Reserving for Catastrophes

1. Reserving for Catastrophes Kay Cleary Catastrophe Risk Management Seminar October 7, 2002

2. Current Catastrophe Reserve Funding (Problem) • After tax • Timing of establishment of a loss reserve • Recognition of catastrophe premiums Reserving for Catastrophes

3. Other Countries • Equalization reserves • Catastrophe reserve Reserving for Catastrophes

4. Two Components of Catastrophe Reserve (Solution) • NAIC mechanism • Internal Revenue Code change Reserving for Catastrophes

5. Internal Revenue Code Change • Deduction from taxable income for loss reserves • HR785 Reserving for Catastrophes

6. NAIC Catastrophe Reserve • Definitions • Design overview • Accounting treatment Reserving for Catastrophes

7. Definitions • Qualifying lines of business • Qualifying catastrophe events • Qualifying losses • Reserve cap • Catastrophe reserve cap factors • Reserve drawdowns/thresholds • Catastrophe year Reserving for Catastrophes

8. Qualifying Lines of Business • Fire & allied lines • Farmowners multiple-peril • Homeowners multiple-peril • Commercial multiple-peril (non-liability portion) • Earthquake • Private passenger & commercial auto physical damage • Inland marine • Non-proportional reinsurance for the qualified lines of business. Reserving for Catastrophes

9. Qualifying Catastrophe Events • Wind & hail • Earthquake and fire following • Winter catastrophes such as snow, ice, freezing • Fire • Tsunami • Flood • Volcanic eruption (including lahar) Reserving for Catastrophes

10. Design Overview • Pre-event reserves • Voluntary • Company specific Reserving for Catastrophes

11. Reserve Additions • Portion of net written premium • Sum of $$ for qualifying lines • Contribution subtracted from taxable income • Individual company vs. group Reserving for Catastrophes

12. Reserve Cap Factors • $40B industry-wide reserve • Data • Methodology Reserving for Catastrophes

13. Data • Both historical experience and modeling • AM Best – 1967 through 1999 • Judgment Reserving for Catastrophes

14. Methodology • Industry direct incurred loss ratios • Mean and standard deviation of loss ratio for each line • Cap each loss ratio at mean plus one standard deviation • Recalculate means and standard deviations using capped loss ratios • Threshold loss ratio for each line of adjusted mean plus two adjusted standard deviations Reserving for Catastrophes

15. Methodology, continued • Calculate loss ratios excess of threshold by line and by year • Calculate loss dollars excess of threshold by line for all years, using 1999 direct written premium • Prorate loss dollars from historical experience to be 2/3 of $40 B • Modeled losses by line, prorated to 1/3 Reserving for Catastrophes

16. Methodology, continued • Add historical losses and modeled losses for each line. • To get initial factors, divide summed losses by 1999 net written premium. • Auto physical damage set to 1% • Recalculate • Round to 5% Reserving for Catastrophes

17. Adjustments • See Appendix C Reserving for Catastrophes

18. Fire 25% Allied lines 85% Farmowners 10% Homeowners 60% CMP 30% (non-liab) Inland marine 20% Earthquake 1630% Auto PD 1% Reinsurance 45% Reserve Cap Factors Reserving for Catastrophes

19. Example - Accumulation (1) (2) (3) (4) LinePremFactor(2) x (3) Home 100,000 .60 60,000 Auto liab 150,000 na 0 Auto PD 80,000 .01 800 Total330,00060,800 Reserving for Catastrophes

20. When are $$ in Reserve Used? • Declaration of a catastrophe • Allowable drawdown amounts & qualifying losses • Federally taxed when taken out Reserving for Catastrophes

21. Declaration of a Catastrophe • Property Claims Service • President • Chief executive official of a state, territory or possession of the United States or the District of Columbia Reserving for Catastrophes

22. Qualifying Losses • Gross qualifying losses • Used in calculations of allowable amounts • Net qualifying losses • Maximum amount that can be draw down • Track by catastrophe year Reserving for Catastrophes

23. Amount of Drawdown Allowed • Amount is larger of: • Excess of gross qualifying loss above 30% prior year’s surplus OR • Excess of gross qualifying loss above 100% prior year’s reserve cap • Up to net qualifying loss Reserving for Catastrophes

24. Example - Drawdown • Gross qualifying losses 1,350 • Salvage, subro & other recoveries 800 • Net qualifying losses 550 • 30% of prior ye surplus 1,853 • Prior year reserve cap 584 Reserving for Catastrophes

25. Excess of gross qualifying loss above 30% prior year’s surplus (1350 minus 1583) = negative OR Excess of gross qualifying loss above 100% prior year’s reserve cap (1350 minus 584) = 766 Amount is Larger of: 766 Reserving for Catastrophes

26. Up to Net Qualifying Loss • Larger amount = 766 • Net qualifying loss = 550 • Allowable drawdown is 550 Reserving for Catastrophes

27. Other Drawdowns Allowed • Amounts in excess of cap • Insolvency Reserving for Catastrophes

28. Accounting Treatment • Single separate reserve • Additions to annual statement blanks • Balance sheet • Statement of income • Notes to financial statements Reserving for Catastrophes

29. State Catastrophe Programs • Florida Hurricane Catastrophe Fund • California Earthquake Authority Reserving for Catastrophes

30. Considerations during Development • Voluntary or mandatory • Lines of business • Perils • Net written premiums • Factors by state as well as by line Reserving for Catastrophes

31. Additional NAIC Activities • Review and update • Accounting and blanks • RBC treatment • Demonstrating financial responsibility framework Reserving for Catastrophes

32. Accounting and Blanks • Need effective date • Need to reconcile voluntary reserve with mandatory reporting Reserving for Catastrophes

33. RBC Treatment • Additional liability;“paid for” from surplus • Increased reserving risk charge? • Catastrophe risk in RBC formula Reserving for Catastrophes

34. Demonstrating Financial Responsibility Framework • Proposed when reserve became voluntary • How company will manage net PML • NAIC status • Considerations Reserving for Catastrophes

35. Funds immediately available Stability in results No credit risk Visible to regulators, investors, policyholders Better tracking of catastrophe premium Potential future tax liability No transfer of risk Reserve as Part of Catastrophe Management Program Reserving for Catastrophes

36. Questions ??? • ClearyK@doi.state.fl.us 850-413-5254 • Judy_Pool_Boutchee@ins.state.il.us 217-524-5376 Reserving for Catastrophes