The Black Box That is
Risk Quantification
The Impact of Loss Quantification in Our Business
September 11, 2013
Charlie Woodman, CPA
Risk Finance Advisory
Willis National Construction
2013 Willis Construction Risk
Management Conference
Sound Familiar?
From your underwriter………
“Due to market conditions and your recent claims experience, we are increasing your
rates by 7%”
From your actuary…….
“Total unpaid losses increased by approximately $900,000 due to adverse loss
development and an increase in claim frequency”
From your broker…….
“The carrier has increased your collateral requirement by $2 million and the LOC
needs to be in place in 30 days”
From the IRS…….
“This is to inform you of the initiation of an issue regarding the valuation of unpaid
loss reserves deductions under IRC Sec 482…the following must be provided
regarding ABC Captive Insurance Company…”
From your DCAA auditor…..
“Your charge for self insurance is disallowed as it is not based on Projected Average
Loss as defined under CAS 416”
Discussion
Loss Quantification: Basics,
esp. Loss Development
Methodology
Quantification Ramifications
 Insurance Risk Transfer Costs
 Collateral Costs
 Financial Reporting & GAAP
 Tax Reporting
 Governmental Contract
Accountability / FAR / CAS
4 years of college,
3 years grad school,
four exams…for this?!
Economics of Insurance: Typical
Commercial Insurance – 1st Dollar /
Guaranteed Cost
•
Components of Traditional
Insurance:
• Expected loss and
ALAE
• Taxes and regulatory
fees
• Overhead and
administration
• Insurer selling and
distribution expense
• Reinsurance and
Intermediary charges
• Risk Margins
Profits & Losses
55 -75%
Fixed (25%-35%)
 Insurance Company
Overhead, Taxes,
Reinsurance Cost,
Commission
Insurance Program Risk Costs with
Large Deductibles / Retentions
Incurred Losses: The Variable Stuff
65% – 90+%
“Fixed
Costs”
Fixed
• Risk Transfer
• Taxes
• Safety & Claims Mgmt
• Loss Control
• Admin & Compliance
Losses: the 800 Pound Gorilla Sitting In The
Corner
 Make up the vast majority of
insurance cost uncertainties
 In Guaranteed Cost: Standard
Premium including Experience
Mods
 In ‘Loss-sensitive Programs’ :
Deductibles and Retentions
 Losses = Pure Loss (claimant
satisfaction costs) + Loss
Adjustment Expense (loss
reconciliation activity costs)
Losses and their uncertainty broken down
into two (2) types:
• Frequency / Burning Losses
(Predictable)
• Severity / Adverse / Catastrophic
Losses: Tougher to Predict - PL /
Comp Op / SDI (Risk Margin)
5
Life Cycle of a Claim
Reserve
4/2/06
Accident occurs
Pure IBNR
8/18/07
Settlement agreed
$30,000 Case
Reserve
8/25/07
Payment sent
$30,000 Case Reserve
7/11/06
Accident reported
Claims in Transit
1/1/07
Estimate revised
$25,000 Case Reserve
9/2/07
Claim draft clears
Closed
8/1/06
Accident entered
into records as $1,000
Formula Reserve
10/5/06
Individual reserve
established
$10,000 Case Reserve
Intro To Losses
 A Loss is the Paid (to date) + Claim (Case) Reserve + Incurred



But-Not-Reported (IBNR)
Certain exposures will have many losses in a given policy year
which may take many years to ultimately reconcile and close.
What is a Loss Reserve?
Amount necessary to settle unpaid claims
Case Reserves
 Claim reported but not yet paid
 Assigned a value by a claims adjuster or by formula
IBNR reserves include: Most difficult to measure and justify
 Reserves for claims not yet reported (pure IBNR)
 Claims in transit
 Development on known claims
 Reserves for reopened claims
Definitions
Pure Losses
 Paid to Date
 Case Reserves
 Claim reported but not yet paid
 Assigned a value by a claims adjuster or by formula
 Bulk + IBNR reserves include:
 Reserves for claims not yet reported (pure IBNR)
 Claims in transit
 Development on known claims
 Reserves for reopened claims
Loss Adjustment Expenses (LAE) are sum of:
 Defense & Cost Containment (DCC) Expense (including
adjusting)
 The Sum of These is referred to as “expected to
ultimate” losses or “projected ultimate losses”
Projected Ultimate Loss
 An estimate of total claims cost
 Within the deductible layer
 For a single policy period
 Once all claims are settled, paid and closed.
 For first party coverage (Property or Builders Risk), losses are
directly measured based on property valuation whether actual cash
value or replacement cost. (Short tail)
 For casualty lines (AL, GL and WC), due to the lengthy period of
time between the occurrence of a claim and final settlement,
estimation of ultimate loss is required.
9
Considerations:
Emergence/Settlement
Emergence (E) vs. settlement (S)
Property
S
A
E
Automobile Liability
S
A
E
Workers Compensation
A
E
General or Professional Liability
A
E
S
S
Basic Loss Measurement Techniques:
Definitions
Sometimes solely Industry-based
Composite to Insurer Expectations
Loss Development Method using Historical Patterns
Triangles
‒ Compiled to measure the changes in cumulative claim activity
over time in order to estimate patterns of future activity.
‒ Loss Development Factor
‒ The ratio of losses at successive evaluations for a defined
group of claims (e.g. accident year).
Components of Loss
Incurred but not
reported (IBNR)
Incurred but not
reported (IBNR)
Outstanding Case
Reserves
Outstanding Case
Reserves
Paid
Paid
Paid
3 months
6 months
Loss Development
Claim Closed
Basic Reserving Techniques:
Compilation of Paid Loss Triangle
Cumulative Paid Losses ($000 Omitted)
 Actuarial
Configuration
Accident
Development Stage in Months
Year
12
24
36
48
60
72
1995
1996
1997
1998
1999
2000
3,780
4,212
4,901
5,708
6,093
6,962
6,671
7,541
8,864
10,268
11,172
8,156
9,351
10,987
12,699
9,205
10,639
12,458
9,990
11,536
10,508
1. The losses are sorted by the year in which the accident occurred.
2. The losses are summed at the end of each year.
3. Losses paid to date are shown on the most recent diagonal.
4. The data is organized in this way to highlight historical patterns.
Basic Reserving Techniques:
Compilation of Paid Loss Triangle
Accident
Year
12
1995
1996
1997
1998
1999
2000
3,780
4,212
4,901
5,708
6,093
6,962
Cumulative Paid Losses ($000 Omitted)
Development Stage in Months
24
36
48
60
6,671
7,541
8,864
10,268
11,172
8,156
9,351
10,987
12,699
9,205
10,639
12,458
9,990
11,536
72
10,508
Final
Total
Cost
???
???
???
???
???
???
Basic Reserving Techniques:
Paid Loss Development Factors
Evaluation Interval in Months
Accident
Year
1995
1996
1997
1998
1999
2000
12-24
1.765
1.790
1.809
1.799
1.834
24-36
1.223
1.240
1.240
1.237
36-48
1.129
1.138
1.134
48-60
1.085
1.084
60-72
1.052
72 to
Ultimate
???
Sample Calculation for Accident Year 1996:
From the end of the accident year (at 12 months) to the end of
the following year1.790
(at 24 months),
paid
losses
for 1996 grew
/ 4,212
7,541
=
12-to-24 Months
79%. During the next year (from 24 to 36 months), paid losses
experienced an additional 24% growth (or development) and so
forth.
Loss Development Factors (LDFs) are also known as:
Basic Reserving Techniques:
Paid Loss Development Factors
Evaluation Interval in Months
Accident
Year
12-24
24-36
1995
1.765
1.223
1996
1.790
1.240
1997
1.809
1.240
1998
1.799
1.237
1999
1.834
2000
Simple Average - All Years
1.799
1.235
Simple Average - Latest 3 Years
1.814
1.239
36-48
1.129
1.138
1.134
48-60
1.085
1.084
60-72
1.052
1.134
1.085
1.052
1.134
XXX
XXX
XXX
XXX
1.085
1.052
Simple Average - Excluding High & Low
1.799
1.239
1.134
Weighted Average - All Years
1.803
1.235
1.134
Selected Loss Development Factors
1.800
1.235
1.134
1.085
1.052
72 to
Ultimate
???
1.070
Basic Reserving
Techniques:
Paid LDM Projections & Reserves
Accident
Year
(1)
Actual
Paid
Losses
@ 12/31/00
(2)
1995
1996
1997
1998
1999
2000
10,508
11,536
12,458
12,699
11,172
6,962
Total
65,335
Selected
LDFs
(3)
1.070
1.052
1.085
1.134
1.235
1.800
Cumulative
Development
Factors to
Ultimate
(4)
1.070
1.126
1.221
1.385
1.710
3.079
Estimated
Ultimate
Losses
[(2) x (4)]
(5)
Actual
Paid
Losses
@ 12/31/00
(6)
Estimated
Loss
Reserves
{(5) - (6)}
(7)
11,244
12,985
15,215
17,588
19,109
21,435
10,508
11,536
12,458
12,699
11,172
6,962
736
1,449
2,757
4,889
7,937
14,473
97,576
65,335
32,241
First: Financial Reporting of
Losses for Contractors
 Financial Reporting is expense recognition
 Costing is a rationalization activity which is a proactive activity
 Financial reporting is the responsibility of Owners, CFOs,
Management, Controllers and Independent CPAs - all share the
risk
 Reliance by various users on financial statements:
 Sureties
 Banks and finance companies
 Regulatory boards - licensing
 Owner and prime contractor prequalification
 Suppliers
 Stockholders (owners)
 Joint venture partners
18
Recognition of Losses: Rule
A loss or group of losses is recorded only when (old FAS 5):
 The likelihood of actual loss is probable, AND
 The amount of the loss is reasonably subject to estimation.
If reasonable estimates of loss or losses produces a range of equally
likely outcomes – (FIN 14) book the minimum.
Importance
• A company cannot set aside reserves for a loss it believes might occur
before it actually happens.
• If a loss occurs, a company must recognize the full value of the loss as an
expense on its financials in the accounting period in which it knows of the
event
• Actual payment reduces a reserve; should not effect earnings.
19
Probability
Remote – the chance of the future
event or events occurring is slight
 Reporting Action: Do nothing or ID as a
Risk of Business, if large, in MD&A
Reasonably Possible – the chance of
the event or events occurring is
more that remote but less than
likely
 Reporting Action: Disclose in Notes
Probable – the future event or events
are likely to occur
 Reporting Action:
 If Measurable: Book to Financials:
Disclose in Notes
 If Immeasurable: Disclose in Notes
under “Claims, Lawsuits and Other
Contingencies”
20
Measurability
Reasonable Reserves
Range of Estimates
Reasonable Sets of Assumptions
Evaluate Uncertainty, Risk of Material Adverse Deviation
Identify Sources of Uncertainty
Book Management’s Best Estimate
Collateral: It All Starts Here
Dear Insured
“We will pay benefits and damages that are covered under this
policy. We will only seek reimbursement for those amounts
that are within the applicable deductible shown above. You
will reimburse us promptly for any deductible amounts and
all Allocated Loss Adjustment Expenses that we have
addressed.”
Sincerely yours,
The Insurer
Standard Indemnity Clause: Large Deductible Program
How Does Collateral Become A Problem?
The “Deductibles” Problem
Commercial Insurance
Specific Excess
Risk Transfer
$1 M
Deductible / Retention
Collateral required for
unpaid claims
Per
Occurrence
Assume 5 policy years
$10M Loss Pick
$1 M paid per year
Report Year
Per Year / Aggregate
Commercial
Aggregate
Protection
Total claim payments by policy year
(Ultimate Loss)
Less claims paid
Plus loss forecast for upcoming
renewal
= collateral requirement
“Stacking” – Over time, collateral
obligations
grow (usually stabilizes after 4-7 years)
Policy Year
Annual
Collateral
Requirement
Let’s Start On The Insurer Side
The Business of Risk
Underwriting
Expected Losses and Allocated Expenses
Risk Margin: Volatility of Loss Frequency & Loss Severity
Unallocated Costs
Loss Adjustment
U/W & Acquisition Costs
Premium Taxes
Fees, Licenses & Bureaus
Other Operating Costs
Portfolio Concentration Adjustments
Investment return off-sets
Required Return on Equity (Surplus) or Opportunity Cost of redirected capital
Insurance Company Dynamics
Surplus is Life
Leverage Writings: i.e. 3:1 Written to Surplus
Defines Single Risk Capacity: i.e. 10% of Surplus exposure
Solidifies Reinsurance Treaties / Relationships
Statutory Accounting Principles
Annual Statement - Yellow Peril / Convention Blank / Yellow
Book, etc
 Liquidation Value
 Drives Statutory Surplus
 Admitted Assets vs Non-Admitted Assets on Surplus
 Schedule F
 Risk Based Capital
Insurer Collateral Emphasis and
Counter-Party Risk Attitude
Paid-Loss Sensitive Programs
Large Deductible
Paid-Loss Retros
“Fronted”
Secure
Losses
Premiums, in some cases
Protection against
Statutory Penalties
Direct Obligation Default by Insureds
Sure, I’m smiling now…
So What Happen with An Insured
Insolvency?
•
Primary Issue -- Does Insurer
Become Responsible for all
Claims Payments? - Probably
•
Insured / Employer Must Keep
Coverage in Place.
•
Insurer May Not Be Permitted to
Cancel Policy.
•
In Liquidation, Insurer Will Most
Likely Have to Pay All Claims
and File Claim for Deductible
Amounts.
Crap. Now what?
The Insured Side
Issues:
Type of Security
Draw on Credit Lines
Other Debt Constraints
Liquidity Issues
Tax Planning
Amount & Timing of Collateral
Control of the Collateral
Change of Insurer Relationships
What Can Be Done?
Don’t Hide from the Issue
Navigating Collateral & Finding Common
Ground
•
Review insured’s payment agreement with their insurance company.
•
•
Defines the rights and obligations of both parties, timing of adjustments (generally at
renewal)
Quantitative analytics / Actuarial calculation of ultimate loss
•
Summary loss information by line and by policy year
•
Large loss listing
•
Historical Exposure Information
•
Understand insurance program design (i.e. ALAE treatment)
•
Challenge Insurer assumptions (loss development factors, renewal
forecasts)
•
Request “paid loss credit” based on the insured’s historical payout
patterns and financial condition
•
Investigate alternative forms (LOC, Cash/asset backed, Insurance
Trusts, etc)
•
Claim reviews / claim closure projects – effect of collateral is intensified
when losses are developed
Insurance Taxation: Basic
Non-Insurance Companies
deduct loss reserves
• Deduct fixed costs, risk transfer
premiums, and only losses
paid in the policy year
• Future losses deducted as paid
in year paid
Insurance companies can
deduct loss reserves
• Advantage: take current year
deductions for all losses paid,
loss reserves & IBNR (reduced
by IRS-imposed discount
So what about the Reserves?
$$$$
I’m not an insurance company, so what?
What if I own a captive? And…
T
h
i
r
d
P
a
r
t
y
W
r
i
t
i
n
g
s
A
p
p
r
o
a
c
h
rd
Unrelated Risk / 3 Party
The captive must qualify as insurance
company for tax purposes
•
•
•
Insurance Risk
Nuance & Common Notions (Insurance
Form)
Risk Shifting & Risk Distribution
P
a
r
e
n
t
S
u
b
S
u
b
S
u
b
S
u
b
S
u
b
O
u
t
s
i
d
e
B
u
s
i
n
e
s
s
C
a
p
t
i
v
e
Tax deductibility hinges on whether or
not the captive is a bona fide
insurance company
• Although there is no “bright line” test,
case law suggests that at least 30% of
the captives risk must be “unrelated” to
the employer in order for the employer
to take a deduction for premiums paid
to the captive
• Alternatively, a captive that meets IRS
requirements as a brother/sister
captive (i.e., Humana structure) does
not require unrelated risk
S
u
b
D
e
d
u
c
t
i
b
l
e
Brother-Sister Approach
Balance Sheet Fact Pattern / “Humana”
Parent
Sub
Sub
Sub
Sub
Sub
Captive
Not
Deductible
Deductible
Sub
Federal Contracts and Loss
Reimbursement
Key regulation* for accounting for insurance costs:
Cost Accounting Standard (CAS) 416, Accounting for Insurance Costs
Cost Accounting Standard (CAS) 403, Accounting for Home Office
Costs
FAR 31.205-19, Insurance and Indemnification
FAR 31.201-5, Credits
FAR 28.3, Insurance
When to evaluate your current accounting practices for insurance
costs?
Contracts will be CAS covered
Contracts subject to Federal Acquisition Regulation 31.205-19,
Insurance and Indemnification
*Full text of FAR clauses can be found at https://www.acquisition.gov/far/index.html
35
Full text of Cost Accounting Standards can be found at
http://www.access.gpo.gov/nara/cfr/waisidx_01/48cfr9904_01.html
FAR Part 31, Cost Principles
Allowability
Factors for determining allowability :“A cost is allowable only when the
cost complies with all of the following requirements”
Reasonableness & Allocability
Cost accounting standards, or otherwise generally accepted accounting
principles and practices appropriate to the circumstances
Terms of the contract
FAR subpart 31.2 limitations
Costs of insurance required by contract are allowable
Costs of general insurance are allowable if reasonable and measured,
assigned and allocated in accordance with the requirements of CAS 416
Costs of business interruption insurance must exclude coverage for lost
profits
Self-insurance program approval is required when:

50% or > of the self-insurance costs allocable to negotiated government contracts
 Self-insurance costs for the fiscal year are anticipated >$200k
36
Insurance Reserves
IBNR (Incurred But Not Reported)
•
While generally understood by Government reviewers to be a
common feature, may be concern that reserves are too large
•
If Government reviewer considers reserve unreasonably large, may
question a portion of the reserve and the related insurance cost
•
To lessen risk of issues with purchased insurance reserves,
contractors and insurance carriers should be prepared to
demonstrate that reserves are reasonable based on:




Exposure to loss
Actual loss experience
Loss Trending and / or Inflation
Loss development experience or “lag” studies
Discounting reserves not expressly required by CAS 416, but DCAA
guidance suggests reserves may be subject to present value discounting
(prompt payment rate)
37
Measurement of Self-insurance
Charges and Reserves
With significant self-insurance, typical practices for recovering
insurance costs are establishing methods for:
1.Estimating annual projected average losses
2.Allocating self-insurance charges to segments and cost objectives
(jobs)
Under CAS 416, three ways to measure projected average loss (PAL)
1.Actual Losses: actual amount of losses (where actual losses not
expected to differ significantly from PAL)
2.Comparable Purchased Insurance: Estimate of the PAL based on the
cost of insurance that could be purchased for the self-insured risk
3.Actuarial Measurement: self-insurance charge based on the
contractor’s or industry experience and anticipated conditions in accordance
with generally accepted actuarial principles
The total of self-insured charges plus insurance charges must not
exceed guaranteed cost insurance for the same exposures
38
Warranty (and CYA Statement)
These discussions were meant to be
general in nature. We at Willis, as
risk management professionals, do
have a layman’s working knowledge
of the tax and accounting issues
associated with many risk financing
arrangements. However, we do not
provide legal, tax or financial
reporting advice. Therefore, none of
our comments in this area may be
relied upon to be either accurate or
indicative of probable outcomes
when applied to specific facts and
circumstances.
Hear no evil, see no evil, do no evil.
I Am Not Here.
Questions
And Thank-You for your Attention
Charlie Woodman, CPA
Risk Finance Advisory
Willis National Construction
2013 Willis Construction Risk
Management Conference