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Industry Reserve Adequacy and Other Hot Topics: Financial Analyst’s Perspectives. 1999 Casualty Loss Reserve Seminar. Scottsdale, Arizona. Presenters. Sarah Hibler - Vice President & Senior Analyst, Moody’s Investors Service Jay Votta - Principal, Deloitte & Touche LLP

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Industry reserve adequacy and other hot topics financial analyst s perspectives l.jpg

Industry Reserve Adequacy and Other Hot Topics: Financial Analyst’s Perspectives

1999 Casualty Loss Reserve Seminar

Scottsdale, Arizona


Presenters l.jpg
Presenters Analyst’s Perspectives

  • Sarah Hibler - Vice President & Senior Analyst, Moody’s Investors Service

  • Jay Votta - Principal, Deloitte & Touche LLP

  • Bill Wilt - Vice President & Senior Analyst, Moody’s Investors Service

Industry Reserve Adequacy - Financial Analyst's Perspectives


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Discussion Topics Analyst’s Perspectives

  • Overview of Reserve Adequacy

    • Results of Moody’s Top 50 Analysis

  • Use of Reserves in Credit and Equity Analysis

    • Reserves play critical role in gauging financial health

  • Reserving Issues in Mergers & Acquisitions

    • Reserves key consideration in structuring deals

Industry Reserve Adequacy - Financial Analyst's Perspectives


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Goals of Session Analyst’s Perspectives

  • Discuss macro-level trends in loss reserves

  • Provide insight into how ‘outsiders’ analyze loss reserves

  • Demonstrate importance of reserves in different contexts:

    • Credit Analysis

    • Equity Analysis

    • M&A Activity

Industry Reserve Adequacy - Financial Analyst's Perspectives


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Top 50 Analysis Analyst’s Perspectives

  • Moody’s Analyzed Top 50 P/C Groups

    • Approx. 2/3 industry reserves and surplus

  • Used annual statement data and internal reserve model

    • Excluded A&E, reinsurance, miscellaneous lines

  • Tested results against independent analyses where available

    • Despite limitations, A/S data can provide credible starting point

Industry Reserve Adequacy - Financial Analyst's Perspectives


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Top 50 Analysis Analyst’s Perspectives

Benefits of Analysis

  • Critical component of capital adequacy and credit analysis

  • Provides greater insight in discussions with companies

  • Independent verification of results

  • Insight into developing trends: quality of earnings, current rate adequacy

  • Separate supportable facts from unsubstantiated rumors in market

Industry Reserve Adequacy - Financial Analyst's Perspectives


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Top 50 Analysis Analyst’s Perspectives

Conclusions

  • Industrywide $12.6 B redundancy at 12/98

    • Represents abut 4% of Reserves and 4.5% of Surplus

      • PPA, WC provide redundancies; CMP, OL show deficiencies

  • Trends in Reserve Margins are Major Story

    • Margins thinning quickly

  • Differences Between Personal and Commercial Insurers

    • Whoever heard of a negative loss trend?

Industry Reserve Adequacy - Financial Analyst's Perspectives


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Top 50 Analysis - Personal Lines Writer’s Current Position Analyst’s Perspectives

Industry Reserve Adequacy - Financial Analyst's Perspectives


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Top 50 Analysis - Retrospective View of PPA Analyst’s Perspectives

Industry Reserve Adequacy - Financial Analyst's Perspectives


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Top 50 Analysis Analyst’s Perspectives

  • Findings - Personal Insurers

    • All showed reserve redundancies

    • The story then?

      • Favorable loss trends early-to-mid 1990s

      • Actuaries/management slow to recognize in rates

    • The story now?

      • Most carriers reducing rates, dividends

      • Loss cost trends ticking upward again

Industry Reserve Adequacy - Financial Analyst's Perspectives


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Top 50 Analysis - Commercial Writer’s Current Position Analyst’s Perspectives

Industry Reserve Adequacy - Financial Analyst's Perspectives


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Top 50 Analysis - Retrospective View of Reviewed Commercial Lines

Industry Reserve Adequacy - Financial Analyst's Perspectives


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Top 50 Analysis Lines

  • Findings - Commercial Insurers

    • More even mix of deficiencies and redundancies

      • WC similarities to PPA

      • legislation and rate reform benefits coupled with loss trends

      • Competition intensifying, loss ratio climbing steadily

    • Significant rate pressures all other commercial lines

      • Most commercial lines show uniformly increasing loss ratio

  • Diversified Insurers

    • Redundancies outweigh deficiencies

      • Favorable PPA and WC experience outweighs other lines

Industry Reserve Adequacy - Financial Analyst's Perspectives


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Top 50 Analysis Lines

Conclusions

  • Industry adequately reserved -- for now

  • How actuaries can help:

    • Expand statement of opinion

    • Include detailed footnotes in Schedule P

    • Expand content of actuarial reports and distribution of reports

  • Reserves Used in Variety of Ways by Many Constituencies…Think Beyond Statement of Opinion

  • Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Industry Reserve Adequacy -- LinesBeyond the Statement of Opinion

    • Moody’s Approach to Insurance Analysis

    • Credit vs. Equity Analysis

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Moody’s Approach to Insurance Analysis Lines

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Moody’s Approach to Insurance Analysis Lines

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Moody’s Approach to Insurance Analysis LinesAnalytical Approach - Benchmark

    • The lowest “Secure” rating has the annual default probability of a “500 Year” event

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Moody’s Approach to Insurance Analysis Lines

    • Traditional Financial Indicators

      • Financial Leverage (Debt/Total Capital)

      • Double Leverage (Inv in Subs+Goodwill)/Equity

      • Fixed Charge Coverage and Cash Flow Coverage

    • In Context of Underlying Business Volatility

    • In Context of Business Cycle

    • Does Legal/Regulatory Structure Inhibit Cash/Capital Flows Across the Group?

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Moody’s Approach to Insurance Analysis LinesA Practical Reserve Example

    • Your typical property/casualty insurer

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Moody’s Approach to Insurance Analysis LinesA Practical Reserve Example

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Credit vs. Equity Analysis LinesWhat Creditors/Policyholders Want

    • Absolute Repayment

    • Minimize likelihood of loss of principal; benchmark is risk-free rate

    • Which translates into:

      • Conservative corporate governance

      • Prudent capital and financial management

      • Capital cushion

      • Strong earnings and cash flows

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Credit vs. Equity Analysis LinesWhat Shareholders Want

    • Relative Return

    • Maximize total return, with acceptable level of risk; benchmark is a market index.

    • Which translates into:

      • Assertive corporate governance

      • High capital efficiency, as measured by ROE

      • Active capital and financial management

      • Growth in top and bottom lines

      • Strong earnings and cash flows

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Credit vs. Equity Analysis LinesContrasting Analytical Styles

    • Basic Motivations

      • Equity and credit analysts both want to be right

      • Credit analysts have pressure from issuers to be more liberal and investors to be more conservative

      • Equity analysts can face substantial implied pressure from issuers

    • Inherent Bias

      • Credit analysts tend to focus on the downside risk

      • Equity analysts tend to focus on the upside opportunity

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Credit vs. Equity Analysis LinesContrasting Analytical Styles - Example

    • Trustworthy’s creditors/policyholders have NO upside

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Industry Reserve Adequacy - Beyond The Statement of Opinion Lines

    • Reserving Issues in Mergers and Acquisitions

      • Actuarial Due Diligence Process

      • Sampling of Solutions to Reserve Uncertainty

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Reserving Issues in M&A LinesActuarial Due Diligence Process

    • Reserve Position

    • Restatement of Reported Results

    • GAAP Adjustments

    • Pro Forma Analysis

    • Appraisal Value

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Actuarial Due Diligence Process LinesReserve Position

    • “Windshield” Analysis

    • Limited Review

      • Business Units

      • Access

      • Time

    • Comprehensive Analysis

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Actuarial Due Diligence Process LinesRestatement of Reported Results

    Source: Consolidated Industry Loss Ratios

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Actuarial Due Diligence Process LinesGAAP Adjustments

    • Assets

    • DAC

    • Premium Deficiencies

    • Policyholder Dividends

    • Contingent Commissions

    • Salvage & Subrogation

    • Federal Income Taxes

    • Other

    • Present Value of Future Profits (PVFP)

    Industry Reserve Adequacy - Financial Analyst's Perspectives


    Actuarial due diligence process pro forma analysis l.jpg
    Actuarial Due Diligence Process LinesPro Forma Analysis

    Assumptions:

    • Premium Growth

    • Earnings Pattern

    • Loss Ratio

    • Expense Ratio

    • Payout Patterns

    • Investment Portfolio Mix

    • Investment Yield

    • Risk Adjusted Discount Rate

    • Time Horizon

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Actuarial Due Diligence Process LinesPro Forma Analysis

    Output:

    • Income

    • Dividends

    • Surplus

    • Cash Flow From Operations

    • “Value”

    • Key Ratios, e.g. RBC

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Reserving Issues in M&A Lines

    Sampling of Solutions to

    Reserve Uncertainty


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    Sampling of Solutions Lines

    • Purchase Accounting

    • Retrospective Adjustments

    • Reinsurance

    • Carve Outs

    • Other

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Purchase Accounting Lines

    • Reserves are increased by seller prior to transaction date

      • Purchase accounting does not allow acquirer to book additional reserves

      • Advantages

        • fattens the pig before it goes to market

      • Disadvantages

        • depresses surplus

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Retrospective Adjustments Lines

    • Future adjustment of sales price based on retrospective reserve estimates

      • Cash settlements

      • Portion of sales price held as a note payable

      • Contingent interest dividend paid to stockholders

      • Advantages

        • Low transaction cost

      • Disadvantages

        • Uncertainty

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Reinsurance Lines

    • Stop loss cover provides protection against adverse reserve development

      • Purchased by seller

        • internal

        • external

      • Purchased by acquirer

      • Advantages

        • alleviates uncertainty associated with reserve development

      • Disadvantages

        • cost

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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    Carve Outs Lines

    • Segregation of “undesirable” business segments and exclusion from transaction

      • Prior to transaction

      • Post transaction

      • Strategic motives

      • Advantages

        • may be only way to attract buyers

      • Disadvantages

        • seller may retain unwanted business

        • Regulatory scrutiny

    Industry Reserve Adequacy - Financial Analyst's Perspectives


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