Collateral Considerations Managing Collateral Amounts and Instruments in Today's Insurance Market

Collateral Considerations SPEAKERS: Raymond J. Rocchio, Jr., Vice President – Specialty Markets, The PMA Insurance Group Lisa K. Wall, CPA, CPCU, ARM, Senior Vice President – Captive Consulting, Lockton Companies Hugh Barit, Chairman & CEO, PRP Performa Limited MODERATOR: Thomas R. McMahon, B. Comm, FCA, President, Cedar Management Limited

Agenda Purpose of Collateral Collateral Components Collateral Determination –Loss Estimate Stacking Principle –Credit Analysis Carrier Rating Collateral Documentation Collateral Instrument –Deductible Programs –Captive Reimbursement Recent Developments Investment Considerations

Purpose of Collateral Statutory Requirements/Benefits Rating Agency Considerations Mandate to Pay Claims Non Admitted Reinsurance

Collateral Components I NSTRUMENT C REDIT A NALYSIS (Financial Strength) L OSS E STIMATE (Exposure) Insurance Companys collateral requirement is based on three components: Estimated deductible losses for the applicable policy periods Actuarially determined Based on insureds own experience, if credible Financial strength of insured Strong insured credit ratings allow for unsecured credits Poor credit ratings may result in surcharged requirement Each carrier has its own criteria and process Collateral instrument to be provided Letters of credit are preferred Other forms may preclude credits earned on financial strength

Collateral Determination Financial Exposure Analysis –Line of Business, Severity, Predictability, Form of Security Financial Statement Analysis Combining the Two What is the Loan?

Collateral Determination Loss Estimate Aggregate Limits –A Cap on a Policys Reimbursement Obligation Specific Limits –A Cap on One Loss Reimbursement Obligation Reimbursed Losses/Expenses Line of Business Considerations –Tail –Payout Pattern –Development Factors

Loss Estimate – Cumulative Collateral Requirement No Growth vs. 10% Growth S TACKING P RINCIPLE

Collateral Determination Credit Analysis Balance Sheet List of Assets and How they are Financed Focus on Trends Assets –Asset Quality Accounts Receivable Inventory Intangibles –Current Assets –Fixed Assets Age Depreciation Methodologies Replacement Requirements

Collateral Determination Credit Analysis Balance Sheet Liabilities –Current Liabilities –Long -Term Debt Equity –Paid in Capital –Retained Earnings –Tangible vs. Intangible Working Capital –Current Assets Less Current Liabilities

Collateral Determination Credit Analysis Income Statement Focus on Trends Revenues Operating Income One Time Gains/Losses Net Income –Retained Earnings –Dividends

Collateral Determination Credit Analysis Cash Flow Statement Hardest Statement to Falsify –Must Tie to Balance Sheet How Cash is Generated; How it is Utilized How Operations are Financed Focus on Trends

Collateral Determination Credit Analysis Cash Flow Statement Operating Cash Flow –Net Income –Non-Cash Expenses –Changes in Working Capital Items Investing Cash Flow Fixed Asset Purchases/Sales –Securities Purchases/Sales –Financing Cash Flow New Borrowings –Debt Repayments –Dividends –Shareholder Withdrawals

Collateral Determination Credit Analysis Banking Relationships –Debt Secured/Unsecured –Interest Rate –Payback Period –Covenants –Credit Line – Letters of Credit Asset Quality –Accounts Receivable –Inventory –Intangibles Litigation/Contingencies Subsequent Events Environmental Exposure Sales Backlog Significant Customers/Suppliers Off Balance Sheet Transactions –Affiliates –Officers –Guaranties Accounting Methodologies –Inventory –Depreciation –Bad Debt Allowance –Managing Results Footnotes

Collateral Determination Credit Analysi s Liquidity –Current Ratio Current Assets/Current Liabilities –Quick Ratio –Working Capital Solvency –Debt/Equity –Long -Term Debt/Equity Profitability –Operating Income/Sales –Net Income/Sales Cash Flow –Time Interest Earned –Debt Service Coverage Ratios

Collateral Determination Credit Analysis L OW H IGH ? Undesirable Desirable ? L OW H IGH UNDERWRITING RISK FINANCIAL RISK

Collateral Determination Credit Analysis Consistent Methodology Over Time Establish Collateral Requirement –Amount Equal to Loss Exposure Surcharge Discount Why?

Collateral Determination Credit Analysis – Carrier Rating Credit rating and unsecured balance varies by Insurance Carrier NUMERICAL RATING QUALITY RATING COLLATERAL ADJUSTMENT 5100EXCELLENTDISCOUNT24 Months Paid Losses 490GOODDISCOUNT12 Months Paid Losses 380FAIRNONE100% of Financial Exposure 270POORSURCHARGE100%+ to Aggregate 160REJECT

Collateral Documentation Security Agreements –Language Requirements Clean, Irrevocable, Evergreen –Benefits Clients Who Have Provided Collateral Events of Default Remedies –Documents collateral review timing and minimum parameters

Deductible Programs Deductible Reimbursement Claimants/ State Carrier Insured Credit Risk Evidence of Coverage

Deductible Programs with Captive Reimbursement Insured Insurance Company TPA 3.I NSURED Contracts with Captive via deductible reimbursement policy Transfer deductible obligation for a premium *Captive * Insurance Company has no contractual relationship with the Captive Insurance Company allows TPA to manage and pay claims Obligated for Insureds losses within the deductible Credit exposure for Insureds losses within the deductible Collateral required to secure future obligations 2.I NSURANCE C OMPANY Issues deductible policy to Insured Requires an Indemnity Agreement from Insured and collateral for deductible obligation I NSURED Pays Insurance Company premium for large deductible program Promises to reimburse for losses 1.I NSURANCE C OMPANY

Recent Collateral Developments Letters of credit are more desired by insurers than ever. Alternative collateral instruments have been less frequently and less favorably accepted in the last 12 months. Insurance Companies in general have increased the surcharge (provided less unsecured credit) for trusts and accept bonds on a very limited basis. Select Insurance Companies are having capacity issues with select banks. List of acceptable banks are dwindling due to rating downgrades and consolidations. Unencumbered verifiable asset-backed letters of credit capacity is available.

Pros Most preferred vehicle Clean, irrevocable, evergreen Statutory acceptance Allows for cash flow friendly approach Easy to administer Cons Reduces borrowing capacity High opportunity and actual cost (especially post 2008) Nonworking form of collateral Concentration risk – Financial Institution rating Pros Same as cash Investment income inures to client Replacement for LC Standardized agreements Cons Some carriers will not accept a working trust that pays claims as billed; some will not accept a nonworking trust Not considered bankruptcy remote Limited investment options Pros Investment income potential Eliminates need for LC Acts as collateral and loss fund Cons Requires significant up-front cash flow Investment rate of return usually lower than clients cost of capital More administration (not preferred form for carriers) Not considered bankruptcy remote Financial Institution rating Pros Does not restrict borrowing or LC capacity May be cheaper than LC fees or opportunity cost of cash collateral Cons Limited carrier acceptance: most will only accept surety for a portion of the collateral requirement Limited number of acceptable sureties Collateral Instrument T RUSTS S URETY C ASH L ETTERS OF C REDIT (LC S )

Investment Considerations M AKING THE R IGHT C HOICE If the captive has a considerable amount of free funds and a longer term investment horizon, then LOC makes more sense. Important that bank is comfortable with underlying collateral and are seen to be in the LOC business for the long term. If a trust is the answer, make sure that excess funds can be withdrawn from the trust effectively.