Benchmarking Key Financial Ratios

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1 Benchmarking Key Financial Ratios 10 May, 2012 Presented by: Mujtaba Datoo, ACAS, MAAA, FCA Actuarial Practice Leader Aon Global Risk Consulting Phone: Fax:

2 Discussion Points Background Financial statement perspective Historical perspective of financial ratios Financial data Key financial ratios Summary 1

3 Background Update of 2010 benchmarking study 20 states participated (29 pools) 2

4 Pooling and Self-Insurance... are... Insurance Enterprises In an insurance enterprise: Unlike other industries/products, pay generally fixed premium up front for a promise to pay claims later Claims will not be known for a while and are subject to variation 3

5 Balance Sheet Surplus Assets Liabilities 4

6 Major Asset and Liability Components Assets: Cash Bonds Other investments Real estate: Limited recognition Etc. Liabilities: Case reserves Case reserve development Incurred But Not Reported (IBNR) reserves Allocated Loss Adjustment Expense (ALAE) Unallocated Loss Adjustment Expense (ULAE) Unearned premium reserves Etc. Outstanding losses are the largest component of liabilities 5

7 Balancing Formula premium + inv income = losses + expenses fixed minimal variable fixed 6

8 Variance Losses are inherently variable Varies by coverage Excess Liability very variable WC indemnity less variable than medical Auto Liability generally more stable Higher SIRs have greater variability 7

9 Sources of Variation Process risk: Associated with projection of future contingencies that are inherently variable Parameter, model risk: Associated with selection of parameters of the model (e.g., selecting inapplicable LDF) Misidentifying a process model (e.g., Poisson for frequency) Surplus provides protection against variation 8

10 Surplus is Key Measure Assets less Liabilities = Surplus Surplus a.k.a. Net assets Pool equity Retained earnings Policyholder s surplus 9

11 Capital Needs Insurance company failures in the 1980s: U.S. Congress investigates NAIC strengthens state solvency standards States set minimum capital requirements Concept not new: Introduced long ago in Wisconsin Requirements applied to banks 10

12 Reasons for Surplus Absorb adverse loss development KEY reason Reinsurers may become insolvent Contingent liabilities Use for rate stabilization Rating agencies Make pool more attractive to Prospective members Reinsurers May be required by state regulators 11

13 Use Regulatory Tests Apply private sector tests: IRIS: Insurance Regulatory Information System Easier to understand and apply Publicly available Not quite apples-to-apples, but apples-to-oranges: Ranges broad enough to make them meaningful 12

14 Other Tests RBC: Risk-Based Capital requirements: Complex; some parameters do not apply to pools Establishes amount of required capital Compares required capital to insurer s surplus Provides regulatory intervention points 13

15 More Tests Other tests exist, but concept is same: A M Best s Capital Adequacy Ratio (BCAR) S & P Capital Adequacy Ratio (CAR) PRISM by Fitch ratings Moody s Risk Adjusted Capital (MRAC) Solvency II under development/review 14

16 Financial Ratios Basic concepts universal Building blocks the same Refinement adds complexity Backward looking Forward looking IRIS RBC Scenario- Based Approach Probabilistic Models Simple Complex 15

17 Data is King! No central depository for public sector Compare to private sector companies Good benchmark of broad indicators Private Carriers data is from Best s Aggregates & Averages Private Carriers This NLC data compiled to provide meaningful results High level data extracted, details vary Designed to yield broad ratios 16

18 Participants: 20 States (including British Columbia) 2011 data provided: AK, AZ, BC, FL, MI, MN, NC, NM, OR, RI, SC, TN, VA, VT, WI data provided up to 2010: GA, NH, PA, SD, WA 17

19 Millions $$ of Net Assets, Net Premiums, Loss Liabilities 1,400 1,200 NLC Pools as of 2010: Net Premiums ~ $598m Net Assets ~ $1,316m Loss Liabilities ~ $1,234m 1, data was available for 15 of the 20 participating states. Net Premiums Net Assets Reserves 18

20 Net Assets by State ~ $1,316m FL 17% GA 10% MI 9% MN 13% NC 7% TN 7% SC 5% BC 6% AZ 3% AK 2% WI 1% WA 0% VT 2% VA 5% SD 2% RI 1% PA 1% OR 4% NH NM 1% 5% 19

21 Key Financial Ratios Focus on 6 key ratios: 1) Premiums (aka contributions)-to-surplus 2) Reserves-to-Surplus 3) Surplus-to-SIR 4) Reserve Development-to-Surplus 5) Operating Ratio 6) Liabilities-to-Liquid Assets 20

22 Why do we look these ratios? Readily available from financial statements Easy to understand and apply Studies show major impairment causes: Inadequate reserves Rapid growth 21

23 Ratio 1: Net Premium-to-Surplus Net premium-to-surplus ratio well within usual range of less than 3:1 Able to: Increase retention Return dividends Increase membership Private Carriers NLC-RISC sample 22

24 AK AZ BC FL GA MI MN NC NH NM OR PA RI SC SD TN VA VT WA WI Total Net Premiums-to-Surplus By State

25 Net Premium-to-Surplus Highs and Lows 6.0 high Varies by pool and year (note: outliers not shown) Average = consolidated NLC sample database high high high avg avg avg high high high high avg avg avg avg avg 0.0 low low low low low low low low high low avg 24

26 Net Premium-to-Surplus Varies by Coverage Long tail coverages have higher ratios WC vs. Liability Need to: Differentiate coverages (e.g., WC from Liability from Property) WC Liability 25

27 Ratio 2: Loss Reserves-to-Surplus Reserve-to-Surplus ratio well within usual range of less than 3:1 Able to withstand adverse development Private carriers NLC-RISC Sample 26

28 AK AZ BC FL GA MI MN NC NH NM OR PA RI SC SD TN VA VT WA WI Total Loss Reserves-to-Surplus By State

29 Loss Reserves-to-Surplus Highs and Lows 12.0 Varies by pool and year (note: outliers not shown) Average = consolidated NLC sample database high high high high high high high high avg avg avg avg avg avg avg avg low low low low low low low low high low avg 28

30 Loss Reserves-to-Surplus Varies by Coverage Reserve-to-surplus ratio varies by coverage higher for WC lower for liabilities, auto Long-tail coverages need more surplus cushion WC Liability 29

31 Ratio 3: Surplus-to-SIR Surplus-to-SIR ratio of greater than 10:1 From the standard that no one risk exposes surplus of more than 10% NLC-RISC sample 30

32 Ratio 4: Reserve Development-to-Surplus Threshold is < 20% Key indicator of adverse development Can also perform 2-year reserve development-to-surplus 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -8.0% -10.0% -12.0% -14.0% -16.0% -18.0% Private Carriers NLC-RISC sample 31

33 Ratio 5: Operating Ratio As % of Premium Net Premiums $598 Millions Add Investment income %* Less Losses and LAE % Less Expenses % Less Dividends 50 8% Equals Operating Results $105 82% * Investment income is stated as a ratio to premium. This is not investment yield. 32

34 Operating Ratio Operating Ratio threshold is less than 100% 120% 100% 80% Operating Ratio > 100% is unprofitable; review loss ratio; review expense ratio 60% 40% 20% 0% Private Carriers NLC-RISC sample 33

35 Ratio 6: Liabilities-to-Liquid Assets Measures the insurer s ability to meet the financial demands Provides rough indication of the possible implications for policyholders if liquidation is necessary Threshold is < 100% 100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Private Carriers NLC-RISC sample 34

36 AK AZ BC FL GA MI MN NC NH NM OR PA RI SC SD TN VA VT WA WI Total Liabilities-to-Liquid Assets By State 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 35

37 Review Ratios Over Longer Time Horizon Not in Isolation but Interdependently Reserve Development to Surplus Operating Ratio Reserve to Surplus Surplus to Retention Premium to Surplus Liquid Assets to Liability 36

38 Ratios are Relativity Concepts Financial ratios are relative measures: Relative to other entities or aggregated insurance companies Data needs adjustment to common levels: Discounted vs. undiscounted Other adjustments (e.g., real estate net admitted asset) 37

39 Absolute Ratios Don t Exist! Absolute measures do not exist! No one right answer Use reasonable ranges Ranges broad enough to encompass meaningful results Compare to similar or peer entities: Account for differences (e.g., SIR, tort limits, coverage, discounting, confidence levels, etc.) 38

40 For Peak Performance Monitor performance tests annually Explain causes for outside usual ranges Take gradual corrective actions Don t wait for the steep climb quick fall! Premium to Surplus Reserves/ Surplus Surplus to SIR

41 Summary Losses are inherently variable Variability cushioned by surplus Set financial targets: Reserves, Premium and SIR to Surplus Understand and apply ratios judiciously Review plan periodically: Details change: SIRs, membership, etc. Compare to peer groups 40

42 Questions? Mujtaba Datoo, ACAS, MAAA, FCA Actuarial Practice Leader Aon Global Risk Consulting (949)

43 Thank You! 42

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