Aon Global Risk Consulting
Ron Schuler FCAS, MAAA
Associate Director & Actuary
ron.schuler@aon.com
Overview
At a minimum, the process of estimating and evaluating
collateral amounts should seek to achieve the following
objectives:
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3.
Provide quantitative or qualitative information to be used for
decision-making by risk management and its partners,
constituents, and counter-parties.
Improve clarity, understanding, and eliminate ambiguities
underlying the collateral determination process.
Provide a robust set of supportable and understood analytics
and information which can be used to better understand and
support the determined collateral position(s) as well as other
related estimates and costs that impact the Total Cost of Risk
(TCOR).
Overview
Understanding A Company’s Collateral Position: Why is it relevant?
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Actual costs, credit capacity, and opportunity costs.
Managing expectations, effective communication, and negotiations require
information (that will be provided to and used by various parties).
Defines positional arguments.
Components of Total Cost of Risk (TCOR) shouldn’t be viewed in isolation, and thus,
collateral impacts other risk financing decisions.
Provides risk management perspective on performance relative to prior expectations,
performance metrics, and/or benchmarks.
Quantifies statistical information which provides insight into trends, operational
changes, or changes in risk profile.
Facilitates efficient audit, accounting, and risk management processes.
Provides prospective guidance for risk management and other financial purposes.
Assist with brokerage support, guidance, and recommendations.
Provide the necessary actuarial documentation which is consistent with actuarial,
financial, and accounting standards of practice.
Overview
Outputs are directly related to information provided to:
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b.
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d.
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f.
g.
h.
i.
Financial Reporting
Accounting / Budget
Risk Management (General)
Benchmarking / Performance Metrics
Internal / External Audit
Insurers / Regulators
Insurance Placement (Brokerage / Captive / Other )
Loss Control / Claims Management
Other Parties (M&A+D / Vendors)
The Basics: Collateral Calculation
Foundation of the Collateral Calculation:
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Actuarial Loss Reserve Analysis – Retrospective
Loss Forecast Analysis – Prospective
Risk Load Analysis – Retrospective & Prospective
Roll-Forward Analysis – Prospective
Financial Strength / Credit Risk Analysis – Prospective
Collateral = Ultimate Loss + Loss Forecast + Risk Load – Actual Paid –
Expected Paid – Working Fund (+/ – ) Other (+/ – ) Credit Adjustment
Other: Overdue Premium, Audit Premium, Retro Adj, LCF, LBA, etc.
The Basics: Collateral Calculation
Collateral Calculation & Negotiation Process: The Challenge
Don’t be a spectator: Actively manage the process.
Challenge the experts.
Challenge the methods, assumptions, data, and considerations
underlying the various analyses.
Challenge the status quo.
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b.
c.
d.
e.
f.
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Analysis vs. Approach
Retrospective & Prospective Components
Core Assumptions: Credibility, Complement, Risk, Coverage, Characteristics ,
Availability of Statistics, & Other
Determination & translation of credit risk to a probability of default (or vice versa)
Other Considerations: Technical and Contractual
Other General: e.g. Funding Options
Every item underlying the collateral calculation can be quantified:
Quantify, Challenge, Understand, Communicate, Repeat.
Collateral Calculation – An Example
ABC Corporation
Collateral Calculation Summary
Workers Compensation
Valuation Date as of 10/31/2008
Workers' Comp
1. Estimated Unpaid Loss Reserve as of 10/31/2008
a) Ultimate Loss
b) Paid Loss
c) Total Unpaid
2. Additional Exposure: 10/31/2008 - 2/28/2009
a) Additional Exposure for Current Policy Year
b) Expected Paid for Current Policy Year and Prior
c) Total Unpaid
3. Subtotal Unpaid as of 3/1/2009
Total Unpaid
4. Risk Load as of 3/1/2009
Included in Items 1 and 2
5. Subtotal as of 3/1/2009
Sum of Items 3 and 4
6. Other Considerations: As of 3/1/2009
a) Working Fund
b) Other
1) Overdue Premium
2) Audit Premium
3) Retro Adjustment
4) LCF
5) LBA
6) Other Misc
c) Subtotal (Sum Item 6 a through b )
7. Subtotal as of 3/1/2009
Sum of Items 5 and 6
Collateral Calculation – An Example
ABC Corporation
Collateral Calculation Summary
Workers Compensation
Valuation Date as of 10/31/2008
Workers' Comp
8. Forecast Policy Year 3/1/2009
a) Loss Forecast
b) Risk Load (Included in Item 8a)
c) LCF
d) Subtotal (Sum Item 8 a through c )
9. Expected Paid: 3/1/2009 - 2/28/2010
a) Expected Paid: Policy Year 3/1/2008 and Prior
b) Expected Paid: Other Considerations (Item 6)
c) Expected Paid: Policy Year 3/1/2009
d) Expected LCF: Policy Year 3/1/2009
e) Subtotal (Sum Item 9 a through d )
10. Total Financial Exposure Estimate
Subtotal ( Item 7 + Item 8d - Item 9d )
11. Present Value Adjustment
a) Unpaid for Pre- 3/1/2008
b) Other Considerations (Item 6)
c) Policy Year 3/1/2009
d) Other Considerations (Item 8c)
e) Subtotal (Sum Item 11 a through d )
12. Present Value of Financial Exposure Estimate
13. Financial Strength Adjustment
14. Estimated Collateral as of 3/1/2009
Probability of Default x Item 9e
Financial Strength / Credit Risk Analysis
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Used to assess financial strength and/or creditworthiness of insured
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Insurer Perspective: There are two types of risk (Reserve, Credit). Insurer is in
the business of insurance (i.e. not a bank), thus primary goal is to eliminate
exposure to credit risk
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Utilized by insurers to determine viability of writing program and/or
underwriting surcharge / discount
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Generally based on insurer judgment versus a more technical evaluation of credit
strength
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Consideration of relevant factors such as general economic conditions and how
they impact the insured, insured pro forma statements, the probability and
timing of default, variance / risk in loss estimates, expected recovery rates,
interest yields, and time value of money.
Financial Strength / Credit Risk Analysis
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Type of financials and information provided impact credit evaluation (Audited, Reviewed,
Compiled, & Internal)
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Preferred financials to review: Latest Audited, Interim, and supplemental information
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Other Information reviewed:
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Public Information: S&P, Moody’s, Fitch, D&B
Company Specific Information: SEC filings, Pro Formas, Interview, etc
Industry Specific Information: Competitive, Industry, Key Economic Variables
Financial credit review results in credit “rating” which, in turn, should be converted to
expected probabilities of default
Probabilities of Default similar to Rating Agencies (S&P, Moody’s, Fitch)
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BBB+ and Above: Investment Grade / Superior
BBB to BBB-: Speculative / Average
B and Below: Distressed / In Default
Financial Strength / Credit Risk Analysis
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Types of financial ratios: Liquidity, Leverage, Profitability, and Cash Flow
Liquidity Ratios: Measure ability to meet short-term obligations.
Net Working Capital = Current Assets less Current Liabilities
Current Ratio = Current Assets / Current Liabilities
Rules of Thumb:
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NWC > 0 for Y year period
CR > 2
Leverage Ratios: Measure the extent to which a company is financed with
debt.
Long-term debt (LTD) to Equity or LTD to Tangible Equity : Provides an indication of long-term solvency.
Tangible Equity = Equity less Goodwill less Intangible Assets
Times Interest Earned (TIE) = EBIT / Interest Expense
Rules of Thumb:
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b.
LTD / E < 1 is acceptable; LTD / E > 2 implies a potential issue to pay interest and principle
3 < TIE < 5 is acceptable; TIE < 3 is poor and TIE > 5 is good
Financial Strength / Credit Risk Analysis
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Profitability Ratios: Measure ability to meet short-term obligations.
Return on Sales = Net Income / Revenue; measures operating margin
Operating Margin = EBIT / Revenue; measures operating margin before interest & tax
Return on Total Assets = Net Income / Total Assets or EBIT / Total Assets; measures how effectively firm
assets are used.
Return on Equity = Net Income / Equity; measure the return on invested capital
Rules of Thumb:
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b.
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Need to review short- and long-term
ROE > Industry Benchmark
Cash Flow Ratios: Measure whether firm is a cash generator or user.
Net Cash Flow: CF > 0 (generator), CF < 0 (user)
CF to Revenue = CF / Revenue; measures the cash generating ability of revenues
CF to CMLTD = CF / CMLTD; measures firms ability to generate sufficient cash to meet short-term fixed
obligations; CMLTD = Current maturity of LTD
Rules of Thumb:
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a.
b.
Need to review short- and long-term
CF / Revenue > 0 is acceptable