FUNDING FOR RETAINED WORKERS COMPENSATION EXPOSURES. Brian Z. Brown Michael D. Price

Transcription

1 FUNDING FOR RETAINED WORKERS COMPENSATION EXPOSURES Brian Z. Brown Michae D. Price

2 Funding for Retained Workers Compensation Exposures ABSTRACT by Brian Z. Brown and Michae D, Price The sef-insured workers compensation market has grown dramaticay over the past five years. An empoyer faces costs and benefits when evauating the decision to retain or sefinsure part of its workers compensation. This paper outines severa1 methods that can be used to estabish funding eves for an entity which retains its workers compensation exposure. We have incuded a discussion of metbods appropriate to estabish the funding eve when the potentia sef-insured maintains an adequate database. In addition, for an empoyer with more imited data, we present three atemative methods for estimating the required funding eve. We aso discuss:. Benefit and cost considerations invoved in sef-insuring; Reguatory requirements associated with sef-insuring; and Funding eve considerations. We beieve that the concepts outined in this paper can assist an entity in: Structuring a sef-insurance program (or deciding whether to sef-insure); and Funding for a sef-insurance program. Finay, the paper may be hepfu to the actuaria or risk management anayst confronted with these issues for the first time. The authors woud ike to thank Gary R. Josephson and Robert K. Bender for reading the initia draft of the paper. Their hepfu comments and suggestions improved the fina version. Additionay, members of the review committee (Steven Visner, Mike Lamb and Lee Smith) provided important guidance. We woud aso ike to thank Rosemary Poeer for her diigente in typing numerous drafts. 202

3 FUNDING FOR RETAINED WORKERS COMPENSATION EXPOSURES INTRODUCTION The sef-insured workers compensation market has grown dramaticay over the past five years. The foowing tabe dispays rhe percentage of the tota market that is sef-insured by caendar year (based on premiums and premium equivaents). Workers Compensation Percentage of Market Sef-Insured ) Caendar Year 1 Sef-Insured Percentage % As the sef-insured market has grown, the need for appropriate funding eves has increased. It is important for sef-insured firms to set aside an appropriate accrua for their retained exposure as most states do not have guarantee funds for sef-insured entities.* ) Sef-nsurance Trends & Perspectives 1992, Johnson & Higgins. The term sefinsurance denotes any program empoying risk retention as the primary method for funding expected osses. This definition incudes sef-insured programs deemed quaified under state aws, but does not incude sef-insured retentions or deductibes in conventiona insurance programs. ) However, it shoud be noted that most states have estabished coatera requirements for sef-insured entities. We wi discuss coatera requirements in Section II. 203

4 Estabishing funding eves for entities that sef-insure their workers compensation exposure is a compex process. This paper defines the term funding eve and describes methods that can be used to estabish funding requirements. The paper is divided into six sections. The first section discusses some of the benefit and cost considerations invoved in deciding whether to commerciay insure or retain some of the exposure in-house. The second section describes some of the significant requirements that states impose on firms that sef-insure their workers compensation exposure. In the third section, the funding eve is defined. The fourth section provides two detaied funding eve cacuations. The first cacuation presented is for an empoyer that has been sef-insured for a number of years and has substantia historica oss and exposure information. The second cacuation is for an empoyer which has ony been sef-insured for a short time period and has imited oss and exposure information. The fifth section of the paper discusses severa1 additiona items which an entity may want to consider in structuring and funding a workers compensation sef-insurance program: Confidente Leves; Discounting; and Excess Insurance. The fina section of the paper is the concusion

5 BENEFITS AND COSTS OF SELF-INSURANCE An empoyer faces costs and benefits when evauating the decision to retain or sef-insure part of its workers compensation exposure. Each organization wi perceive the overa vaue of sef-insuring differenty. A) Benefits of Sef-Insuring Workers Comoensation Exoosures The potentia benefits of sef-insuring Workers Compensation exposures resut from: Cost Savings to Empoyers Enhanced Awareness and Contro of Loss Costs Other Considerations Cost Suvinas to Emoovers Lower cost is often considered to be the most impottant benefit of sef-insurance. However, cost shoud not be considered in isoation. The cost of sef-insuring must be considered in reation to tbe cost of purchasing insurance from the commercia marketpace and the increased risk assumed by the sef-insured empoyer. Premiums charged by commercia insurers contain severa1 distinct components incuding expected oss costs, operating expenses, risk oad, and protit. The sef-insured entity can potentiay achieve cosí savings in three of these four premium components. 205

6 The expected oss costs underying commercia premiums generay refect the insurance company s estimate of the average oss cost for a group of simiar insureds. To the extent that the entity considering sef-insurance has ower expected oss costs than the average entity in the group, tbis difference is reaized as cost savings by the sef- insurer. That is, the sef-insurer reaps the fu benefit of better than expected oss experience. Furthermore, the sef-insurer benefíts directy and immediatey from any reduction in expected oss costs which resuts from the successfu impementation of oss contro or oss prevention strategies. This incentive to sef-insure has not escaped the attention of the commercia marketpace. There are numerous mechanisms avaiabe to the commercia insurer wishing to compete for the business of the better than average risk, incuding experience rating, retrospective rating, prospective rating (e.g., schedue rating) and dividend pans. However, a of these options either diute or deay (or both) the fu1 benefit of good oss experience. Additionay, for an entity which encounters difficuty obtaining insurance from the vountary market, sef-insurance is a means to avoid the stigma and increased costs associated with purchasing coverage in the residua market. The operating expense component of commercia premiums may incude a provision for such costs and services as caims handing, underwriting, taxes, dividends, assigned risk assessment, administrative costs, marketing, acquisition costs, and overhead. Sef- insurance may potentiay eiminate or reduce the need for severa1 components of operating expense, thus resuting in cost savings to the sef-insured entity. Sef-insured

7 entities wi not incur expenses for underwriting, marketing, dividends, or acquisition of business (commissions). Aso, subject to various state reguations, sef-insured entibes may be exempt from assigned risk assessments. Sef-insurers can further achieve COSI savings by retaining the provision for profit in the rates. We beieve that the sef-insurer cannot avoid the uncertainty of outcomes associated with retaining its exposures to oss. This cost wi be borne by the sef-insurer either through the opponunity cost of funds, in excess of the expected vaue, set aside for possibe adverse caim resuts or the need to borrow from other parts of the organization (or an outside source) during those years with poor oss experience. Commercia insurers often incude a provision in their rates, known as a risk oad, to compensate for this uncertainty. More discussion on this component wi foow in a ater section. Enhanced Awareness and Contro of Loss Cosrs As a consequence of the decision to sef-insure workers compensation exposures, the empoyer becomes responsibe for many aspects of the risk management and financing processes that may otherwise be addressed by the commercia insurer. Caims handing, database management. oss prevention and oss contro ftmctions are often moved in-house or contracted with a third party provider. Oftentimes this may provide the sef-insurer with a firsthand opportunity to witness the magnitude of the financia1 and human costs associated with workpace accidents. Sef- 207

8 insuring may provide a more direct ink between empoyer actions such as oss contro and oss prevention and the company s bottom ine. Thus, greater awareness may often ead to measures enacted with the intention of reducing costs and providing a safer workpace. Other Considerations The empoyer is abe to guarantee the avaiabiity of coverage (subject to reguatory approva). Whie for Workers Compensation insurance, a empoyers are required to obtain coverage, if not from the vountary market then from the residua market, many empoyers wish to avoid the stigma of being considered a substandard risk if they are forced to obtain coverage from an assigned risk mechanism. Furthermore, whie coverage avaiabiity is guaranteed. there is no guarantee that an insured can pace its business with the company of its choice. By means of potentia cost savings and enhancemenr of empoyee morae, the empoyer is given a direct incentive to aggressivey rehabiitate injured workers. This not ony may resut in cost savings for the empoyer, but there is a societa benefit associated with restoring an individua to a state of heath and productivity. Furthermore, overa empoyee oyaty may be enhanced. The sef-insurer retains more contro over the caims handing process, and thus has more authority over decisions to deny caims or investigate fraud. 208

9 Finay, the sef-insurer retains authority over its investment portfoio, that is, it contros the assets which back the iabiities incurred by sef-funding. This freedom aows the company to potentiay seek higher ratea of return than what may be refected in commercia premiums. B) Costs of Sef-Insuring for Workers Comoensation Exnosures The costs of sef-insuring for Workers Compensation exposures resut from: Increased Variabiity of Insurance Reated Costs Additiona Staffing Costs Other Considerations Increased Variabiitv of Insurance Reated Costs Whie the expected vaue of costs under a sef-funding arrangement may be equa to or ower than the cost of purchasing commercia insurance, the variabiity of these costs is potentiay much greater to the sef-insured entity. This resut foows from consideration of the Law of Large Numbers. That is, the reative variance associated with the coective outcomes of mutipe contingent events. is ower than the reative variance associated with the outcome of a singe contingent event. Premiums charged by commercia insurers and funding eves estabished by sef- insurers may contain a provision for contingencies referred to as a risk oad. The reative magnitude of the risk oad is usuay dependen1 on the variance of possibe

10 osses reative to the expected amount of osses associated with insuring exposures. Additionay, it may be more diffícut for the sef-insurer to accuratey determine the utimate vaue of its anticipated oss costs, than it is for an insurance company to deveop rates that are adequate on an overa basis. This characteristic, referred to as parameter risk, can aso be attributed to the Law of Large Numbers. That is, estimates of caim frequency and severity which are derived from a arge credibe database, such as those avaiabe fo most arge comrnercia insurers are more statisticay reiabe than estimates deveoped from smaer ess credibe databases such as those maintained by sef-insurers. An insurance company can provide coverage for a arge number of empoyers, who are diverse both economicay and geographicay, whie a sef-insurer is Iimited to providing coverage for its own exposures. Thus, the insurance company requires a proportionatey smaer oading for the risk that osses wi, in the aggregate, exceed their expected vaue by some percentage. than does the sef-insurer. This differentia represents a cost of sef-insurance. A reated cost resuts from the fact that, in contrast to the purchase of commercia insurance. the amount of funding required to pay insurance caims is unknown. Athough estimates are made and funding eves may incude a risk oad, the actua cost of sef-insuring may not be known for many years. This uncertainty can compicate the financia1 panning process of the empoyer. This compication can be viewed as a cost of sef-insurance. 210

11 Additiona Staffwza Costs The empoyer that decides to sef-insure must provide or contract for many services otherwise provided by the commercia insurer, incuding caims handing, database management, and oss controiprevention services. These services are essentia to the successfu management and financing of workers compensation exposures. Other services required by a sef-insurer incude audit, actuaria. and investment management services. Therefore. the sef-insurer must either purchase these services from an outside party. or move the functions in-house. Often, especiay at first, the sef-insurer cannot undettake these operations as cost effectivey as they were provided by the commercia insurer. Generay. additions to staff wi be required to perform or monitor these functions, as we as hande other administrative tasks associated with managing a sef-insurance program. Skied risk management personne wi be required to supervise these functions as we as address the technica needs of the program (e.g.. what excess imits of coverage to purchase). Often. a company must purchase computer hardware and software to estabish a risk management database required for monitoring and anayzing exposures to oss. Actuaria. audit, and investment management services can be purchased from professiona firms speciaizing in these areas. 211

12 t shoud aso be noted that the commercia insurer, due to economies of scae, may provide better service and/or provide the service at a ower overa cost than the sef- insured entity. Other Considerations One additiona cost associated with the decision to sef-insure, is the potentia adverse impact of sef-insuring on the empoyer s reationship with its empoyees. If the empoyer chooses to move the caims adjusting process in-house, the empoyer and the empoyee can be thrust into an adversaria1 reationship under certain circumstances. Consider the decision to deny caims. If the empoyer denies an empoyee s caim, the empoyer may be viewed as unsympathetic by the injured person s friends and co-workers. This can have a damaging effect on the firm s reationships and reputation. Simiar difficuties arise if the empoyer takes a hard ine on investigating and eiminating frauduent caims. For these reasons many firms which sef-insure their exposures to oss choose to contract for caims management services with a third party administrator (TPA). The TPA is often viewed as an objective decision maker, baancing the goas of the empoyer against the needs and rights of injured workers. Another potentia cost is the avaiabiity and affordabiity of excess insurance. Many sef-insured entities wi want (or be required) to purchase excess insurance and this subjects these companies to: 212

13 The uncertainty regarding market conditions, and the effect upon the avaiabiity and affordabiity of the coverage; and The credit risk associated with future excess insurance recoveries. It shoud be noted that we regard Federa Income Tax considerations to be outside the scope of this paper. II. SELF-INSURANCE REGULATORY REOUIREMENTS Most states have estabished requirements to provide funds for injured workers in the case of a sef-insured entity s banktuptcy. In addition, states have attempted to imit the avaiabiity of sef-insurance to financiay strong firms. This section discusses severa1 common sef-insurance requirements imposed by the various states. The requirements are divided into initia fiing requirements and additiona requirements. Sef-insurance initia fiing requirements often incude: 1) A parenta guarantee (if appicabe); 2) The most recent audited financia1 statement of the entity considering sef-insurance; and 3) Loss experience and payro information. 3) The Sef-Insurance Manua by C. C. Liy and H. G. Boggs, NILS Pubishing Company summarizes each state s statute reated to workers compensation sefinsurer requirements. 213

14 The parenta guarantee is a promise by the parent corporation to guarantee the workers compensation payments of a subsidiary. This requirement wi decrease the credit risk associated with the sef-insured entity s exposure by committing not ony the subsidiary s assets but aso the parents assets to guarantee the sef-insurers workers compensation payments. The second requirement, a recent audited financia1 statement, aows the state fo tinanciay evauate the potentia (or current) sef-insured empoyer in order to determine if the empoyer is financiay strong enough to sef-insure. This procedure shoud minimize the number of financiay weak sef-insured empoyers. The ast requirement. of requesting oss and payro information. aows the Insurance Department to determine the reasonabeness of the coatera (which is discussed ater). As a note, some states have estabished additiona and more specific requirements. For exampe, the Vermont reguations require that the appicant must meet target ratios in six categories.4 If a sef-insured empoyer meets the initia fiing requirements and the state is satisfied with the entity s financia1 condition then two additiona requirements may be imposed: 4) There are target ratios for minimum: cash fow. iquidity, working capita, net Worth, profitabiity, and turnover. 214

15 Excess insurance; and 9 Security or bonding. Onc reason to require excess insurance is to increase the predictabiity of the sef-insured empoyer s retained oss experience. The purchase of excess insurance may make the oss experience more predictabe from year to year and may reduce the probabiity of an insovency (of the sef-insured entity) due to poor oss experience in one particuar year. States wi usuay require rxcess insurance if the sef-insured empoyer has some financia1 shottcomings. The importance of excess insurance and its reationship to the fünding eve wi be discussed in Section V. The security or coatera requirement is the mechanism the states have estabished to compensate caimants in the event of a sef-insured empoyer s bankruptcy. Most states do not have guarantee funds covering the obigations of sef-insured empoyers. Therefore many states require sef-insured empoyers fo provide the state with a etter of credit (LOC) or surety bond. Thesr funds woud then be avaiabe in the case of a sef-insured empoyer s bankruptcy. States use various methods to estabish the security requirement. In reviewing the various state reguations. it appears that many states use one (or more) of the foowing three methods to determine the amount of security:. A minimum tat doar amount: A factor times case reserves; or A formua approach based on rhe recent oss experience of the insured. 215

16 A few states require an actuaria anaysis to assist in determining the amount of coatera. It shoud be noted that states do not require security for municipaities and poitica subdivisions that sef-insure. This may be due to the fact that these entities typicay have tax authority and therefore are unikey to be unabe to meet caim obigations. This section has discussed some of the more common sef-insurance requirements. However, specific requirements vary significanty from state to state. III. FUNDING LEVEL The discussion of the funding eve in this section assumes that the sef-insured entity is utiizing a risk financing technique, for its retained exposure, which invoves earmarking assets. A partia ist of the most commony used risk financing techniques for retained exposures incude: Current expensing of osses;. An unfunded reserve: A funded reserve (i.e. earmarking assets); Use of borrowed funds; and Retention through an affiiated ( captive ) insurer. 51 Head. George L. and Horn, Stephen II. Essentias of the Risk Management Process, Voume II (Insurance Institute of America, Inc.) 216

17 There are advantages and disadvantages associated with each of the above mentioned techniques. A partia ist of the reasons for using a funded reserve as a risk financing technique incude: 1) It may be more ikey that iquid assets wi be avaiabe to pay for retained osses. If an entity earmarks assets for retained exposures, oftentimes a cash fow (or duration) anaysis wi be perfotmed on the retained exposure. 2) Accounting considerations may require the entity to estabish a baance sheet reserve for its retained exposure. The appicabe standard board statements are Financia1 Accounting Standards Board (FASR-5) for private companies and Govemmenta Accounting Standards Board (GASB-10) for pubic entities.@ 3) Reguators may prefer that fin-m formay estabish a funded reserve. In fact, some states have aowed, in essence, a forrnay structured funded reserve (escrow account) to meet the coatera requirements estabished by the state. Two potentia disadvantages of a ftmded reserve as a risk fmancing technique are a): 6) It shoud be noted that these accounting obigations coud be met through an urtfimded reserve. T) An escrow account is a written agreement entered into among three parties. Funds are deposited for safekeeping with the third party as custodian. The custodian or depository is obiged to foow stricty the terms of the agreement agreed upon by the other parties. 8) IBID ) 217

18 1) The entity may have better use of its funds than merey to invest in financia1 instruments in anticipation of future osses. The firm may be abe to eam more by deviating funds to reguar productive activities; and 2) The funded reserve may appear as ide funds and be used for other corporate purposes. The required Fund is defined as the amount of assets needed to satisfy a past years retained insurance obigations pus insurance obigations for the upcoming sef-insurance year. This is anaogous to (but not identica fo) an insurance company s: Liabiities as of year-end; pus. Next year s premium. The required Fund for a sef-insured empoyer consists of the foowing eements: t Liabiities as of year-end Caim iabiities (incuding a provision for aocated oss adjustment expenses (ALAE); Other oss adjustment expense iabiities; Any potentia oss sensitive premium reated obigations prior to sef-insuring (e.g., additiona retrospective rating pan premium); c 218

19 Expected additiona excess insurance premium payments for prior years exposure (due to a positive payro audit); Second injury fund assessments. taxes payabe, etc.; Other (genera) expense iabiities: and A provision for uncoectibe excess insurance.. Funding obigations for the upcoming sef-insurance year Caim costs incuding ALAE; Unaocated oss adjustment expense (ULAE) costs; Marketing/saes costs (for a group sef-insurer); Excess insurance cost; Second injury fund assessment. taxes etc.; and Orher expense (expected to be incurred in the upcoming sef-insurance year) As a note, the above mentioned caim costs refer to the retained (after the appication of excess insurance) exposure. We are assuming that a sef-insurance year wi provide coverape for a caims occurring during the year. The Funding Leve for the upcoming year, is then equa fo: The prior years iabiities: pus The funding obigations for the upcoming sef-insurance year; minus 219

20 . The amount of assets earmarked to pay for obigations. If investment income is intended to remain in the Fund, then the assets shoud incude the acctued investment income. We have not defined caim costs with regard to whether the amount is discounted or undiscounted or whether the amount is an expected vaue or estabished at some confidente eve amount. The fifth section of the paper wi discuss these concepts. There are probaby other ways to define funding eves; however, it appears that many sef-insured entities use the definitions discussed in this section. V. FUNDING LEVEL EXAMPLES In this part of the paper, we wi outine approaches that can be used fo estimate the tünding needs of a sef-insured empoyer. the caim reated iabiities as of year-end. and the expected caim costs for the upcoming year. We wi assume that the sef-insured empoyer is abe to estimate the amount of non-caim reated items (e.g. excess insurance costs). In addition, we wi provide funding eve cacuations for two scenarios. Scenario number one - the sef-insured empoyer has adequate data to utiize severa1 commony accepted actuaria projection methods; and 220

21 . Scenario number two - the sef-insured empoyer does not have sufftcient data to utiize commony used actuaria protection techniques and therefore some creative but necessary techniques are required. A) Adeauate Data Examoe For scenario one, the empoyer has been sef-insured for ten years. The empoyer purchases specific excess coverage above $500,000 per caim. The empoyees are in two casses (based on NCCI cass codes). We wi first discuss a procedure to project gross osses. As a note, it may not be necessary to project gross osses to estimate net osses. However, we wi discuss the projection of gross osses for the foowing two reasons: A projection of net osses coud invove subtracting projected excess osses from gross osses; and If any excess carriers are insovent or financiay troubed, mis may necessitate a projection of gross osses to estimate an uncoectibe excess insurance provision. The foowing data is avaiabe by sef-insured year and deveopment year: 221

22 . Exhibit 1-dispays the empoyer s paid oss experience (incuding ALAE); Exhibit 2-dispays the empoyer s incurred oss experience (incuding ALAE); Exhibit 3-dispays the corresponding caim count data (for ost time caims); and Exhibit 4-dispays the empoyer s average incurred severity. Additionay, Exhibit 5 dispays the sef-insured empoyers workers compensation payro by sef-insured year and cass. Proiecrion of Gross Losses Based on the above mentioned data items, we can use severa1 methods to estimate utimate osses by sef-insured year. As a technica note, we wi use the term oss fo incude both oss and ALAE. The unpaid caim iabiity can then be computed as the utimate osses ess the osses paid-to-date. The foowing generay accepted projection methods are used to project utimate osses by sef-insured year: Paid oss deveopment (Exhibit 6);. Incurred oss deveopment (Exhibir 7) A counts times averages method (Exhibit 8);. An expected oss method (Exhibit 9); A trended pure premium approach (Exhibit 10); and A Bomhuetter-Ferguson method (Exhibit 11). 222

23 We wi not provide the detais on these methods in the text as they are reativey we documented in the actuaria iterature. However the exhibits shoud be reativey sef expanarory. We shoud note that if more refined data is avaiabe, severa1 enhancements coud be made to the projection methods outined on Exhibits 6 through. For exampe, the projection methods outined on Exhibits 6 through coud be performed separatey: 1) By cass; 2) By type of oss (medica. indemnity. and expenses); or 3) A combination of 1 and 2 from above (i.e., by cass for medica costs versus by cass for indemnity costs). The further breakouts of the data may revea1 trends not apparent by viewing the daca more gobay. However, the further breakouts wi invove ess data and hence invove credibiity considerations. It shoud aso be noted that whie we have not expicity introduced credibiity into the oss projection methods, we have used various projection methods. Presumaby the anayst wi be in a position to assign credibiity to the various projection methods in seecting utimate osses. 223

24 The above mentioned data items and hence the above estimates are gross (Le. before the appication of the entity s excess insurance program). In the above mentioned gross oss projections we have assumed that there were no unusuay arge osses that woud distort the projections. If there had been unusuay arge osses, we woud recommend that they be treated separatey. Proiection of Net Losses Severa1 methods can be used to estimate the retained osses for the entity and we wi discuss two sets of methods. The first set derives the retained osses by repeating the projection techniques performed for gross osses. However. retained osses are used in ieu of gross osses in consttucting the trianges. Therefore, individua osses wi be imited at the per caim retentions. With regard to aggregate recoveries, it may be more reasonabe to contstruct trianges gross of aggregate retentions and imit the projected osses at the aggregate retention. As a note, both the B-F method and the expected oss method wi require an independent estimate of the utimate retained osses. These retained osses can be cacuated based on: An estimate of unimited osses; and Excess ranos pubished by the Nationa Counci on Compensation Insurance (NCCI). The second technique is a Bornhuetter-Ferguson method for the excess ayer and invoves subtracting estimated excess osses from gross osses. The a-priori estimate of utimate excess osses is based on the seected gross osses and an estimate of the 224

25 percentage of osses which wi exceed a specific amount. For discussion purposes, we reied on excess ratios pubished by Mr. Wiiam R. Giam in Retrospective Rating: Excess Loss Factors PCAS LXXVIII. Page 1. These excess ratios wi vary by state hazard group. However a discussion of the procedures necessary to cacuate excess ratios is beyond the scope of this paper. Severa1 sources can be used to estimate tbe excess reporting pattems. A partia ist incudes: Data pubished by the Reinsurance Association of America (RAA); Data from A. M. Best s for reinsurancc companies; and Data from the individua entity (if the entity is arge enough). It shoud be noted that both the RAA data and A. M. Best data have severa1 imitations incuding: A mixture of attachment points and retention eves are refected in the data; A mixture of different types of risks; Varying company reporting requirements and reserving phiosophies. and A mixture of different reinsurance arrangements (e.g., excess of osses, quota share) 225

26 Exhibit 12 dispays the cacuation of the a-priori excess osses. Exhibit 13 dispays the Bornhuetter-Ferguson cacuation for excess osses. The retained osses are then cacuated by subtracting the estimated excess osses from the estimated gross osses. Exhibit 14 dispays our seected:. Gross osses;. Excess osses;. Retained osses; and. Retained Unpaid Caim Liabiity The expected vaue of osses for the upcoming year (1994) then can be determined based on: An expected oss method; and A trended pure premium approach. Exhibit 15 summarizes these estimates. The required Fund (on an expected vaue basis) is then equa to the sum of: The net unpaid caim iabiities; pus The expected retained caim costs for the upcoming year 226

27 Exhibit 15 dispays the cacuation. B) LIMITED DATA EXAMPLE The XYZ Manufdcturing Company has sef-insured its workers compensation exposures for the past six (6) years. Whie the firrn has paid over $9,OOO,ooO in caims during that time period, they have ony recenty begun to estabish case reserves for individua caims. Aggregate oss payments are avaiabe by caendar year, but individua caim detai is not avaiabe. In addition, the paid oss data is avaiabe for medica versus indemnity payments. The Company has recenty estabished a database capturing information on a open and newy reponed caims as of January 1, The accident date and the current reserve amount are captured; however, prior payments and prior reserve eves on open caims are not known. Reserves are avaiabe separatey for medica versus indetnnity osses. In addition. the Company has not captured exposure information by NCCI cass code. The absence of a compete set of cumuative data trianges for paid and incurred osses poses a unique probem for estimating the unpaid caim iabiities of the Company. as traditiona actuaria methodoogies cannot be empoyed without modification. The first step is to estimate the required reserve eves for the Company from inception of the sef-insured period as of year-end 1993 (sef-insured years ). 227

28 Three nonstandard actuaria techniques wi be empoyed to estimate the utimate osses of the XYZ Manufacturing Company: Case Reserve Deveopment Method; Caendar Year Incrementa1 Payment Method; and A de-trended Bomhuetter-Ferguson projection method. For referente, Exhibit 16 dispays the avaiabe oss experience of the Company. Case Reserve Deveopnrent Method The case reserve deveopment method is simiar to the paid and incurred oss deveopment methods. A set of mutipicative factors, which vaty according to the maturity of a given accident year, are appied to the known case reserves for each accident year as of a common evauation date. The factors are referred to as case deveopment factors. For a given year, the product of the case deveopment factor and the case reserve amount yieds an estimate of the tota unpaid osses (incuding IBNR) for that accident year. Case deveopment factors can be derived from cumuative paid and incurred oss deveopment factors. Consider, P, = Paid oss deveopment factor from t months to utimate 1, = Incurred oss deveopment factor from t months to utimate

29 P = Paid osses at t months of deveopment 1 = Incurred osses at t months of deveopment U = Utimate osses Then, on an expected vaue basis (P) x (P,) = U impies P = (U)I(P,) (1) x (13 = U impies 1 = (U)/(J) We desire a factor, k, such that (on an expected vaue basis): (I-P) x (k) = (U-P); that is case reserves at t months. (I-P), mutipied by the factor k yieds tota unpaid osses, (U-P). Therefore, on an expected vaue basis: (I-III, - UIPJ x (k) = U - U/P, (U) x (VI, - /PJ x (k) = (U) x (1 - /PJ (IA, - /PJ x (k) = (1-1PJ Thus, k = (1 - /PJI(/I, - /P,). In the case of XYZ no credibe deveopment history exists from which to seect paid and incurred deveopment factors. Therefore, externa1 data sources wi be used to derive deveopment pattems. Exhibit 17 dispays paid and incurred deveopment factors based on our interpretation of data pubished by NCCI in a specific state, for medica and 229

30 indemnity osses, as we as the cacuation ofcase deveopment factors according to the formua derived above. Exhibits 18 and 19 depict the appication of the case deveopment factors to the case reserves of the Company and the resuting estimates of unpaid osses. Cuendar Year Incremenra Payrnenr Merhod The caendar year incrementa1 payment method is based on an assumed oss payout pattem. a oss trend. and an exposure (payro) trend to derive a factor which can be appied to caendar year paid osses to produce an estimate of unpaid osses for a accident years. The payout pattetn empoyed is derived from the deveopment pattem we used in the case deveopment method. Exhibir 20 dispays the seected payment pattems. For the purposes of this exampe, we wi assume that medica osses (pure premiums) wi increase ata rate of 10% annuay. whie indenmity osses wi increase by 3% armuay. As a note, these trends are in excess of payro growth. We wi assume that XYZ s exposures have increased by approximatey 4% per year (incuding payro growth). A good starting pace for trend factors woud be a bureau fiing. For exampe NCCI provides separate medica and indemnity oss ratio trends in most states. 230

31 AY,, denote an accident year at time t NJ Then. AY, is an accident year ar time (t-) AYI is an accident year at time (t-2) AY, is an accident year at time (t-k) Let P, represen1 the incrementa1 percentage of utimate osses paid in year t Then. given the amount paid in caendar year t on AY, osses, unpaid Iosses at time t on AY, exposures can be estimated by mutipying caendar year payments by the foowing factor: (1 c P;),i: P, That is. rhe ratio of rhe percentage of utimate osses yet fo be paid at time t, fo the percentage paid in year t That is AY, is the first accident year and its maturity is I years from inception. 231

32 Aowing for the effect of trends in accident year oss costs and exposures, the factor to estimate unpaid osses on AY, exposures is given by: (1 - C P,)f +r),=, P,.,! +r) As a note, the trend factor is the product of the oss and exposure trend. Notice that the trend factor, (1 +r) coud be factored out of this expression. yieding the resut that trend is irreevant to the cacuation of the reserve for a singe accident year. However. as wi be seen beow, trend is important when mutipe accident years are combined. Now suppose that the caendar year osses resuting from k accident years are known. but their breakdown by accident year is unknown. An expression can be deveoped which when appied to the caendar year payments at time t yieds an estimate of unpaid osses, for a accident years, at time t. Conceptuay. this expression shoud refect the sum of a future payments for each of the k accident years, divided by the sum of the caendar year t payments for each of the k accident years (based on an assumed payment pattern). The expression is: c n=o P,, (+r) 232

33 This expression can be seen to be the ratio of the sum of the numerators for each of the k accident year factors to the sum of the denominators for each of the k accident year factors. Notice that the trend factor cannot be factored out of this expression. The trend factor impacts the reative weights given to each accident year factor. Exhibits 21 and 22 dispay the mechanics of the methodoogy as we as the resuting estimate of unpaid indemnity and medica osses for the XYZ Manufacturing Company. As a note, this mode can aso be used to vary the future trend from historica averages. For exampe if XYZ entered into a ong-term contract with a particuar hospita that woud reduce expected future medica costs by 1% per year (and amost a of the injured workers were treated at this hospita), then this 1% reduction coud be factored into the mode. The future projected medica payments woud be reduced by 1% annuay or mutipied by a factor of (.99) (where x is the number of years from the date the ong-term contract began to the date the projected payment is made). De-Trended Bomhuetter-Fernuson Method The ast method discussed is a de-trended Bornhuetter-Ferguson projection method. This method can be used to estimate the unpaid caim iabiity as we as provide an estimate of the upcoming year s expected osses. For this method the foowing eements are required: 233

34 An estimate of utimate osses for the most recent year; An assumed reporting pattern for incurred osses; An assumed oss trend; and An assumed exposure method. For the XYZ Company. the utimate osses for 1993 can be estimated based on incurred and/or paid oss projection methods. The utimate osses for prior accident years can then be estimated based on the combined oss and exposure trend. For exampe, the utimate osses for sef-insured year 1990 can be estimated by dividing the 1993 utimate osses by (1 +r)j. A Bomhuetter-Ferguson method can then be used to estimate the IBNR reserves by year (the case reserves can then be added to estimate the unpaid caim iabiity). Exhibit 23 dispays the cacuation. The upcoming year s expected osses can then be estimated by mutipying the resuts of the incurred projection method by the seected trend factor of (1 +r). Exhibit 24 dispays this cacuation. Exhibit 25 dispays the seected unpaid caim iabiity at aong with expected 1994 caim costs. The funding for 1994 is then equa to required Fund ess the amount of assets set aside to pay caim iabiities. VI. ADDITIONAL CONSIDERATIONS This section wi discuss additiona factors besides cost estimates, that an entity may want to consider in structuring a sef-insured program (and determining a funding eve): 234

35 The variabiity associated with cost estimates; The time vaue of money; and Issues reated to excess insurance. Loss Probabih Leves The estimates described in Section V are expected vaues. Therefore, a significant percentage of the time (50% for a symmetric oss distributiony the actua osses wi exceed the estimates derived in Section V. The attached Exhibit 26 dispays a distribution of actua osses for the upcoming sef-insurance year for a risk with $500,000 of expected osses. As this graph dispays, for a risk with expected osses of $500,000, there is a 9.6% probabitty that actua osses wi exceed $1.000,000 in the upcoming sef-insurance year. The sef-insured entity wi want to consider this information in determining funding eves. Exhibit 27 dispays some of the key figures underying the graph. In determining the probabiity eve at which to fund, the risk may aso want to consider: How easy it woud be to obtain additiona funds if oss experience is worse than expected?; Woud bonds have to be iquidared at a oss to fund for adverse insurance resuts?; This distribution is based on our interpretation of data pubished by the NCCI. Specificay the distribution is based on the second derivative of the insurance charge curve. The state and hazard group adjustment is based on an Iinois hazard group IV risk. 235

36 What are the insurance costs reative to the net worth, saes, and net income of the entity?; and What is the corporation s phiosophy with regard to assuming risk? These factors aong with the variabiity of osses shoud be used by the entity to determine the funding eve. As we discussed previousy, the caim cost funding for the next year is equa to: Next year s projected caim costs; pus The caim reated iabiities for the prior years as of year-end; minus The assets earmarked to pay caim iabiities. In deriving probabiity eves, we are interested in the distribution of the funding eve. The assets as of year-end are fixed (ignoring credit risk); therefore; the probabiity eve is a function of the combined distribution of: Next year s caim costs; and The future oss payments associated with the unpaid caim iabiities for prior years as of year-end. Whie a discussion of the combined aggregate oss distribution is outside the scope of this paper, we woud point the interested reader to Hospita Sef-Insurance Funding: A Monte 236

37 Caro Approach by Dave Bickerstaff in the Spring 1989 Edition of the CAS Forum. This is one of the few papers that attempts to estimate the aggregate oss distribution of the combination of: The tun-off of the fund s prior years osses; pus The prospective year s osses. Discounting Another item that the sef-insured entity may wish to consider is the time vaue of money. The attached Exhibit 28 dispays how $100 of workers compcnsation osses are projected to be paid out over time. If the entity invested funds and received interest payments equa to 6% of the invested ünds annuay, then ess than $100 coud be invested at the beginning of the period to cover the expected oss payments. This is due to the fact that the interest payments wi aso be avaiabe to pay for future oss payments. In this exampe, approximatey $90 invested at the beginning of the period, aong with projected interest payments (at 6%) are anticipated to be suficient to cover the expected oss payments contained on Exhibit 28. Indetermining discounted unpaid caim iabiities, the Actuaria Standards Board has outined severa1 issues and considerations that an actuaty shoud take into account in Actuaria Standard of Practice No Discounting of Property and Casuaty Loss and Loss Adjustment Expense Reserves, A pattia ist of issues and considerations incude: 237

38 The timing of future payments and potentiay a range of payment-timing estimates; The seected interest rate for discounting; and Risk margins associated with the discounted oss reserves (as the discounting process introduces additiona uncertainties). The entity may aso want to consider the interaction of the oss payment stream and the probabiity eve of the undiscounted osses. For exampe, if the entity suffers an unusua number of arge caims (resuting in a reativey high probabiity eve) it may be more ikey that the payment pattern wi be extended. Large ifetime workers compensation caims are typicay paid-out over an extended time period. This factor has resuted in some anayses assuming that the discounted probabiity eve amounts are simpy equa to the undiscounted amounts mutipied by the present vaue factor (based on the premise that this assumption is conservative). With this assumption, the discounted probabiity eve amounts coud be computed by mutipying the undiscounted amounts by a uniform factor of.90. Excess Insurance Issues It appears that the most common types of excess insurance for workers compensation are: Per occurrence coverage; and Aggregate coverage. The per occurrence coverage provides coverage in excess of a doar threshod per occurrence. 238

39 Aggregate coverage imits the entity s exposure in tota for a sef-insured year. It provides coverage in excess of a doar threshod for a caims occurring in a sef-insured year. Excess insurance reduces the variabiity associated with the retained caim iabiities. The per occurrence coveragc imits individua caim amounts that are retained; therefore, for a arge caim ony the first $ x wi be retained. The aggregate coverage imits the retained osses for any one sef-insured year and therefore provides an upper imit fo the retained exposure (ignoring credit risk and poicy imits being exhausted). Exhibit 29 dispays the effect of the per occurrence excess insurance on the distribution of costs for the upcoming sef-insurance year. The exhibit dispays the probabiity eve amounts for a risk with $500,000 of expected unimited osses (both with and without a $50,000 per occurrence Ioss imit). In addition. we have added a provision for the cost of excess insurance. As a note, for iustrative purposes. wr have assumed that the excess msurer woud incude a 25% oading of the undiscounted expected vaue to determine premium. ) If the risk does not purchase per occurrence excess insurance, the actua caim payments are projected to exceed $980,000 one year in every ten or 10% of the time. However if the risk Based on our interpretation of data pubished by NCCI. ) Whie the 25% on the face of it appears ow (for expenses. protit, and a risk margin) ir shoud be noted that excess workers compensation payments are made over an extended period of time. Therefore, if the excess insurer refects the time vaue of money the discounted expected osses wi be significanty ess than the undiscounted amounts. 239

40 purchases excess insurance, the corresponding probabiity for approximatey $98O,OCM of insurance costs is 5% or one year in every twenty. Exhibit 30 graphicay dispays the distribution of oss outcomes assuming the risk purchased per occurrence excess insurance. In comparing Exhibit 30 and Exhibit 26 it shoud be noted that: The distribution of insurance costs is ess dispersed for the risk that purchases excess insurance; and The risk is forgoing the possibiity of very favorabe insurance costs (with the purchase of excess insurance) for reducing the possibiity of adverse oss experience. VI. CONCLUSION This paper has outined severa1 methods that can be used to estabish funding eves for an entity which retains its workers compensation exposure. In addition we have discussed: Denefit and cost considerations invoved in sef-insuring: Reguatory requirements associated with sef-insuring; and Funding eve1 considerations. We beieve that the concepts outined in this paper can assist an entity in: Structuring a sef-insurance program (or deciding whether to sef-insure); and Funding for a sef-insurance program. 240

41 Sef Insured Year o8 Izo sao ,011 1, ,599 2,150 2,050 2, , , ,445 2,500 1, , ,701 2,001 2,550 1, ,600 1,130 1, LI30 1,170 1, 30 DeveopmentFacton 6) Sef Insured YEGK 223.?u!zi %!!3 1.oam Is saa oo I.W , Averese Coumn Sum ooo Seected Age ta Age Factor Seeced Cumuative Factor oa TaO 1) Incuding AL4E Note: In seectng actors, we woud suggest rewewng ABC Company data as we as deveopment facfors pubished by Ihe NCCI for sate X Note, The mcxstrecentdia~ona has been braught fo year end based WI daa Ihrough September 30

42 SdI Insureu _---- YSX , , ,096 1,151 1, ,170 1, ,396 1,500 1,540 1, , ,501 1, ,590 1, , ,950 2, ,900 2,011 2, ,340 2,465 2,550 1,700 2,376 2,675 2,400 2,995 2,600 DeveoDment Factors Sefnsured Yt?X Ma L?&oB muzc! Average CoumnSum Seected Age to Age Factor Seected Cumuatw Fac!c, Ta Note. 1" s&ctmg Lctors. we woud suggest rewewmg ABC Company data asweas deveopment factors pubshed by Ihe NCCI for X "-*- TL^ --=+ r~ant r~noonahas been broughtto yearend based on data through Sepember 30

43 Exhibit 3 WI,nsure* Year "Iramate aaim me ilqcql!m Umae Frequenq Per SMiiion G ?e ! Doveopmont Facton Sensured Year &se s!i4e!qa! , , ooo OO I *verage Coumn Sum , Seected Age 10 Age Factor Seected Cumuare Facor ooo Tat