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Finite Risk in 2003

Times Change, Yet Fundamentals Remain The

Same2003 Seminar On Reinsurance2003 Seminar On Reinsurance

Presented byPresented byDavid Koegel, ACAS, MAAADavid Koegel, ACAS, MAAA

Enterprise Advisors/Imagine GroupEnterprise Advisors/Imagine Group

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Finite Risk Reinsurance Contracts

Usually “retrospectively rated” with contractual adjustments based on experience - premium adjustments (e.g., additional premiums, premium refunds) - coverage adjustments in subsequent years (e.g., retention

increases, dual triggers)

Normally contemplate the time value of money in pricing

Always contain aggregate limits of liability

Ordinarily transfer enough risk to satisfy FAS 113

Frequently cover multiple years and different insurance risk classes/lines of business

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Finite Reinsurance Spectrum

FORMAT- Aggregate Excess Loss- Loss Portfolio Transfer- Quota Share

FINITE SOLUTIONS

RISKS

TIME DIMENSION

- Retrospective- Prospective

FUNDING

- Pre-funded - Post-funded

- Underwriting - Credit

- Timing - Interest rate

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Lower costs in exchange for the client’s Lower costs in exchange for the client’s increased participation in ultimate lossesincreased participation in ultimate losses

Accelerate recognition of equity in loss reservesAccelerate recognition of equity in loss reserves

Reduce leverage ratios (NPW/PHS, Net Reduce leverage ratios (NPW/PHS, Net Liabilities/PHS) to more acceptable levelsLiabilities/PHS) to more acceptable levels

Stabilize unforeseen fluctuations in earningsStabilize unforeseen fluctuations in earnings

Improve reserve adequacy for long tail businessImprove reserve adequacy for long tail business

Narrow the gap between cost of capital and ROENarrow the gap between cost of capital and ROE

Finite solutions address specific client needs not typically provided by the traditional reinsurance market

Finite Risk Needs

5

-5%

0%

5%

10%

15%

20%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

ROE Cost of Capital

ROE vs. Cost of Capital: U.S. P/C Insurance: 1991 – 2002

Source: The Geneva Association, Ins. Information Inst.

Large gap between industry cost of capital & rate of return

14.6

pts

10.2

pts

US P/C insurers averaged 6.9 points of shortfall in return relative to cost

of capital since 1991

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Industry IssuesWorkers’ Compensation

Increasing cost driven by rising medical care and wage loss payments not fully offset by declining claim frequency

Leading cause of U.S. insurer failures in 2002 as 15 of the 39 companies that failed primarily wrote WC line of business

Since the 9-11-01 (previous to which terrorism coverage was virtually free of charge) prices have risen as insurers now monitor catastrophe exposures more carefully

RMS estimates that a major San Francisco earthquake today could cause 78,000 injuries, 5,000 deaths & over $7 billion in WC losses

Residual markets in 38 states and D.C. remain a significant percentage of the total workers compensation market

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Industry Issues

Medical Malpractice

Growing losses with declining investment income widens the gap between revenues and claims

Rising claim frequency & severity, higher urban area incidences and soaring defense costs have precipitated rate increases

More expensive reinsurance further strains insurers' net income

Reduction in supply of coverage drives prices up further as insurers exit the profit elusive medical malpractice business

Cap on non-economic damages of $250,000 in California since 1975 has losses are more predictable and stabilized rates

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Industry Issues

Liability Insurance and Excess Casualty MarketsLiability Insurance and Excess Casualty Markets

New and existing liability challenges are putting American businesses New and existing liability challenges are putting American businesses and their insurers under tremendous pressureand their insurers under tremendous pressure

Cost of insuring corporate America is increasing with the rising tide Cost of insuring corporate America is increasing with the rising tide of lawsuits from Enron to asbestos and mold to medical malpracticeof lawsuits from Enron to asbestos and mold to medical malpractice

On average, cost of the U.S. tort system consumed 2% of GDP On average, cost of the U.S. tort system consumed 2% of GDP annually since 1990, expected to rise to 2.4% by 2005annually since 1990, expected to rise to 2.4% by 2005

Loss trend in excess layers is 3 times the ground-up trend and nearly Loss trend in excess layers is 3 times the ground-up trend and nearly 10 times the primary trend10 times the primary trend

Other difficult issues continue to plaque the industry such as Other difficult issues continue to plaque the industry such as construction defects, EPL, rising jury awards and terrorismconstruction defects, EPL, rising jury awards and terrorism

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Finite Reinsurance

Sample Transactions

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Sample Transaction #1 - (Workers’ Compensation)

Primary Objective: Lowering CostSolution Maintain current retention & limits.

Increase DP from $6M to $9.6M.

Reduce Reinsurer’s Margin slightly to $1.4M (15% of DP).

Increase percentage refund from years 3-7 after inception such that the net “rate on line” is reduced to 12%-35% during that time period.

In exchange for reducing the reinsurer’s downside insurance risk by $3.6M, PIC has potential for cost savings up to $3.3M.

SituationPEO Ins. Co (“PIC”) has the following workers compensation reinsurance program:

Coverage = $9.5M xs of $0.5M each and every loss; aggregate limit = $12M.

Deposit Premium = $6M.

Reinsurer’s Margin = $1.5M (25% of DP).

“Rate on Line” = 40%-50% after experience refund upon commutation, the percentage of which varies from years 3-7 after inception.

PIC seeks to reduce cost in exchange for reducing reinsurer’s downside insurance risk exposure.

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Sample Transaction #1 - (Workers’ Compensation)

Primary Objective: Lowering CostDeposit

PremiumReinsurers

MarginNet DepositPremium

Existing 6,000,000 1,500,000 4,500,000Proposed 9,600,000 1,440,000 8,160,000

3 4 5 6 7 8

Existing 27.5% 17.5% 12.5% 7.5% 0.0% 0.0%

Proposed 100.0% 95.5% 88.0% 80.5% 73.0% 65.5%

3 4 5 6 7 8

Existing 4,762,500 5,212,500 5,437,500 5,662,500 6,000,000 6,000,000

Proposed 1,440,000 1,807,200 2,419,200 3,031,200 3,643,200 4,255,200

3 4 5 6 7 8

Existing 40% 43% 45% 47% 50% 50%

Proposed 12% 15% 20% 25% 30% 35%

3 4 5 6 7 8

$ 3,322,500 3,405,300 3,018,300 2,631,300 2,356,800 1,744,800

% 70% 65% 56% 46% 39% 29%

"Rate-on-Line" at end of year:

Savings at end of year:

% Prem. Refund upon Commutation by end of year:

Cost to Reinsured (no loss scenario) at end of year:

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SituationNewDocs Ins. Co. (“NDIC”) is confident their Loss Ratio will not exceed 70% after reflecting time value of money imbedded their long-tail reserves for the current accident year. NDIC believes regulators will allow reserve discounting, but not before five years of operating experience.

Their current year forecast is as follows:Subject Net Earned Premium = $50M.Ultimate Loss & LAE Ratio = 85% ($42.5M).

NDIC seeks an aggregate cover, on a funds withheld basis, that will reduce it’s reported Loss Ratio up to 15%, at a cost not > $1M. NDIC is open to structure protections that contain the reinsurer’s downside risk so long as reinsurance accounting is granted

Solution Aggregate excess of loss coverage

attaching at a level below forecast.Limit = $14M.Retention = $30M (60% LR).Premium = $10M on a funds withheld basis accruing interest at 6% per year.Reinsurer’s Margin = $1M.

Structure protections include: (i) reduced reinsurer’s share if UNL in excess of Retention > Limit; (b) cap on claims contributing to subject UNL; (c) adjustments to coverage if credit covenants breached; (d) financial incentives to commute; (e) offset.

NDIC & local regulator flexibility can facilitate cost effective coverage not otherwise available for less troubled lines of business.

Sample Transaction #2 - (Medical Malpractice) Primary Objective: Recognizing Reserve Equity

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SituationLong-Tail Lines Ins. Co. (“LTLIC”) has unacceptably high premium & reserves to surplus ratios. LTLIC has thought about purchasing a finite cover in the past but the need to reduce underwriting leverage wasn’t as great as is currently.

Their current year forecast is as follows:

Subject Net Earned Premium = $150M.Ultimate Loss & LAE Ratio = 100%.Net Written Premium/Surplus = 3:1.Net Reserves/Surplus = 7:1.

LTLIC seeks a quota share or aggregate excess of loss cover to significantly reduce it’s net leverage ratios.

Sample Transaction #3 - (Liability & Excess Casualty)

Primary Objective: Reducing Leverage RatiosSolution Split layer aggregate excess of loss

coverageLayer A = 30% xs 70% LRLayer B = 30% p/o 50% xs of 100% LRPremium = 30% of SNEP = $45MCeding Commission = 10% at 95% or greater LR, sliding to 20% at 85% LRReinsurer’s Margin = 5% of Ceded Premium = $2.25M

Alternative structure considered is a quota share with 2nd layer in excess of a retained loss ratio corridor above expected.

LTLIC’s leverage ratios can drop to 1.9:1 & 5.6:1, respectively, freeing up capacity to write new targeted business.

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60%

70% Loss Ratio

100% Loss Ratio ($150M)

30% of top layer in 1st 100% LR

(30% xs 70% LR)

70% LTLIC ($105M)

30% Reinsurer ($45M)

70% LTLIC ($52.5M)

30

% R

ein

su

rer

($2

2.5

M)

150% Loss Ratio ($225M)

30% part of 50% ($75M) xs

of 100% LR

Assumptions:

SNEP = $150M; Reserves = $350M; PHS = $50M

Estimated Ultimate Loss Ratio = 100% ($150M)

Proposed Terms:

Ceded Premium = 30% SNEP = $45M

Ceding Commission = 10% ($4.5M) at 95% LR or greater, sliding to 20% ($9M) at an 85% LR

Limit = 150% ({30%+15%}/30%) of Ceded Premium = $67.5M

Margin = 5% of Ceded Premium = $2.25M

Reinsured Layers

Layer B

Layer A

Sample Transaction #3 - (Liability & Excess Casualty)

Primary Objective: Reducing Leverage Ratios

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Dave Koegel

The Imagine Group

Enterprise Advisors, Inc.

One Liberty Plaza, 6th Floor

New York, NY 10006

Phone: 212-707-0823

Fax: 212-707-0801

E-mail: dkoegel@imagine.bm

Web Site: www.theimaginegroup.com

Speaker Contact Information