Funding Framework for Maturing Public Entity Pools Association of Governmental Risk Pools 2012 Institute for Management & Leadership

PwC Financial Expectations of Pools Have Matured 20+ Years Ago Functioning program addressing availability and affordability crisis Adequacy of funding levels was a secondary concern Current Environment External and internal scrutiny of funding levels Pools expected to deliver stable and competitive rates - Surplus required to support this strategy Members have their own financial demands –Want rate relief/dividends Reassessments not a viable funding option 2

PwC Funding Minimums versus Funding Targets Funding Minimum Regulatory Threshold –IRIS Ratios –Risk Based Capital (RBC) Runoff/Liquidation Perspective Funding Target Capital requirement to support program risk –All financial risks –Current and prospective Ongoing concern perspective 3 Regulation developed in context of having sufficient resources left in a troubled company to rehabilitate or liquidate

PwC Illustrative Funding Framework for Pools

PwC Regulatory Minimum (Point of Failure) Three Situations 1.Regulation exists –Point of failure defined 2.No regulation –Surplus becoming negative may indicate failure 3.Cash call is a viable and accepted business strategy –Point of failure does not exist

PwC Target Funding Range Target operating range for surplus Minimum and maximum –Based on risk and risk tolerance Why a range versus singular point? Core goal is rate stability In delivering stable rates, costs fluctuate and so surplus fluctuates Range allows fluctuation so core goal can be met

PwC Above or Below Target Funding Range Surplus above target range Rate relief, distributions, etc. Surplus below target range Adopt rate strategies to increase surplus Reduce risk of program (lower SIR) 4 4

PwC Current Situation with Pools Need to assess funding adequacy Look to insurance industry for perspective Find regulatory thresholds Result is a perception of excess surplus which leads to: 1.Inappropriate funding decisions 2.Inability to respond to scrutiny 8

PwC Common Pool Solvency Measures The “Confidence Level” Incomplete measurement of program risk –Historical unpaid claims only Misleading - Percentage scale - Generally misunderstood by stakeholders Not used in broader insurance marketplace Made sense in the context of pooling when use started More of a “minimum” than a “target” 9

PwC Common Pool Solvency Measures Risk-Based Capital Regulatory Tool –Developed for a specific context –Not “capital based on risk” Formula approach –Assumes risk categories are similar across industry Surplus levels 10 times RBC levels are common 10 “…will not compute the precise amount of capital an insurer needs to maintain in a competitive, dynamic and uncertain marketplace.”

PwC Common Pool Solvency Measures Benchmark Financial Ratios Dependent on benchmark values Issues –Variation in business models –“Cash call” viability –Risk differences –Excess versus primary –Tort caps 11 The concept of a “one size fits all” set of pool financial ratios to define funding targets is flawed as it is not an “apples to apples” comparison.

PwC Use of Capital Modeling to Develop Funding Targets ProfileCase Study Example Annual Contribution$11 million Liability Retention$1.5 million Property Retention$250 thousand Number of Members25 Primary ExposureAuto liability 12

PwC Process 1.Target Funding Statement 2.Review ALL major risks facing the pool 3.Review the pool’s own risk profile coverage, retention, risk management program, etc in contrast to formula approach 4.Risk Aggregation reflecting correlation 13 Business Model Risk Capital Requirements

PwC Target Funding Statement “We would like to have enough fund to protect our members from a 1-in-100 to 1-in-200 year event in the next year, under the current retention or the $5m liability retention” Indicator What are we measuring? (all options eventually come back to fund level) Severity What is the tolerable level of this selected “indicator”? Frequency What is the tolerable frequency that the selected indicator hits the selected severity Time Horizon What time horizon is the fund supposed to protect? Extremity 14

PwC Major Risk Categories What could deteriorate the current fund level? Most of the asset and liability items are variable, as well as the profitability of the next year’s business, putting the total fund value at risk. AssetLiability + Fund County Investment Pool$27.5mUnpaid Reserves$10.9m Reinsurance recoverable$0.7mOther Liabilities$0.3m Other current assets$0.3mTOTAL LIABILITIES$11.2m Non-current assets$0.4m Equity in reinsurer$1.2mTOTAL FUND$18.9m TOTAL ASSET$30.1m 15

PwC Major Risk Categories Underwriting Risk that the next year’s business result may deviate from plan Catastrophic events Systemic losses Reinsurance cost Market cycle Price inadequacy, etc. Reserving Risk that the eventual loss & expense may exceed booked reserves Excessive inflation Judicial environment on certain claim types Latent claims, etc. Asset & Credit Risk that the value of investment asset and receivables may decrease County Investment Pool – exposed to interest rate risk and default risk Reinsurer failure Operational Any other unplanned expense that may arise from operation External events such as an earthquake People related (turn over, fraud, reputational) System and process failure, etc. Simulation based approach using historical data Stress scenario test approach based on discussions 16

PwC Underwriting Risk – Auto Liability Example Observations: Reinsurance program reduces the volatility greatly. The result is validated through the pool’s historical experience. 17

PwC Reserving Risk – Auto Liability Example 18 Observations: The familiar concept of “Confidence Level” in reserve variability Reviewed reserve variability from known (reported) claims vs. unknown (pure IBNR) claims separately

PwC Asset Risk County investment pool is with governmental and municipal bonds, which are subject to interest rate risk. Given the history of the treasury rates, the year-on-year interest rate increases were: Based on the bond asset amount, reserve amount and net asset duration, loss of value at the following scenarios is estimated at: Treasury Bond1-in-101-in-201-in-501-in-1001-in-200* 3 year bond 1.48% 1.79% 1.93% 2.47% 2.74% 1-in-101-in-201-in-501-in-1001-in-200 Loss of Bond Value$1.1m$1.4m$1.6m$1.9m$2.1m 19

PwC Credit Risk The reinsurer relationship has risk, from various aspects. If the financial strength of reinsurer weakens, the following elements are at risk. 1.Reinsurance recoverable: $0.7M 2.Current year transferred risk provision: $1.2M 3.The equity investment: $1.2M 4.Need to purchase reinsurance from another reinsurer in stressed situation: $2.2M for full year Using the default probability distribution by insurer’s rating [based on AM Best publications], the distribution of the fund need related to the reinsurer relationship is estimated to be: 1-in-101-in-201-in-501-in-1001-in-200 Reinsurer Risk$0.8m$1.0m$1.4m$1.6m$1.8m Observation: All reinsurance relationships have some element of risk, but the risk will vary depending on the financial strength. 20

PwC Operational Risk Typically something not intended or budgeted for and hard to quantify due to lack of historical data. Low Frequency / High Impact:  MANAGE or PROTECT WITH SURPLUS High Frequency / High Impact:  ACTIVELY MITIGATE & MANAGE Low Frequency / Low Impact:  Pay as it happens High Frequency / Low Impact:  Budget for it Impact Frequency 21

PwC Operational Risk Focused on high impact & low frequency items People related: Fraud, turnover System: Failure of software vendor, hacking leading to impaired privacy External events: Natural disaster leading to power outage, damage to the office building and infra-structure CategoryStress Scenarios$ Impact People  Fraud by accountant, taking balance of the account out [1-in-50?]  Fraud by claimant [1-in-10?] $250k $100k System  Software vendor failure leading to purchase of new software, extensive conversion work, and training [1-in- 20?]  Privacy impaired, needing to send out notice [1-in-20?] $500k $250 per record External Events  Magnitude 7 earthquake, causing damages to the pool property and business interruption [1-in-50] $250k 22

PwC Risk Aggregation Once all the individual risks are quantified, We don’t simply sum across these numbers to get overall funding need, because this assumes that all those events are occurring at the same time (100% correlated), which is an unduly pessimistic assumption. Developed a correlation structure (between lines of business, and between risk categories, etc.) to reflect diversification and aggregated the funding level across those components. ALGL APD UnderwritingReservingAsset & CreditOperational Int. rate Count er- party Equity Extern al SystemPeople Total Funding Need PR ALGL APDPR 23

PwC High Level Study Result – Target Funding Range 24

PwC Issues Addressed Capital Requirements –Proper perspective for board –Target to manage program Better decision making –Can we entertain a higher SIR? Which coverage? –Is the Pool in a position to add members or a coverage? –Investment mix change? Respond to Potential Scrutiny –Internal –External 25

PwC What should pools do? Step 1: Clarity on your business model 26 Risk Cash Call Risk SurplusCash Call Risk Surplus or Pooling industry timeline “Mutual Insurance Company” model – Adequate surplus is critical “Group Self-Insurance” model – Surplus level is not that important

PwC What should pools do? Step 2: Evaluate your financial metrics Is your funding policy: –Consistent with the business model? –Regularly updated or validated? Funding targets defined? Prepared to provide an effective response to inquiries over funding levels? 27

PwC What should pools do? Step 3: Adopt a risk-based decision framework Rate level decisions consistent with funding objectives? Appropriate levels of reinsurance? Impact of change in investment mix? Cost/benefit of “A rated” reinsurer versus “B rated” option? Is the pool operating efficiently? 28 Informed decisions require information

Funding Framework for Maturing Public Entity Pools Whitepaper on pool solvency metrics available at: For further discussion regarding pool solvency measures and framework, please contact: Kevin L. Wick, FCAS, MAAAHyeji Kang, FCAS Martin Ménard, FCAS, MAAA Managing DirectorDirectorDirector +1 (206) (312) (802) This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. © 2012 PricewaterhouseCoopers LLP. All rights reserved. In this document, “PwC” refers to PricewaterhouseCoopers LLP which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.