OSBIE 2010 ANNUAL REPORT ONTARIO SCHOOL BOARDS INSURANCE EXCHANGE

Transcription

1 OSBIE 2010 ANNUAL REPORT ONTARIO SCHOOL BOARDS INSURANCE EXCHANGE

2 OUR VISION Evolving to the Ultimate Benefit of Subscribers OUR MISSION Working with subscribers to provide value added insurance services at stable costs OUR VALUE STATEMENTS PEOPLE To attract, retain and develop the right staff, which allows us to provide service excellence, leadership, and learning. CUSTOMIZATION To ensure availability of insurance coverages and adapt our product and services to meet our members evolving needs. PREVENTION To differentiate ourselves through the delivery of risk management products and services to our members. OWNERSHIP To promote and share the benefits of membership. ACCOUNTABILITY To be a good corporate citizen by demonstrating a high degree of ethical conduct and responsible corporate governance.

3 BOARD OF DIRECTORS 2010 Dean Carrie NORTH WES T Michel Paulin NORTH EAST/C HAIR Michael Clarke EAST Gord Greffe EAST Cathy Modesto MID NORTH Diane Cayen-Arnold MID NORTH Ed Hodgins CORE Lynn Schaule CORE Penny Allen WESTERN/VICE-CHAIR Gerry Thuss WES TERN Françoise Fournier C ENTRAL 2010 ANNUAL REPORT 3

4 REPORT OF THE CHAIRPERSON On behalf of the Board of Directors I am pleased to report to you on the results of OSBIE s 24 th year of operation. Our school board-owned and directed organization had another very successful OSBIE produced a net income of $6.76 Million in 2010 as a result of a favourable claims experience and improved investment income. For a Non- Profit organization, this is an outstanding performance. This has allowed the Board of Directors to approve the increase in the Liability limits to $24 Million which provides Subscribers with more protection in these highly litigious times as well as further strengthen the Guarantee Fund. In the past six years total refunds to Subscribers amounted to $15,587,000. In addition to the School Council Liability insurance and Accident insurance for school board members and named officers (introduced in 2007), OSBIE has also been successful in growing a new Facility User Group Insurance program that has experienced significant growth in Also, the Subscriber survey continues to produce excellent results as well as provide constructive information to further improve services to School Board members. Lastly, OSBIE now insures 32 joint ventures; four of which were added in With respect to the operation of the Board of Directors, our Governance Committee continued its work in the development of a new comprehensive governance policy framework adapted to a growing and increasingly complex organization. Finally, the Audit committee held quarterly meetings to fulfill its mandate in dealing with financial and regulatory matters. The following actions were also taken by the Board in 2010: Reviewed the 2010 Strategic Plan outcomes and the 2011 Operational Plan. Approved the 2011 Budget. Approved the 2011 Premium Funding Strategy and the increase in policy limits Reviewed reinsurance arrangements for each line of insurance. Reviewed the regional boundaries as a result of School Authority consolidations Completed the evaluation of the Chief Executive Officer s performance for 2010 Reviewed and approved the Investment Strategy and guidelines Reviewed the succession planning for the CEO position and for all department managers. This year also has marked the introduction of 2 new Directors namely Gerry Thuss from Huron-Perth CDSB and Lynn Schaule from Dufferin Peel CDSB who have undergone a full orientation and are now productive members of our Board. In closing, I wish to extend my sincere appreciation to the OSBIE employees who, under the leadership of our CEO Jim Sami, continue to deliver solid financial and operational results and quality services to our member school boards. I also want to thank my fellow Directors for their invaluable contributions, insight and guidance throughout Finally, to all seventy one (71) school board members, a sincere thanks for your support. As OSBIE is approaching its 25 th anniversary, we should all be proud of this truly collective achievement. Michel Paulin CHAIR ANNUAL REPORT

5 CHIEF EXECUTIVE OFFICER S REPORT On behalf of OSBIE, it is my great pleasure to provide you with highlights of our annual results. This past year proved to be a great success for us in terms of financial and operational results. The organization achieved underwriting net income for all lines of business. In addition to the underwriting profit, the investment side of the business proved just as successful with solid investment income and great appreciation of the overall value of our portfolio. The overall financial impact was an improvement of just over $12 Million or put another way, an appreciation of 26% of Subscribers value (equity) in the organization. The solid financial results have allowed our Board of Directors to approve Management s recommendation to increase the Liability policy limits to $24 Million to offer better protection to our subscribers. We have continued to implement our Long Term Strategic Plan and have seen further development in the additional lines of business we introduced and are also grateful to our subscribers for supporting those new lines of business. While financial results are important to us, what gives us the greatest satisfaction, is the quality of service that we provide to our subscribers. The annual survey results indicated our subscribers not only continue to place their trust in our organization but they also expressed a high level of satisfaction with all of our departments. The feedback that we receive through those subscriber surveys provides us with solid input that will help develop future Underwriting and Risk Management plans. My deepest thanks go to our Board of Directors for their unwavering support of the organization and for the guidance, assistance and support that they provided to me throughout the year. The OSBIE staff is our most valuable asset and my thanks go to our management group and to our staff who have embraced and are committed to a culture of continuous improvement. We have set some exciting plans for 2011 that will see us aim to provide our client base with the highest levels of innovative solutions and services to meet our subscribers evolving insurance and risk management needs. Jim H. Sami CHIEF EXECUTIVE OFFICER 2010 ANNUAL REPORT 5

6 AUDITORS REPORT To the Subscribers of Ontario School Boards Insurance Exchange We have audited the accompanying financial statements of Ontario School Boards Insurance Exchange ( the Exchange ), which comprises the balance sheet as at December 31, 2010 and the statement of operations, comprehensive income, guarantee fund and cash flows for the year then ended, and a summary of significant accounting policies and other explanatory information. Management s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with Canadian generally accepted accounting principles, and for such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error. Auditor s Responsibility Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with Canadian generally accepted auditing standards. Those standards require that we comply with ethical requirements and plan and perform an audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on our judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, we consider internal control relevant to the Exchange s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Exchange s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, these financial statements present fairly, in all material respects, the financial position of the Exchange as at December 31, 2010, and the results of its operations and its cash flows for the year then ended in accordance with Canadian generally accepted accounting principles. Chartered Accountants, Licensed Public Accountants Toronto, Canada February 18, 2011 APPOINTED ACTUARY S REPORT To the Subscribers of Ontario School Boards Insurance Exchange I have valued the policy liabilities of Ontario School Boards Insurance Exchange for its balance sheet at December 31, 2010 and their change in the statement of income for the year then ended in accordance with accepted actuarial practice in Canada, including selection of appropriate assumptions and methods. In my opinion, the amount of policy liabilities makes appropriate provision for all policyholder obligations, and the financial statements fairly present the results of the valuation. Richard Gauthier FCIA FCAS MAAA Toronto, Ontario February 11, ANNUAL REPORT

7 BALANCE SHEET December 31, 2010, with comparative figures for 2009 ASSETS Cash and cash equivalents $ 30,549,375 $ 21,287,437 Investments (note 3) 152,238, ,777,588 Accrued investment income 1,298,700 1,299,858 Prepaid reinsurance ceded 440, ,000 Prepaid expenses 30,000 34,301 Premiums and accounts receivable 34,809 2,898 Reinsurance recoverable (note 6) 583,148 1,748,001 Salvage and subrogation recoverable 6,451,811 5,450,557 Capital assets (note 4) 417, ,235 $ 192,044,254 $ 174,492,875 LIABILITIES AND GUARANTEE FUND Liabilities: Claims liabilities (note 6) $ 103,643,936 $ 101,214,816 Premiums received in advance 28,025,414 25,346,942 Accounts payable and accrued liabilities 1,362,125 1,259,745 Sales tax payable 1,816,721 1,439,118 Premiums in trust 10,558 62, ,858, ,323,030 Guarantee Fund (note 10): Reserves required by the Financial Services Commission of Ontario 50,000 50,000 Additional guarantee funds 49,245,920 42,485,985 Accumulated other comprehensive income 7,889,580 2,633,860 57,185,500 45,169,845 Commitments (note 11) $ 192,044,254 $ 174,492,875 See accompanying notes to financial statements. On behalf of the Board of Directors: Chair Vice-Chair 2010 ANNUAL REPORT 7

8 STATEMENT OF OPERATIONS December 31, 2010, with comparative figures for 2009 Revenue: Gross premiums earned $ 35,919,067 $ 35,327,015 Less reinsurance premiums ceded 2,347,574 2,367,039 Net premiums earned 33,571,493 32,959,976 Expenses: Claims incurred (note 6) 26,412,975 29,167,978 Underwriting, general and administration 1,906,074 1,871,522 Premium taxes 1,129,427 1,040,109 29,448,476 32,079,609 Income before the undernoted 4,123, ,367 Investment and other income (note 3(b)) 2,636,918 3,391,311 Net income $ 6,759,935 $ 4,271,678 See accompanying notes to financial statements. STATEMENT OF COMPREHENSIVE INCOME Year ended December 31, 2010, with comparative figures for 2009 Net income $ 6,759,935 $ 4,271,678 Other comprehensive income: Unrealized gains on available-for-sale assets 3,093,837 11,757,876 Recognition of realized losses on available-for-sale assets 2,161,883 1,684,000 5,255,720 13,441,876 Comprehensive income $ 12,015,655 $ 17,713,554 See accompanying notes to financial statements ANNUAL REPORT

9 STATEMENT OF GUARANTEE FUND Year ended December 31, 2010, with comparative figures for 2009 Reserves required by the Financial Services Commission of Ontario: Balance, beginning and end of year $ 50,000 $ 50,000 Additional guarantee funds: Balance, beginning of year 42,485,985 40,464,307 Net income 6,759,935 4,271,678 Refund to subscribers - (2,250,000) Balance, end of year 49,245,920 42,485,985 Accumulated other comprehensive income: Balance, beginning of year 2,633,860 (10,808,016) Other comprehensive income 5,255,720 13,441,876 Balance, end of year 7,889,580 2,633,860 Total Guarantee Fund $ 57,185,500 $ 45,169,845 Accumulated other comprehensive income: Balance, end of year, consists of: Unrealized gains on available-for-sale assets 7,889,580 2,633,860 Total accumulated other comprehensive income $ 7,889,580 $ 2,633,860 See accompanying notes to financial statements ANNUAL REPORT 9

10 STATEMENT OF CASH FLOWS Year ended December 31, 2010, with comparative figures for 2009 Cash provided by (used in): Operations: Net income $ 6,759,935 $ 4,271,678 Items not involving cash: Accrued investment income 1, ,071 Loss on sale of investments 2,169,861 1,851,730 Amortization of capital assets 46,351 63,391 Bond amortization 118,473 49,952 Change in non-cash operating items (600,732) (1,146,611) Claims liabilities, net 3,593,973 (2,616,863) Premiums received in advance 2,678,472 (3,570,113) 14,767,491 (857,765) Financing: Refund to subscribers - (2,250,000) Investments: Bonds purchased (27,177,791) (14,715,118) Equities purchased (15,485,754) (17,562,725) Proceeds from investment disposals: Bonds 28,030,250 8,700,000 Equities 9,139,377 20,960,800 Additions to capital assets (11,635) (22,538) (5,505,553) (2,639,581) Increase (decrease) in cash and cash equivalents 9,261,938 (5,747,346) Cash and cash equivalents, beginning of year 21,287,437 27,034,783 Cash and cash equivalents, end of year $ 30,549,375 $ 21,287,437 See accompanying notes to financial statements ANNUAL REPORT

11 NOTES TO FINANCIAL STATEMENTS Ontario School Boards Insurance Exchange (the Exchange ) was formed under the Reciprocal Insurance Exchange Agreement for School Boards in the Province of Ontario (the Agreement ) dated August 15, 1986 and as amended on January 1, 2002, among various school boards subscribing to the Agreement. The Exchange is licensed by the Financial Services Commission of Ontario to provide aircraft, non-owned automobile, owned automobile, fidelity, legal expense, liability, marine, property and boiler and machinery insurance to its subscribers in accordance with Part XIII of the Insurance Act, Ontario, R.S.O The Exchange commenced operations on January 1, 1987 and has 77 ( ) subscribers. Subscriptions to the Exchange come up for renewal at the end of a five-year subscription period. The next date for the renewal of policies is January 1, Significant accounting policies: (a) Basis of presentation: These financial statements have been prepared in accordance with Canadian generally accepted accounting principles applied on a basis consistent with that of the preceding year. The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the year. Actual results could differ from those estimates. (b) Premiums: Premiums are earned over the term of the related policy period. As the Exchange s policy year ends December 31, there are no unearned premiums at December 31. Premiums received in advance relate to premiums received in the current year for the policy period commencing January 1 of the following year. (c) Financial instruments: All financial instruments other than insurance contracts, are measured in the balance sheet at fair value, except for loans and receivables and other financial liabilities, which are measured at amortized cost. All financial instruments previously classified as investments are designated as available-for-sale ( AFS ) securities. AFS securities are carried at fair value whereby the unrealized gains and losses are included in accumulated other comprehensive income ( AOCI ) until sale or other-than-temporary impairment is recognized, at which point cumulative unrealized gains or losses are included in investment income. Realized gains and losses on sale and write-downs to reflect other-than-temporary impairments in value are included in net realized gain on sales of securities. Dividends and interest income from these securities are included in Investment income and are recorded as they accrue. Income distributions from Canadian income trusts are recorded as income when received. Dividend income on common and preferred shares is recorded on the ex-dividend date. The Exchange accounts for all financial instruments using settlement date accounting. Transaction costs related to the purchase of financial instruments are recorded as part of the carrying value. The Exchange conducts a regular review to identify and evaluate securities that show objective indications of possible impairment. An impairment is charged to income if the fair value of a security falls below its cost/amortized cost, and the decline is considered other-than-temporary. Factors considered in determining whether a loss is other-than-temporary include the length of time and extent to which fair value has been below cost; financial condition and near-term prospects of the issuer; and our ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery ANNUAL REPORT 11

12 1. Significant accounting policies (continued): (d) Cash and cash equivalents: Cash and cash equivalents include cash on account and investments in money market instruments. (e) Capital assets: Capital assets and leasehold improvements are stated at cost. Amortization is provided using the straight-line basis at the following annual rates: Asset Rate Building 3.33% Equipment and furnishings 20% Computer equipment 33% Building improvements 20% Automobile 25% (f) Claims liabilities: Provision has been made for the estimated liability for all reported and outstanding claims using a case-basis evaluation plus an amount for adverse development and for claims incurred to December 31, which have not yet been reported to the Exchange. Expected reinsurance recoveries on claims liabilities are recognized as assets on the same basis. The computation of these provisions takes into account the time value of money using discount rates based on projected investment income from the assets supporting these provisions. Since the amounts are necessarily based on estimates of future trends in claim severity and other factors which could vary as the claims are settled, the ultimate liability may be more or less than the estimated amounts. Although it is not possible to measure the degree of variability inherent in such estimates, management believes that the unpaid claims amounts and related adjustment expenses are adequate. The estimates are periodically reviewed by an actuary and, as adjustments to these liabilities become necessary, they are reflected in current operations. (g) Reinsurance: The Exchange records reinsurance balances on the balance sheet on a gross basis to indicate the extent of credit related to reinsurance, and records its obligations to subscribers on a net basis in the statement of operations to indicate the results of its retention of premiums written. Amounts recoverable from reinsurers are estimated in a manner consistent with the related claims liabilities. (h) Income taxes: As an exchange under the Insurance Act of Ontario, the Exchange is not subject to income taxes and, accordingly, no provision for income taxes has been made in these financial statements ANNUAL REPORT

13 2. Future changes in accounting policies International Financial Reporting Standards In February 2008 the Canadian Accounting Standards Board ( AcSB ) confirmed that all publicly accountable enterprises, including the Exchange, will be required to adopt International Financial Reporting Standards (IFRS). For the Exchange, IFRS will be effective for the period commencing January 1, 2011, including the preparation and reporting of one year of comparative information. Accordingly, the transition date in those comparative financial statements will be January 1, The Exchange has completed the scoping phase of the project, consisting of project initiation and awareness, identification of high-level differences between Canadian GAAP and IFRS, project planning and resourcing. The Company has determined that there are no measurement differences between Canadian GAAP and IFRS that will have an impact on the opening financial position of the Company at the transition date. As well, the results of operations under IFRS will not differ from Canadian GAAP. Financial statement disclosures under IFRS will differ from Canadian GAAP. 3. Investments: Bonds: Government $ 42,012,308 $ 53,847,055 Corporate 71,409,813 60,409,882 Equities: Common shares 25,081,707 23,024,333 Mutual and pooled fund units 13,735,064 6,496,318 $ 152,238,892 $ 143,777,588 The fair values of securities are based on quoted market values. Fair values of cash and cash equivalents and accrued investment income approximate their carrying values due to the short-term maturity of these items. (a) Liquidity: Maturity profile as at December 31, 2010: Within 1 year 1-3 years 3-5 years 5-10 years Over 10 years Bonds $ 26,007,267 $ 47,078,946 $ 22,155,624 $ 18,180,284 $ - Maturity profile as at December 31, 2009: Within 1 year 1-3 years 3-5 years 5-10 years Over 10 years Bonds $ - $ 34,602,629 $ 51,251,250 $ 28,403,058 $ - The weighted average yield for debt securities based on market value at December 31, 2010 is 3.99% ( %) ANNUAL REPORT 13

14 3. Investments (continued): (b) Investment and other income: Interest $ 4,161,550 $ 4,559,308 Dividends 830, ,192 Loss on sale of investments (2,169,861) (1,851,730) Investment expenses (291,640) (166,465) 2,530,839 3,301,305 Other income 106,079 90,006 $ 2,636,918 $ 3,391,311 (c) Fair values: The Exchange uses a fair value hierarchy to categorize the inputs used in valuation techniques to measure fair value. The extent of the Exchange s use of quoted market prices (Level 1), internal models using observable market information as inputs (Level 2) and internal models without observable market information as inputs (Level 3) in the valuation of bond and equity investments, as well as derivatives were as follows: 2010 Level 1 Level 2 Level 3 Total Equities $ 33,799,161 $ 5,017,610 $ - $ 38,816,771 Bonds - 113,422, ,422,121 Total $ 33,799,161 $ 118,439,731 $ - $ 152,238, Equities $ 29,520,651 $ - $ - $ 29,520,651 Bonds 10,000, ,256, ,256,937 Total $ 39,520,651 $ 104,256,937 $ - $ 143,777,588 The Exchange did not have any significant transfers between Level 1 and Level 2 included in the fair value hierarchy. The Exchange has no holdings in the Level 3 category ANNUAL REPORT

15 4. Capital assets: Accumulated Net book Net book Cost amortization value value Land $ 205,000 $ - $ 205,000 $ 205,000 Building 204,804 73, , ,674 Equipment and furnishings 144, ,727 11,487 18,844 Computer equipment 80,623 59,762 20,861 17,414 Building improvements 472, ,405 29,782 37,011 Automobile 67,000 47,458 19,542 36,292 $ 1,173,828 $ 756,309 $ 417,519 $ 452, Limits of liability: (a) Liability insurance: The limit of liability for liability insurance is a maximum amount on any one loss of $20,000,000 ( $20,000,000) in the event of a liability claim and to a maximum amount of $20,000,000 ( $20,000,000) in the event of series of claims arising out of a single occurrence. The Exchange has obtained reinsurance protection on these policies to an amount not exceeding $15,000,000 ( $15,000,000) on each and every occurrence or a series of claims arising out of a single occurrence in excess of $5,000,000 ( $5,000,000). (b) Property insurance: The property insurance policy provides for payment in the event of any one loss or a series of losses arising out of a single occurrence in excess of the individual subscriber s deductible without limit. The Exchange has obtained reinsurance protection on these policies to a limit of $250,000,000 subject to a retention of $5,000,000 ( $5,000,000) on each claim on property damages and $500,000 ( $500,000) per claim for extra expenses, subject to an annual aggregate retention in the amount of $15,000,000 ( $15,000,000) beyond which the retention reduces to the subscriber s deductible. The Exchange has obtained reinsurance, whereby they share in the losses at a rate of 25% for losses between 5,000,000 and $10,000,000 and at 50% for losses between $10,000,000 and $20,000,000. (c) Boiler and machinery insurance: The boiler and machinery insurance policy provides for payment in the event of any one loss or a series of losses arising out a single occurrence in excess of the individual subscriber s deductible. From 1992 to 2008 the Exchange boiler and machinery program was 100% reinsured. Since 2008, the Exchange insures this program through a subscription policy with another boiler insurer. The Exchange shares in these losses at a rate of 25%, and the policy has a limit of $15,000,000 ( $15,000,000), subject to a retention equal to the subscriber s deductible. (d) Owned automobile insurance: The insurance policy for subscriber-owned automobiles provides for payment in the event of any one loss or series of losses arising out of a single occurrence to a maximum for liability claims of $20,000,000 ( $20,000,000) subject to recoverability of the individual subscriber s deductible. The Exchange has obtained reinsurance coverage for third party liability claims and accident benefits on these policies to an amount not exceeding $20,000,000 ( $20,000,000) subject to retention of $3,000,000 ( $3,000,000) per claim ANNUAL REPORT 15

16 6. Claims liabilities: (a) Nature of claims liabilities: Claims liabilities and related reinsurance recoverable are estimates subject to variability and the variability could be material in the near term. The variability arises because all events affecting the ultimate settlement of claims have not taken place and may not take place for some time. Variability can be caused by receipt of additional claim information, or significant change in severity or frequency of claims from historical trends. The estimates are principally based on the Exchange s historical experience. Methods of estimation have been used which the Exchange believes produce reasonable results given current information. The Exchange strives to establish adequate claim liabilities at the original valuation date. However, as time passes, the ultimate cost of claims becomes more certain. During 2010, the Exchange experienced favourable claims development of $4,096,312 ( favourable claims development of $4,034,000). The table below details the claim liabilities by risk categories: Gross Ceded Gross Ceded General liability $ 93,794,596 $ - $ 86,941,440 $ - Property, boiler and machinery and crime 8,024, ,148 12,785,849 1,748,001 Automobile 1,825,319-1,487,527 - $ 103,643,936 $ 583,148 $ 101,214,816 $ 1,748,001 Management has concluded that the best estimate of the fair value of claims liabilities currently available is the amount calculated by the Appointed Actuary. The Actuary s calculated value as at December 31, 2010 amounted to $103,643,936 ( $101,214,816) is gross of estimated reinsurance of $583,148 ( $1,748,001). The reinsurance recoveries deducted from claims incurred were $78,152 ( $38,270). Insurance ceded under reinsurance arrangements does not relieve the Exchange of its primary liability to the subscriber. No information has come to the Exchange s attention indicating that any of its current reinsurers will not be able to honour their liabilities under these reinsurance contracts. (b) Discounting of the claims liabilities and related reinsurance recoveries: The provision for claims liabilities and related reinsurance recoveries is discounted using rates based on the projected investment income from the assets supporting the provisions, and reflecting the estimated timing of payments and recoveries. The discount rate used in the valuation was 3.86% ( %). The gross provision and reinsurance recoverable estimates are as follows: Discounted Undiscounted Discounted Undiscounted Gross provision $ 103,643,936 $ 102,673,148 $ 101,214,816 $ 99,454,000 Reinsurance ceded 583, ,126 1,748,001 1,715, ANNUAL REPORT

17 7. Financial risk management: The primary goals of the Exchange s financial risk management are to ensure that the outcomes of activities involving elements of risk are consistent with the Exchange s objectives and risk tolerance, and to maintain an appropriate risk/reward balance while protecting the Exchange s balance sheet from events that have the potential to materially impair its financial strength. Balancing risk and reward is achieved through aligning risk appetite with business strategy, diversifying risk, pricing appropriately for risk, mitigating risk through preventive controls and transferring risk to third parties. The Exchange s exposure to potential loss from financial instruments is primarily due to underwriting risk along with various market risks, including interest rate risk and equity market fluctuation risk, foreign currency risk, liquidity risk, as well as credit risk. (a) Underwriting risk: Underwriting risk is the risk that the total cost of claims and acquisition expenses will exceed premiums received and can arise from numerous factors, including pricing risk, reserving risk, catastrophic loss risk and reinsurance coverage risk. Our underwriting objective is to develop business within our target market on a prudent and diversified basis and to achieve underwriting results of up to a 113.5% combined ratio. (i) Pricing risk: Pricing risk arises when actual claims experience differs from the assumptions included in pricing calculations. Historically, the underwriting results of the property and casualty industry have fluctuated significantly due to the cyclicality of the insurance market. The market cycle is affected by the frequency and severity of losses, levels of capacity and demand, general economic conditions and price competition. We price our products taking into account numerous factors including claims frequency and severity trends, product line expense ratios, special risk factors, the capital required to support the product line, and the investment income earned on that capital. These factors are set in conjunction with our actuary, and are reviewed and adjusted periodically to ensure they reflect the current environment. (ii) Reserving risk: Reserving risk arises due to the length of time between the occurrence of a loss, the reporting of the loss to the insurer and ultimate resolution of the claim. Claim provisions are expectations of the ultimate cost of resolution and administration of claims based on an assessment of facts and circumstances then known, a review of historical settlement patterns, estimates of trends in claims severity and frequency, legal theories of liability and other factors. Variables in the reserve estimation process can be affected by receipt of additional claim information and other internal and external factors, such as changes in claims handling procedures, economic inflation, legal and judicial trends, legislative changes, inclusion of exposures not contemplated at the time of policy inception and significant changes in severity or frequency of claims relative to historical trends. Due to the amount of time between the occurrence of a loss, the actual reporting of the loss and the ultimate payment, provisions may ultimately develop differently from the actuarial assumptions made when initially estimating the provision for claims. The Exchange s provision for claims are reviewed separately by, and must be acceptable to, the independent appointed actuary, and an external valuation actuary ANNUAL REPORT 17

18 7. Financial risk management (continued): (a) Underwriting risk (continued): (iii) Catastrophic loss risk: Catastrophic loss risk is the exposure to losses resulting from multiple claims arising out of a single catastrophic event. Property and casualty insurance companies experience large losses arising from manmade or natural catastrophes that can result in significant underwriting losses. Catastrophes can cause losses in a variety of property and casualty lines and may have continuing effects which could delay or hamper efforts to timely and accurately assess the full extent of the damage they cause. The incidence and severity of catastrophes are inherently unpredictable. The Exchange s exposure to insured risks is managed through the use of reinsurance. The Exchange reinsures claims from a single catastrophe over $5 million to a maximum of $250 million. The net retained amount of $5 million represents less than 20% of the Exchange s Guarantee Fund. Reinsurance coverage risk arises because reinsurance terms, conditions and/or pricing may change on renewal, particularly following catastrophes. (iv) Reinsurance risk: The Exchange relies on reinsurance to manage the underwriting risk, however, reinsurance does not release the Exchange from its primary commitments to its policyholders. Therefore, the Exchange is exposed to the credit risk associated with the amounts ceded to reinsurers. The Exchange assesses the financial soundness of the reinsurers before signing any reinsurance treaties and monitors their situation on a regular basis. In addition, the Exchange has minimum rating requirements for its reinsurers. The Exchange tenders reinsurance requirements on a regular basis to ensure that the best price possible is obtained. The Exchange works with well established reinsurers that have expertise in their field as well as an understanding of the business. Management reviews reinsurance programs to manage cost-efficiency and reduce the likelihood of coverage gaps. (b) Credit risk: (i) Invested assets: The Exchange s risk management strategy is to invest primarily in debt instruments of high credit quality issuers and to limit the amount of credit exposure with respect to any one issuer. The Exchange attempts to limit credit exposure by imposing portfolio limits on individual corporate issuers as well as limits based on credit quality. The breakdown of the Exchange s fixed income portfolio, by the DBRS Rating, or where unavailable the S&P rating, is presented below: Fair value % of total Fair value % of total AAA $ 5,151,878 5 $ - - AA 78,389, ,764, A 20,706, ,492, BBB/R2+ 9,174, ,000,000 5 $ 113,422, % $ 114,256, % ANNUAL REPORT

19 7. Financial risk management (continued): (b) Credit risk (continued): (ii) Reinsurance recoverable and receivable: Credit exposure on the Exchange s reinsurance recoverable and receivable balances exists at December 31, 2010 to the extent that any reinsurer may not be able or willing to reimburse the Exchange under the terms of the relevant reinsurance arrangements. The Exchange has policies which limit its exposure to individual reinsurers and a regular review process to assess the creditworthiness of reinsurers with whom it transacts business. Internal guidelines generally require reinsurers to have A ratings. Any exceptions are subject to CEO approval. In 2010, the Exchange has reinsurance recoverable balances of $507,023 ( $1,642,325) which is due from FM Global the property reinsurer. (c) Liquidity risk: Liquidity risk is the risk of having insufficient cash resources to meet financial commitments and policy obligations as they fall due, without raising funds at unfavourable rates or selling assets on a forced basis. Liquidity risk arises from the general business activities and in the course of managing the assets and liabilities. The liquidity requirements of the Exchange s business have been met primarily by funds generated from operations, asset maturities and income and other returns received on securities. Cash provided from these sources is used primarily for claims and claim adjustment expense payments and operating expenses. The timing and amount of catastrophe claims are inherently unpredictable and may create increased liquidity requirements. To meet these cash requirements, the Exchange has policies to limit and monitor its exposure to individual issuers or related groups and to ensure that assets and liabilities are broadly matched in terms of their duration and currency. The Exchange also holds a portion of invested assets in liquid securities. At December 31, 2010, the Exchange has $30,549,375 ( $20,722,078) of cash and cash equivalents. In addition, the Exchange has a line of credit available in the amount of $500,000 ( $500,000). Along with the expected maturity profile of The Exchange s investment portfolio, the following table shows the expected payout pattern of the unpaid claim liabilities. Expected payout pattern of unpaid claims as at December 31, 2010: Within 1 year 1-5 years 5-10 years Over 10 years Total $ 23,335,000 $ 55,968,000 $ 13,990,000 $ 3,823,000 $ 97,116,000 Expected payout pattern of unpaid claims as at December 31, 2009: Within 1 year 1-5 years 5-10 years Over 10 years Total $ 23,440,000 $ 48,249,000 $ 17,985,000 $ 4,342,000 $ 94,016, ANNUAL REPORT 19

20 7. Financial risk management (continued): (d) Market risk: Market risk is the risk of loss arising from adverse changes in market rates and prices, such as interest rates, equity market fluctuations, foreign currency exchange rates, and other relevant market rate or price changes. Market risk is directly influenced by the volatility and liquidity in the markets in which the related underlying assets are traded. Below is a discussion of the Exchange s primary market risk exposures and how those exposures are currently managed. (i) Interest rate risk: Fluctuations in interest rates have a direct impact on the market valuation of the Exchange s fixed income securities portfolio and liability values. Historical data and current information is used to profile the ultimate claims settlement pattern by class of insurance, which is then used in a broad sense to develop an investment policy and strategy. Generally, our investment income will move with interest rates over the long-term. Short-term interest rate fluctuations will generally create unrealized gains or losses. Generally, the Exchange s interest and dividend investment income will be reduced during sustained periods of lower interest rates as higher yielding fixed income securities are called, mature, or are sold and the proceeds are reinvested at lower rates, and will likely result in unrealized gains in the value of fixed income securities the Exchange continues to hold, as well as realized gains to the extent the relevant securities are sold. During periods of rising interest rates, the market value of the Exchange s existing fixed income securities will generally decrease and gains on fixed income securities will likely be reduced or result in realized losses. As at December 31, 2010, management estimates that an immediate hypothetical 100 basis point, or 1%, parallel increase in interest rates would decrease the market value of the fixed income securities by $3,177,843 ( $4,119,000), representing 2.8% ( %) of the $113,422,121 ( $114,256,937) fair value fixed income securities portfolio, and decrease the value of unpaid claims reserves by $3,045,000 ( $3,007,000), thus partially offsetting the change in market value of bonds. Conversely, a 100 basis point decrease in interest rates would increase the market value of the fixed income securities and value of unpaid claims reserves by the same amounts, respectively. If it was necessary for us to complete an unexpected quick liquidation of assets to meet our policy obligations, interest rate fluctuations could result in realized gains or losses greater than the change in reserve values. Computations of the prospective effects of hypothetical interest rate changes are based on numerous assumptions, including the maintenance of the existing level and composition of fixed income security assets at the indicated date, and should not be relied on as indicative of future results. The analysis in this section is based on the following assumptions: 1) the securities in the Exchange s portfolio are not impaired; 2) interest rates and equity prices move independently; 3) shifts in the yield curve are parallel; and, 4) credit and liquidity risks have not been considered. In addition, it is important to note that AFS securities in an unrealized loss position, as reflected in OCI, may at some point in the future be realized either through a sale or impairment. (ii) Equity market fluctuation risk: Fluctuations in the value of equity securities affects the level and timing of recognition of gains and losses on securities held, and causes changes in realized and unrealized gains and losses. General economic conditions, political conditions and many other factors can also adversely affect the stock markets and, consequently, the value of the equity securities the Exchange owns. To mitigate these risks, the Exchange establishes an investment policy which is approved by the Board of Directors. The policy sets forth limits for each type of investment and compliance with the policy is closely monitored. The Exchange manages market risk through asset class diversification, policies to limit and monitor its individual issuers and aggregate equity exposure ANNUAL REPORT

21 7. Financial risk management (continued): (d) Market risk (continued): (ii) Equity market fluctuation risk (continued): As at December 31, 2010, management estimates that a 10% increase in equity markets, with all other variables held constant, would impact OCI by approximately $3,882,000 ( $2,952,000). A 10% decrease in equity prices would have the corresponding opposite effect, impacting OCI by the same amounts. Stocks comprise 25.5% ( %) of the fair value of the Exchange s total investments. (iii) Foreign exchange risk: Foreign exchange risk is the possibility that changes in exchange rates produce an unintended effect on earnings and equity when measured in domestic currency. This risk is larger when assets backing liabilities are payable in one currency and are invested in financial instruments of another currency. The Exchange monitors the exposure of invested assets to foreign exchange and limits these amounts when deemed necessary and mitigates foreign exchange rate risk. The Exchange may nevertheless, from time to time, experience losses resulting from fluctuations in the values of these foreign currencies, which could adversely affect operating results. As at December 31, 2010, the Exchange held no instrument of another currency. 8. Pension plan: All employees of the Exchange are eligible to be members of the Ontario Municipal Employees Retirement System ( OMERS ), a multi-employer pension plan. The plan provides defined pension benefits to employees based on their length of service and rates of pay. From the inception date of September 1, 2004 to December 31, 2010, eligible employees contributed at rates between 6% and 9% of earnings. The Exchange contributions equal the employee contributions to the plan. During the year ended December 31, 2010, the Exchange contributed $121,740 to the plan. As this is a multi-employer pension plan, these contributions are the Exchange s pension benefit expenses. No pension liability for this type of plan is included in the Exchange s financial statements. The Exchange had an outstanding letter of credit with OMERS in the amount of $130,000, which expires on September 30, Structured settlements: The Exchange, in the normal course of settling certain insurance claims, purchases annuities from unrelated life insurance companies who are licensed in Canada and regulated by the Superintendent of Financial Institutions Canada. These life insurance companies then make periodic payments to the Exchange s claimants. The Exchange is exposed to credit risk to the extent that any of the life insurance companies are unable to continue making these annuity claims payments. The Exchange s maximum exposure to credit risk for these types of arrangements is approximately $17,290,975 ( $17,727,105) as at December 31, This exposure is reduced to the extent of coverage provided by the life insurance industry Assuris insurance plan. The Exchange has determined that no credit risk provision is required at December 31, ANNUAL REPORT 21

22 10. Guarantee fund: (a) In accordance with the Agreement, subscribers were not obliged to contribute any amounts to the Exchange in the form of a capital contribution. The Guarantee Fund, therefore, represents the cumulative excess of income over expenses, including investment income, and may be used to cover potential future catastrophe claims or reduce future premiums as appropriate. The Agreement provides that additional assessments may be made to the subscribers to the extent that premiums collected are insufficient to cover the claims and expenses experienced by the Exchange. Similarly, where accumulated funds are in excess of funds required to meet the obligations in respect of claims arising, the Agreement provides for the issue of premium credits. The Board of Directors approved the refund of $nil ( $1,500,000) to liability subscribers, $nil ( $nil) to property subscribers and $nil ( $750,000) to automobile subscribers. The Insurance Act of Ontario requires the Exchange to maintain a Guarantee Fund of at least $50,000. (b) The additional guarantee funds relate to the following underwriting groups: General liability $ 24,775,568 $ 22,287,149 Property, boiler and machinery and crime 15,309,141 11,757,653 Automobile 9,161,211 8,441,183 $ 49,245,920 $ 42,485, Commitments: In December 2008, the Exchange entered into an agreement to lease office space until Minimum rent payable for each of the next three years is as follows: 2011 $ 24, , , Capital management: Capital is comprised of the Exchange s Guarantee Fund. As at December 31, 2010, the Exchanges Guarantee Fund was $57,185,500 ( $45,169,875). The Exchange s objectives when managing the capital are to maintain financial strength and protect its claim paying liabilities. Senior executive management works with the actuary to develop the capital strategy and targets for each line of business. The liability target is 55% of annual written premium. Property and auto targets are set based on the self retention of the related reinsurance policy. Distribution of excess capital back to members is evaluated by the actuary and senior executive management on an annual basis, and any distributions are made based on the determinations of the Actuary. The Exchange can build its capital through member contributions directly to the surplus account of the Exchange. The minimum capital levels for the Exchange are monitored by their regulator, the Financial Services Commission of Ontario ANNUAL REPORT