Strategic Planning for Captive Growth
A Capital Modelling Perspective
Strategic Planning for Captive Growth
Speakers:
• William Montanez, Director, Risk Management, Ace Hardware
• Jeff Doffing, Director & Actuary, Aon Risk Consulting
• Jim McNichols, Risk Modeling Actuary, Aon Risk Consulting
Moderator:
• Robert Paton, Executive VP, Aon Captive Managers
Strategic Planning for Captive Growth
Ace Hardware Corporation (Ace)
– Founded in Chicago (1924) by local hardware store owners
to leverage group purchasing power
– Current Corporate Headquarters in Oak Brook, Illinois
• Established Ace Insurance Agency in 1981
• Formed Bermuda based captive in 1996
– Largest retailer-owned hardware cooperative in the industry
– Each store is independently owned by local entrepreneurs
– 4,400 Retailer owned & operated stores worldwide
– 4,100 US based locations
Strategic Planning for Captive Growth
Captive Background for New Age Insurance, Ltd (“NAIL”)
– Formed by Ace Hardware in 1996 as a Class 3 (re)insurer
with $1 million of capital and several strategic objectives:
•
•
•
•
•
•
Achieve long term insurance cost savings
Stabilize insurance expenses for corporate and retail
Minimize administrative and operating costs
Attain efficient funding levels for retained risk
Enhance coverage options for retail operations
Increase retail risk program market penetration
Strategic Planning for Captive Growth
• Captive (NAIL) Profile and Performance
– Underwrites WC/GL/Auto/Property exposures (related risk
& 3rd party) at varying retentions averaging $500,000/occ.
•
•
•
•
•
2009 Gross/Net Written Premium = $12.5 MM/10.5 MM
2000-2009 Average Loss & ALAE ratio = 70%
2000-2009 Average Expense ratio = 15%
2009 Year End Loss & ALAE Reserves = $21.0 MM
2009 Year End Capital & Surplus = $24 MM
Basic Financial Diagnostics
NAIL Retailer Gross Written Premium
$9,000,000
$8,000,000
$7,000,000
$6,000,000
$5,000,000
$4,000,000
$3,000,000
$2,000,000
$1,000,000
$0
7/1/01-02
7/1/02-03
7/1/03-04
7/1/04-05
Package
WC
7/1/05-06
Total
7/1/06-07
7/1/07-08
7/1/08-09
Basic Financial Diagnostics
Premiums and Losses
Net Earned Prem
CY Loss & LAE
16,000
14,000
12,000
10,000
8,000
6,000
4,000
2,000
2000
2001
2002
2003
"Difference is Apparent U/W Gains"
2004
2005
2006
2007
2008
2009
Basic Financial Diagnostics
Historical Investment Returns
(% of Assets)
9.0%
8.0%
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
2000
2001
2002
2003
5 Yr Gov't
2004
Aaa Corp
2005
NAIL
2006
2007
2008
2009
Basic Financial Diagnostics
Historical Change in Surplus
5,000
4,500
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Historical Cumulative Surplus
Average Annual Growth = 20%
25000
20000
15000
10000
5000
0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Capital Requirements - Regulatory
• Bermuda Statutory Capital / Surplus Requirements
– Requisite statutory capital and surplus must exceed the
greater of A or B or C
• A) Class 3 Minimum => $1,000,000
• B) Premium Level Test (20% / 5:1) => $2,000,000
• C) Loss Reserve Level Test (15% / 6.7:1) => $3,000,000
NAIL Statutory capital & surplus @12/31/2009 = $24,000,000
Bermuda Regulatory Excess Statutory Surplus = $21,000,000
Capital Requirements - Regulatory
3.0
Premium to Surplus
TheRatio
ratio of net written premiums to total capital and
surplus has decreased from 2005 to 2009. Bermuda
allows up to a 5:1 ratio. A 2:1 ratio is considered
conservative. This measure indicates that NAIL has
significant underwriting capacity available. At a 2:1
ratio, NAIL could write an additional $37.1mm of
premium.
Premium to Surplus Ratio
2.5
2.0
1.5
1.2
1.5
1.3
1.2
1.2
0.9
1.0
0.6
0.6
0.4
0.5
0.0
2001
2002
2003
2004
2005
2006
Fiscal Year Ending 12/31
2007
2008
2009
Capital Requirements - Regulatory
4.0
Reserves to Surplus Ratio
The ratio of loss & ALAE reserves to total capital and surplus
has continued to decrease. This measures the degree to
which surplus would be impaired if loss & ALAE reserves
are undervalued due to inflation or other factors. A typical
range is 2:1 to 4:1, so NAIL is now significantly below that
range.
3.5
Reserves to Surplus Ratio
3.0
2.5
2.4
2.2
2.5
2.1
1.9
2.0
1.8
1.4
1.5
1.1
0.8
1.0
0.5
0.0
2001
2002
2003
2004
2005
2006
Fiscal Year Ending 12/31
2007
2008
2009
Historical Underwriting Variability
Retailer Loss Ratio Total
120%
100%
80%
60%
40%
20%
0%
7/1/01-02
7/1/02-03
7/1/03-04
7/1/04-05
7/1/05-06
Loss Ratio Total
7/1/06-07
7/1/07-08
7/1/08-09
Historical Loss Reserve Variability
Historical Reserve Risk Volatility
as a % of (Loss Reserve + UEPR)
0.0%
2000
2001
2002
2003
2004
2005
-2.0%
-4.0%
-6.0%
-8.0%
-10.0%
-12.0%
-14.0%
-16.0%
-18.0%
-20.0%
Calendar Year
2006
2007
2008
2009
Historical Asset (Bonds & Equities) Variability
Difference between (MV Bonds) and (Bonds @Amort Cost)
2nd Difference between (MV Bonds) and (Am_Cost Bonds)
= {Mark-to-Market Valuation Adjustments}
1,000
2,000
500
1,500
-
1,000
(500)
500
(1,000)
(1,500)
(500)
(2,000)
(1,000)
(2,500)
(1,500)
(3,000)
(2,000)
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
(3,500)
2000
2002
2004
2006
2008
Capital Requirements – Liquidation Scenario
NAIL RISK PROFILE*
(A) EST. RESERVE @ 9/30/09
(B) EST. RESERVE SURPLUS
(C) NAIL EQUITY @ 10/31/09
(D) AFTER TAX RESERVE SURPLUS
(E) EQUITY LIQUIDATION VALUE
CONFIDENCE LEVEL
EXPECTED 65% 70% 95%
99%
$18.7 $20.4 $21.9 $34.9 $39.3
$3.2 $1.4 $0.0 ($13.1) ($17.4)
$23.8 $23.8 $23.8 $23.8 $23.8
LIQUIDATION SCENARIO
$2.1 $0.9 $0.0 ($8.6) ($11.5)
$25.9 $24.7 $23.8 $15.2 $12.3
Capital Requirements
• Financial Statement Statutory Surplus = $24,000,000
• Bermuda Regulatory Excess Statutory Surplus = $21,000,000
• Liquidation Scenario Excess Surplus = $12,300,000
Capital Requirements – Risk Based
• Economic Capital/Dynamic Risk Capital/Solvency II Capital
– All these terms denote risk based capital approaches which
are designed to better capture the inherent effects from
more extreme / Black Swan events. Recent examples
would include:
• Mortgage CDO induced banking credit crisis
• New Zealand earthquake
• Australian & Mississippi floods
• Japan earthquake/tsunami/nuclear fallout
• Commodities market price bubble
• Alabama & Missouri tornados
Capital Requirements – Risk Based
• Economic Capital Modeling
– Requires dynamic risk modeling techniques to analyze all of
the key risk exposures, namely;
•
•
•
•
•
Underwriting risk (i.e., in-force premium risk)
Reserve variability (i.e., prior years reserve changes)
Interest rate (primarily within the investment portfolio)
Credit risk (corporate bonds & reinsurance recoverable)
Equity investment volatility (including F/X risks)
Capital Requirements – Risk Based
• Economic Capital Modeling Perspective
– 1 year forward time horizon
– 1:200 stress level events
Underwriting Risk (Example)
• Frequency
• Severity
• Aggregate claims distribution
• Stochastic (i.e., Monte Carlo) simulated outcomes
• Stress level thresholds (e.g., Black Swans)
• Economic capital contribution
Underwriting Risk – Example (Corp WC-Only)
Stochastic Simulation (aka Monte Carlo)
WC Claims Severity > $10,000/claim
WC Claims Frequency
X <= 187.00
5.0%
3
X <= 234.00
95.0%
800,000
700,000
600,000
500,000
2
400,000
1.5
300,000
200,000
1
100,000
0.5
170
180
190
200
210
220
230
240
250
Confidence Level
Mean = 210 claims
Actual
Curve Fitted
99%
98%
97%
96%
100%
0
95%
95%
94%
93%
92%
91%
90%
89%
88%
87%
87%
0
86%
Relative Frequency
2.5
Underwriting Risk – Example (Corp WC-Only)
Corporate WC – Simulated Losses
2010 Accident Year
Direct
NET
Monte Carlo
Mean
Direct
Net
3,246,900
2,997,000
5.0%
1,087,400
1,083,600
15.0%
1,579,700
1,539,700
25.0%
1,977,300
1,910,400
35.0%
2,348,000
2,234,400
45.0%
2,724,200
2,550,200
55.0%
3,130,200
2,916,600
65.0%
3,576,500
3,294,400
75.0%
4,099,400
3,767,600
85.0%
4,938,000
4,444,200
95.0%
6,597,700
5,947,300
98.0%
7,849,600
6,935,200
99.0%
9,154,800
7,973,800
99.5%
9,750,400
8,800,000
7,000,000
6,000,000
5,000,000
4,000,000
3,000,000
2,000,000
1,000,000
0
Confidence Level
Underwriting Risk – Example (Corp WC-Only)
Net
99.5th
Percentile
Losses
8,800,000
Expected
Earned
Premium
(3,500,000)
Required
Risk Capital
5,300,000
Capital Requirements – Risk Based
• Economic Capital Modeling Results (U/W Risk variable only)
– Stochastic Simulation of each LOB variable at 1:200 stress
•
•
•
•
•
•
•
Work Comp - Corp
$ 5.3 MM
Work Comp - Retail
2.1 MM
Gen Liab. - Corp & Retail
1.6 MM
Auto Liab. - Corp & Retail
1.0 MM
Auto PD - Corp & Retail
0.5 MM
Retail Property
2.0 MM
Sum
$12.5 MM
Required Economic Capital => $ 8.5 MM*
* does not equal the sum of the parts due to portfolio effects
Capital Requirements – Risk Based
• Economic Capital Modeling Results (All 5 key risk variables)
– Stochastic Simulation at 1:200 stress, 1 yr time horizon
•
•
•
•
•
•
Underwriting Risk
Reserve Variability
Interest Rate
Credit Risk
Equity Volatility
Sum
$ 8.5 MM
2.0 MM
3.5 MM
0.5 MM
2.5 MM
$17.0 MM
Required Economic Capital => $14.0 MM*
* does not equal the sum of the parts due to portfolio effects
Capital Requirements
• Financial Statement Statutory Surplus = $24,000,000
• Bermuda Regulatory Excess Statutory Surplus = $21,000,000
• Liquidation Scenario Excess Surplus = $12,300,000
• Risk Modeling Based Excess Surplus = $10,000,000
Capital Requirements – Rating Agency
A.M. Best – Best Capital Adequacy Ratio (BCAR)
Capital Adequacy Ratio Estimation
B1
B2
B3
B4
B5
B6
B7
Fixed Income Securities
Equity Securities
Interest Rate
Credit
Loss & LAE Reserves
Net Premiums Written
Business Risk
600,000
1,500,000
250,000
200,000
5,000,000
3,000,000
-
Unadjusted Required Capital (Sum B1=>B7)
Covariance Adjustment (i.e., Portfolio Effect)
Net Required Capital (“NRC”)
10,550,000
(4,150,000)
6,400,000
Reported Surplus
Loss Reserve Equity
Adjusted P/H Surplus (“APHS”)
14,000,000
2,000,000
16,000,000
Capital Adequacy Ratio [APHS/NRC] =
2.50
Capital Requirements – Rating Agency
A.M. Best – Best Capital Adequacy Ratio (BCAR)
Capital Adequacy Scale (2009)
RATING
A++
A+
A
AB++
B+
MINIMUM SCORE
1.75
1.60
1.45
1.30
1.15
1.00
MEDIAN SCORE
2.65
2.60
2.50
2.25
2.00
1.70
XS Capital Employment Options
• Risk capital DRM analyses demonstrated that NAIL is carrying
approximately $10 million in “excess” Capital/Surplus
• ACE/NAIL are considering three strategic growth options
1.
Providing additional property coverage to the 350
retailers located in coastal properties.
2.
Increasing third party participation from all retailers by
lowering BOP rates 10%.
3.
Writing Umbrella Excess Coverage for retailers.
XS Capital Employment Options
1. Providing additional property coverage to the 350
retailers located in coastal properties
Incremental Increase in Earned Premium = $3.5 MM
Expected Loss & ALAE = $1.4MM
Expected Underwriting Gain/(Loss) = $2.1 MM
(i.e., Expected U/W Loss Ratio = 40%)
1:200 Adverse Cat Loss & ALAE Projection = $13.5 MM
DRM estimated Capital Charge* = $10.0 MM
* On a stand alone basis – before any reduction from portfolio effect
XS Capital Employment Options
2. Increasing third party participation by all retailers by lowering
BOP rates by 10%
Incremental Increase in Earned Premium = $2.5 MM
Expected Loss & ALAE = $2.0 MM
Expected Underwriting Gain/(Loss) = $0.5 MM
(i.e., Expected U/W Loss Ratio = 80%)
1:200 Adverse Loss & ALAE Projection = $4.5 MM
DRM estimated Capital Charge* = $2.0 MM
* On a stand alone basis – before any reduction from portfolio effect
XS Capital Employment Options
3.
Writing Umbrella Excess Coverage for retailers
Incremental Increase in Earned Premium = $1.0 MM
Expected Loss & ALAE = $0.1 MM
Expected Underwriting Gain/(Loss) = $0.9 MM
(i.e., Expected Loss Ratio = 10%)
1:200 Adverse Cat Loss Projection = $8.0 MM
DRM estimated Capital Charge* = $7.0 MM
* On a stand alone basis – before any reduction from portfolio effect
XS Capital Employment: $10mm available Capital
Retailer
Growth
Option
Premium
Growth
Estimate
Expected Relative
U/W Gain Capital
Charge
Business Considerations
Underwrite
Coastal
Coverage
$3.5 mm
$2.1mm
$10.0mm • Represents 9% of total stores
• Reduce political distractions
• Improve cross selling opps.
10% BOP
Rate
Decrease
$2.5mm
$0.5mm
$2.0mm
• Service more Ace retailers
• Provides more pricing flexibility
• Minimal capital usage allows for
additional captive expansion
Underwrite
Umbrella
Coverage
$1.0mm
$0.9mm
$7.0mm
• Reduce subsidy of 3rd parties
• Customize coverage
• Overall program pricing flexibility