Interpreting Financial Ratios and Using Financial Ratios for Decision Making on Retention Levels,

Setting Target Equity Levels and Dividend Reimbursements

CAJPA 2006

Fall Conference and Training SeminarSeptember 20 – 22, 2006

South Lake TahoePresented by:

Mujtaba Datoo, ACAS, MAAAActuarial Practice Leader

ARM Tech23701 Birtcher Drive, Lake Forest, CA 92630

(949) 470-4343 • FAX (949) 470-4340 • www.armtech.com

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Discussion Points

• Conceptual framework• Variability

Need for surplus Confidence level, contingency margin

• Target surplus level• Equity position• Dividend release• Summary

So how do you get So how do you get to your goal?to your goal?

Different people get there differently, or not…

The English PlanThe English Plan

Depending on the wind, the striker’s position may vary…

The German PlanThe German Plan

Radical, efficient, unstoppable… (ball’s speed may reach 180 mph)

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Pooling and Self-Insurance,Insurance mechanism

• Essentially the business is an insurance enterprise

Pay generally fixed premium up front for a promise to pay claims later

Claims will not be known for a while and are subject to variation

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Balancing Formula

Premium + inv income = losses + expenses

fixed fixedminimal variable

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Variance…

• Losses estimates are inherently variable• Confidence Level is a statistical measure• Varies by coverage

Excess Liability – very variable WC – indemnity less variable than medical part Auto Liability – generally more stable

• The greater the SIR, the greater the potential for variability

9

Sources of variation

• Process risk risk associated with projection of future contingencies

that are inherently variable

• Parameter risk risk associated with selection of parameters of the

model, e.g. selecting the wrong LDF

• Model risk Misidentifying a process model, e.g. Poisson for

frequency

Surplus provides primary protection against adverse deviation

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Surplus is key measure

• Assets minus Liabilities = Surplus

• Surplus a.k.a. Net assets Pool equity Retained earnings Policyholder’s Surplus

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What are your assets

• Cash• Bonds• Other investments• Real estate• Accounts receivables• Etc.

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What are your liabilities

• Claims payable Case reserves Case reserve development Incurred But Not Reported (IBNR) reserves Allocated loss adjustment expense (ALAE)

• Unallocated loss adjustment expense (ULAE)• Other expense payable• Etc.

Outstanding Losses are the largest component of liabilities

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Reasons for Surplus

• Absorb adverse loss development – KEY reason• Reinsurers may become insolvent

Contingent liabilities

• Use for rate stabilization• Rating agencies• Make pool more attractive to

Prospective members Reinsurers

• Required by state regulators (private sector)

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Determining Surplus Adequacy,the considerations

• Lines of coverage Long tail, short tail Amount of reserves

• Retention level, i.e. SIR• Annual contribution (premium) volume• Strategic plan

Competitive environment Target levels

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Financial Measures

• Used by private sector to determine Financial solidity Developed to weed out financially troubled companies Many measures from simple to complex

• IRIS ratios: Premium to Surplus (3:1), etc.• Risk Based Capital (RBC) requirements

• Basic building blocks are the same

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How much Surplus?

• Set key financial measure targets Premiums Contributions to Surplus Reserves to Surplus SIR to Surplus

• Financial ratios based on private sector experience Applies to public entities – same risk measure concept Not quite apples to apples, say apples to oranges!

• Benchmark range is still a good guide

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Premium-to-Surplus

• Premium-to-surplus ratio well within usual range of less than 3:1

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

2000

2001

2002

2003

2004

benc

hmar

k

Able to:

Increase retention,

Return dividends,

Increase membership

AM Bests – Workers Comp

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Loss Reserves-to-Surplus

• Reserve-to-surplus ratio well within usual range for WC of 3 (to 4):1

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2000

2001

2002

2003

2004

benc

hmar

k

Able to withstand adverse development

AM Bests – Workers Comp

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Retention Levels Depends on:

• Amount of Surplus• Subjective willingness to bear risks

The “flinch test”

• Excess insurance pricing Market availability

• Other benchmarks, measures

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Freakonomics

Risk = hazard + outrage

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SIR-to-Surplus

0.0

2.0

4.0

6.0

8.0

10.0

12.0

2003

2004

2005

benc

hmar

k

• SIR-to-surplus ratio well above 10:1

Able to withstand more large claims (up to retention levels)

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Ratios are relativity concepts

• Financial ratios are all relative measures Relative to other companies Data adjusted to common levels

• Discounted vs. undiscounted• Market value of investments

• Absolute measures do not exist! No one right answer Use reasonable ranges Compare to your similar entities

The Italian PlanThe Italian Plan

Iron defense, small ideas in midfield, passes to striker..and…Penalty

The Brazilian PlanThe Brazilian Plan

… no comments!

The Australian PlanThe Australian Plan

They manage to lose the game by themselves, no help needed.

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The Dividend Decision

• How much income is available for release?• Relate to Surplus target levels

Use confidence level measures Accumulate surplus gradually to target levels Release in staggered amounts Wait for claims to close or sufficient period to

minimize variability

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Equity, conceptually

Premium Contribution FY 2004/05

Plus Investment income earned 2004/05

Less Program expenses 2004/05

Losses paid in 2004/05

Loss reserves

Other adjustments/dividend payable

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Equity calculation, Funds available

Fiscal

Period

Ending

Contributions

Inv.

Income

accrued

Limited

Losses

Paid

Operating

Expenses

Dividends

Declared

Funds

available

(1) (2) (3) (4) (5) (6)(7) = (2)+(3) - (4) - (5) -(6)

1997 $1,858 $45 $558 $1,143 $226 ($23)

1998 2,274 197 496 1,090 381 503

1999 1,486 60 937 746 17 (153)

2000 3,234 348 675 1,570 0 1,356

2001 3,082 314 803 1,109 0 1,485

2002 3,097 242 532 1,437 0 1,369

2003 3,174 160 505 1,339 0 1,489

2004 3,356 133 284 1,322 0 1,882

2005 1,250 41 81 608 0 602

TOTAL 22,815 1,545 4,875 10,367 624 8,493

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Equity calculation, Equity above Confidence Level

Fiscal

Period

Ending

Funds

available

Outstanding

Losses

And ULAE

Equity

Confidence

Level

Target

Additional

Funds

For C/L

Equity

Above

C/L

(1) (2) (3)(4)

(2) – (3)(5) (6)

(7)

(4) - (6)

1997 $(23) $0 ($23) 90% $0 ($23)

1998 503 10 492 90% 9 483

1999 (153) 0 (153) 90% 0 (153)

2000 1,356 6 1,329 90% 6 1,323

2001 1,485 156 1,329 90% 137 1,1,91

2002 1,369 670 699 90% 129 570

2003 1,489 612 877 90% 211 660

2004 1,882 903 978 90% 154 824

2005 602 516 85 90% 32 53

TOTAL 8,493 2,876 5,616 680 4,915

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Equity calculation, Target Equity Release

Fiscal

Period

Ending

Equity

Above

C/L

Target

Equity

Release

Equity

Above

C/L

(1)(7)

(4) - (6)(5)

(7)

(4) - (6)

1997 ($23) 100% ($23)

1998 483 75% 362

1999 (153) 75% (153)

2000 1,323 50% 661

2001 1,1,91 50% 595

2002 570 25% 142

2003 660 25% 166

2004 824 0% 0

2005 53 0% 0

TOTAL 4,915 1,752

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Equity release

• Use Fund Year Accounting Relates to members who participated in the same

years

• Accumulate gradually Through rate additions Assessments

• Release in staggered stages When all claims are closed, or Longer waiting and release time for long-tail lines

• Ensure overall financial targets are met

In their plan, they try all possible hypotheses.

Oh No! Oh No! Oui, Oui Oui, Oui …they forgot the goal…they forgot the goal

The French PlanThe French Plan

Mujtaba’s PlanMujtaba’s Plan

Survey the field, build advancing strategies, and strike…..

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The Big Picture…

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Projected Financial PositionAs of June 30, 2005

Program at about 75% confidence level

$0

$5

$10

$15

$20

$25

Investment Income 1.1 1.1 1.1

Confidence Level Margin 0.0 1.8 5.7

Discounted Liabilities 11.5 11.5 11.5

Other Liabilities 18.9 3.4 3.4 3.4

Assets Available 18.9 18.9 18.9 18.9 18.9

Assets Expected 70% 90%

Surplus $4 M

What are your goals?What are your goals?

For a long-term, financially solid win…

Surplus is cushion for adverse deviation, etc.

Make gradual, incremental changes

Understand underlying concepts, assumptions

Compare to peer group or entity

Set reasonable targets

Monitor regularly, adjust if necessary

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Summary

• Losses are inherently variable• Variability cushioned by surplus• Set target financial measures

Reserves, premium and SIR to Surplus

• Establish dividend release formula Calculate equity position by Fund Year Accumulate surplus gradually, release slowly

• Review plan periodically Details change, e.g. SIRs, membership, etc. Does it work and achieve equity?

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Questions?

Thank you.

Mujtaba Datoo, ACAS, MAAAActuarial Practice LeaderARM Tech(949) 470-4342mujtaba_datoo@armtech.com