distorted/understated

Adds reinsurance recoverable credit riskAdds reinsurance recoverable credit risk Protects volatility but increases reins Protects volatility but increases reins

dependencedependence Short term solution to a long term problemShort term solution to a long term problem

SummarySummary

Understand what the contract is trying to doUnderstand what the contract is trying to do Understand the accounting of the contractUnderstand the accounting of the contract Understand the impact of that acctg on Understand the impact of that acctg on

BCARBCAR Make the appropriate BCAR adjustmentsMake the appropriate BCAR adjustments Need to update adjustments each yearNeed to update adjustments each year Any adjustments to assuming company?Any adjustments to assuming company? Commutation of these contracts also Commutation of these contracts also

requires adjustments to BCARrequires adjustments to BCAR Never allow rating to be more than 1 rating Never allow rating to be more than 1 rating

level above true picture before credit for risk level above true picture before credit for risk transfer transfer

Effect of Effect of Reinsurance on Reinsurance on

BCARBCAR

Questions/Questions/Comments?Comments?