1 CAS Casualty Loss Reserve Seminar September 13-15, 2004 Reserving for Title Insurance and Residual Value Coverage Alan Hines, FCAS PwC LLP Reserving

1

CAS

Casualty Loss Reserve Seminar September 13-15, 2004

CAS

Casualty Loss Reserve Seminar September 13-15, 2004

Reserving for Title Insurance

and

Residual Value Coverage

Alan Hines, FCAS

PwC LLP

Reserving for Title Insurance

and

Residual Value Coverage

Alan Hines, FCAS

PwC LLP

2

Overview of Residual Value CoverageOverview of Residual Value Coverage

Insured Exposure: Protects the owner of an asset against a severe reduction in the

market value at a fixed point in time.

Definitions: Asset Expiration: Fixed Point in Time Insured Value: fcn (Expected Residual Value) anticipates

depreciation greater than expected depreciation. Residual Value: fcn (Market Value or Book Value) defined by

policy terms Insured Loss: (Residual Value < Insured Value) at Asset

Expiration Attachment Ratio – Insured Amount / Original Value Coverage Ratio – Insured Amount / Current Value

Insured Exposure: Protects the owner of an asset against a severe reduction in the

market value at a fixed point in time.

Definitions: Asset Expiration: Fixed Point in Time Insured Value: fcn (Expected Residual Value) anticipates

depreciation greater than expected depreciation. Residual Value: fcn (Market Value or Book Value) defined by

policy terms Insured Loss: (Residual Value < Insured Value) at Asset

Expiration Attachment Ratio – Insured Amount / Original Value Coverage Ratio – Insured Amount / Current Value

3


Assets Insured

Vehicles

Real Estate

Aircraft

Commercial Equipment – special machinery, construction equipment, railroad locomotives, computers & electronics

Assets Insured

Vehicles

Real Estate

Aircraft

Commercial Equipment – special machinery, construction equipment, railroad locomotives, computers & electronics

4


Who Purchases Coverage

Automobile Dealerships

Banks and Finance Companies

Credit Tenant Lease Arrangers (guarantying the balloon payment on the note)

Commercial Equipment Manufacturers with leasing programs

Who Purchases Coverage

Automobile Dealerships

Banks and Finance Companies

Credit Tenant Lease Arrangers (guarantying the balloon payment on the note)

Commercial Equipment Manufacturers with leasing programs

5


Competitors in Market Active ???: AIG, Great American, Chubb, RVI, QBE,

Mitsui Sumoto, and a few small specialty insurers

Inactive???: Gulf (Travelers), St. Paul, Reliance, Philadelphia, Royal Sun Alliance (FSL), Swiss Re (North American Specialty), Hartford, ACE

Difficulty assessing since there is no annual statement line for this coverage. Usually under Aggregate Write-in or Financial Guaranty

Competitors in Market Active ???: AIG, Great American, Chubb, RVI, QBE,

Mitsui Sumoto, and a few small specialty insurers

Inactive???: Gulf (Travelers), St. Paul, Reliance, Philadelphia, Royal Sun Alliance (FSL), Swiss Re (North American Specialty), Hartford, ACE

Difficulty assessing since there is no annual statement line for this coverage. Usually under Aggregate Write-in or Financial Guaranty

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Material Risk Factors

Economic Downturn

Excess Production (supply)

Market Trends – (demand)

Innovations – Rendering Asset Obsolete

Material Risk Factors

Economic Downturn

Excess Production (supply)

Market Trends – (demand)

Innovations – Rendering Asset Obsolete

7


Two Types of Products

Asset Value Risk – protects the residual value at lease termination.

FASB 13 Risk - This is residual value insurance to allow for the lessee and lessor to use the most favorable accounting treatment for the lease

Two Types of Products

Asset Value Risk – protects the residual value at lease termination.

FASB 13 Risk - This is residual value insurance to allow for the lessee and lessor to use the most favorable accounting treatment for the lease

8

FASB 13 RiskFASB 13 Risk

Accounting Treatment for Leases

- Finance lease accounting – lessor can smooth earnings over the term of the lease

- Operating lease accounting – earnings are realized at the latter part of the lease

To Qualify for financing lease treatment:

PV (Lease payments + guaranteed residual value)

must be > 90% fair value of leased asset at lease inception

Lessee and Lessor need not use same treatment when 3rd party guarantees the residual value.

- Lessee can use operating lease treatment with off-balance sheet financing that results in delayed expense recognition

Accounting Treatment for Leases

- Finance lease accounting – lessor can smooth earnings over the term of the lease

- Operating lease accounting – earnings are realized at the latter part of the lease

To Qualify for financing lease treatment:

PV (Lease payments + guaranteed residual value)

must be > 90% fair value of leased asset at lease inception

Lessee and Lessor need not use same treatment when 3rd party guarantees the residual value.

- Lessee can use operating lease treatment with off-balance sheet financing that results in delayed expense recognition

9

FASB 13 RiskFASB 13 Risk

Insured value established to meet 90% test

Low risk of loss

Do policies meet FAS 113 risk transfer requirements?

Insured value established to meet 90% test

Low risk of loss

Do policies meet FAS 113 risk transfer requirements?

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Establishing Insured ValuesEstablishing Insured Values

Establishing Insured Values 90% rule for FASB13 Auto Leasing Guide - Percentage thereof Residualized MSRP Underwriting Models to Project Residual Value

Establishing Insured Values 90% rule for FASB13 Auto Leasing Guide - Percentage thereof Residualized MSRP Underwriting Models to Project Residual Value

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Establishing Market Value at ExpirationEstablishing Market Value at Expiration

PV – Black Book, Auction Value RE – Appraisal Value – defined approach CE – Green Book Aircraft – Blue Book

Specific policy provisions regarding return conditions and which value/method to use.

PV – Black Book, Auction Value RE – Appraisal Value – defined approach CE – Green Book Aircraft – Blue Book

Specific policy provisions regarding return conditions and which value/method to use.

12

Accounting IssuesAccounting Issues

Incurred Loss – When is a loss incurred?A. At policy (asset) expiration. Accident year is asset

expiration date.B. Proportionally over the life of asset – when there is a

reasonable expectation that the residual value of the asset will be less than the insured value at asset expiration, the expected value of the earned loss shall be recorded. Accident year of paid loss is distributed proportional to asset term.

C. Must match method for earning premium

Incurred Loss – When is a loss incurred?A. At policy (asset) expiration. Accident year is asset

expiration date.B. Proportionally over the life of asset – when there is a

reasonable expectation that the residual value of the asset will be less than the insured value at asset expiration, the expected value of the earned loss shall be recorded. Accident year of paid loss is distributed proportional to asset term.

C. Must match method for earning premium

13


Earned Premium – How is premium earned?A. Expenses earned over policy period, remainder at

policy (asset) expirationB. Proportionally over the life of policy assetC. Sum of digits method – (like rule of 78) sometimes

used for FASB 13 risk

Earned Premium – How is premium earned?A. Expenses earned over policy period, remainder at

policy (asset) expirationB. Proportionally over the life of policy assetC. Sum of digits method – (like rule of 78) sometimes

used for FASB 13 risk

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Reserves:

- Limited use of Case Basis reserves. Multiple asset policies with reporting requirements and settlement lag

- IBNR Reserve – To match premium recognition

- Premium Deficiency Reserve Testing Required

- Statutory reserves – Some states may establish statutory reserve requirements

Reserves:

- Limited use of Case Basis reserves. Multiple asset policies with reporting requirements and settlement lag

- IBNR Reserve – To match premium recognition

- Premium Deficiency Reserve Testing Required

- Statutory reserves – Some states may establish statutory reserve requirements

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US GAAP Accounting: Insurance or Derivative? FAS 133 – Accounting for derivatives and

hedging activities:- When the residual value is based on an asset appraisal, or

proceeds from a sale exception 10 (e) (2) is met and the contract may be treated as insurance.

- When the residual value is based on reference to an asset valuation guide (Black Book, Blue Book, Green Book) instead of a specific asset appraisal, the contract does not qualify for the 10 (e) (2) exception and must be accounted for as a derivative.

- When based on a combination of a multiple underlyings (ie higher of…), accounting based on contract’s predominant characteristics. Under 10(e) no exception if residual value of other underlyings is highly correlated to guide book!

US GAAP Accounting: Insurance or Derivative? FAS 133 – Accounting for derivatives and

hedging activities:- When the residual value is based on an asset appraisal, or

proceeds from a sale exception 10 (e) (2) is met and the contract may be treated as insurance.

- When the residual value is based on reference to an asset valuation guide (Black Book, Blue Book, Green Book) instead of a specific asset appraisal, the contract does not qualify for the 10 (e) (2) exception and must be accounted for as a derivative.

- When based on a combination of a multiple underlyings (ie higher of…), accounting based on contract’s predominant characteristics. Under 10(e) no exception if residual value of other underlyings is highly correlated to guide book!

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Estimating Loss Reserves Estimating Loss Reserves

Loss Ratio Approach

Aggregate Models

– Frequency Severity Approach

– Development of Coverage Ratios

Econometric Modeling

– Individual Asset

– Asset Classes

Loss Ratio Approach

Aggregate Models

– Frequency Severity Approach

– Development of Coverage Ratios

Econometric Modeling

– Individual Asset

– Asset Classes

17

Estimating Loss ReservesEconometric Modeling


Database of Insured Assets Original Appraisal Date and Value Most recent value and valuation date Asset Termination Date and Insured Value Asset Characteristics: PV - make, model, year, VIN

RE – age, construction, location, use Policy Parameters: deductibles, offset, limits, mileage/asset

condition charges, settlement terms

Database of Insured Assets Original Appraisal Date and Value Most recent value and valuation date Asset Termination Date and Insured Value Asset Characteristics: PV - make, model, year, VIN

RE – age, construction, location, use Policy Parameters: deductibles, offset, limits, mileage/asset

condition charges, settlement terms

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Projection Assumptions Probability of reaching full term

Probability of return to lessor at end of term

Current book value

Depreciation

Projection Assumptions Probability of reaching full term

Probability of return to lessor at end of term

Current book value

Depreciation

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Probability of Reaching Full Term Not Constant

Varies by length of lease

Varies by type of vehicle

Function of market value gain or loss

Probability of Reaching Full Term Not Constant




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Probability of a PV Lease Reaching Full Term

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

-25% -20% -15% -10% -5% 0% +5% +10% +15% +20% +25%

Market Value Gain as % of MSRP

Pro

ba

bil

ity

of

Fu

ll R

etu

rn

24 36 48 60

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Probability of Vehicle Being Returned to Lessor




Probability of Vehicle Being Returned to Lessor




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Probability of a PV Lease Being Returned to Lessor Full Term

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

-25% -20% -15% -10% -5% 0% +5% +10% +15% +20% +25%


Pro

ba

bil

ity

of

Fu

ll R

etu

rn

24 36 48 60

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Probability of Return, 5-Year Leases by Segment

20%

25%

30%

35%

40%

45%

50%

-20% -15% -10% -5% 0% +5% +10% +15% +20%


Pro

ba

bil

ity

of

Fu

ll R

etu

rn

LUXURY VEHICLE PASSENGER CAR SUV TRUCK VAN

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PV Depreciation Data Sources

Auto Leasing Guide (ALG)

Black Book Used Vehicle Guide

Bureau of Labor Statistics (CPI)

Global Insight (DRI) economic indices

Manheim Used Vehicle Indices

PV Depreciation Data Sources

Auto Leasing Guide (ALG)

Black Book Used Vehicle Guide

Bureau of Labor Statistics (CPI)

Global Insight (DRI) economic indices

Manheim Used Vehicle Indices

25



Modeling Used Vehicle Depreciation Vehicle Attributes – Make, Segment, Body Style, Age

Product cycle (age of body style)

Seasonality

Supply – Competition Index (dealer incentives), Used Vehicle Stock Index (by segment), New Vehicles Sold (lagged 3-5 years)

Demand – Consumer Confidence, Unemployment

Economic Factors – New and Used Car Price Index, New Car Auto Loan Rate, CPI

Modeling Used Vehicle Depreciation Vehicle Attributes – Make, Segment, Body Style, Age

Product cycle (age of body style)

Seasonality

Supply – Competition Index (dealer incentives), Used Vehicle Stock Index (by segment), New Vehicles Sold (lagged 3-5 years)

Demand – Consumer Confidence, Unemployment

Economic Factors – New and Used Car Price Index, New Car Auto Loan Rate, CPI

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Estimating Loss ReservesEconometric Modeling:Estimating Depreciation


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28



75

80

85

90

95

100

105

110

115

Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03

Compact Luxury Midsize Sports SUV

75

80

85

90

95

100

105

110

115

Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03

Compact Luxury Midsize Sports SUV

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Estimating Loss ReservesEstimating Depreciation

Average Monthly Depreciation – 1999 Vehicles

Estimating Loss ReservesEstimating Depreciation

Average Monthly Depreciation – 1999 Vehicles

Ave. Monthly Ave. Monthly Ave. Monthly

Vehicle Type Depreciation Vehicle Type Depreciation Vehicle Type Depreciation

SUV Luxury Mid Size

Ford Explorer 2.16Lincoln Continental 1.98 Ford Taurus 2.23

Chevrolet Blazer 2.04

Chevrolet Corvette 1.21

Chevrolet Malibu 2.11

Toyota 4Runner 1.23 Lexus GS300 1.43 Toyota Camry 1.42

Honda CRV 1.21 Acura RL 1.57 Honda Accord 1.34

Mitsubishi Montero 1.57

Mitsubishi 300GT 0.96

Mitsubishi Gallant 1.88

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Monthly Depreciation Rates ’00 to ’04 (All Segments)Weighted Average Black Book

Month 2000 2001 2002 2003 2004Wt.

Average

January -1.64 -1.81 -0.67 -1.25 -1.50 -1.26

February -1.62 -1.22 1.52 -1.79 -1.24 -0.84

March -2.97 -1.29 0.44 -1.65 -0.92 -0.90

April -1.41 -1.36 -0.38 -1.66 -0.59 -0.95

May -0.88 -0.79 -1.02 -1.25 0.54 -0.47

June -1.95 -0.88 -1.58 -1.33 -0.35 -0.99

July -2.23 -1.74 -1.45 -0.45 -1.72 -1.26

August -0.54 -1.38 -1.21 -0.55 -2.25 -1.40

September -1.48 -1.80 -1.64 -0.16 -1.69 -1.20

October -0.79 -1.28 -2.50 -0.32 -1.24

November -2.24 -7.92 -4.50 -2.41 -3.75

December -3.06 -1.10 -3.00 -2.27 -2.45

Wt. Average -1.75 -1.91 -1.34 -1.26 -1.07

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PV Underwriting Considerations

Who is insured, Bank or Dealer

Type of Vehicles

Mileage and Condition

Length of Lease

Market Trends

Optional Equipment

Deductibles

PV Underwriting Considerations

Who is insured, Bank or Dealer

Type of Vehicles

Mileage and Condition

Length of Lease

Market Trends

Optional Equipment

Deductibles

32



Real Estate

Long Term Projections

Monitor Mark to Market Coverage Ratios

Monitor Concentration of Risk

Assess loss of stressed markets by assessing relative position of the cycle and cycle delta for historical depressions.

Real Estate

Long Term Projections

Monitor Mark to Market Coverage Ratios

Monitor Concentration of Risk

Assess loss of stressed markets by assessing relative position of the cycle and cycle delta for historical depressions.

33



Real Estate Depreciation Data Sources

National Real Estate Index - Global Real Analytics

Standard & Poors

Cushman & Wakefield and SIOR Market Reports

Property & Portfolio Research, Inc (ppr.info)

CB Richard Ellis (cbre.com)

Torto Wheaton Research (trw.com)

Real Estate Depreciation Data Sources

National Real Estate Index - Global Real Analytics

Standard & Poors

Cushman & Wakefield and SIOR Market Reports

Property & Portfolio Research, Inc (ppr.info)

CB Richard Ellis (cbre.com)

Torto Wheaton Research (trw.com)

34



Modeling Real Estate Depreciation Property Type – Office, Retail, Industrial, Hotel/Motel,

Other

Location – Standard Metropolitan Statistical Areas, State Average, National Average

Supply/Demand – Average Market Rent, New Starts, Completions, Vacancy Rates, Net Absorption, Total Occupancy

Economic Factors – Market Capitalization Rates, Interest rates, Employment

Modeling Real Estate Depreciation Property Type – Office, Retail, Industrial, Hotel/Motel,

Other

Location – Standard Metropolitan Statistical Areas, State Average, National Average

Supply/Demand – Average Market Rent, New Starts, Completions, Vacancy Rates, Net Absorption, Total Occupancy

Economic Factors – Market Capitalization Rates, Interest rates, Employment

35


Real Estate Depreciation


Real Estate Depreciation

National Average

0

50

100

150

200

250

1985

Q4

1986

Q4

1987

Q4

1988

Q4

1989

Q4

1990

Q4

1991

Q4

1992

Q4

1993

Q4

1994

Q3

1995

Q1

1995

Q3

1996

Q1

1996

Q3

1997

Q1

1997

Q3

1998

Q1

1998

Q3

1999

Q1

1999

Q3

2000

Q1

2000

Q3

2001

Q1

2001

Q3

2002

Q1

2002

Q3

2003

Q1

2003

Q3

2004

Q1

Pri

ce

ps

f Industrial

Office

Retail

Suburban Office

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Estimating UPR ReservesThree NAIC Tests

Estimating UPR ReservesThree NAIC Tests

Test #1 – Best estimate of the amounts refundable to contract holders.

Test #2 – Gross premium multiplied by the ratio of gross losses and expenses incurred during the unexpired term to the total gross losses and expenses under the contract (nominal basis).

Test #3 – The present value of the expected future losses and expenses.

Test #1 – Best estimate of the amounts refundable to contract holders.

Test #2 – Gross premium multiplied by the ratio of gross losses and expenses incurred during the unexpired term to the total gross losses and expenses under the contract (nominal basis).

Test #3 – The present value of the expected future losses and expenses.

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Estimating UPR ReservesEstimating UPR Reserves

Test 1: Not applicable Test 1: Not applicable

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NAIC Tests 2 & 3 for UPR ReservesNAIC Tests 2 & 3 for UPR Reserves

Proportion Back-End

Company Company

1 GWP 100 100

2 EP 35 10

3 UEP 65 90

4 Tot Expense 28 28

5 Incurred 22 22

6 Remaining 6 6

7 Projected Loss 110 110

8 Incurred 38.5 0

9 Remaining 71.5 110

Test 2

10 Ratio (9+6)/(4+7) 56.2% 84.1%

11 Required UEP 56.2 84.1

Test 3

12 Discount Factor 90% 90%

13 PV (Loss & Expense) = (12)x[(9) +(6)] 69.8 104.4

14 UPR Reserve = Max [(3), (11), (13)] 69.8 104.4

15 Total Reserves (8) + (14) 108.3 104.4

Documents

1 CAS Casualty Loss Reserve Seminar September 13-15, 2004 Reserving for Title Insurance and Residual Value Coverage Alan Hines, FCAS PwC LLP Reserving