The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary in Identifying and Helping Mitigate Financial Risk Both on the Balance Sheet and in Underwriting and Financial Considerations Presented at the Casualty Loss Reserve Seminar By: Presented at the Casualty Loss Reserve Seminar By: Ronald T. Kuehn, FCAS, MAAA, CPCU, ARM, FCA Consulting Actuary September 12, 2005 Ronald T. Kuehn, FCAS, MAAA, CPCU, ARM, FCA Consulting Actuary September 12,

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary Items Covered DDR Reserve Asset Liability Matching/Cash Flow Testing/Discounting Reinsurance Issues Risk Transfer Cost of Reinsurance Collectibility Items Covered DDR Reserve Asset Liability Matching/Cash Flow Testing/Discounting Reinsurance Issues Risk Transfer Cost of Reinsurance Collectibility 2 2

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary DDR Reserve Free tail for death disability and retirement Started in early 1980’s when insurers stopped offering occurrence policies Originally held as loss or unearned premium reserve Currently must be disclosed in opinion and displayed in Exhibit B DDR Reserve Free tail for death disability and retirement Started in early 1980’s when insurers stopped offering occurrence policies Originally held as loss or unearned premium reserve Currently must be disclosed in opinion and displayed in Exhibit B 3 3

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary DDR Reserve Items Required to Compute DDR Reserve (per insured) Age Policy Inception Date Premium Also need withdrawal rates by age, assumed retirement age, and decrement (death and disability) tables DDR Reserve Items Required to Compute DDR Reserve (per insured) Age Policy Inception Date Premium Also need withdrawal rates by age, assumed retirement age, and decrement (death and disability) tables 4 4

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary DDR Reserve NAIC Accounting Practices and Procedures Manual “Reserve is required to assure that amounts collected by insurers to pay for these benefits are not earned prematurely and that an insurer with an aging book of business will not show adverse operating results simply because an increasing portion of insureds is earning the benefits for which it has paid” DDR Reserve NAIC Accounting Practices and Procedures Manual “Reserve is required to assure that amounts collected by insurers to pay for these benefits are not earned prematurely and that an insurer with an aging book of business will not show adverse operating results simply because an increasing portion of insureds is earning the benefits for which it has paid” 5 5

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary DDR Reserve- Steps in Modeling Accrued Liability 1. Develop current cost of tail benefit, adjusted for population 2. Project cost by multiplying by annual growth in premiums 3. Compute present value of step 2 at entry age based on mortality, interest and withdrawal 4. Compute present value of step 2 at attained age based on mortality, interest and withdrawal 5. Compute annuity factor from attained age to retirement, based on premium growth, mortality and withdrawal 1. Develop current cost of tail benefit, adjusted for population 2. Project cost by multiplying by annual growth in premiums 3. Compute present value of step 2 at entry age based on mortality, interest and withdrawal 4. Compute present value of step 2 at attained age based on mortality, interest and withdrawal 5. Compute annuity factor from attained age to retirement, based on premium growth, mortality and withdrawal 6 6

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary DDR Reserve- Steps in Modeling Accrued Liability (cont.) 6. Compute annuity factor from entry age to retirement, based on premium growth, mortality and withdrawal 7. EANC equals step (3) divided by step (5) 8. Normal cost at attained age equals step (7) times growth in premium between entry and attained ages 9. Accrued liability equals step (4) minus [ step (8) times step (6) ] 10. Term cost equals probability of death or disability times step (1) 6. Compute annuity factor from entry age to retirement, based on premium growth, mortality and withdrawal 7. EANC equals step (3) divided by step (5) 8. Normal cost at attained age equals step (7) times growth in premium between entry and attained ages 9. Accrued liability equals step (4) minus [ step (8) times step (6) ] 10. Term cost equals probability of death or disability times step (1) 7 7

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary DDR Reserve-Entry Age Normal Funding EANC- Level percent of future malpractice premiums (from physician’s original date of insurance) equal to present value of projected retirement benefits Accrued Liability-Present value of future projected retirement benefits less present value of future normal costs Term Cost- Cost of providing benefit to the insureds who die or become disabled during the current year DDR Reserve-Entry Age Normal Funding EANC- Level percent of future malpractice premiums (from physician’s original date of insurance) equal to present value of projected retirement benefits Accrued Liability-Present value of future projected retirement benefits less present value of future normal costs Term Cost- Cost of providing benefit to the insureds who die or become disabled during the current year 8 8

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary DDR Accrued Liability Comparison 9 9

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary Asset Liability Matching /Cash Flow Testing Actuaries currently do not generally have to perform cash flow testing and asset liability matching calculations In the future, actuaries may be much more involved in cash flow testing and asset liability matching Asset Liability Matching /Cash Flow Testing Actuaries currently do not generally have to perform cash flow testing and asset liability matching calculations In the future, actuaries may be much more involved in cash flow testing and asset liability matching 10

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary Asset Liability Matching /Cash Flow Testing New Bermuda Requirements for Opinion Letter and Discounting Company can hold discounted reserves Loss Reserve Specialist (actuary) cannot assume a discount rate but decline responsibility for the rate LRS cannot advise that assets have not been reviewed, since assets affect the choice of discount rate Amount must be set aside for variations in ultimate losses, payment dates and interest rates LRS must include statement that assumptions are appropriate (Note: The Bermuda Registrar of Companies has not yet implemented these requirements) Asset Liability Matching /Cash Flow Testing New Bermuda Requirements for Opinion Letter and Discounting Company can hold discounted reserves Loss Reserve Specialist (actuary) cannot assume a discount rate but decline responsibility for the rate LRS cannot advise that assets have not been reviewed, since assets affect the choice of discount rate Amount must be set aside for variations in ultimate losses, payment dates and interest rates LRS must include statement that assumptions are appropriate (Note: The Bermuda Registrar of Companies has not yet implemented these requirements) 11

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary Asset Liability Matching /Cash Flow Testing Data Needed for Asset- Liability Cash Flow Modeling Payment Pattern Estimate of Ultimate Loss (and ALAE) Allocation of Invested Assets Used to Meet Liabilities Assumed Interest Rate and Borrowing Rate Asset Liability Matching /Cash Flow Testing Data Needed for Asset- Liability Cash Flow Modeling Payment Pattern Estimate of Ultimate Loss (and ALAE) Allocation of Invested Assets Used to Meet Liabilities Assumed Interest Rate and Borrowing Rate 12

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary Asset Liability Matching /Cash Flow Testing 13

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary Asset Liability Matching /Cash Flow Testing 14

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary Asset Liability Matching /Cash Flow Testing 15

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary Asset Liability Matching /Cash Flow Testing Value of Asset Liability Testing Determine if assets and liabilities are properly matched Determine if borrowing is needed Enable readjustment of invested assets Show true cost of payment of liabilities Asset Liability Matching /Cash Flow Testing Value of Asset Liability Testing Determine if assets and liabilities are properly matched Determine if borrowing is needed Enable readjustment of invested assets Show true cost of payment of liabilities 16

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary Reinsurance Issues Model Construction and Data Needed to Analyze a Reinsurance Treaty Copy of the treaty Clear understanding of treaty terms Subject premium, ceded premium Projected total and ceded losses Understanding of cash flows, inner aggregates, etc. under the treaty Reinsurance Issues Model Construction and Data Needed to Analyze a Reinsurance Treaty Copy of the treaty Clear understanding of treaty terms Subject premium, ceded premium Projected total and ceded losses Understanding of cash flows, inner aggregates, etc. under the treaty 17

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary Reinsurance Issues Modeling Expected Cash Flows Under Reinsurance Treaty Reinsurance Issues Modeling Expected Cash Flows Under Reinsurance Treaty Need to generate number of paid claims by year For each claim, generate a “loss” based on historic severities Pay out loss according to assumed pattern Sum (and limit, if necessary) all losses for each year Rank yearly results to compute confidence intervals Need to generate number of paid claims by year For each claim, generate a “loss” based on historic severities Pay out loss according to assumed pattern Sum (and limit, if necessary) all losses for each year Rank yearly results to compute confidence intervals 18

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary Reinsurance Issues Reinsurance Risk Transfer Analysis Compute discounted value of cash inflows and outflows Treaty must provide for significant probability of significant loss to reinsurer (amounts not specified) If contract does not meet required criteria, actuary should discuss with management whether proposal should be accepted Reinsurance Issues Reinsurance Risk Transfer Analysis Compute discounted value of cash inflows and outflows Treaty must provide for significant probability of significant loss to reinsurer (amounts not specified) If contract does not meet required criteria, actuary should discuss with management whether proposal should be accepted 19

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary Reinsurance Issues Expected PV of Cash Flows Under Reinsurance Treaty ($000) Reinsurance Issues Expected PV of Cash Flows Under Reinsurance Treaty ($000) YearPV Amount 14,700 2(1,800) 3(1,300) 4-end(1,300) Total Cash Flows300 Premium Ceded5,000 Net Cost of Reins6.0% 20

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary Reinsurance Issues Net Cost of Reinsurance Difference between ceded premium and ultimate ceded loss (and LAE, if applicable) on a present value basis, divided by premiums ceded Ceded losses may be estimated directly or as difference of gross and net Actuary can show management if ceding certain losses is profitable or is accomplished at relatively low cost. If not, management may want to commute the treaty. Reinsurance Issues Net Cost of Reinsurance Difference between ceded premium and ultimate ceded loss (and LAE, if applicable) on a present value basis, divided by premiums ceded Ceded losses may be estimated directly or as difference of gross and net Actuary can show management if ceding certain losses is profitable or is accomplished at relatively low cost. If not, management may want to commute the treaty. 21

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary Reinsurance Issues Treaty Prob. of Reins Loss Loss to Reinsurer Proj. Net Cost of Reins. A10%5%3.0% B10%15%3.0% C10%20%4.5% D10%25%7.0% 22

The Reserving Actuary’s Role in Risk Assessment: Value Added by the Reserving Actuary Reinsurance Issues-Recoverability Determine Best’s rating of company’s reinsurers Discuss collectibility problems with management May need to perform additional investigation if any reinsurers are in financial difficulty and may not be able to meet obligations Reinsurance Issues-Recoverability Determine Best’s rating of company’s reinsurers Discuss collectibility problems with management May need to perform additional investigation if any reinsurers are in financial difficulty and may not be able to meet obligations 23