industry reserve adequacy and other hot topics: financial analyst’s perspectives 1999 casualty...

Industry Reserve Adequacy and Other Industry Reserve Adequacy and Other Hot Topics: Financial Analyst’s Hot Topics: Financial Analyst’s

PerspectivesPerspectives

1999 Casualty Loss Reserve Seminar

Scottsdale, Arizona

1999 CLRS Industry Reserve Adequacy - Financial Analyst's Perspectives

2

PresentersPresenters

Sarah Hibler - Vice President & Senior Analyst, Sarah Hibler - Vice President & Senior Analyst, Moody’s Investors ServiceMoody’s Investors Service

Jay Votta - Principal, Deloitte & Touche LLPJay Votta - Principal, Deloitte & Touche LLP

Bill Wilt - Vice President & Senior Analyst, Bill Wilt - Vice President & Senior Analyst, Moody’s Investors ServiceMoody’s Investors Service


3

Discussion TopicsDiscussion Topics

Overview of Reserve AdequacyOverview of Reserve Adequacy– Results of Moody’s Top 50 AnalysisResults of Moody’s Top 50 Analysis

Use of Reserves in Credit and Equity AnalysisUse of Reserves in Credit and Equity Analysis– Reserves play critical role in gauging financial Reserves play critical role in gauging financial

healthhealth

Reserving Issues in Mergers & AcquisitionsReserving Issues in Mergers & Acquisitions– Reserves key consideration in structuring dealsReserves key consideration in structuring deals


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Goals of SessionGoals of Session

Discuss macro-level trends in loss reservesDiscuss macro-level trends in loss reserves Provide insight into how ‘outsiders’ analyze loss Provide insight into how ‘outsiders’ analyze loss

reservesreserves Demonstrate importance of reserves in different Demonstrate importance of reserves in different

contexts:contexts:– Credit AnalysisCredit Analysis

– Equity AnalysisEquity Analysis

– M&A ActivityM&A Activity


5

Top 50 AnalysisTop 50 Analysis Moody’s Analyzed Top 50 P/C GroupsMoody’s Analyzed Top 50 P/C Groups

– Approx. 2/3 industry reserves and surplusApprox. 2/3 industry reserves and surplus

Used annual statement data and internal reserve Used annual statement data and internal reserve modelmodel– Excluded A&E, reinsurance, miscellaneous linesExcluded A&E, reinsurance, miscellaneous lines

Tested results against independent analyses where Tested results against independent analyses where availableavailable– Despite limitations, A/S data can provide credible Despite limitations, A/S data can provide credible

starting pointstarting point


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Top 50 AnalysisTop 50 Analysis

Benefits of AnalysisBenefits of Analysis– Critical component of capital adequacy and credit Critical component of capital adequacy and credit

analysisanalysis

– Provides greater insight in discussions with companiesProvides greater insight in discussions with companies

– Independent verification of resultsIndependent verification of results

– Insight into developing trends: quality of earnings, Insight into developing trends: quality of earnings, current rate adequacycurrent rate adequacy

– Separate supportable facts from unsubstantiated rumors Separate supportable facts from unsubstantiated rumors in marketin market


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ConclusionsConclusions– Industrywide $12.6 B redundancy at 12/98Industrywide $12.6 B redundancy at 12/98

» Represents abut 4% of Reserves and 4.5% of SurplusRepresents abut 4% of Reserves and 4.5% of Surplus PPA, WC provide redundancies; CMP, OL show PPA, WC provide redundancies; CMP, OL show

deficienciesdeficiencies

– Trends in Reserve Margins are Major StoryTrends in Reserve Margins are Major Story» Margins thinning quicklyMargins thinning quickly

– Differences Between Personal and Commercial Differences Between Personal and Commercial InsurersInsurers

» Whoever heard of a negative loss trend?Whoever heard of a negative loss trend?


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Top 50 Analysis - Personal Lines Writer’s Top 50 Analysis - Personal Lines Writer’s Current PositionCurrent Position

Reserve Adequacy as % of PHS: Personal Writers of Top 50

-45%-30%-15%

0%15%30%45%60%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

Personal Writers

Def

/(Red

) as

% o

f PH

S

Reserve Def/(Red) as % of PHS


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Top 50 Analysis - Retrospective View of PPATop 50 Analysis - Retrospective View of PPA

Industry Aggregate - Personal Auto Liability

-25.0%

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Year End

Adeq

uacy

% o

f Car

ried

Rese

rves

Def/(Red) as % of Carried Reserves


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Findings - Personal InsurersFindings - Personal Insurers– All showed reserve redundanciesAll showed reserve redundancies

– The story then?The story then?» Favorable loss trends early-to-mid 1990sFavorable loss trends early-to-mid 1990s

» Actuaries/management slow to recognize in ratesActuaries/management slow to recognize in rates

– The story now?The story now?» Most carriers reducing rates, dividendsMost carriers reducing rates, dividends

» Loss cost trends ticking upward againLoss cost trends ticking upward again


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Top 50 Analysis - Commercial Writer’s Top 50 Analysis - Commercial Writer’s Current PositionCurrent Position

Reserve Adequacy as % of PHS: Commercial Writers of Top 50

-45%-30%-15%

0%15%30%45%60%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17Commercial Writers

De

f/(R

ed

) a

s %

of

PH

S

Reserve Def/(Red) as % of PHS


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Top 50 Analysis - Retrospective View of Top 50 Analysis - Retrospective View of Reviewed Commercial LinesReviewed Commercial Lines

Industry Aggregate - Commercial Lines Only

-14.0%

-12.0%

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Year End

Adeq

uacy

% o

f Ca

rried

Res

erve

s

Def/(Red) as % of Carried Reserves


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Findings - Commercial InsurersFindings - Commercial Insurers– More even mix of deficiencies and redundanciesMore even mix of deficiencies and redundancies

» WC similarities to PPAWC similarities to PPA

» legislation and rate reform benefits coupled with loss trendslegislation and rate reform benefits coupled with loss trends

» Competition intensifying, loss ratio climbing steadilyCompetition intensifying, loss ratio climbing steadily

– Significant rate pressures all other commercial linesSignificant rate pressures all other commercial lines» Most commercial lines show uniformly increasing loss ratioMost commercial lines show uniformly increasing loss ratio

Diversified InsurersDiversified Insurers– Redundancies outweigh deficienciesRedundancies outweigh deficiencies

» Favorable PPA and WC experience outweighs other linesFavorable PPA and WC experience outweighs other lines


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ConclusionsConclusions– Industry adequately reserved -- for nowIndustry adequately reserved -- for now

– How actuaries can help:How actuaries can help:» Expand statement of opinionExpand statement of opinion

» Include detailed footnotes in Schedule PInclude detailed footnotes in Schedule P

» Expand content of actuarial reports and distribution of reportsExpand content of actuarial reports and distribution of reports

Reserves Used in Variety of Ways by Many Reserves Used in Variety of Ways by Many Constituencies…Think Beyond Statement of Constituencies…Think Beyond Statement of OpinionOpinion


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Industry Reserve Adequacy -- Industry Reserve Adequacy -- Beyond the Statement of OpinionBeyond the Statement of Opinion

Moody’s Approach to Insurance AnalysisMoody’s Approach to Insurance Analysis

Credit vs. Equity AnalysisCredit vs. Equity Analysis


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Industry FundamentalsCompetitive Dynamics

Barriers to EntryRegulation

Market/Product Trends


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Industry FundamentalsCompetitive Dynamics

Barriers to EntryRegulation

Market/Product Trends

Company FundamentalsBusiness Fundamentals Financial Fundamentals

Strategic Focus Investment RiskDistribution Channels Liquidity

Franchise Value Reserve AdequacyManagement Use of ReinsuranceGovernance Profitability

Legal Structure Capitalization & Funding


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Moody’s Approach to Insurance Analysis Moody’s Approach to Insurance Analysis Analytical Approach - BenchmarkAnalytical Approach - Benchmark

Default Probabilities for Selected Time Horizons

0.0000%

0.5000%

1.0000%

1.5000%

2.0000%

2.5000%

3.0000%

3.5000%

4.0000%

Aaa Aa A Baa

Moody's Rating

Pro

bab

ilit

y o

f D

efa

ult

1 Year

5 Years

10 Years

The lowest “Secure” rating has the annual The lowest “Secure” rating has the annual default probability of a “500 Year” eventdefault probability of a “500 Year” event


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Traditional Financial IndicatorsTraditional Financial Indicators– Financial Leverage (Debt/Total Capital)Financial Leverage (Debt/Total Capital)

– Double Leverage (Inv in Subs+Goodwill)/EquityDouble Leverage (Inv in Subs+Goodwill)/Equity

– Fixed Charge Coverage and Cash Flow CoverageFixed Charge Coverage and Cash Flow Coverage

In Context of Underlying Business VolatilityIn Context of Underlying Business Volatility

In Context of Business CycleIn Context of Business Cycle

Does Legal/Regulatory Structure Inhibit Does Legal/Regulatory Structure Inhibit Cash/Capital Flows Across the Group?Cash/Capital Flows Across the Group?


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Moody’s Approach to Insurance AnalysisMoody’s Approach to Insurance Analysis A Practical Reserve Example A Practical Reserve Example

Trustworthy Insurance Company

Total assets 1,500 Financial Leverage 30%Gross Leverage 4.3

Reserves 1,000 Operating Leverage 1.4 Debt 150 Equity 350 Return on Assets 3%

1,500 Return on Equity 14%Return on Premium 10%

Premiums 500 Net Income 50 Combined Ratio 105%

Your typical property/casualty insurerYour typical property/casualty insurer


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Moody’s Approach to Insurance AnalysisMoody’s Approach to Insurance Analysis A Practical Reserve Example A Practical Reserve Example

Assumption: Reserve Charge = 20% of Total Reserves

Before After

Premiums 500 500 Losses & Expenses 525 725 Underwriting Loss (25) (225)

Net Investment Income 112 104

Interest Expense 9 9 Income before Income Taxes 78 (130)

Net Income 50 (84)

Surplus 500 366

Available Dividend Capacity Net Income 50 -

10% of Surplus 50 37


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Credit vs. Equity AnalysisCredit vs. Equity AnalysisWhat Creditors/Policyholders WantWhat Creditors/Policyholders Want

Absolute RepaymentAbsolute Repayment Minimize likelihood of loss of principal; Minimize likelihood of loss of principal;

benchmark is risk-free ratebenchmark is risk-free rate Which translates into:Which translates into:

– Conservative corporate governanceConservative corporate governance

– Prudent capital and financial managementPrudent capital and financial management

– Capital cushionCapital cushion

– Strong earnings and cash flowsStrong earnings and cash flows


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Credit vs. Equity Analysis Credit vs. Equity Analysis What Shareholders WantWhat Shareholders Want

Relative ReturnRelative Return Maximize total return, with acceptable level of Maximize total return, with acceptable level of

risk; benchmark is a market index.risk; benchmark is a market index. Which translates into:Which translates into:

– Assertive corporate governanceAssertive corporate governance

– High capital efficiency, as measured by ROEHigh capital efficiency, as measured by ROE

– Active capital and financial managementActive capital and financial management

– Growth in top and bottom linesGrowth in top and bottom lines

– Strong earnings and cash flowsStrong earnings and cash flows


24

Credit vs. Equity Analysis Credit vs. Equity Analysis Contrasting Analytical StylesContrasting Analytical Styles

Basic MotivationsBasic Motivations– Equity and credit analysts both want to be rightEquity and credit analysts both want to be right

– Credit analysts have pressure from issuers to be more Credit analysts have pressure from issuers to be more liberal and investors to be more conservativeliberal and investors to be more conservative

– Equity analysts can face substantial implied pressure Equity analysts can face substantial implied pressure from issuers from issuers

Inherent BiasInherent Bias– Credit analysts tend to focus on the downside riskCredit analysts tend to focus on the downside risk

– Equity analysts tend to focus on the upside opportunityEquity analysts tend to focus on the upside opportunity


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Credit vs. Equity Analysis Credit vs. Equity Analysis Contrasting Analytical Styles - ExampleContrasting Analytical Styles - Example

-100%

-75%

-50%

-25%

0%

25%

50%

75%

100%

2%

17%

32%

47%

62%

77%

92%

107%

122%

137%

152%

167%

182%

197%

212%

227%

242%

257%

272%

287%

Combined Ratio

Rate

of

Retu

rn

Shareholders Creditors Policyholders

Trustworthy’s creditors/policyholders have NO upsideTrustworthy’s creditors/policyholders have NO upside


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Industry Reserve Adequacy - Beyond The Industry Reserve Adequacy - Beyond The Statement of OpinionStatement of Opinion

Reserving Issues in Mergers and AcquisitionsReserving Issues in Mergers and Acquisitions

– Actuarial Due Diligence ProcessActuarial Due Diligence Process

– Sampling of Solutions to Reserve UncertaintySampling of Solutions to Reserve Uncertainty


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Reserving Issues in M&AReserving Issues in M&AActuarial Due Diligence ProcessActuarial Due Diligence Process

Reserve Position Reserve Position Restatement of Reported ResultsRestatement of Reported Results GAAP AdjustmentsGAAP Adjustments Pro Forma AnalysisPro Forma Analysis Appraisal ValueAppraisal Value


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Actuarial Due Diligence ProcessActuarial Due Diligence ProcessReserve PositionReserve Position

““Windshield” AnalysisWindshield” Analysis Limited ReviewLimited Review

– Business UnitsBusiness Units

– AccessAccess

– TimeTime

Comprehensive AnalysisComprehensive Analysis


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Actuarial Due Diligence ProcessActuarial Due Diligence ProcessRestatement of Reported ResultsRestatement of Reported Results

Source: Consolidated Industry Loss Ratios

Other Liability Workers' CompensationYear CY AY Difference Year CY AY Difference1988 85.5 60.1 -25.4 1988 94.2 94.0 -0.21989 84.1 68.2 -15.9 1989 94.7 95.3 0.61990 82.7 71.7 -11.0 1990 94.6 93.2 -1.41991 78.4 72.2 -6.2 1991 99.3 86.3 -13.01992 103.4 74.7 -28.7 1992 97.1 75.4 -21.71993 95.2 77.5 -17.7 1993 84.0 69.3 -14.71994 97.6 79.9 -17.7 1994 73.4 69.0 -4.41995 110.3 80.5 -29.8 1995 67.7 73.4 5.71996 91.0 80.4 -10.6 1996 69.5 75.7 6.21997 81.4 81.0 -0.4 1997 69.5 78.7 9.2

Personal Auto Liability Medial MalpracticeYear CY AY Difference Year CY AY Difference1988 93.2 90.1 -3.1 1988 106.2 59.6 -46.61989 94.1 91.5 -2.6 1989 73.1 63.3 -9.81990 95.0 89.9 -5.1 1990 86.4 74.2 -12.21991 90.0 83.6 -6.4 1991 83.4 92.5 9.11992 86.3 81.8 -4.5 1992 107.0 99.0 -8.01993 85.4 82.4 -3.0 1993 87.8 104.7 16.91994 83.1 84.2 1.1 1994 77.0 109.2 32.21995 79.7 82.6 2.9 1995 78.9 116.7 37.81996 77.4 82.5 5.1 1996 84.5 114.7 30.21997 74.9 82.3 7.4 1997 83.2 118.0 34.8


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Actuarial Due Diligence ProcessActuarial Due Diligence ProcessGAAP AdjustmentsGAAP Adjustments

AssetsAssets DACDAC Premium DeficienciesPremium Deficiencies Policyholder DividendsPolicyholder Dividends Contingent CommissionsContingent Commissions Salvage & SubrogationSalvage & Subrogation Federal Income TaxesFederal Income Taxes OtherOther Present Value of Future Profits (PVFP)Present Value of Future Profits (PVFP)


31

Actuarial Due Diligence ProcessActuarial Due Diligence ProcessPro Forma AnalysisPro Forma Analysis

Assumptions:Assumptions:– Premium GrowthPremium Growth

– Earnings PatternEarnings Pattern

– Loss RatioLoss Ratio

– Expense RatioExpense Ratio

– Payout PatternsPayout Patterns

– Investment Portfolio MixInvestment Portfolio Mix

– Investment YieldInvestment Yield

– Risk Adjusted Discount RateRisk Adjusted Discount Rate

– Time HorizonTime Horizon


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Actuarial Due Diligence ProcessActuarial Due Diligence ProcessPro Forma AnalysisPro Forma Analysis

Output:Output:– Income Income

– DividendsDividends

– SurplusSurplus

– Cash Flow From OperationsCash Flow From Operations

– ““Value” Value”

– Key Ratios, e.g. RBCKey Ratios, e.g. RBC

Reserving Issues in M&AReserving Issues in M&A

Sampling of Solutions toSampling of Solutions to

Reserve UncertaintyReserve Uncertainty


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Sampling of SolutionsSampling of Solutions

Purchase AccountingPurchase Accounting Retrospective AdjustmentsRetrospective Adjustments ReinsuranceReinsurance Carve OutsCarve Outs OtherOther


35

Purchase AccountingPurchase Accounting

Reserves are increased by seller prior to Reserves are increased by seller prior to transaction datetransaction date– Purchase accounting does not allow acquirer to book Purchase accounting does not allow acquirer to book

additional reservesadditional reserves

– AdvantagesAdvantages» fattens the pig before it goes to marketfattens the pig before it goes to market

– DisadvantagesDisadvantages» depresses surplusdepresses surplus


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Retrospective AdjustmentsRetrospective Adjustments

Future adjustment of sales price based on Future adjustment of sales price based on retrospective reserve estimatesretrospective reserve estimates– Cash settlementsCash settlements

– Portion of sales price held as a note payablePortion of sales price held as a note payable

– Contingent interest dividend paid to stockholdersContingent interest dividend paid to stockholders

– AdvantagesAdvantages» Low transaction costLow transaction cost

– DisadvantagesDisadvantages» UncertaintyUncertainty


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ReinsuranceReinsurance

Stop loss cover provides protection against adverse Stop loss cover provides protection against adverse reserve developmentreserve development– Purchased by sellerPurchased by seller

» internalinternal» externalexternal

– Purchased by acquirerPurchased by acquirer

– AdvantagesAdvantages» alleviates uncertainty associated with reserve developmentalleviates uncertainty associated with reserve development

– DisadvantagesDisadvantages» costcost


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Carve Outs Carve Outs

Segregation of “undesirable” business segments Segregation of “undesirable” business segments and exclusion from transactionand exclusion from transaction– Prior to transactionPrior to transaction

– Post transactionPost transaction

– Strategic motivesStrategic motives

– AdvantagesAdvantages» may be only way to attract buyersmay be only way to attract buyers

– DisadvantagesDisadvantages» seller may retain unwanted businessseller may retain unwanted business

» Regulatory scrutinyRegulatory scrutiny

industry reserve adequacy and other hot topics: financial analyst’s perspectives 1999 casualty...

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