Copyright 2015 The Ins4tutes

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2 ARM 56 Review CAD004 Speaker: Michael Elliott, CPCU, AIAF, The Institutes

3 Learning Objectives At the end of this session, you will: Dissect the most challenging ARM 56 course topics. Practice ARM 56 exam questions. Familiarize yourself with the ARM 56 exam format.

4 What to Expect on the Exam Educational Objectives Balanced Exam Pretest Items

5 Test-Taking Tips Get the easy ones Don t get bogged down early Use the mark for later review feature Eliminate the obviously wrong answers Use your scratch paper to keep track

6 Assignment 1 IntroducCon to Risk Financing

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9 Risk Financing Goals Pay for negative consequences of an event Maintain liquidity Manage uncertainty Comply with legal and regulatory requirements Minimize the cost of risk

10 Cost of Risk Retained losses Risk transfer costs Loss control expenses Risk management administrative costs

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13 The Prouty Approach suggests that losses with low severity and low frequency should be A. Transferred B. Avoided C. Retained D. Prevented

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15 Assignment 2 Estimating Hazard Risk

16 EsCmaCng Hazard Losses Collect and organize past data Limit individual losses Apply loss development and trend factors Forecast losses

17 One step in forecasting expected losses based on historical data is to limit individual losses. Which one of the following occurs as a result of limiting individual losses? A B C D There is a reduction in the size of the sample that can be used for forecasting. The variability of forecast losses increases. The forecaster is better able to match losses to the layer that is being forecast. The organization will be able to reduce or eliminate losses.

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21 In developing its loss forecast, HCB Company's risk management professional prepares the following loss triangle: Months from Beginning of Accident Year Accident Year X2 $105,231 $157,003 $176,771 $188,676 $194,678 20X3 $101,137 $165,780 $189,083 $199,440 20X4 $115,781 $178,912 $192,801 20X5 $120,980 $167,413 20X6 $118,605 What is the 30- to 42-month period-to-period loss development factor for HCB Company for year 20X4? A: 1.08 B: 1.15 C: 1.43 D: 1.67

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24 Applying Increased Limits Factors

25 Assume total losses, limited to $100,000 per loss, equal $3,000,000. Based on the factors in the table above, estimated losses limited to $500,000 per loss equal A. $1,364,000 B. $2,114,000 C. $4,258,000 D. $4,650,000

26 Probability Interval (of a Total Loss Probability Distribution) Representation that shows the probability of outcomes falling within certain ranges of a probability distribution. The probability interval is determined by the areas underneath a probability distribution curve. 26

27 VariaCon from Expected Losses 27

28 Assignment 3 Transferring Hazard Risk Through Insurance

29 Ideally Insurable Loss Exposure Pure risk Accidental loss Definite in time and measurable Large number of similar, independent exposures Not simultaneous and not catastrophic Economically feasible to insure

30 Excess Liability Insurance Excess liability insurance is insurance coverage for losses that exceed the limits of underlying insurance or a retention amount. It is not an umbrella and most often takes one of three basic forms, which are: Following form Self-contained form Combination form 30

31 One form of excess liability insurance incorporates provisions of the underlying policy and then modifies the provisions with additional conditions or exclusions. This type of coverage is called A: A self-contained excess liability policy. B: An umbrella excess liability policy. C: A following-form excess liability policy. D: A combination excess liability policy.

32 Assignment 5 Retrospective Rating Plans

33 Retrospective Rating Plan Premium (Basic Premium + Converted Losses + Excess Loss Premium) x Tax Multiplier Subject to maximum and minimum premium amounts 33

34 1. Basic Premium covers the insurer acquisition costs, overhead, and profit. Basic premium is expressed as a percentage of the standard premium. Standard premium is calculated by using state rating classifications and rates, applying them to an insured s estimated exposures (for example, sales for a CGL policy or payroll for workers compensation policy) for the policy period. 34

35 2. Converted Losses incurred losses multiplied by a loss conversion factor, which is a factor used to account for the unallocated portion of loss adjustment expenses (which includes, for example, rent for the office space of the claims department that cannot be allocated to a specific claim.) 3. Excess Loss Premium compensates the insurer for the risk that an individual loss will exceed the loss limit, which is the limit or cap on a single loss that the insurer will apply to the loss when calculating the retrospective premium (that way an insured is not subject to the maximum premium just because of a single bad claim when otherwise the loss experience during the coverage period was good). Excess loss premium is expressed as a percentage of the standard premium and is multiplied by the loss conversion factor. 35

36 4. Tax Multiplier adds an amount for state premium taxes, license fees, service bureau charges, and residual market loadings. It is expressed as a factor that is multiplied by the other components of the retrospective formula. 5. Maximum Premium amount that the retrospective rating plan premium will not exceed. Maximum premium is expressed as a percentage of the standard premium. 6. Minimum Premium amount that the retrospective rating plan premium will not fall below. Minimum premium is expressed as a percentage of the standard premium. 36

37 Example of a RetrospecCve RaCng Plan Premium CalculaCon Assume that Cranston Manufacturing Company (Cranston) has the following cost factors for its incurred loss retrospeccve racng plan: Policy Limit $1,000,000 per occurrence Standard Premium $700,000 Basic Premium 20% Loss Conversion Factor 1.10 Loss Limit $500,000 per occurrence Excess Loss Premium 5% Tax MulCplier 1.04 Maximum Premium 150% Minimum Premium 40% Group 1 - $300,000 incurred losses Group 3 - $700,000 incurred losses Group 2 - $400,000 incurred losses Group 4 - $800,000 incurred losses 37

38 Analysis: The basic premium is 20% of the $700,000 standard premium, which is $140,000. The excess loss premium is 5% of the $700,000 standard premium, which is $35,000, mulcplied by the loss conversion factor of 1.10, for a total of $38,500. The maximum premium is 150% of the $700,000 standard premium, which is $1,050,000, and the minimum premium is 40% of the $700,000 standard premium, which is $280,000. We now have all we need to determine the retrospeccve racng plan premium as a funccon of incurred loss by applying the retrospeccve racng formula. [$140,000 + (Level of Incurred Losses x 1.10) + ($35,000 X 1.10)] x

39 Incurred Losses Premium $ 50,000 $ 280,000 minimum premium applies 100, , , , , , , , , , , , , , ,000 1,050,000 maximum premium applies 39

40 Comparison of Incurred Loss with Paid Loss RetrospecCve RaCng Plans Incurred loss retrospeccve racng plan Insured organizacon pays premium based on incurred losses. Benefit from taking a larger tax deduccon on premium based on incurred rather than paid losses. Paid loss retrospeccve racng plan Insured organizacon pays basic premium, excess loss premium, and contributes to an escrow fund for paid losses. Cash flow benefit from paying premium as losses are paid rather than incurred. Basic premium increased to compensate insurer for loss of cash flow. 40

41 Assignment 6 Reinsurance

42 Reinsurance FuncCons Increase large line capacity Provide catastrophe proteccon Stabilize loss experience Provide surplus relief Facilitate withdrawal from a market segment Provide underwricng guidance 42

43 Surplus Relief Premium revenue earned over time Acquisition expenses charged immediately For a growing insurance company, mismatch creates a drain on policyholders surplus Assets Liabili4es Surplus + premium revenue - acquisi4on expenses (not matched with revenue) 43

44 Facilitate Withdrawal From a Market Segment When withdrawing from a market segment the primary insurer has several options, which include: Stop selling new policies Cancel all policies Purchase porsolio reinsurance 44

45 Portfolio reinsurance is a reinsurance agreement that reinsures the loss exposures of an entire type of insurance, class of business, or geographic area. Important points to remember: 1. It is an excep4on to the rule that reinsurers do not accept all the liability for specified loss exposures of a primary insurer. 2. While reinsured, the primary insurer retains direct obliga4ons to insureds (not a nova4on). 3. OYen requires approval from the state insurance department. 45

46 Types of Reinsurance Faculta4ve Treaty Pro rata Excess of loss

47 Quota Share (pro rata)

48 Surplus Share (pro rata)

49 XYZ Insurance Company has a 9-line surplus share treaty with a retention $100,000 and a maximum cession of $900,000. Policy A insures a building for $500,000. If there is a $50,000 loss under Policy A, how much of it will XYZ retain? A: $0 B: $5,000 C: $10,000 D: $50,000

50 Excess of Loss Reinsurance

51 Assignment 7 Captive Insurance

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53 Types of Cap4ves Single- parent (pure) Group Associa4on cap4ve Risk reten4on group Rent- a- CapCve Segregated Cell Cap4ve

54 Advantages of a Captive 1. Reducing the cost of risk 2. Benefiting from cash flow 3. Obtaining insurance not otherwise available 4. Direct access to reinsurers 5. Negotiating with insurers 6. Centralizing loss retention 7. Tax advantages 8. Controlling losses 9. Obtaining rate equity 54

55 Disadvantages of a Captive 1. Capital and start-up costs 2. Sensitivity to losses 3. Pressure from parent 4. Premium taxes and residual market loadings 55

56 For which one of the following types of captives must the owners be from the same industry? A. Group captive B. Protected cell captive C. Rent-a-captive D. Risk Retention Group

57 Assignment 9 Transferring Financial Risk

58 Types of Financial Risk Market Risk Interest rate risk Exchange rate risk Liquidity risk Credit Risk Price Risk

59 DerivaCves Forward contracts Options Swaps

60 Which one of the following gives the holder the right to buy or sell an asset for a specific price? A. Forward B. Option C. Security D. Swap

61 SecuriCzaCon

62 With a securitization, income-producing assets, such as mortgage receivables, are transferred to a special purpose vehicle (SPV) in exchange for cash. These assets are A. Converted into forward contracts. B. Sold to investors. C. Traded on an open exchange. D. Used to collateralize securities sold to investors.

63 Assignment 10 Transferring Hazard Risk to the Financial Markets

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65 With an insurance securitization, the special purpose vehicle (SPV) is often called a transformer because it tranforms A. A loss index into indemnity. B. Cash into securities. C. Insurable risk into investment risk. D. Primary insurance into reinsurance.

66 Contingent Capital Standby credit is an arrangement whereby a bank or another financial institution agrees to provide a loan to an organization in the event the organization suffers a loss. Contingent surplus notes are surplus notes that have been designed so that an insurer, at its option, can immediately obtain funds by issuing surplus notes at a pre-arranged rate of interest. Catastrophe equity puts are rights to sell equity (stock) at a predetermine price in the event of a catastrophic loss. 66

67 Assignment 11 Allocating Costs of Managing Hazard Risk

68 Allocating risk management costs Costs of accidental losses not reimbursed by insurance or other outside sources 2. Insurance premiums 3. Costs of risk control techniques 4. Costs of administering risk management activities 68

69 1. Incurred loss basis keep track of incurred losses, just as an insurance company would; including IBNR 2. Claims-made basis keep track of losses for claims made, just as an insurance company would; does not include IBNR 3. Claims-paid basis keep track of amounts paid on losses during the accounting period, regardless of when the losses occurred 69

70 Prospective cost allocation cost fixed at beginning of accounting period Retrospective cost allocation cost estimated at beginning of accounting period an adjusted as loss costs are known 70

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74 Q & A 74

75 EO 6.04 Describe the administration of retrospective rating plans. Collateral requirements for paid loss retrospective rating plans For financial accounting purposes an organization must recognize its retained losses as they are incurred. The additional premium owed (as determined by the retrospective rating formula) must be recognized as a liability on the organization s next balance sheet and as an expense on the organization s next income statement. With a paid loss retrospective rating plan, premium payments are based on when losses are paid, not when they are incurred. But for financial accounting purposes, an organization must recognize additional premium owed when the losses are incurred, not when they are paid. Incurred but not reported (IBNR) losses must also be recognized if they can be estimated with reasonable accuracy. 75

76 EO 9.02 Explain how finite risk insurance plans operate, including: Types of risks covered Experience fund terms and calculation guidelines Variations in the terms of plans Common Characteristics of Finite Risk Plans The limits of coverage apply on an aggregate basis. The term of coverage is usually for five to ten years. The premium is usually 50% or more of the policy limits. The insurer shares profit with the insured, including investment income. The insured is allowed to commute the policy. 76

77 Types of Risk Covered 1. Underwri4ng risk is the risk that an insurer s losses and expenses will be greater than the premiums and the investment income it expects to earn under the insurance contract. 2. Investment risk is the risk that an insurer s investment income will be lower than it expects and includes 4ming risk and interest rate risk. Timing risk is the risk, under an insurance contract, that the insured s losses will be paid faster or more slowly than expected. Interest rate risk is the risk that interest rates will be below the expected rate during the term of the insurance contract. 3. Credit risk is the risk that an insurer will not collect the premiums owed by its insured. 77

78 Prospective versus Retroactive Plans Prospective plan is a risk financing plan arranged to cover losses from events that have not yet occurred Retroactive plan is a risk financing plan arranged to cover losses from events that have already occurred 78

79 Loss Portfolio Transfers Loss portfolio transfer is a type of retroactive plan that applies to an entire portfolio of losses. The losses usually have established reserves, but uncertainty exists as to the timing of the loss payments and the potential for further loss development. 79

80 EO Analyze the concerns of organizations transferring risk and investors supplying capital. Important DefiniCons Financial security of the par4es supplying the risk capital (the credit risk). Basis risk: the risk that the amount an organiza4on receives to offset its losses might be greater than or less than its actual losses. 80

81 EO Describe the practical considerations of selecting a cost allocation basis. An organiza4on s accoun4ng system can influence alloca4on. An organiza4on s opera4ons may be subject to more than one tax system. Each department should be charged at least a minimum amount for risk management services regardless of exposure or loss experience. If an organiza4on is highly decentralized, each department may be purchasing its own insurance. Cost alloca4on should penalize or reward each department according to its risk management costs. Use of computerized risk management informa4on systems (RMIS) has become standard in many industries. Cost alloca4on systems should remain as consistent as possible from year to year. 81