CAS Exam 7 Notes - Part 3 Annual Statement

Transcription

1 CAS Exam 7 Notes - Part 3 Annual Statement

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3 Contents NAIC Annual Statement 1 Gorvett et al.: Data sources Feldblum: Insurance Expense Exhibit Feldblum: Schedule P Feldblum: Schedule F Feldblum: Notes to the financial statements Feldblum: Statutory surplus - Computation, pricing, and valuation IASA - Ch. 2: Assets IASA - Ch. 5: Other liabilities, capital and surplus IASA - Ch. 8: Other expenses IASA - Ch. 9: Investment income IASA - Ch. 10: Other income and direct charges and credits to surplus Additional Notes

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5 Gorvett et al.: Data sources NAIC Annual Statement Each insurance company file an Annual Statement with the insurance department of each state within which the company is licensed to do business Due date: March 1 of the year following the operating year Primary source of regulatory information, and prepared under SAP Important components of the Annual Statement Title page (page 1) - Identifies the company, address, state of domicile, officers, directors, and other administrative information Balance sheet (pages 2 and 3) - Lists the assets (page 2) and the liabilities and surplus accounts (page 3) of the insurer, as of the end of the operating (generally calendar) year Income statement (page 4) - Shows the statutory income earned during the year. Premiums, losses, and investment income are identified in broad, general categories Statement of cash flows (page 5) - Cash movements during the year. Identifies cash flows resulting from premiums collected, losses paid, expenses paid, and investments Underwriting and Investment Exhibit - Multi-part exhibit with greater details, regarding: Interest, dividends, and real estate income Capital gains Premiums written and earned, by line of business Losses paid and incurred, by line of business Expenses Analysis and Reconciliation of Assets - Shows changes in asset categories during year Five-Year Historical Data - Provides historical data for each of the following: Gross and net written premiums, by line of business categories Underwriting and investment income, policyholder dividends, and taxes Various balance sheet items (e.g., admitted assets, losses, UEPR) Asset allocations by investment category Capital and surplus accounts Gross and net losses paid Various operating ratios One- and two-year loss development Schedule A - Shows real estate acquired/sold during year, real estate owned at year-end Schedule D - Shows activities in bonds and common stocks during the year, and the holdings in each at the end of the year. Bonds are listed separately, and summarized by Type - governments, political subdivisions, etc... Quality (classes 1 through 6) Maturity distribution - five categories: maturing < 1yr, 1-5yr, 5-10yr, 10-20yr, 20+yr Schedule F - Shows amount of ceded reinsurance, by assuming reinsurer. Documents sources/amounts of assumed reinsurance, and funds held on account of unauthorized reinsurance Schedule P - Only data in the Statement that is configured on an AY basis. Ten years of information are included for each major line of business category, including: Direct and assumed, ceded, and net earned premiums Direct/assumed and ceded loss payments Direct/assumed and ceded allocated loss adjustment expense payments Salvage and subrogation received Unallocated loss adjustment expense payments Losses and allocated loss adjustment expenses unpaid On a case basis (direct/assumed and ceded) Bulk and IBNR (direct/assumed and ceded) Unallocated loss adjustment expenses unpaid 1

6 In addition, various loss development triangles are provided for the major line of business categories. Ten-year triangles (on a net basis) are provided for total incurred losses and allocated loss adjustment expenses, cumulative paid loss and ALAE, and bulk and IBNR reserves Schedule T - Shows direct premiums and losses by state Insurance Expense Exhibit - Premiums, losses, and expenses allocated to statutory LOBs Statement of Actuarial Opinion Document in which a qualified actuary, generally appointed by a company s board of directors, opines on the company s loss and loss adjustment expense reserves, including Scope paragraph that identifies the subjects being opined upon Opinion paragraph in which the actuary expresses an opinion on those subjects One or more relevant comments paragraphs that permit the actuary if necessary, to qualify or explain the opinion, e.g. collectibility of reinsurance, discounting,... Important piece of information for regulators A. M. Best Collects, compiles, and publishes information for property-liability and life insurance industries Promulgates ratings estimating insurer s ability to meet its future obligations to its p/h A. M. Best produces a number of different statistical compilations and other publications, including: Aggregates and Averages Annual publication provides aggregate industry financial values, both current and historical Specific sections of the publication include consolidated industry information, historical time series of important financial and operating results, performance measures by line of business, and summaries of results for the leading P&C companies Insurance Reports Annual volume providing summary reports on P&C insurers, with current and some historical financial and operating information on both an individual company and a group basis Includes description of Best s rating system, list of companies by location (city/state), list of companies that changed names/retired (voluntarily or involuntarily) recently The summary report on each company includes the rationale for the current Best s rating and a five-year history of ratings and key financial indicators, a review and description of the company s business and operations, and a summary of recent financial performance Best s rating process Results in two distinct ratings Best s Rating Opinion of a company s financial strength, operating performance, and market profile Based on both quantitative and qualitative evaluations Includes secure ratings (A++ through B+), and vulnerable ratings (B and below) Financial Performance Rating Financial and operating evaluation Based primarily on a quantitative analysis Ratings range from FPR 9 (very strong) to FPR 5 (good) in the secure category, and FPR 4 (fair) to FPR 1 (poor) in the vulnerable category The quantitative tests can be categorized into three groups Profitability tests - E.g., combined ratio, operating ratio, change in surplus Leverage tests - E.g., premium-to-surplus ratio, liabilities-to-surplus ratio Liquidity tests - E.g., net cash flow, agents balances to surplus The qualitative evaluation includes the following five areas: (i) spread of risk, (ii) adequacy and soundness of reinsurance, (iii) quality and estimated market value of assets, (iv) adequacy of loss reserves, and (v) management 2

7 Standard & Poor s Provides evaluations and ratings on the claims paying ability of P&C insurance companies For each company rated, on a scale of AAA to CCC, S&P provides a corporate summary, including A rationale for the rating A review of the company s business A summary of management and corporate strategy A summary of historical operating performance Descriptions of the company s underwriting, investments, capital, liquidity, and reinsurance Other sources of insurance industry data ISO Provides actuarial and statistical services and information to the P&C industry Ratemaking information (such as loss costs) for a particular line and in a particular state Research reports which compile and analyze information with regard to important topics Risk/return and profitability of the industry Projecting and financing catastrophic risks Personal auto insurance profitability and costs Legal defense costs Health care costs NCCI Insurance advisory organization Focuses its efforts and services on workers compensation Publishes articles and perspectives on the workers compensation industry and environment RAA P&C reinsurance trade association Work with state and federal authorities Produces periodic reports regarding reinsurance data, including historical reinsurance loss development study, and annual reinsurance underwriting review GAAP Financial Statements Publicly traded insurers are required to file a variety of reports with the SEC These include an annual report to shareholders, and a yearly Form 10-K Reports prepared on a GAAP basis, interesting complement to statutory filings Other sources of information Sources of general business and economic information are becoming critical for actuaries because: Operating environment is now multinational Insurer performance is linked to economic and financial conditions Ratemaking is taking on a total rate of return perspective Broad planning perspective provided by dynamic financial analysis Some such sources include the following: Wall Street Journal Ibbotson Associates - Stocks, Bonds, Bills and Inflation Yearbook provides long-run historical information on interest rates, inflation, and equity market performance, useful for analyzing long-term financial trends and the correlations between financial variables Commercial forecasting services Academic publications Internet-based sources The Casualty Actuarial Society Web Site FRED (Federal Reserve Economic Data) database Web Site U.S. Census Bureau Web Site State insurance department Web Sites 3

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9 Feldblum: Insurance Expense Exhibit Introduction The Insurance Expense Exhibit (IEE), filed by April 1 as a supplement to the statutory Annual Statement, provides additional information All revenues/expenditures, whether or not associated w/ particular policies, allocated to LOBs Various sets of operating returns are calculated, so that profitability by LOB may be measured Expense allocation may be complicated, but it is not conceptually difficult Investment income allocation, however, particularly when used to measure the total return by LOB, requires subjective assumptions How should surplus be allocated to LOBs? Should investment returns on p/h supplied funds differ from those on capital/surplus funds? How should p/h supplied funds be defined? The structure of the IEE The structure of the IEE is as follows Part I - Allocation to expense groups Part II - Allocation to LOBs net of reinsurance Part III - Allocation to lines of direct business written Part I of the IEE divides expenses along two dimensions Expense classification - Advertising, rent, salaries, or equipment Expense groups - LAE, other underwriting expenses, investment expenses The IEE has a more refined division of other underwriting expenses into Acquisition, filed supervision, and collection expenses General expenses Taxes, licenses and fees Part II shows allocation of all revenues and expenditures to LOBs, net of reinsurance Part III shows similar allocation for direct business, except that investment income is not included In Parts II and III, LOBs are shown along the vertical axis (rows), and revenue and expenditure categories are shown along the horizontal axis (columns) Decimal point in IEE LOB indicates that finer breakdown is being used than in the UIE IEE Part II - Allocation to LOBs net of reinsurance Allocation of investment income by line of business The purpose of Part II is to allocate elements of total profit (or loss) net of reinsurance to LOBs Three levels of the allocation procedure Conceptual - The philosophy underlying the allocation procedure Components - The insurance elements comprising the allocation formula, as well as the adjustments made to several of these elements Data - The data sources for the elements of the allocation formula Conceptual level The allocation of investment income to LOBs in the IEE rests upon three principles Investment income is allocated to each LOB in proportion to the investable funds associated with each LOB. Investable funds consist of Funds attributable to insurance transactions Funds attributable to capital and surplus Funds attributable to insurance transactions are loss reserves plus UPR minus prepaid expenses and minus uncollected premiums Capital/surplus funds allocated to LOB in proportion to total reserves plus EP for the year Component level The allocation procedure uses the following principles to derive the items in the conceptual level 5

10 For balance sheet items, the averages of the current year-end values and prior year-end values are used. These balance sheet items are (aka mean surplus, mean reserves,... ): Net loss and LAE reserves Net unearned premium reserves (UPR) Net agent s balances Policyholder surplus Prepaid expenses, or acquisition expenses, are Commission and brokerage expenses incurred Taxes, licenses, and fees incurred Other acquisition, field supervision, and collection expenses incurred One half (1/2) of general expenses incurred Net investment gain or loss is composed of Net investment earned Net realized capital gains or losses It does not include unrealized capital gains or losses The allocation 1) Allocate the company s mean surplus to LOB in proportion to: Mean net L&LAE reserves + Mean net UPR + EP for the year UPR not adjusted for agent s balances/prepaid expenses, in this part of allocation procedure. UPR represent amount insurer is required to hold, not amount of investable funds derived from premiums 2) Determine the company s overall investment gain ratio as: Net investment gain (Mean net L&LAE reserves + Mean net UPR - Mean net agent s balances + Mean p/h surplus) Net investment gain (or loss) is composed of net investment income earned and net realized capital gains or losses. It does not include unrealized capital gains or losses Agent s balances are a component of WP and therefore of UPR. But agent s balances are not an investable asset Subtracted from UPR in determining investment gain ratio SAP: Prepaid expenses = expenditure, not asset. Prepaid expenses reduce p/h surplus Already subtracted from investable assets in denominator of investment gain ratio In this part of the formula, reserves, agent s balances, and surplus are for all lines combined 3) For each LOB, the investment gain on funds attributable to insurance transactions (Col 18) = [company s investment gain ratio] [funds attributable to insurance transactions] for that LOB Funds attributable to insurance transactions = Mean net L&LAE reserves + Mean net UPR [1 - (Prepaid expenses / WP)] - Mean net agent s balances Prepaid expenses are funded from surplus since the full (gross) UPR must be held as a liability Ratio of prepaid expenses to WP shows % of each premium dollar funded from surplus The mean net UPR are therefore multiplied by the complement of this ratio 4) For each LOB, investment attributable to capital and surplus (Col 20) = [Total investment gain for that LOB] minus [investment gain on funds attributable to insurance transactions] Total investment gain for that LOB = [company s investment gain ratio] [investable funds associated with that LOB] Investable funds associated with that LOB equal that LOB s: Mean net L&LAE reserves + Mean net UPR - Mean net agent s balances + Mean p/h surplus Data level All the data elements for the allocation of investment income to LOB are taken from the Annual Statement or from prior columns of the IEE 1. Net loss and LAE reserves - Taken from AS pg. 11, UIE, Part 3A, Col 5, net losses unpaid excluding LAE, plus Col 6, unpaid LAE. Mean determined by averaging current/prior AS 2. Net unearned premium reserves - Taken from AS pg. 9, UIE, Part 2A, Col 5, total reserve for unearned premium. Mean value is determined by averaging amounts in current/prior AS 6

11 3. Net prepaid expenses - Determined from the prior columns in Part II of the IEE as Net prepaid expenses = (Col 12 + Col 13 + Col /2 Col 15) 4. Net agent s balances - For all lines combined, taken from AS pg. 2. By LOB, taken from Col 11 of Part II of the IEE. Mean determined by averaging current/prior AS and IEE 5. Written and earned premiums - NWP taken from Col 1 of Part II and net EP from Col 2 6. Mean p/h surplus - For all lines combined, avg of Cols 1 and 2 on line 26 of AS pg Policyholders surplus ratio - Defined as the ratio of surplus to the sum of loss reserves, UPR, and annual EP: PHS ratio = PHS tot (LR tot + UPR tot + EP tot ) 8. Surplus allocated to each LOB - Determined as product of [surplus ratio] and [sum of loss reserves, UPR, and annual EP] for that LOB: PHS lob = PHS ratio (LR lob + UPR lob + EP lob ) 9. Net investment gain - Taken from AS pg. 4, Statement of Income, line 9A, net investment gain or loss. It is the sum of line 8 ( net investment income earned, or interest, dividends, and rent) and line 9 ( realized capital gains or losses ) 10. Investment gain ratio - Defined as the investment gain divided by investable assets IGR = IG (LR tot + UPR tot + PHS tot - AB tot ) 11. Investment gain by LOB on funds attributable to insurance transactions - (Col 18) IG it = IGR {LR lob + UPR lob [1-(PPE lob /WP lob )] - AB lob } 12. Investment gain by LOB attributable to capital and surplus - (Col 20) IG cs = [IGR (LR lob + UPR lob + PHS lob - AB lob )] - IG it The 1992 revisions Before 1992, there was a separate capital and surplus account, similar to a line of business The investment income attributable to capital and surplus was not allocated to LOBs In 1992, the separate capital and surplus account was removed, and the investment income attributable to capital and surplus is allocated to LOBs Before 1992, the investment income allocated to LOBs reflected primarily bond returns, not common stock dividends or capital gains Thus, the investment yield on funds attributable to capital and surplus differed from the investment yield on funds attributable to insurance transactions In 1992, stock dividends and realized capital gains are treated as other investment income, so the difference in investment yields has been eliminated More funds are attributable to insurance transactions in 1992 and subsequent IEE than were attributed to policyholders in the pre-1992 IEE Profit or loss Part II of the IEE shows three columns of profit or loss Col 17 - Pre-tax profit or loss excluding all investment gain Col 19 - Profit or loss excluding investment gain attributable to capital and surplus Col 21 - Total profit or loss All 3 columns are pre-federal income tax, though pre-tax caption appears only in Col 17 The profit or loss equals revenues minus expenditures, on an accrual (not paid) basis Col 1 WP on paid basis. Col 2 EP on accrual basis. EP not WP used in calculation Cols 7-10, the loss reserves, LAE reserves, and UPR are liabilities, not expenditures. Col 11 Agents balances = asset, not revenue item. Cols 7-11 do not enter calculation Col 16, other income, is a revenue item. Cols 3-6 (policy benefits, losses incurred, LAE incurred, and p/h dividends) and are expenditure items Enter calculation The formula for Col 17 is therefore Col 17 = Cols Investment income is a revenue item Col 19 equals Col 17 + Col 18 Col 21 equals Col 19 + Col 20 7

12 Allocation procedures - An illustration 1. Allocation of surplus to lines of business Workers Comp Other Liability Figures in Millions Agents balances, 12/31/9X Earned Premium, year ending 12/31/9X Loss and LAE reserves, 12/31/9X 1,400 1, Unearned premium reserves, 12/31/9X In this allocation, there is no adjustment of the UPR for agent s balances or for prepaid expenses Mean surplus is the average of the 12/31/95 and the 12/31/96 surplus Mean Surplus = ($500M + $700M) 2 = $600M Mean surplus is used because investment income is earned over the course of the year Mean reserves also used for loss, LAE and unearned premium. 96 EP is used, not the avg. WC: Sum of mean res. and ann. EP = (1, ,700)/2 + ( )/ = $2,100M OL: Sum of mean reserves and annual EP = ( )/2 + ( )/ = $900M Mean surplus allocated to WC = (600) 2,100/(2, ) = $420M Mean surplus allocated to OL = (600) 900/(2, ) = $180M 2. Investment gain ratio Investment income and surplus ($Millions) Net investment income, year ending 12/31/9X Realized capital gains, year ending 12/31/9X Unrealized capital gains, year ending 12/31/9X Policyholders surplus, year ending 12/31/9X Net investment gain for 96 is used, not the average of 95 and 96 It consists of net investment income earned and net realized capital gains Does not include unrealized capital gains/losses Net investment gain = = $300M Reserves/agent s balances/surplus figures needed for company as a whole, not for each LOB Mean net loss and LAE reserves = (1, , )/2 = $2,150M Mean net unearned premium reserves = ( )/2 = $200M Mean net agents balances = ( )/2 = $50M Mean policyholders surplus = ( )/2 = $600M The investment gain ratio is then $300M / ($2,150M + $200M - $50M + $600M) = 10.34% 3. Prepaid ( acquisition ) expenses Workers Comp Other Liability Figures in Millions Written premium, year ending 12/31/9X Commission & brokerage, year ending 12/31/9X Taxes, licenses & fees, year ending 12/31/9X Other acquisition expenses, year ending 12/31/9X General expenses, year ending 12/31/9X For prepaid expenses, we use the 96 figures, not the average of 95 and 96 For WC, prepaid expenses = /2 = $100M For OL, prepaid expenses = /2 = $50M The prepaid expense ratio is prepaid expenses divided by WP, not EP, because acquisition expenses, u/w expenses, and premium taxes all relate to WP, not to EP 4. Investment gain on funds attributable to insurance transactions For each LOB, investment gain on funds attributable to insurance transactions = [company s investment gain ratio] [funds attributable to insurance transactions] for that LOB Prepaid expenses adjustment to mean net UPR Prepaid expenses are $100M for WC and $50M for OL The 1996 WP is $500M for WC and $200 for OL 8

13 The prepaid expenses adjustment factor is [1 - (prepaid expenses)/wp] The prepaid expenses adjustment factor is 80% for WC and 75% for OL For WC, the funds attributable to insurance transactions are (1, ,700)/2 + ( )/2 80% - ( )/2 = $1,590M For OL, the funds attributable to insurance transactions are ( )/2 + ( )/2 75% - ( )/2 = $665M The investment gain on funds attributable to insurance transactions is therefore 10.34% $1,590M = $165M for WC 10.34% $665M = $69M for OL 5. Investment gain attributable to capital and surplus For each LOB, investment gain attributable to capital and surplus (Col 20) = [Total investment gain for that LOB] minus [investment gain on funds attributable to insurance transactions] Total investment gain for the LOB = [company s investment gain ratio] [investable funds associated with the LOB] Distinction between investable funds attributable to insurance operations and investable funds associated with the LOB The former has an adjustment for prepaid ( acquisition ) expenses The latter includes surplus allocated to LOB Since prepaid expenses are already deducted from surplus, there is no deduction for prepaid expenses from the UPR in the investable funds associated with the LOB For WC, the investable funds associated with the LOB are (1, ,700)/2 + ( )/2 - ( )/ = $2,030M For OL, the investable funds associated with the LOB are ( )/2 + ( )/2 - ( )/ = $870M The total investment gain by LOB are 10.34% $2,030M = $210M for WC 10.34% $870M = $90M for OL The investment gain attributable to capital and surplus are then $210M - $165M = $45M for WC $90M - $69M = $21M for OL Part III - Allocation to lines of direct business written The purpose of Part III is to allocate elements of profit (or loss) on a direct basis to LOBs. Part III simulates what the results would be without reflecting the effect of reinsurance Two differences with Part II Because most Annual Statement exhibits show net experience, not direct experience, there are few direct cross-checks from Part III of the IEE to the Annual Statement Because investment income relates to net experience, not to direct experience, there are no investment income columns in Part III of the IEE Profit or loss Part III shows only u/w gain/loss, Col 17 - Pre-tax profit or loss excluding all investment gain Column 17 of Part III is calculated in the same fashion as Column 17 of Part II: revenues minus expenditures, on an accrual basis Pre 1992, Part III used to show a theoretical investment income figure for direct business. Such figures are not included in the current IEE The measurement of profitability Prospective versus retrospective Profitability measurement mostly deals with the pricing of insurance products Pricing is fundamentally a prospective task The IEE, in contrast, is a retrospective measure of insurance profitability 9

14 Allocation of surplus The allocation of surplus is the first step in the IEE allocation of investment income. It is also an essential component of financial pricing models for insurance products The retrospective surplus allocation procedure begins with the company s actual surplus and proceeds to subdivide it by LOB. One of two methods is used for this allocation i) Allocation by leverage ratios, such as premium to surplus or reserves to surplus ratios ii) Allocation by relative risk of each LOB, quantified by volatility of each LOB s LR The IEE uses leverage ratios Some analysts have opined that reserve leverage ratios may serve as a proxy for risk. I.e., the slow-paying lines, such as PL or MedMal, are also the more risky lines This reasoning is specious: Some high risk lines are fast paying (property insurance in CAT regions), and some slow paying lines are low risk lines (WC pension claims) The prospective surplus assumptions used for pricing generally proceeds in one of two manners i) The needed surplus is determined for each LOB independently of the surplus required for other LOBs or of the overall surplus needs of the insurance company. This needed surplus is calculated by consideration of the line s volatility in conjunction with selected calibration yardsticks, such as probability of ruin or expected p/h deficit ii) The insurance industry as a whole is assumed to be neither over-capitalized nor undercapitalized. The overall industry capital would be allocated to LOBs, by means of leverage ratios or relative risk measures. Once the appropriate leverage ratio is determined for any given LOB, any particular company s needed capital is determined from this leverage ratio This assumption is justified by the efficiency of capital markets and the competitiveness of the insurance product markets Differs from former procedure in that leverage ratios/relative risk measures are calibrated to achieve existing industry surplus for all LOBs combined Reserve run-off versus new business To accurately set rates, the pricing actuary must estimate the amount of investment income to be earned for each dollar of new business However, reserves considered by pricing actuary are not reserves held by company. Rather, they are anticipated reserves that will be held in the future for each dollar of new business The IEE, in contrast, has a retrospective measurement of profitability. The investment income that is allocated is the investment income that is actually earned on the assets supporting the held reserves in each LOB The difference between the two approaches is the clearest when the company grows or declines in a LOB. For the steady state company, the IEE information can be used in rate setting One is tempted to say that the IEE and the pricing actuary are addressing different questions and therefore come up with different answers This explanation is incorrect The IEE aims to compute the total profit or loss in each LOB In theory, one should compute this figure by using discounted reserves For prospective ratemaking, one would use anticipated losses discounted at an expected interest rate or investment yield For retrospective profitability measurement, one would use actual losses discounted at market interest rates or current investment yields In theory, Column 19 of Part II - Profit or loss excluding investment gain attributable to capital and surplus - should be computed by using discounted loss costs In practice, the IEE uses investment income on funds attributable to insurance transactions as a proxy for the amount of discount This procedure is reasonable for companies in a steady state It is misleading when a company grows or declines significantly in a particular LOB 10

15 Insurance returns and investment returns A traditional insurance industry practice is to divide a company s operational results into underwriting income and investment income Underwriting income that takes no account of the time value of money does not properly measure the profitability of insurance operations The IEE rectifies this problem by allocating the investment income earned by the company to LOBs. In doing so, it must consider what investment income to allocate There are three interlocking components of this issue i) What portion of the company s investment income should be considered when measuring the return on insurance operations?. IEE procedure addresses this by considering separately The investment income on funds attributable to insurance transactions The investment income attributable to capital and surplus ii) Which investable assets should be associated with funds attributable to insurance transactions and which investable assets should be associated with capital and surplus? There is a common view that loss reserves and UPR should be supported by fixed income securities, such as bonds/mortgages, because of relative safety of these instruments Capital and surplus, however, may be supported by common stock and other equities (real estate) because of higher yields afforded by these financial instruments The current IEE does away with this differentiation. The aforementioned common view is only one investment strategy, not necessarily the optimal one. It is not the place of the IEE to prescribe/presume of the investment strategies of companies iii) What investment returns should be allocated to the insurance operations? One may answer the last question in several ways i) Allocate all investment income ii) Differentiate by type of investment income Unrealized capital gains/losses are not included in the IEE allocation The theoretical justification is that unrealized capital gains represent unanticipated and random market movements that do not reflect the company s investment strategy However, the realization of capital gains is often driven by federal income tax considerations or by short-term needs for cash In fact, inclusion of only realized capital gains often distorts profitability measurements The reason for the exclusion of unrealized capital gains from the allocation of investment income in the IEE is that unrealized capital gains and losses are a direct credit or charge to surplus. They do not flow through the statutory income statement, just as they do not flow through the GAAP income statement and they are not included in taxable income iii) Allocate risk-free investment income An approach that is gaining significant acceptance in the actuarial community is that only a risk-free investment return should be ascribed to underwriting operations In this approach, investment income allocated to LOBs does not depend on type of assets owned by company or on investment performance of company s securities Rather, all investable assets would be assigned a risk-free rate of return for the purpose of allocating investment income to LOBs Remaining investment income stems from the performance of the investment department; it has nothing to do with the total return associated with the insurance operations Perspectives on the IEE procedures IEE allocation procedures to be treated with caution: Useful for some purposes but not for others... both from regulator s/insurer s point of view, financial results shown in IEE for various LOBs cannot/should not be used to measure whether rates are adequate or excessive Nor should the IEE figures be used to determine if the capital used to support a line of business is earning a satisfactory return... 11

16 ... a regulated enterprise has a right to the opportunity to earn an adequate rate of return. However, the right to an adequate rate of return does not extend to all individual services provided by the regulated entity but rather applies to the enterprise as a whole... An independent measure of the return of personal auto and homeowners is not useful to the company because the financial results of personal auto and homeowners are dependent on each other The rate of return for the entire enterprise is the appropriate consideration from both the regulator s and company s point of view in many important applications. Therefore, it must be recognized that an allocation of surplus to the various lines of business may be arbitrary... according to the new IEE, since the underwriting and investment income is allocated based on national surplus, the loss of surplus caused by Hurricane Andrew will cause the profitability of automobile insurance in Massachusetts to improve 12

17 Feldblum: Schedule P Introduction Purposes of the schedule Regulator s major tool to monitor company solvency and safeguard the public trust Designed to measure loss and LAE reserve adequacy, both retrospectively and prospectively Displays triangles of losses/claims/premiums, showing observed development over past 10 years Structure Part 1 is a detailed view of the company s current reserve structure, showing gross and ceded reserves by LOBs and type of reserve (loss vs. expense, case vs. bulk) on an AY basis Part 2 provides a retrospective test, by AY and LOB, of reserves held in past years Loss triangles in Part 2-6 provide data for several prospective tests of reserve adequacy Part 3 displays paid loss triangles The difference between Parts 2 and 4 provides reported loss triangles Part 5 shows claim count figures Part 6 shows premium triangles Other purposes Payments/reserves for L&LAE by LOB/AY Isolates business with good/poor experience AY figures show effects of changes in loss reserve margins on the CY results of the AS Provides loss payment patterns for IRS discounting and provides disclosures needed to gross up losses for interest discounts and for anticipated salvage and subrogation Provides data for computing RBC reserving/wp risk charges and provides the loss payment patterns for the investment income offset in the formula Shows % of premiums and losses associated with loss-sensitive contracts for the RBC offset. Shows the sensitivity of premiums and reinsurance commissions to losses on these contracts Separates occurrence from claims-made for the RBC claims-made offset Supports Appointed Actuary s opinion on L&LAE reserve adequacy Shows development of exposure year premiums from audits and retro adjustments More accurate comparison of LR by AY and info to determine the tax basis EP for such LOBs Shows direct plus assumed vs. ceded experience Examine effects of reinsurance on AY LRs Shows claim count development patterns and changes in average claim severity by year Better analysis of claims dept. performance Not limited to solvency regulation and tax filings. Used to estimate a company s net worth Experience Long-tailed (casualty) lines show the 10 most recent AY plus a prior years row A. Homeowners/Farmowners B. Private Passenger Auto Liability/Medical C. Commercial Auto/Truck Liability/Medical D. Workers Compensation E. Commercial Multiple Peril F. Medical Malpractice (occurrence in 1, claims-made in 2) G. Special Liability (Ocean Marine, Aircraft, Boiler & Machinery) H. Other Liability (occurrence in 1, claims-made in 2) M. International R. Products Liability (occurrence in 1, claims-made in 2) The short-tailed (first party property) lines show the two most recent AY and a prior years row I. Special Property (Fire, Allied Lines, Inland Marine, Earthquake, Glass, Burglary & Theft) J. Auto Physical Damage K. Fidelity / Surety L. Other (Credit, Accident and Health) S. Financial Guaranty / Mortgage Guaranty 13

18 Summary exhibits The summary exhibits show 10 AY and a prior years row for all LOBS combined. Ten AY and a prior years row must be kept for all LOBs IRIS tests (retro/prospective tests of reserve adequacy) are based on the Part 2 summary The Schedule P exhibits Structure Part 1 shows cumulative experience by AY at the statement date Most of the figures in Part 1 are audited by an independent CPA SAO should reconcile to Part 1 Parts 2-6 show the supporting historical triangles Parts 2-5 are cumulative AY data Part 6 is cumulative exposure year data, which is the premium equivalent of AY L&LAE Part 7 policy year exhibits are not intended to support the Part 1 information CY premiums in Part 1, Cols 1-3, are not changed for subsequent earned but unbilled premiums or accrued retrospective premiums. Losses/expenses in subsequent columns are cumulative AY figures Prior years rows CY EP are not shown for prior years row in Part 1 (cells are crossed out). Exposure year EP in Part 6 prior years row reflect current CY contributions to old exposure years Part 1 prior years row: Loss/expense payments and S&S reimbursements are those made in most recent CY Not a cumulative amount. Same procedure used for exposure year EP in Part 6 For the Part 3 prior years row, the loss and expense payments are those made since January 1 of the second calendar year shown along the column headings The unpaid L&LAE reserves in the prior years rows are the reserves for old AY evaluated at The current statement date for Part 1 At each December 31 for Parts 2 and 4 At each December 31 for outstanding claims in Part 5 Reported/closed claim triangles in Part 5 use Part 3 format, not the Part 1/6 format Data types Part 1: Separately for direct & assumed and for ceded Judge effect of reinsurance recoverables The net LR is influenced by the reinsurance market at the current time: In soft reinsurance markets, the net LR appears better than in hard markets The direct & assumed LR reflects the quality of the primary s book of business Good predictor of both the direct and net LRs in future years Parts 2-4: Net losses plus DCC expenses. No corresponding triangles for direct business Part 5: Claim count triangles for direct & assumed. No corresponding triangles for net or ceded Part 6: Historical development of direct & assumed exposure year EP ( 1) and of ceded exposure year EP ( 2). A net triangle can be formed by subtraction Part 7: Policy year EP, losses and reinsurance commissions for loss-sensitive contracts LAE are divided between defense and cost containment (DCC) and adjusting and other (AAO) Historical loss triangles for direct & assumed business can be formed by joining the Part 1 exhibits from successive years. However, changes in intercompany pooling agreements and discrepancies between the Schedule P exhibits of different years distort these triangles Part 1 - Current valuation Premiums Part 1 premiums are recorded by CY. Once entered, they are frozen, and not adjusted for subsequent earned but unbilled premiums (from exposure audits) or accrued retro premiums Illustration An insurance Co. issues retro rated WC. Worse than expected adverse development raises the loss figures and the associated premiums at subsequent valuations 14

19 The additional losses are assigned to the appropriate AY in Parts 1-4 In Part 1, the additional premiums received are assigned to the current CY, not the years when policies were issued or the premium was earned Part 1 shows overstated LRs for the year when the losses occurred and understated LRs for the year in which the additional premiums are billed In Part 1, the prior years row shows payment made or received in the current year, or reserves held on open cases as of the statement date No figures are shown for premiums on the prior years row since current CY adjustments do not affect previous CY premiums Loss and loss expense payments Cols 4-11 show loss and LAE payments by AY For the individual AY, these are cumulative payments For the prior years row, the payments are those made in the current CY only Salvage and subrogation (S&S) received Col 4 (direct & assumed loss payments) and Col 5 (ceded loss payments) are net of S&S Col 10 (S&S received) is for information only. Not used to calculate other cols Col 11 (total net paid) equals Cols Calendar year reconciliation Schedule P, Part 1, shows cumulative paid losses by AY. The Underwriting and Investment Exhibit (UIE), Part 3, shows paid losses in the most recent CY The Annual Statement cross-checks determine the calendar year paid losses from figures in current/previous Schedule P, and compare with UIE The CY payments for loss plus DCC can be derived from Part 3 of the current Schedule P. Part 3 of the UIE shows pure loss payments, without DCC Loss adjustment expenses Before 1998, LAE were divided between ALAE and ULAE ALAE were expenses related to particular claims, e.g. legal fees paid to outside counsel ULAE were expenses not related to individual claims, e.g. rent, utilities, overhead costs For pricing, most companies include ALAE with losses. ULAE included as a loading The expenses included in ALAE and ULAE differed somewhat by company Difficulties for bureau ratemaking and for accounting supervision 90s: Rating bureaus & NCCI, began standardizing the coding of ALAE vs. ULAE DCC and AAO - Principles Three principles govern the 1998 definitions of LAE Classification by type of expense, regardless of relating to specific claims Classification uniform for all companies. No discretion permitted for classifying LAE The new definitions divide expenses into two groups: (i) Expenses that vary with the amount of loss are DCC, and (ii) Expenses that vary with the number of claims, or which do not vary with either amounts of loss/number of claims are AAO The first two principles take precedence if they conflict with the third principle Sch. P interrogatory 2 requires the company to acknowledge using new definitions DCC: Legal defense fees, cost of expert witnesses, and fees to defend claims AAO: Adjustor s fees, general claim dept. overhead not grouped into DCC category (rent) Declaratory judgment actions Before codification, 3 views regarding allocation of DJA attorney fees 1. Companies pay these legal defense costs to absolve themselves of liability. Legal defense costs coded as ALAE Same coding should be used for DJA 2. DJA costs are related not to the defense of claim, but to the determination of coverage Similar to other adjusting costs and should be coded as ULAE 3. DJA costs not related to claims but to policy interpretation Coded as general expenses 15

20 Of the three (ALAE, ULAE, general expenses), only ALAE affects the IRIS adverse loss reserves development tests, since only ALAE is included in Schedule P, Part 2, summary Under view 1, DJA were unanticipated costs and adverse development was large Under the revised NAIC definitions of LAE, DJA costs are coded as AAO Distribution of AAO AAO in Cols 8-9 are claims dept. overhead/salaries. Assigned to AY by formula Schedule P contains cols for direct plus assumed and for ceded AAO. AAO rarely ceded in reinsurance since they cannot be easily measured/associated with individual losses Distinction between direct plus assumed and ceded applies only to AY 1997 and subsequent. Prior to AY 1997, net AAO shown as direct plus assumed Previous statutory procedure - for CY before 1997 The ULAE payments paid during the most recent CY should be distributed to the various years in which losses were incurred as follows (1) 45% to the most recent year (2) 5% to the next most recent year (3) Balance to all years (incl. most recent) losses paid for each AY during most recent CY If the distribution in (1) or (2) produces an accumulated distribution to each year in excess of 10% of the EP for such years, disregarding all distributions made under (3), such accumulated distribution should be limited to 10% of EP and the balance distributed according to (3) The assumptions underlying this procedure are 50% ULAE incurred when claim reported, 50% when claim settled 90% of claims reported during year accident occurred, 10% reported following year Limitations of the previous procedure 45%+ ULAE assigned to most recent AY Too high for lines with long lags Assumed 50% AAO amount of loss settlement, but many AAO components (setting up claim files) more closely related to number of claims than to size of loss Revised method The AAO payments and reserves should be allocated to the years in which the losses were incurred based on the number of claims reported, closed, and outstanding in those years When allocating AAO between companies in a group/pool, AAO should be allocated in the same % used for the loss amounts and claim counts, and then allocated to AY For reinsurers, AAO assumed should be reported according to the reinsurance contract For AAO incurred by reinsurers, or when suitable claim count information is not available, AAO should be allocated by a reasonable method The method alluded to is preferred but not mandatory Illustration of revised method Distribute AAO to AY in 3 steps Dollar amount by type of claims depend on time period of sample and subsequently increase with inflation. Convert dollar amounts to relativities not affected by inflation Compile the number of claims reported, outstanding, and closed with and without payments by AY from Schedule P, Part 5 Distribute CY AAO payments to AY by claim counts weighted with relativities Relativities - Denoting cost of maintaining an o/s claim through end of the year as 1 AAO unit, restate cost of closing without payment (e.g. 2 units), cost of closing with payment (e.g. 3 units) and cost of reporting a claim (e.g. 4 units) Claim history Schedule P, Part 5, shows three types of cumulative AY direct plus assumed claim count triangles: (i) Closed with payment, (ii) Outstanding, and (iii) Reported A triangle of claims closed without payment may be formed by subtraction Closed w/out payment = Reported - Outstanding - Closed w/ payment 16

21 The Schedule P shows cumulative claim counts, but incremental CY counts are needed for distributing AAO. The incremental counts are the difference between the two last diagonal except for the prior years row which is already an incremental count Distribution AAO distribution by AY distribution of weighted claims by AY Weighted claims = (reported counts) (reporting relativity) + (closed w/ pay counts) (closed w/ pay relativity) + (closed w/out pay counts) (closed w/out pay relativity) + (outstanding counts) (outstanding relativity) Sch. P requires cumulative figures Need to add cumulative AAO payments from previous Sch. P to results of current allocation, except for prior years row Old statutory method based on number of claims reported, closed and o/s. However, makes assumption that 50% of AAO is paid when claim is reported and 50% of AAO paid when loss is paid. Current procedure no longer requires this assumption Claim counts Column 12 shows the number of claims reported on direct and assumed business. The LOBs may be grouped into 3 categories for claim count coding: Reported claim counts for 9 LOBs: HO, PPA, CA, WC, CMP, OL, MedMal, APD and PL. For these lines, claims o/s are in Col 25 and claims closed w/ and w/out pay in Part 3 The remaining primary LOBs show the number of claims outstanding in Col 25, but they need not show the reported/closed claims The non-proportional reinsurance lines (A, B, and C) need not show any claim counts. Claim counts are difficult to assign to non-proportional reinsurance: A large claim may reverberate through several excess reinsurance layers. Rules for the percentage of a claim shown by each reinsurer would be arbitrary An aggregate retention in XOL would cause reinsurance recoverable stemming from the complete book of business No claim count Average claim severities Claim count information can be used in several ways: Cumulative losses paid cumulative claims closed with pay Avg. paid claim cost Cumulative losses reported (claims closed with pay + outstanding claims) Avg. incurred claim cost for non-frivolous claims Outstanding case reserves outstanding claims Avg. size of case reserves Claims may be counted either per claim (i.e. per accident) or per claimant Carriers may use either definition, but they must be consistent for all LOBs. The choice is reported in Schedule P interrogatory 6 Direct and assumed versus ceded Claim count info uses direct and assumed business, not ceded or net business The assumed business on primary LOBs is assumed proportional business, whereas the ceded business on primary LOBs includes ceded non-proportional business Assumed claim counts on proportional reinsurance uses the same proportion as losses With regard to intercompany pooling agreements, claim counts should be reported in accordance with the pooling arrangement Same procedure used for proportional reinsurance between unaffiliated entities For non-proportional reinsurance, assumed, ceded and net claim counts are not shown Loss and loss expense reserves Cols show data by AY on unpaid amounts: losses, LAE, anticipated S&S, and claims To avoid inconsistency among companies, Sch. P divides reserves between case reserves and bulk plus IBNR reserves. All actuarial reserves, whether for development on known claims or emergence of unreported claims, comprise the bulk plus IBNR reserves 17