Trends in Capital Adequacy AGRiP Fall Educational Forum October 3, 2016 Kevin Wick, FCAS, MAAA Kevin.L.Wick@pwc.com 206-398-3518

Weak Signals “Let’s save money by increasing our retention” “We should be able to get better investment returns than we are getting” “Wouldn’t it be great if we can add more members?”

Initial pooling business model Risk Insurance unaffordable or unavailable Pooling risks offered greater cost stability versus being without coverage Initial “capital” came from retroactive assessment ability Surplus levels were small and not that important Temporary structure Surplus Cash Call

Financial expectations of pools have matured Members now expect: Stable and low rates Financial soundness Customized coverages Financial uncertainty fully supported by surplus Long-term financial viability Permanent Structure Risk Surplus Surplus

Benchmarking Common measures Reserve to surplus Premium to surplus Net retention to surplus RBC ratio BCAR ratio Etc.

Benchmark source data is important to understand Indicates a variety of practices and there is no “standard” or “norm for the industry” Benchmarking can be very useful and an efficient way to gauge performance Relevant Relevance of Source Not useful Limited value Not Relevant Inconsistent Consistent Consistency of Source

Insurer reserve to surplus ratios Source: Reserve to Surplus Ratios from 2015 Statutory Filings

Insurer risk based capital ratios Source: ACL RBC Ratios from 2015 Statutory Filings

Determining capital targets Risk Measurement Risk Appetite Capital Requirements

Risk measurement process Step 3: In a similar manner, the total funding need is determined through a risk aggregation process. Step 2: The individual risks are aggregated into four broad categories considering interdependencies. Total Funding Need Underwriting Reserving Asset & Credit Operational Counter- party Prop APD Prop APD Int. rate People System Equity Hazards GL AL GL AL WC WC Step 1: The uncertainty associated with each of these risk elements is measured.

Overall results

Trend 1: Pools generate significant financial uncertainty Underlying Reasons Smaller Risk concentration Risk taking “independence” culture Implication for using “insurance industry” measures

Trend 2: Investment risk often overlooked Risk/Reward Analysis Focus on the reward – easier to measure & understand. Plug into budget to see benefit. Risk harder to measure. Does not go into budget. Where does it go? Better returns  more risk More risk  more capital needs Pitfalls Extreme risk not considered Misunderstanding the use of surplus

Trend 3: Sources of financial uncertainty varies significantly Source of risk varies significantly Tort caps reduce underwriting risk Catastrophe risk dominates property focused pools Asset/credit risk varies from 8% to 68% of total risk Health trusts have more operational risk

Context for risk appetite What is the insurance industry context where a cash call is not an option? Secure rating (B+) - roughly between 1-in-100 and 1-in-250, though not specified by agencies Rating Agencies European and other developed countries set the “target” capital level at 1-in-200 Global Insurance Regulation

Trend 4: Pools recognize their capital needs differ from the “insurance industry” Ability to “manage” book? Restrictions on rate actions? Ability to replenish capital? Members rely on other services

Some pools are looking at a longer time horizon Fund balance in target range – all is good Target moved up but so did fund balance – board feels great

Pools tend to under estimate their capital requirement Pools tend to generate more risk than insurers Size, risk concentration, independence Impact: Under estimate capital needs Reliance on “insurance industry” metrics Investments can lose value Reinsurers and excess carriers may fail Not all risks are considered Being prepared to withstand a 1-in-100 year event not extreme for a permanent structure Simply using “insurance industry” data points may not be sufficient Risk appetite does not consider extreme enough events

So, what about the weak signals? “Let’s save money by increasing our retention” “We should be able to get better investment returns than we are getting” “Wouldn’t it be great if we can add more members?” Risk Surplus Surplus MORE RISK = MORE CAPITAL NEEDS

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