Optimal Retention Levels –
How to get in the “Zone”
Panelists:
James Evans, Albert Risk Management Consultants
Stephen DiCenso, Milliman, Inc.
Matthew Byrne, Cathedral Indemnity Company
Moderator:
Michael Meehan, Milliman, Inc.
August 13, 2014
© 2014 VCIA; Speaker materials used by VCIA under license.
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Agenda
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•
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Industry Landscape
Management Considerations
Risk Appetite
Board Perspective
Actuarial Framework
Total Cost of Risk (“Traditional Approach”)
Cost of Capital Approach
Captive Case Study – Cathedral Indemnity
Company
1
Some Management Considerations
in Risk Retention Strategies
James Evans, Albert Risk Management Consultants
2
A Tale of Two Captives
Cathedral Indemnity Co.
 Single Parent
 Formed 2012
 Deductible
reimbursement cover
 Property, WC
 Looking at increasing
specific or aggregate limit
Cup Re
 Single Parent
 Formed 2010
 Reinsurance Company
 Liability
 Looking at increasing
percentage participation
in various layers
3
Common Elements
of these Scenarios

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
Pricing exercises
Cost-benefit analysis
Decision making in the face of uncertainty
Volatility in results
Multiple variables
4
Multiple variables

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
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
External pricing
Time value of money
Impact of underwriting cycles on future pricing
Capital considerations
Loss expectancies
5
Two Common
(possibly opposing) Perspectives
 Income Statement-(Re)Insurance as an
expense
 Balance Sheet-(Re)Insurance as contingent
capital
6
Income Statement Perspective
 (Re)insurance is an expense
 Cost/Benefit analysis often relies on a single
assumption
 Decision based on current year arbitrage
 Focus on Cost of Risk
 Short horizon (one year)
 Funding shaped by spot pricing
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Balance Sheet Perspective
 (Re)insurance is contingent capital
 Cost/benefit analysis includes range of
assumptions/outcomes
 Decision based on most effective long-term cost
and use of capital
 Includes Cost of Capital
 Longer horizon (multi-year)
 Funding shaped by probability simulation
8
Some Common Challenges
 Behavioral rules of thumb
 Familiarity with (re)insurance pricing and
operations
 Availability of tools and techniques to improve
decision making
 Relationship of scale and volatility/variability
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Considerations for
Decision Makers
 How can I move beyond rule of thumb
approach?
 What tools/techniques are appropriate and
available to understand/quantify the variability of
losses and costs in the retained exposure?
 How do I price and fund the exposure?
 What are the long-term financial implications of
retention strategy?
 How do the options under consideration affect
capital management strategy?
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Actuarial Framework
Stephen DiCenso, Milliman, Inc.
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Retention Analysis –
2 Views to Discuss
 “Traditional” Approach
 Cost of Capital Approach
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“Traditional” Approach
 Evaluate expected cost of risk at retained limit
•
•
Estimate loss cost per exposure unit based on
historical losses or industry experience
Account for operating expenses
 Evaluate cost of excess insurance (i.e., above
retained limit)
•
Quotes from commercial insurance market
 Sum of retained losses and excess insurance is total
cost of risk (TCOR)
 Run various proposed retentions and select scenario
with lowest TCOR
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“Traditional” Approach –
Compare Options
Figure 1
Current
Retention
Cost Component
Expected Losses (in $M)
Excess Insurance (incl. expenses)
Total Cost of Risk (TCOR)
Change in TCOR vs. $3M
$3M
Proposed Retentions
$4M
$5M
$6M
$7M
$8M
$9M
$10M
10.02
10.42
10.70
10.93
11.11
11.25
11.38
11.49
1.80
1.30
0.90
0.65
0.43
0.24
0.18
0.13
11.82
11.72
11.60
11.58
11.53
11.49
11.56
11.62
(0.10)
(0.21)
(0.24)
(0.29)
(0.32)
(0.26)
(0.20)
-
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“Traditional” Approach –
Single Year View
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“Traditional” Approach – Ten Year View
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Cost of Capital Approach
 Evaluate TCOR (similar to Traditional Approach) to
calculate “savings” in moving to proposed retention(s)
 Evaluate Cost of Capital at proposed retention(s)
•
Estimate capital required (“at risk”) at retained limit to
fund adverse loss scenario
 Capital at risk = 90th percentile loss amount minus
expected loss
•
Estimate Cost of Capital required to fund adverse loss
scenario
 We assume the internal cost of capital (“hurdle rate”) is
15%
cont.
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Cost of Capital Approach
cont.
 Sum of TCOR and Cost of Capital is total
cost of risk and capital (TCORAC)
 Run various proposed retentions and select
scenario with lowest TCORAC
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Cost of Capital Approach –
Example
Current
Proposed
$3M Retention $8M Retention
Change
(A)
Expected retained losses
$10.02
$11.25
$1.24
(B)
Adverse retained losses (90th percentile)
$14.51
$17.91
$3.40
(C)
Capital needed to fund potential for adverse losses
= (B) - (A)
$4.50
$6.66
$2.16
(D)
Cost of capital
15%
15%
(E)
Cost of holding capital to fund potential adverse losses
= (C) x (D)
$0.67
$1.00
$0.32
(F)
Excess insurance
$1.80
$0.24
($1.56)
(G)
Total cost of risk = (A) + (E) + (F)
$12.49
$12.49
$0.00
The $8M retention does not look favorable (i.e., looks
equivalent) when considering the cost of capital
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Cost of Capital Approach –
Example
cont.
Here’s what it boils down to from a financial standpoint:
Current
Proposed
$3M Retention $8M Retention
Change
(H)
Excess insurance
Expected excess losses
Cost of renting insurer's capital in excess layer
$1.80
$1.24
$0.56
$0.24
$0.00
$0.24
($1.56)
($1.24)
($0.32)
(I)
Cost of using internal capital in excess layer
$0.00
$0.32
$0.32
(J)
Cost of capital = (H) + (I)
$0.00
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Cost of Capital Approach –
Compare all Options
Conclusion: $5M retention has lowest cost at 90th percentile
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Cost of Capital Approach
cont.
 For a given internal cost of capital (“Hurdle
Rate”), this decision can also be looked at as:
•
The Decision Ratio: change in cost of renting insurer’s
capital vs. capital at risk
 If Decision Ratio > Hurdle Rate, then choose higher
retention – it’s worth the risk, as cost of insurance is too
high
 If Decision Ratio < Hurdle Rate, then stay at current
retention – insurance cost is less than cost of capital
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Other Considerations
 Alternative adverse loss scenarios can be modeled
•
based on company risk tolerance
 Alternative Cost of Capital rates can be modeled as
well
 Remember to incorporate the effect of the insurance
market cycle
•
Run the model frequently to adjust to commercial
market excess costs
 This work falls under broader Theory of Risk
Reduction, an evolving area of research
•
these are two common methods, but others exist as
well
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Captive Case Study
Matthew Byrne, Cathedral Indemnity Company
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Two views from a Board and CFO evaluation of the
feasibility approach in forming a captive:
Risk retention pool and Self funded risk thought
processes
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Responsibility and
Accountability
 Board members have the responsibility to look after the
shareholders (members) interest in a for-profit or
(nonprofit) firm with the view of making a profit or in the
case of a nonprofit governing the multiplicity of specific
missions with finite capital. Duties in both forms of
organization include care, loyalty and obedience.
 The CFO role is to help formulate the business strategy
allocating capital and the defining the risk, providing risk
mitigation programs to fit the risk profile of the
organization.
 Both Core and Non-core risks are evaluated and form the
means to allocate capital.
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CFO or Board Thought
Process & Outcome
1. The only certainty is that there is no certainty
2. Despite uncertainty we must act
3. Judge decisions not only on results but also on
how they are made
4. Decisions are a matter of weighting probabilities
•
•
•
Probabilities alone are insufficient when payoffs are
skewed
People are averse to loss when they make choices
between risky outcomes
Focus on probability is sound when outcomes are
symmetrical but completely inappropriate when payoffs
are skewed
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CFO or Board Thought
Process & Outcome
“Risk has an unknown outcome, but we know what
the underlying outcome distribution looks like.
Uncertainty also implies an unknown outcome, but
we don’t know what the underlying distribution
looks like. Objective probability is the basis for risk,
while subjective probability underlies uncertainty.”
Frank Knight – Risk, Uncertainty
and Profit
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Road from Uncertainty to
Probability in Decision-Making
 Degrees of belief are subjective probabilities.
 Propensities-based probabilities reflect the
properties of the object or system
 Frequencies relates here the probability is
based upon a large number of observations
within a specific reference class. Without an
appropriate reference class, there can be no
frequencies-based probability assessment
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Risk Retention Pool Choice in
Forming a Captive
 Already managing and sharing risk on pooled basis
 Legal issues of the retention pool’s multiplicity of state insurance laws
and compliance with State insurance commissions
 Desire to domicile the pool in a rigorous regulated environment such
as Vermont with a knowledgeable captive industry and regulator
 Desire for the captive to assume all the underwriting, operating
financial and accounting functions while members retain all authority
and participation agreement remain in force
 Opportunity to establish additional lines of risk retention for our
members and reduce costs while allocating capital prudently.
 Providing insurance capacity to our members in hard markets and
transferring risk in soft markets
 Access to reinsurers as a captive company
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Self-insured (funded) Risk Choice in
Forming a Captive for Workers
Compensation
 Already assuming a retained risk on a pay as you go basis
 Our WC balance sheet reserve account was not actuarially
determined
 Coordination among Claims TPA, our entities that we
provide workers comp coverage and us was scattered and
payments (cash flow) no one specific party responsible.
“Seat of the pants” not a good execution strategy
 Provide low, stable long term cost for an insurance-like
program with improved risk management
 Contain the long term cost of risk, assuring availability of
funds to pay losses and build capacity to broaden risk
financing in leveraging capital and reinsurance markets
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Rationale for a Captive
 Financial Leverage
 Formality of Risk Funding Program
 Flexibility to Change Underwriting Focus,


Loss Reserves, Coverages and Risk Transfer
Strategies
Regulatory Oversight
Objective:
• Long term opportunity to translate the loss
prevention, risk management and claims
management discipline for the Archdiocese into
reducing risk financing costs
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Types of Firm Risk
Core risks
• These are risks the firm is literally
in business (mission) not to get rid
of
• Each of these entities bears and
manages those risks so that it can
earn returns (provide service for
mission) in excess of the risk-free
rate
• In the case of a non-profit earning
return is substituted for providing
capital prudently so as to preserve
the intergeneration equity of its net
assets to enhance the mission
Non-core risks
• These are risks to which the firm
primary business (mission)
exposes it but that the firm does
not necessarily need to retain to
engage in its primary business
function
• That results in risk management
alternative decisions
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Strategies of Retention Decision:
Core vs. Noncore
RETAIN
NEUTRALIZE
TRANSFER
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Risk Team
BOARD/CEO
CFO
CASH FLOW
CAPITAL
ALLOCATION
CRM
CAPITAL
BUDGETING
RISK
CONSULTANT
ACTUARY
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Risks and Rewards
 Summarize the risks of the ultimate loss as actuarially
calculated
 Match the risk profile to your confidence level of the High
and Low probabilities of loss and expected values
 Select the confidence level most appropriate to the risk
assumed
 Always value a project, service or firm on its net present
value of cash flows as capital decisions affect both short
term and long term cash flows
 CASH IS KING
 Retain Capital and Surplus through Captive formation
 Pay yourself
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Questions?
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