CAS
Casualty Loss Reserve Seminar
September 13-15, 2004
Reserving for Title Insurance
and
Residual Value Coverage
Alan Hines, FCAS
PwC LLP
1
Overview 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
2
Overview of Residual Value Coverage
Assets Insured

Vehicles

Real Estate

Aircraft

Commercial Equipment – special machinery,
construction equipment, railroad locomotives,
computers & electronics
3
Overview of Residual Value Coverage
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
4
Overview of Residual Value Coverage
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
5
Overview of Residual Value Coverage
Material Risk Factors

Economic Downturn

Excess Production (supply)

Market Trends – (demand)

Innovations – Rendering Asset Obsolete
6
Overview of Residual Value Coverage
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
7
FASB 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
8
FASB 13 Risk

Insured value established to meet 90% test

Low risk of loss

Do policies meet FAS 113 risk transfer
requirements?
9
Establishing Insured Values
Establishing Insured Values
 90%
rule for FASB13
 Auto Leasing Guide - Percentage thereof
 Residualized MSRP
 Underwriting Models to Project Residual Value
10
Establishing Market Value at Expiration
– Black Book, Auction Value
 RE – Appraisal Value – defined approach
 CE – Green Book
 Aircraft – Blue Book
 PV
 Specific
policy provisions regarding return
conditions and which value/method to use.
11
Accounting Issues

Incurred Loss – When is a loss incurred?
A.
B.
C.
At policy (asset) expiration. Accident year is asset
expiration date.
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.
Must match method for earning premium
12
Accounting Issues

Earned Premium – How is premium earned?
A.
B.
C.
Expenses earned over policy period, remainder at
policy (asset) expiration
Proportionally over the life of policy asset
Sum of digits method – (like rule of 78) sometimes
used for FASB 13 risk
13
Accounting Issues

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
14
Accounting Issues
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!
15
Estimating Loss Reserves

Loss Ratio Approach

Aggregate Models
–
Frequency Severity Approach
–
Development of Coverage Ratios

Econometric Modeling
–
Individual Asset
–
Asset Classes
16
Estimating Loss Reserves
Econometric 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
17
Estimating Loss Reserves
Econometric Modeling
Projection Assumptions

Probability of reaching full term

Probability of return to lessor at end of term

Current book value

Depreciation
18
Estimating Loss Reserves
Econometric Modeling
Probability of Reaching Full Term Not Constant

Varies by length of lease

Varies by type of vehicle

Function of market value gain or loss
19
Estimating Loss Reserves
Econometric Modeling
Probability of a PV Lease Reaching Full Term
100%
Probability of Full Return
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
-25% -20% -15% -10%
-5%
0%
+5% +10% +15% +20% +25%
Market Value Gain as % of MSRP
24
36
48
60
20
Estimating Loss Reserves
Econometric Modeling
Probability of Vehicle Being Returned to Lessor

Varies by length of lease

Varies by type of vehicle

Function of market value gain or loss
21
Estimating Loss Reserves
Econometric Modeling
Probability of a PV Lease Being Returned to Lessor Full
Term
100%
Probability of Full Return
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
-25% -20% -15% -10%
-5%
0%
+5% +10% +15% +20% +25%
Market Value Gain as % of MSRP
24
36
48
60
22
Estimating Loss Reserves
Econometric Modeling
Probability of Return, 5-Year Leases by Segment
Probability of Full Return
50%
45%
40%
35%
30%
25%
20%
-20%
-15%
-10%
-5%
0%
+5%
+10%
+15%
+20%
Market Value Gain as % of MSRP
LUXURY VEHICLE
PASSENGER CAR
SUV
TRUCK
VAN
23
Estimating Loss Reserves
Econometric Modeling
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
24
Estimating Loss Reserves
Econometric Modeling
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
25
Estimating Loss Reserves
Econometric Modeling:
Estimating Depreciation
26
Estimating Loss Reserves
Econometric Modeling:
Estimating Depreciation
27
Estimating Loss Reserves
Econometric Modeling:
Estimating Depreciation
115
110
105
100
95
90
85
80
75
Jan-01
Jul-01
Jan-02
Compact
Jul-02
Luxury
Midsize
Jan-03
Sports
Jul-03
SUV
28
Estimating Loss Reserves
Estimating Depreciation
Average Monthly Depreciation – 1999 Vehicles
Ave. Monthly
Vehicle Type
Depreciation
Ave. Monthly
Vehicle Type
SUV
Luxury
Ford Explorer
2.16
Lincoln
Continental
Chevrolet
Blazer
Depreciation
Ave. Monthly
Vehicle Type
Depreciation
Mid Size
1.98
Ford Taurus
2.23
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
1.57
Mitsubishi
300GT
0.96
Mitsubishi
Gallant
1.88
Mitsubishi
Montero
29
Monthly Depreciation Rates ’00 to ’04 (All Segments)
Weighted Average Black Book
Month
2000
2001
2002
2003
2004
Wt.
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
30
Estimating Loss Reserves
Econometric Modeling
PV Underwriting Considerations

Who is insured, Bank or Dealer

Type of Vehicles

Mileage and Condition

Length of Lease

Market Trends

Optional Equipment

Deductibles
31
Estimating Loss Reserves
Econometric Modeling
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.
32
Estimating Loss Reserves
Econometric Modeling
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)
33
Estimating Loss Reserves
Econometric Modeling
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
34
19
85
19 Q4
86
19 Q4
87
19 Q4
88
19 Q4
89
19 Q4
90
19 Q4
91
19 Q4
92
19 Q4
93
19 Q4
94
19 Q3
95
19 Q1
95
19 Q3
96
19 Q1
96
19 Q3
97
19 Q1
97
19 Q3
98
19 Q1
98
19 Q3
99
19 Q1
99
20 Q3
00
20 Q1
00
20 Q3
01
20 Q1
01
20 Q3
02
20 Q1
02
20 Q3
03
20 Q1
03
20 Q3
04
Q1
Price psf
Estimating Loss Reserves
Econometric Modeling
Real Estate Depreciation
National Average
250
200
150
100
Industrial
Office
Retail
Suburban Office
50
0
35
Estimating UPR Reserves
Three 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.
36
Estimating UPR Reserves

Test 1: Not applicable
37
NAIC 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
56.2%
84.1%
Test 2
10
Ratio (9+6)/(4+7)
11
Required UEP
56.2
84.1
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
Test 3
38