NLC-RISC TRUSTEES CONFERENCE 2016

As a trustee, why do I need to know about this stuff? 1. The pool manages a lot of money; and 2. Pool finances can be unfamiliar and confusing; and 3. I have a fiduciary responsibility for all this!!!

Understanding pool finances What’s that actuarial stuff all about? Things you need to know about pool financial statements Balance sheet Revenue and expense Managing the pool’s fund balance (Or “surplus” or “member equity” or “retained earnings” or “net assets” or whatever you call it in your pool) Setting premium rates

Confusing Things About Pool Finances What are those actuaries really doing? What the heck is IBNR?

What are the actuaries really doing?

Why do claim costs grow? New claims filed Increased reserves because new info suggests claim is likely to be more expensive than we first thought Some old claims end up costing more than we thought

What are the actuaries really doing?

What is IBNR? “Incurred But Not Reported” Difference between what you have paid and reserved on individual claim files and total amount the actuaries estimate those claims will ultimately really cost.

What are the actuaries really doing?

Why is this important? 1. We need to make sure we’re setting aside enough funds now to cover what those claims will ultimately cost. Just the case reserves won’t be enough. 2. We need to make sure we’re setting our premiums high enough to cover what the claims will ultimately cost us. Not just what it first looks like they might cost.

Questions to ask when looking at pool financial statements Looking at the balance sheet Looking at the revenue and expense statement

Questions to ask when looking at pool financial statements When looking at fund balance (or “surplus” or “member equity” or “net assets” or whatever your pool calls it) you need to know: 1. Are the liabilities stated at ultimate value or discounted to present value? 2. Are liabilities stated at “best estimate” or at some confidence level above 50%?

Ultimate Value vs. Present Value LiabilitiesUndiscountedDiscounted to present value Work comp$184 million$144 million Property/casualty$41 million$40 million Minnesota pool – projected claims payout

“Best estimate” There’s an equal chance of estimate being wrong high or being wrong low Same as a 50% confidence level “90% confidence level” There’s a 90% chance that the ultimate cost will turn out to be less than the estimate LiabilitiesBest estimate90% confidence level Work comp$184 million$224 million Property/casualty$41 million$54 million

LMCIT work compClaim liabilitiesFund balance Liabilities stated at ultimate cost $184 million$71 million Liabilities stated at present value $144 million$111 million Liabilities stated at 90% confidence level $224 million$31 million Three ways to state the pool’s liabilities and fund balance…...and all three are accurate and correct!!!

LMCIT work compClaim liabilitiesFund balance Liabilities stated at ultimate cost $143 million$94 million Liabilities stated at present value $114 million$123 million Liabilities stated at 90% confidence level $174 million$63 million Three ways to state the pool’s liabilities and fund balance…...and all three are accurate!!!

Questions to ask when looking at pool financial statements When looking at net income figure: 1. Did the estimated cost of losses incurred in previous years increase or decrease significantly? 2. How did losses incurred this year compare to what was projected? 3. Were there significant capital gains or losses on investments? Realized gains or losses Unrealized gains or losses

Questions to ask when looking at pool financial statements

On the balance sheet… 1. Are the claim liabilities shown discounted or undiscounted? 2. Are the claim liabilities shown at “best estimate” or at a higher confidence level? On the revenue and expense page… 1. Did the estimated cost of losses incurred in previous years increase or decrease significantly? 2. How did the new losses incurred this year compare to what was projected? 3. Were there significant capital gains or losses on investments? Realized gains or losses Unrealized gains or losses

Questions to ask when looking at pool financial statements On the balance sheet… 1. Are the claim liabilities shown discounted or undiscounted? 2. Are the claim liabilities shown at “best estimate” or at a higher confidence level? On the revenue and expense page… 1. Did the estimated cost of losses incurred in previous years increase or decrease significantly? 2. How did the new losses incurred this year compare to what was projected? 3. Were there significant capital gains or losses on investments? Realized gains or losses Unrealized gains or losses

Why do we need a fund balance at all?

Fund balance (or “surplus,” or “member equity,” or whatever your pool calls it) Why do we need a fund balance? We might have more losses this year than our premiums were designed to pay for. Losses from prior years could turn out to cost more than we estimated and reserved for. Reinsurers might become insolvent. We might have investment losses. If loss trends change, we can “phase in” rate increases over a couple years and avoid rate shocks to members’ budgets. It makes it feasible to experiment with covering new risks. It lets us generate more investment income.

Fund balance (or “surplus,” or “member equity,” or whatever your pool calls it) Why do we need a fund balance? Losses could turn out to be more than projected and reserved for Reinsurers might become insolvent We might have investment losses If loss trends change, we can “phase in” rate increases over a couple years and avoid rate shocks to members’ budgets It makes it feasible to experiment with covering new risks It lets us generate more investment income

Conventional minimums – the “red flag” levels Risk-based capital formula 3:1 net premium to surplus 9:1 gross premium to surplus 4:1 loss reserves to surplus 10:1 surplus to retention

Minnesota pool – work comp fund balance minimums Minnesota pool - property/casualty fund balance minimums

Minnesota pool – work comp fund balance minimums Minnesota pool - property/casualty fund balance minimums

Conventional minimums Risk-based capital formula 3:1 net premium to surplus 9:1 gross premium to surplus 4:1 loss reserves to surplus 10:1 surplus to retention Some ways to set surplus targets Target higher ratios; e.g. 1:1 premium to surplus 2:1 reserves to surplus 20:1 surplus to retention Target confidence levels; e.g. 95% or 99% confidence level Other formulas; e.g. 300% of risk-based capital amount 300% of BCAR “Dynamic” analyses – the “what if” approach

What do we do if we have more fund balance (or “surplus,” or “equity,” or whatever your pool calls it) than we need? Some different ways to return it to members Reduce premium rates to a below-cost level Provide renewal premium credit Issue dividend checks Make safety grants

What do we do if we have more fund balance (or “surplus,” or “equity,” or whatever your pool calls it) than we need? Some different ways to allocate it among members Proportionate to premiums Proportionate to premiums minus losses Current year’s experience Total experience from all year Membership longevity

An issue to be thinking about… Suppose a regulator or a legislator or a member says the pool has more money than it needs and should return the excess to the members… …Are we prepared to respond? Do we have a policy on how much fund balance we need? Can we explain why the target we’ve chosen is appropriate? Have we been following our policy and returning any unneeded funds to our members?

An issue to be thinking about… Suppose a regulator or a legislator or a member says the pool has more money than it needs and should return the excess to the members… …Are we prepared to respond? Do we have a policy on how much fund balance we need? Can we explain why the target we’ve chosen is appropriate? Have we been following our policy and returning any unneeded funds to our members?

Some other considerations… Is membership increasing, decreasing, stable? Can we assess members if necessary? Would assessing be an OK thing to do, or would it be a big problem? Are the risks we’re covering changing? Because we’ve changed our coverage? Because of changes in law, environment, financial conditions….? How much risk do we retain? Might that change? Competition Might we be criticized for not having enough fund balance and being financially shaky? Might it be a competitive advantage to have returned funds to members? How are our funds invested? How solid are our reinsurers? How much safety margin is there in our premium rates?

Setting premium rates

Besides the projected losses, we also have to pay for: Administrative expenses Reinsurance costs Loss cost: $ 96 per vehicle Expense:+$ 45 per vehicle Reinsurance:+$ 3 per vehicle =$144 per vehicle

Setting premium rates

Some ways to build a cushion into the revenue stream Use a higher confidence level for loss cost projections to build the premium rates Set rates to fund undiscounted losses, rather than discounted loss Future investment income provides the cushion Use your investment income as that cushion Income on your fund balance Income on your loss reserves (if the reserves are undiscounted) Build in a flat dollar amount E.g., raise the premium rate by $X per vehicle

Setting premium rates

Do we need to build our fund balance? How much cushion do we want to have in case of higher-than- expected losses? Are our risks changing, so that future loss patterns may be different from historical patterns? Cyber risk? Securities litigation? Cancer presumption? More frequent severe storms? Etc. What’s our competitive situation? What’s our overall rate action like? What’s our members’ financial situation like?

Setting premium rates Do we need to build our fund balance? How much cushion do we want to have in case of higher-than- expected losses? Are our risks changing, so that future loss patterns may be different from historical patterns? Cyber risk? Securities litigation? Cancer presumption? More frequent severe storms? Etc. What’s our competitive situation? What’s our overall rate action like? What’s our members’ financial situation like?

Setting premium rates Some good questions to ask when you’re setting premium levels: At this premium level, how much loss can we pay for and still break even? How does that compare with what we’ve actually seen historically?

Setting premium rates Some things to remember Over time, premiums plus investment income need to cover losses and expenses. If they don’t, you’ll go broke. The “market rate” sometimes isn’t enough. Sometimes competitors offer “loss leader” pricing. Sometimes competitors are just plain dumb. Loss costs are predictable, but not perfectly predictable. The past is a good guide, but it’s not an infallible guide. Losses will vary from year to year, and it can be by a lot. Just because it’s never happened, that doesn’t mean that it can’t.

Setting premium rates Some things to remember Over time, premiums plus investment income need to cover losses and expenses. If they don’t, you’ll go broke. The “market rate” sometimes isn’t enough. Sometimes competitors offer “loss leader” pricing. Sometimes competitors are just plain dumb. Loss costs are predictable, but not perfectly predictable. The past is a good guide, but it’s not an infallible guide. Losses will vary from year to year, and it can be by a lot. Just because it’s never happened, that doesn’t mean that it can’t.

Rate schedules and cost allocation Why is this important? Fairness among members Competitive strategy Some questions to think about Between coverages: Are some coverages being “subsidized” by other coverages? Within coverages: Does our rate system allocate costs of that coverage appropriately among members? Experience rating?

Rate schedules and cost allocation Why is this important? Fairness among members Competitive strategy Some questions to think about Between coverages: Are some coverages being “subsidized” by other coverages? Within coverages: Does our rate system allocate costs of that coverage appropriately among members? Experience rating?

Rate schedules and cost allocation Why is this important? Fairness among members Competitive strategy Some questions to think about Between coverages: Are some coverages being “subsidized” by other coverages? Within coverages: Does our rate system allocate costs of that coverage appropriately among members? Experience rating?

Understanding pool finances What’s that actuarial stuff all about? Things you need to know about pool financial statements Balance sheet Revenue and expense Managing the pool’s fund balance (Or “surplus” or “member equity” or “retained earnings” or whatever you call it in your pool) Setting premium rates