OCTOBER 2009
Handling claims in runoff: Challenges and opportunities
Accessing claim liabilites in the U.S. runoff market
What’s My IBNR? The allocation of IBNR to specific contracts
When in runoff, should you commute your underlying exposures?
European runoff transactions and Solvency II
Forecasting asbestos claims in the aviation industry
P&C
PERSPECTIVES
Current Issues in Property and Casualty
Inside the Runoff Market
Handling claims in runoff: Challenges and opportunities
By William R. Azzara, Principal and Senior Consultant, and Christine M. Fleming, J.D., ACAS, MAAA
Claims handling is the key to success in most runoff operations.
Entities in runoff are often faced with challenges—and
opportunities—related to claims handling not typically seen in
ongoing operations. For example, one of the biggest differences
between ongoing operations and runoff operations may be the
opportunity to settle claims; potential issues involving impacts
on future business or client retention are no longer concerns for
the runoff company. However, opportunities enjoyed by the runoff
company (such as the ability to resolve claims free of marketing
concerns and potential customer influences) could be quickly
overshadowed by problems stemming from the handling of runoff
claims. In this article, we will identify some of the issues runoff
companies need to address to ensure that claims are handled
properly and resolved efficiently.
Long-tailed claims
Runoff business often contains an unusually high proportion of
long-tailed claims. For example, a typical runoff book might include
claims involving asbestos, pollution, construction defect, and
catastrophic or lifetime workers’ compensation claims. These types
of claims involve complex issues pertaining to coverage, causation,
and damages. Thorough investigation and efficient resolution
of complicated, long-tailed claims can be challenging. Creative
settlement approaches are required, and identifying the likelihood
of settlement—and posting the appropriate case reserve—is
difficult. Despite best efforts, settlement attempts often fail, and
reserves may need to be adjusted from expected settlement value
to expected full or lifetime exposure, introducing yet another
element of uncertainty and complexity. Thus, the very nature of the
underlying claims in a runoff book of business presents challenges
to even the most experienced claims handler.
Staffing issues
In addition to the difficulties posed by the types of claims
commonly found in a runoff book of business, staffing issues
present challenges as soon as a company goes into runoff. Staffing
and management needs and roles must be re-evaluated. Staffing
considerations will be affected by whether the claims are handled
in-house by the company’s claims department or moved to an
outside third-party administrator (TPA).
For claims that are moved to a TPA, management may find it
more difficult to communicate and enforce company policy with
respect to claims handling. Additional resources will be required
to ensure that the company’s goals, philosophies, and practices
are consistently adhered to. In addition, unlike in-house claim
department staff, TPA staff have not been trained by the company
and may not have the natural incentive to support company goals.
Managers whose prior role was essentially supervisory, and who
were able to rely upon and delegate to company claims staff,
may now find themselves in a much more hands-on position.
Claims personnel who now find themselves in an oversight role
may discover that it is very different from their prior experience of
supervising or handling the claims directly.
Even if runoff claims continue to be handled by the company’s
in-house claims staff, management will need to reassess its role.
Claims personnel may sense that the company is cutting back,
and staff turnover rates may increase. The quality of the claims
handling will diminish as morale drops or as workloads increase.
Management will need to be involved, and clear communication
will be vital to ensure consistency and quality in the claims
department’s handling of the runoff claims.
Other staffing considerations include the experience level required
to properly handle the claims, as well as the workloads appropriate
for these types of claims. The quality of the claims handling will
vary dramatically depending upon whether the staff has the
requisite experience to handle runoff claims. Handling these types
of claims will require expertise in the areas of complex coverage
terms, expert report analyses, legal analyses, and complex medical
projections. A company that assigns the runoff business to an
inexperienced staff, or a staff with inadequate training, will lose
valuable opportunities to resolve the claims efficiently.
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Current Issues in Property and Casualty
The quality of the claims handling will also vary depending on
whether the claims handlers have pending workloads that are too
heavy (e.g., claims handling becomes claims processing), or too
light (leading to inefficiency and poor morale). Regular reviews of
all open files to determine whether they should remain open would
be helpful for assessing workloads and evaluating staffing needs.
Regardless of whether claims are handled by a TPA or by the
in-house claims staff, it may be necessary to tighten and/or
formalize some basic control elements in order to improve the
consistency in the quality of the claims handling. For example, the
company should develop a formal claims audit process to regularly
assess the quality of technical claims handling on open claims.
Management should review claims and document their review,
along with action plans for follow-up. Large loss reports should be
produced and reviewed by management on a regular basis, and a
strategy developed to bring them to resolution. Reports should also
be produced for claims that are open for a specified period of time
with no activity and/or with low reserves, as well as for claims that
have closed for inactivity (as opposed to claims that have settled
and closed with finality). Finally, management will need to quickly
identify those claims that require additional oversight. Often these
claims are identified by case-incurred dollar thresholds. However,
claims that have not reached that threshold often pose the more
immediate concern, as this group by definition contains those
claims that have not yet been identified as high-exposure claims.
Reinsurance collectibility and data mining
Related to the issue of identifying the oversight or high-exposure
claims is the matter of reinsurance collectibility. Of critical
importance to the runoff entity is its ability to secure reinsurance
recoveries through the timely reporting of claims. Claims need to be
quickly identified as high-exposure claims, management reports need
to be documented, and action plans need to be prepared (including
a mechanism for reporting to, and following up with, reinsurers).
Similarly, obtaining recoveries from third parties through subrogation
efforts, as well as second injury funds for workers’ compensation
claims, is also of paramount importance to runoff operations.
2 :: OCTOBER 2009
Another concern for all companies, but especially for companies in
runoff, is the ability of the claims staff to “data mine.” Data mining
involves collecting and extracting key pieces of information from the
claims system for inclusion in management reports. By easily and
quickly compiling information from the claims system into reports,
management can identify and track significant trends and the
amount of resources required to run off the business. Meaningful
management information reports are key to monitoring claims
activity. If a claims operation cannot easily extract and dissect the
data in the claim system, more resources will be required to compile
and check the data in the management reports. Thus, for a runoff
book, it is critical to determine the time and resources that will
be needed to extract the data into a usable format to support key
management decisions. Moreover, as business is run off, the finance
and actuarial departments need to receive vital information. As fewer
claims remain open, actuaries will rely more on claims personnel
for information regarding key assumptions, such as the potential
for reopenings and unanticipated adverse development. Again, the
ability to extract this information quickly and accurately is critical.
Conclusion
Entities in runoff are often faced with claims handling opportunities
and challenges that are less common or less significant for
ongoing operations. For a company to run off a line of business
efficiently and effectively, the company and its claims department
will have to reevaluate and reassess issues such as the complexity
of claims, ensuring compliance with company goals, staffing
needs, management roles, reinsurance and third-party recoveries,
and claims system technology. Ensuring sound claims handling
practices consistent with the company’s philosophy is the key to
this successful outcome.
William R. Azzara is a principal and senior consultant with the Princeton,
N.J., office of Milliman and can be reached at [email protected].
Christine M. Fleming is a claims management consultant and actuary
with the Boston office of Milliman and can be reached at
[email protected].
P&C PERSPECTIVES
Current Issues in Property and Casualty
Accessing claim liabilities in the U.S. runoff market
By Tom Ryan, FCAS, MAAA
A capital solution
Estimates of claim liabilities related to property and casualty
(P&C) insurance business in runoff in the U.S. market run quite
high, but the ability to access these liabilities is often constrained.
The primary reason is the lack of an insurance business transfer
mechanism that will allow ongoing entities to carve out runoff
business in a manner that is both effective and acceptable to
regulators and policyholders. This article discusses the current
constraints faced in the U.S. market and proposes an original
solution that will allow runoff specialists and other investors
greater access to these liabilities.
Current U.S. runoff market: Running in place?
Recent reports estimate the size of the U.S. runoff market at
between $150 billion and $200 billion in liabilities, making it the
largest runoff market in the world. The U.S. market is believed to
be larger than both the U.K. and European markets, but it is not
as advanced as those markets in terms of the level of activity,
effectiveness, and sophistication of potential solutions. There is
growing interest in, and demand for, U.S. market runoff liabilities
as evidenced by the formation and growth of runoff specialists,
a cottage industry of support service providers, and the rapid
growth of the Association of Insurance & Reinsurance Run-off
Companies (AIRROC). This demand seems to beg for better
ways of making the liabilities accessible to the market.
With regard to the supply side of the equation, a recent market
survey1 indicates that most companies holding high amounts of
runoff reserves want finality and seek to end the potential volatility
associated with these liabilities. Maintaining runoff exposures
and liabilities has many risks and disadvantages, especially for a
company that maintains ongoing operations as well. The primary
risk is the potential for deteriorating loss experience, particularly
for older books that contain asbestos and excess layer liabilities.
The volatility and historic under-projection of the liabilities for
these segments can negatively affect earnings and represents a
potential drag on ratings.
Depending on their size and type, the liabilities can also be a
distraction to management and result in unnecessary allocation
of capital to nonproductive operations. Some companies are
content to let their reserves run off naturally without seeking an
external solution, but most want to be proactive and seek an
effective solution.
Given the apparent high level of demand, the seemingly large
supply of liabilities, and the disadvantages of maintaining runoff
liabilities, why haven’t more solutions (those providing real finality)
been realized? What are the problems with the current alternative
solutions in place? Could there be a more creative and effective
way to access these liabilities?
Current solutions: A sampling
A partial explanation for the inertia in the U.S. runoff market may be
the structure of the market itself. Although many liabilities reside in
standalone entities that are in runoff, the majority remain within the
discontinued operations units of numerous ongoing companies. A
recent survey by PricewaterhouseCoopers2 suggested that 60% of
participants manage runoff in a discontinued business department
or division, and only 36% manage runoff in a completely separate
legal entity devoted to discontinued business. This contrasts with
the situation in the U.K., where the runoff market is dominated by
numerous smaller single entities.
The path to finality is a bit easier and well-traveled for
discontinued operations that are maintained in a separate entity.
The buying and selling of an entire entity housing runoff liability
can be a straightforward transaction. There are regulatory
hurdles to face, but regulators can be reliable partners in a sale
if policyholders are protected and the sale removes any risks of
insolvency and the resulting potential administrative burdens.
Things get difficult when a company seeks solutions for only a
portion of its runoff book—perhaps one line of business, or just
those liabilities related to certain years or from a certain program.
Companies seeking a runoff solution can explore any of several
solutions currently in use. Let’s consider three of them: retroactive
reinsurance, solvent schemes of arrangement, and novations.
Retroactive reinsurance. Insurers can seek solutions from
reinsurers offering adverse-development covers or loss-portfolio
transfers. These covers seek to put a limit on the future liabilities
of the cedant. Reinsurance has the advantage of sometimes
allowing a company to maintain control over its claims, thereby
avoiding regulatory and policyholder disputes and, importantly,
sidestepping any potential for damage to the company’s
reputation. However, the accounting benefits of retroactive
reinsurance are limited. On a statutory accounting basis,
loss and loss-adjustment expense reserves must be recorded on
a gross of insurance basis. Any additional surplus resulting from
the transaction is restricted as a special surplus fund until the
liabilities transferred have been recovered or terminated.
Other disadvantages include the potential high cost of the
reinsurance protection, the potentially inadequate protection in
an adverse scenario, and the long-term financial security of the
reinsurer involved.
1 PwC Advisory, U.S. Discontinued Insurance Business Survey, 2006. Available at http://www.reinsurancefocus.com/uploads/PWCInsuranceRun-offReport.pdf
2 Ibid.
OCTOBER 2009 :: 3
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Current Issues in Property and Casualty
Schemes of arrangement. A solvent scheme of arrangement
is a process in which a solvent company may commute all
policies within the purview of the scheme. These schemes are
commonplace in the U.K., but they are considered controversial
in the U.S. because they basically allow a company to reorganize
without regard for bankruptcy laws. In the United States, current
rules allow implementation of a solvent scheme only by an
insurance or reinsurance entity domiciled in the state of Rhode
Island, and it must have court approval, regulatory support,
and a favorable creditor vote. Unlike schemes in the United
Kingdom, a scheme in Rhode Island can only be used to run off
the entire book of business within an entity—not just specific lines
or years. To date, there have been no solvent schemes arranged
in Rhode Island.
Novations. A novation is an agreement to replace one party
to an insurance policy or reinsurance agreement with another
company from the inception of the coverage period. The novated
contract replaces the original policy or agreement. Also known as
cancel and rewrite, these transactions usually require policyholder
and regulatory approval. A novation exposes the initial carrier to
reputation risk if problems with claims management arise.
Each of these solutions offers its own advantages, but there are
some common threads in their disadvantages. These include:
• lack of clear accounting benefits
• necessary regulatory and policyholder approval
• the potential for reputation risk
Other hurdles for these alternatives include the implicit
requirement that any liabilities must be of a certain volume for the
solution to work economically. Most of these transactions may not
be worth doing if the runoff liabilities involved are small.
To be optimal, any proposed solution will have to address these
hurdles by meeting all of the following criteria:
• allowing insurers to retain some form of control over
claim management
• satisfying regulatory and policyholder concerns
• reaping real accounting benefits
• applying to both large and small books of business
New solution: A cat bond/MBS mash-up?
A possible solution to the problem of linking supply and demand
in the U.S. runoff market might be found by looking at recent
innovations related to the capital markets and incorporating some
of their successful elements.
Catastrophe bonds (cat bonds) are used by P&C insurers and
reinsurers to transfer the risk of catastrophic losses to the capital
markets. In brief, cat bonds work as investors loan principal
amounts to insurers that may be reduced or lost entirely if certain
4 :: OCTOBER 2009
triggers related to natural catastrophic losses are met. If the
triggers are met, the principal is transferred to the insurers or
reinsurers sponsoring the bond. In return for the risk of receiving
reduced or even no principal back, investors are compensated at
above-average yields. Many investors favor cat bonds because
of these high yields and because the risk and returns involved
are thought to be uncorrelated with the return from other
investments, providing diversification.
Mortgage-backed securities (MBS), which some investors
currently regard with disdain, in fact were fairly innovative in
terms of allowing mortgage lenders to continuously offload
risk, write new business, and allow easy access to outside
investors. In a typical MBS process, mortgage lenders would
originate mortgages and sell them to be pooled in mortgage
trusts. Investment banks, working as aggregators, would create
securities using the mortgages of many different originators.
These securities could be structured in different ways, creating
tranches that contained varying levels of mortgage-default risk.
Those tranches with greater probability of default provided higher
returns to investors.
Could it be possible to take elements of each of these
securitization processes and combine them to produce a solution
for accessing runoff liabilities?
Discontinued operations bonds (DCOBs):
The basics
Might issuing discontinued operations bonds be a solution? How
could this work? In basic form, originators (those companies
holding runoff reserves) could provide runoff reserves to an
aggregator, likely an investment bank, for packaging. The
aggregator would package the reserves from many different
originators into securities for investors—perhaps sorting the
reserves by line of business, estimated time to payment (duration
of reserves), geography, type of claim, or originator. Each package
would have its own risk profile based on the historic volatility of
the reserves involved and the time to payment. Investors would
supply principal to the aggregator, which would then be provided
back to the originating insurer or reinsurer as capital. This capital
would be invested and leveraged by the company to generate
new and (hopefully) profitable business. The return on the new
business would be used to finance the interest payments to the
investors on the principal provided.
If the reserves ceded to the aggregators develop adversely (claim
payments are greater than reserved for), principal is used to cover
the adverse development and is lost to the investor. If the reserve
development is favorable, the entire principal is returned to the
investors at the end of some specified period. This solution is
a mix of cat bonds and MBS in that there is a potential loss of
principal due to unanticipated liability payments (as in a cat bond),
but the originator gets immediate use of the capital invested in the
security (as in an MBS).
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The following are some further details relating to DCOBs:
• Structuring securities. When forming reserve packages,
the aggregator may use actuarial techniques to quantify
variability in reserves and identity correlation across segments.
Combining different lines or time periods may result in
some diversification benefits, lowering the risk of adverse
runoff in total.
• Claims management. Originating companies could maintain
and manage claims to resolution, avoiding any regulatory
and policyholder concerns or reputation risk. Alternatively,
investors could also provide management of claims (subject
to certain approvals by the originators) to receive bonus
returns for reserve savings (payments below expectations).
To better align profitability objectives, outsider investors
who manage claims could also share any savings with the
originating companies.
• Loss triggers. The triggers involved in these securities could
rely on both adverse development of subject reserves and
links to industry deterioration in the form of loss ratios or
reserve levels. This type of dual trigger may help to mitigate
any moral hazard, as the industry performance would be
outside the control of the originating company. Also, there
could be a corridor of losses (or deductible) above the carried
reserves so originators would suffer losses first before tapping
into the provided principal. Linking to industry values for a
trigger could spur the creation of various loss indices for the
P&C insurance industry.
• Terms of securities. The terms of the securities could vary,
from single-year commitments (which may be more favorable to
short-term investors) to longer terms related to final resolution
of all claims. For the longer-term securities, aside from the
promised returns, principal could be returned in relation to
decreases in reserves as claims are closed, decreasing the
risk of lost principal.
• Rating of securities. The rating of these securities
would be primarily dependent on the view of reserve
adequacy—a viewpoint perhaps best offered by independent,
appointed actuaries.
Evaluating the potential
Do the economics work? Can insurers generate enough profit
on the newly supplied capital to satisfy the return required by
investors? These questions are key to evaluating the possibilities
of DCOBs or any other solution. The answer likely depends on
1) the amount of capital/principal provided (versus the need
relative to reserves in runoff) and 2) the profitability of the new
business written to support the return payments.
In terms of the amount of capital required, the safety cushion on
the current reserve level necessary to ensure finality will vary by
the type of reserve included, the volume, and the level of finality
the originator is seeking to achieve. Any new capital can be
leveraged by using industry-standard premium-to-surplus ratios to
generate a multitude of new business.
Whether this new business will be profitable enough to cover
the security expenses will depend on the business entity and the
vagaries of the underwriting cycle. It would be useful to do some
basic financial modeling to test the economic reasonableness of
the solution under various scenarios.
There are additional questions regarding the DCOB solution,
such as the effect of these transactions on risk-based capital
calculations and their accounting impact.
The most obvious disadvantage is the exposure to significant
moral hazards related to supplying reserves that are known to be
deficient to investors. Similar to the MBS market, originators may
pass poorly performing liabilities for a quick cash-out. One hopes
that the market could react quickly to this hazard and identify
and penalize any “bad players.” Penalties could include being
excluded from future transactions or paying higher returns to
future investors.
If the market is efficient in providing an outlet for runoff liabilities,
originating insurers and reinsurers will want to maintain access
to the market on favorable terms. Providing deficient reserves on
a continuous basis would hinder their treatment in the proposed
market. Moreover, because reserves provided to the aggregator
would still be included on each originator’s financial statements
as carried reserves, originators of deficient reserves would risk
negative ratings of their overall financial security and invite greater
regulatory review.
However, the potential advantage of a DCOB solution is that it
would allow insurers and reinsurers a chance to achieve some
finality on their runoff liabilities while gaining access to capital.
This alone would seem to indicate that a DCOB solution, or
something similar, is worth further exploration.
Conclusion
The U.S. runoff market is large and likely to grow in the near
future because of the current soft market conditions. The holders
of runoff liabilities are hungry for finality, and there appears to
be plenty of demand. Traditional runoff solutions have stalled,
forcing a need for a new process to link supply and demand.
Incorporating practices from established capital market solutions
might lead to an innovative and effective solution.
Tom Ryan is a principal and consulting actuary with the New York office of
Milliman and can be reached at [email protected].
OCTOBER 2009 :: 5
P&C PERSPECTIVES
Current Issues in Property and Casualty
What’s My IBNR? The allocation of IBNR to specific contracts
By Jason Russ, FCAS, MAAA
When a reinsurance company is in runoff, management often
chooses to commute individual assumed reinsurance contracts
as a major part of the company’s strategy. Commutations
typically require negotiation between the reinsurer and the
cedant, and the amount of loss incurred but not reported (IBNR)
is a potential source of significant uncertainty. IBNR is intended
to cover both development on reported claims, sometimes
referred to as incurred but not enough reported (IBNER), and
losses expected on claims to be reported in the future, often
referred to as pure IBNR.
Actuarial analysis: A cautionary word
One of the tools frequently used in the commutation process is
an actuarial analysis. Oftentimes, however, the actuarial analysis
used may have been produced for another purpose, such as the
determination of IBNR for a larger portfolio. Is it reliable to use the
same actuarial analysis to assist in the commutation? What are the
dangers in doing so?
What do you mean by “produced for another purpose”—aren’t the
numbers the same, no matter the purpose?
Not necessarily. Consider two separate actuarial reports:
• Actuarial Report A was prepared specifically to analyze a single
reinsurance contract. The actuary considered the specific terms
of the reinsurance contract and evaluated the individual claims
ceded under the contract.
• Actuarial Report B was prepared for the reinsurer to assist the
reinsurer in determining aggregate reserves to book. Once the
overall reserve level was determined, the actuary allocated the
reserve to the individual reinsurance contracts.
All else being equal, Report A is more likely to produce a reliable
figure to use in the commutation than Report B. In Report B, the
estimate for this one reinsurance contract was not the focus of
the actuary, but rather an afterthought; the actuary’s focus was on
the overall figure.
So does that mean that Report B is useless?
No, of course not. But to make the best use of it, be sure to
discuss the use with the actuary who did the work. Ask questions
to understand the methodology and assumptions underlying the
work, in particular the allocation to the reinsurance contract. It is
important to understand the basis for the allocation.
Best way to allocate
Say an actuarial report does allocate IBNR to each contract. What
is the best way to allocate IBNR to individual contracts?
6 :: OCTOBER 2009
In some actuarial reports, the total IBNR estimate includes
within it estimates of the ultimate cost of individual claims. This
is fairly common in the context of asbestos, pollution, and other
health hazard claims, where a ground-up exposure model might
be used by the actuary. When such a model is used, the results
by claim could be used to determine some of the amounts
associated with each reinsurance contract.
Many actuarial reports, however, do not include estimates of
individual claims. Traditional actuarial methods project losses
in the aggregate by accident year or underwriting year, with
no differentiation between losses from different contracts. In
such cases, allocations to individual contracts would likely
be done in the aggregate as well, using statistics such as
paid losses, case reserves, and incurred losses, as in the
following examples:
• Paid losses. One method of allocation to contract is to allocate
unpaid losses in proportion to paid losses and then subtract
case reserves in order to obtain IBNR. Such a method would
be appropriate if the ultimate losses for all contracts were paid
out at the same pace, e.g., if 60% of the ultimate losses for
contract A have been paid to date, 60% of the ultimate losses
for contract B have been paid as well. But what if one contract
is paid out more slowly than another? A high excess contract
that has not yet had any losses paid would be assigned zero or
negative IBNR in this procedure, when it may be the contract
that should be assigned the highest IBNR!
• Case reserves. Another method of allocation to contract is
to allocate IBNR in proportion to case reserves. As with the
paid-loss allocation, the case-reserves allocation assumes
that contracts are at similar maturity levels. In addition,
it assumes that case-reserve strength is similar across
contracts. Case-reserves allocation can be a very volatile
calculation; in runoff situations, case reserves are normally
a fraction of the cumulative amount paid to date, and they
could also be significantly smaller than the IBNR. Consider
a contract with significant paid-loss activity but low case
reserves: Should this contract have little IBNR or a lot of
IBNR? If the case reserves are low because most of the
claims have been closed out and little exposure remains, low
IBNR may be appropriate; on the other hand, if low case
reserves result from poor claims handling on the part of the
ceding company, the IBNR need may be high.
• Incurred losses. IBNR may be allocated in proportion to
incurred losses (paid losses plus case reserves). As with
case reserves, this relies on assumptions concerning similar
maturity and case-reserve adequacy across contracts. However,
the result would be more stable than using case reserves solely,
as the cumulative paid losses are included in the consideration.
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These three methods can have very different results. To illustrate,
consider an example in which there are three contracts. In total,
$15,000 has been paid, $750 is case reserved, and the IBNR is
estimated as $1,500. The table below illustrates the paid losses
and case reserves by contract:
Paid
Case
If it is because all of the underlying policies have been exhausted
or all of the underlying claims have been closed, it may be
appropriate to assign no IBNR to this contract. On the other
hand, if the case reserves are zero because the ceding company
has slipped in its handling of the claims, a large IBNR figure may
be appropriate.
Incurred
Contract A
10,000
-
10,000
Contract B
-
500
500
Contract C
5,000
250
5,250
Total
15,000
750
15,750
As for Contract B, here nothing has been paid to date, but the
case reserves are larger than those for the other two contracts.
Why has nothing been paid—is there something in the contract
language that precludes payments? Or perhaps it is a higher layer
than the other contracts, and losses just haven’t reached that
level yet? If it’s because of the contract language, negative IBNR
may be appropriate to offset the unnecessary case reserves; if it’s
because losses haven’t yet reached the level, substantial IBNR
may be needed.
How should the $1,500 of IBNR be allocated among the
contracts? The next table shows the results of each of the three
allocations discussed above.
More complete knowledge can lead to informed judgments.
Communicate!
IBNR allocated using
Paid
Case
Incurred
#1
#2
#3
Contract A
10,000
-
10,000
1,500
-
952
Contract B
-
500
500
-500
1,000
48
Contract C
5,000
250
5,250
500
500
500
Total
15,000
750
15,750
1,500
1,500
1,500
Note how different the indications are across methods.
Of course, these aren’t the only three methods that could be used
to allocate IBNR. Another approach could be to consider recent
activity rather than cumulative figures, assigning contracts with
significant payments in the last few years more in future loss than
contracts that have been inactive after large historical payments.
And, as mentioned earlier, actuarial models that evaluate individual
claims can project values by contract directly (although pure
IBNR may still need to be allocated in some fashion).
So what can we do better?
Communication with the actuary is key to understanding the
process and getting the best results. In particular:
• Ask the actuary the purpose of the analysis, and tell the actuary
how you intend to use it.
• Discuss the methodology with the actuary. Understand its
limitations and potential biases.
• Ask the actuary if IBNR can be separated into IBNER and
pure IBNR components. Your claims department may have
insights on the IBNER component, and you may wish to
record it through additional case reserves to specific claims.
This will also enable you to have a more informed discussion
with your cedants, as the IBNER component is less subject to
disagreement than the pure IBNR component.
• Facilitate communication between the actuary and your claims
department on recent observed activity, ceding company casereserve levels, results of audits, etc., in order to inform the
actuary’s judgment. More information is better!
So which is best?
It depends.
Consider Contract A. This contract has the largest paid amount,
but there are no case reserves. Why are there no case reserves?
After having these thorough discussions, there is little doubt that
you will be better prepared for your commutation discussions.
Jason Russ is a principal and consulting actuary with the New York office of
Milliman and can be reached at [email protected].
OCTOBER 2009 :: 7
P&C PERSPECTIVES
Current Issues in Property and Casualty
When in runoff, should you commute your underlying exposures?
Don’t overlook the capital benefits
By Lori Julga, FCAS, MAAA
One common strategy for insurance companies that have runoff
liabilities is to commute their underlying exposures in order to
remove the liabilities from their balance sheet. Commutations
involve a contractual agreement to pay the insured a lump sum
of cash immediately in exchange for an end to the insurer’s longterm commitment of continuing to pay any and all future claims.
Commutations can involve single claims, groups of claims, or
entire insurance/reinsurance contract(s).
Typically, insurance companies that negotiate commutations do so
for several reasons, including:
• to eliminate the uncertainty of the unpaid claim liabilities and
associated volatility
• to reduce the administrative expenses associated with the
claim liabilities
• to avoid having to deliver bad news about adverse
development to upper management or shareholders
• to free themselves from insureds with whom they no longer
have a good relationship
By eliminating the runoff liabilities—or a portion of them—a company
can release the surplus needed to support these liabilities and use
the capital to support other initiatives.
Measuring the effect of commutations
One way to measure the effect of commutations on capital needs
under alternative scenarios is to look at the risk-based capital
(RBC) requirement. The RBC requirement establishes a minimum
level of capital needed to support insurance risk for insurance
regulation. The RBC indications are based on an intricate formula
that is derived from the insurance company’s assets, premiums,
recoverables, and reserves. Although the initial capital factors are
uniform across the industry, the resulting capital factors from the
formula would vary according to each company’s own experience
and mix of business.
Table 1 displays the results of a hypothetical P&C insurance
company. Note that in this example:
• the assets are $750 million
• the reserves are $650 million
• surplus is $100 million
The RBC indication is $99.4 million.
• to allow upper management to focus their attentions on
ongoing operations
There is, however, an additional reason for commuting runoff
liabilities that companies often overlook: to free up the capital that is
associated with the liabilities. Both life and property/casualty (P&C)
insurance companies must carry surplus to cover the various risks
involved in an insurance operation. This surplus is used to support
the company’s asset risk (from fixed income, equities, and credit), as
well as its underwriting risk (from reserves and premiums).
Commutations can, in many cases, reduce the capital requirements.
In this example, the company’s surplus of $100 million is slightly
higher than the RBC indication of $99.4 million. Most companies,
however, maintain a larger margin above the RBC indications than
in this example.
Because a P&C company’s RBC requirement is largely driven by
the underwriting components, especially the reserving risk (R4 in
the example above), reducing the amount of unpaid claim liabilities
(reserves) should reduce the RBC indications. One way to do
this is to commute some long-tailed liabilities, such as workers’
compensation reserves or asbestos and pollution liabilities.
Table 1: ABC P/C Insurance Company Results
Before Commutation
RBC Category
Amount
Overall capital factor
RBC requirement
R0
Asset risk – subsidiary insurance company
R1
Asset risk – fixed income
R2
Asset risk – equity
100,000,000
0.071
7,140,000
R3
Asset risk – credit
48,000,000
0.043
2,040,000
R4
Underwriting risk – reserves
650,000,000
0.151
98,329,785
R5
Underwriting risk – premium
100,000,000
0.128
12,793,382
N/A
N/A
$99,441,747
Total RBC after covariance*
* The authorized control level would be 50% of this indication or $49.7 million.
8 :: OCTOBER 2009
0
0.000
0
$650,000,000
0.002
$1,050,000
P&C PERSPECTIVES
Current Issues in Property and Casualty
The example in Table 1 includes workers’ compensation reserves
at $269.8 million, or 42% of the total reserves. Table 2 (below)
illustrates the potential decrease in the RBC, assuming that
$20 million of workers’ compensation reserves are commuted.
The $20 million represents 7.5% of the company’s unpaid
workers’ compensation claim liabilities.
Thus, commutations can increase the percentage of a company’s
surplus to its RBC requirements, in essence creating a margin. This
benefit is in addition to the other commutation benefits mentioned
above, including that commutations reduce the uncertainty of the
liabilities and allow management to focus on current operations.
It is important to note that this example is for illustrative purposes
only. The results would vary by company depending on any
number factors, including:
To measure only the effect of the underwriting risk component,
we assume that the company has paid the insured $20 million in
bonds and reduced $20 million of its liabilities, for no effect on
carried surplus. Depending on the structure of a commutation, the
company may pay more or less than what it carries as a liability for
those exposures. Therefore:
•
•
•
•
•
•
•
• the assets are now $730 million
• the reserves are $630 million
• surplus is still at $100 million
type of company (life or P&C)
distribution of assets
distribution of reserves
loss development by line of business
premium
expense ratio
the lines of business commuted
Conclusion
The resulting change in the RBC requirement is approximately
$2.2 million ($99.4 million less $97.2 million), or 11% of the
commuted reserves.
When evaluating the costs and benefits of commutations of runoff
liabilities, companies should take into consideration the capital
effect. Long-tailed lines of business, such as workers’ compensation,
general liability, and medical malpractice, account for a large
proportion of runoff liabilities. These lines typically carry a high RBC
charge because of the uncertainty of the risks and the lengthy time
periods involved. Workers’ compensation claims, for example, can
persist in some cases for as long as 40–50 years as claimants
live out their lives receiving payments. If such uncertainties can
be reduced or eliminated through commutations, then the capital
requirement will decrease—in some cases, quite substantially.
Now let’s take a look at how a larger commutation might affect
these figures. If the company were to commute 50% of its
WC reserves ($135 million), the RBC requirement would be
$13.3 million lower than without the commutation, or 9.9% of
the commuted value.
Table 3 summarizes the results of the RBC indications, comparing
the results with and without the commutations.
Lori Julga is a principal and consulting actuary with the Milwaukee office of
Table 2: ABC P/C Insurance Company After
Milliman and can be reached at [email protected].
$20 Million Commutations
RBC Category
Amount
R0
Asset risk – subsidiary insurance company
R1
Asset risk – fixed income
R2
Asset risk – equity
R3
Asset risk – credit
R4
Underwriting risk – reserves
R5
Underwriting risk – premium
Overall capital factor
RBC requirement
0
0.000
0
$630,000,000
0.002
$1,050,000
100,000,000
0.071
7,140,000
48,000,000
0.043
2,040,000
630,000,000
0.153
96,085,033
100,000,000
0.128
12,793,382
N/A
N/A
$97,222,671
Total RBC after covariance*
Table 3
Capital
Company surplus/RBC requirement
Company surplus
$100 million
NA
RBC without commutations
$99.4 million
100.6%
RBC with a $20 million commutation
$97.2 million
102.9%
RBC with a $135 million commutation
$86.1 million
116.1%
OCTOBER 2009 :: 9
P&C PERSPECTIVES
Current Issues in Property and Casualty
European runoff transactions and Solvency II
By Jeffrey A. Courchene, FCAS, MAAA
In April 2009, after intense negotiations, the European Parliament
formally adopted the Solvency II Framework Directive (FD), and its
co-legislature, the European Union’s (EU) Economic and Financial
Affairs Council (EcoFin), confirmed the decision in May 2009.
The Solvency II standard-model framework imposes heavy
documentation/disclosure requirements and a rather large risk
charge on runoff reserves, which could provide an incentive to
companies to consider their runoff strategies more seriously.
To date, however, runoff vehicles in Continental Europe
have not developed to the extent they have in the United
Kingdom, and as a result, Continental European companies
with significant runoff operations have begun to look toward
London for ways of dealing with their discontinued operations.
The European Solvency II initiative defines a risk-based approach
to quantifying and managing regulatory capital. Solvency II is
based upon three pillars:
1.
2.
3.
risk quantification
risk management and governance
risk reporting and disclosure
Pillar 1 requires risk carriers to calculate both a minimum capital
requirement (MCR) and a solvency capital requirement (SCR). The
SCR is measured at the 99.5% confidence level over a one-year
time horizon and covers all of the risks that a risk carrier faces,
including insurance risk, market risk, credit risk, and operational
risk. Breach of SCR will lead to supervisory intervention, and
breach of MCR will lead to ultimate supervisory action, potentially
in the form of revoking an institution’s insurance license or forcing
it to liquidate. Insurers may use a market-wide standard model or
develop an internal model that is subject to an application process
and regulatory approval prior to implementation.
Pillar 2 defines the details of the supervisory review process,
including requirements with respect to a system of governance.
The requirements provide for the establishment and documentation
of a risk-management function, an internal audit function, and an
actuarial function, as well as an the preparation of an own risk and
solvency assessment (ORSA). Pillar 3 focuses on transparency,
defining explicit and uniform disclosure requirements that facilitate
the comparison of capital adequacy across companies, groups,
and/or markets.
How Solvency II affects discontinued operations
Solvency II will require all companies to reappraise their use of
regulatory capital. This will almost certainly lead to an increased
focus on optimizing the use of capital. Capital tied up in duplicated
business activities will be rationalized, potentially leading to
restructuring and/or discontinued operations. Discontinued
operations will become progressively more unattractive. Each
10 :: OCTOBER 2009
discontinued operation (a company, a branch, or a book of
business) will be in runoff.
Even without the driver of Solvency II, companies already run off
operations for a variety of reasons:
•
•
•
•
•
unprofitable lines of business (LOB)
inadequate return on shareholders’ funds
pressure from regulators and rating agencies
change in corporate strategy
competition
One assumption underlying Solvency II is that, as capital
requirements are more closely aligned with risk exposure, a majority
of the non-life (re)insurance companies in the EU will enjoy a lower
solvency ratio compared with Solvency I.1 A solvency ratio is defined
as the required capital divided by available assets. For portfolios
in runoff, however, it is expected that required capital will increase.
Other things being equal, runoff portfolios will generally receive a
lower diversification benefit in terms of correlations with other LOBs
and correlations with exposures in other geographical markets.
Furthermore, because of limited historical data (oftentimes even
more limited than active business), the statistical reliability of
valuation models tends to be less than ideal. The result is that
technical provision estimates are often wide ranging, and risk
charges are commensurately high.
Finally, high-risk charges generally do not run off uniformly with
the exposures. As a result, the risk charge for a runoff portfolio is
often even higher relative to the technical provisions than for an
active portfolio.
Risk charge. Within the standard model framework as currently
defined by the fourth Quantitative Impact Study (QIS4), a runoff
portfolio’s risk charge would be largely driven by the reserving risk
component of the non-life insurance risk module and the counterparty
risk for the reinsurance component of the credit risk module. In a
simplified case where there is no reinsurance protection, for example,
the risk charge for a single-market, third-party liability runoff portfolio
would be 45% of the best estimate of claims outstanding.
Quantifying the risk charge in the Solvency II standard model involves
using a volume measure—in this case, the discounted best estimate of
claims outstanding—and a standard deviation estimate of 15%, the figure
provided as a market-wide estimate by the Committee of European
Insurance and Occupational Pensions Supervisors (CEIOPS). The
standard model uses a log-normal assumption to quantify the 99.5% risk
charge, which is effectively 3.021 standard deviations, or 45%.
1 CEIOPS’ report on its fourth Quantitative Impact Study (QIS4) for Solvency II,
November 2008.
P&C PERSPECTIVES
Current Issues in Property and Casualty
Before relying on this 45% figure, though, one should understand
that the market-wide standard deviation estimates for LOBspecific reserving risk in the standard model framework (which
underlies the 45% figure) will be recalibrated during the coming
months and, therefore, could change. Furthermore, if the insurance
supervisor does not believe that the standard formula properly
reflects the actual risk (which could clearly be the case here), he
or she has the power to change the parameters or demand that
an undertaking develops a better solution in the form of an internal
model or a partial internal model.
identification and mitigation of the risk in the ORSA. A more robust
approach, however, is often difficult, as actuarial resources may be
less available than for active portfolios. In particular, according to
Article 47 of the FD, the actuarial function will need to undertake
more comprehensive checks on the data (which is often lacking),
oversee the calculations of technical provisions (which cannot
be calculated using standard actuarial techniques), and opine on
the adequacy of underwriting policy and reinsurance (the latter of
which is a daunting task, as collectibility is often dependent on
varying interpretations of the manifestation of a claim).
In a case where reinsurance is recoverable, adding a charge
for counterparty default credit risk would be dependent on the
rating class of the applicable reinsurer (AAA, AA, A, etc.), which
determines the probability of default, and an expected loss-given
default (LGD) equal to 50% of the recoverable at the 99.5% level,
less collateral.
Segmentation: A key conclusion of CP #27 is that undertakings
should not necessarily be required to use the same segmentation
for different elements of the calculation (e.g., best estimate, risk
margin, SCR, MCR, etc.), but the segmentation should be the
best for the purpose. Using the minimum level of segmentation
would lead to the dominant use of a third-party liability or casualty
class of business only. In practice, it is likely that a more detailed
segmentation is required to capture the different characteristics of
the various claims types, e.g., individual disease claims.
How the final FD and subsequent consultation
papers affect the runoff market
The key provisions of Solvency II are manifest in the FD and the
implementation measures are becoming transparent through the
release of consultation papers (CPs), but there is still significant
uncertainty about the treatment of runoff business.
Applicability: According to Article 4, Paragraph 1 of the FD,
undertakings are exempt if they satisfy certain conditions for
the past three years and are expected to continue to satisfy
conditions for the next five years. Despite this exemption,
regulators may still request Solvency II compliance for businesstransfer or capital-repatriation proposals.
Undertakings are exempt from Solvency II if they satisfy all of
the following:
• gross written premium (GWP) is less than €5 million
• gross technical provisions are less than €25 million
• group gross technical provisions are less than €25M (if
belonging to a group)
• business does not include liability or credit and surety
insurance risks
• reinsurance GWP is less than €0.5 million or 10% of GWP
• reinsurance gross technical provisions are less than €2.5
million or 10% of gross technical provisions
Appropriateness of standard model parameters: The
parameters of the standard model do not reflect the unique
and specialized risk profile of runoff insurers, e.g., those with
claims in such areas as asbestos, pollution, and health hazards.
Therefore, the regulator is likely to consider changing the shape
and the parameters of the standard formula (SCR), as Article
108a of the FD allows for.
Actuarial function: The fact that runoff liabilities are complex
and highly uncertain necessitates a robust approach to the
Solutions for finality
According to a recent market survey of discontinued business in
Europe, the total estimated European runoff market is €196 billion,
78% of which exists outside of the United Kingdom and Ireland. A
large amount of the discontinued business in continental Europe
is managed alongside ongoing business. Historically, continental
European companies have taken a passive approach to runoff
management, with little external disclosure of its existence. Two
well-known and highly observed recent successes may be the
motivation required for the market to shift to a more proactive
approach to addressing the challenges of runoff business.
Runoff portfolios on the European continent are currently almost
entirely dealt with by the insurer or reinsurer itself, or at least
within the group. Continental European (re)insurance groups can
choose from a number of options to restructure both live and
runoff operations in order to generate capital and operational
efficiency, including commutation, merger/demerger, solvent
schemes (in some cases), and portfolio transfers.
Commutations: Commutation is a legal technique that is used,
for the most part, in reinsurance. It refers to the termination of
a relationship of insurance and is always dependent upon the
agreement of the relevant parties. A commutation provides the
cedant with cash that it can direct into writing new business or
helping the balance sheet if in runoff, and it enables the reinsurer
to identify and remove individual exposures, releasing it from
all future obligations and reducing its reserving liabilities and
respective risk charges under Solvency II.
Merger and demerger: By means of a demerger,2 an insurance
or reinsurance company can transfer its portfolio, in whole or
2 In accordance with the German Reorganization Act 1995.
OCTOBER 2009 :: 11
P&C PERSPECTIVES
Current Issues in Property and Casualty
in part, together with any associated assets, to a subsidiary
company. In the case of a merger or demerger, contractual
relationships with third parties, such as reinsurers and
retrocessionaires, can also be transferred. However, a merger or
demerger is possible only if shareholders from both parties agree
to the measures at their respective annual general meetings. A
merger or demerger is possible not only within a country, but also
cross-border within the EU and European Economic Area (EEA)
into a Societas Europaea (SE). Regardless of whether or not the
merger or demerger is effected cross-border, approval from all
affected regulatory authorities is normally required.
Solvent schemes. A solvent scheme3 is a flexible legal technique
available in the United Kingdom requiring the consent of a specific
majority of creditors. It can be used to achieve a compromise
between an insurance company and its policyholders, and to
achieve a final resolution of the relevant portfolio. A solvent
scheme will always require the sanction of a U.K. court, however,
whose jurisdiction could be exercised only after demonstration of
sufficient connection (see below).
Portfolio transfers: The technique of portfolio transfers is available
for the portfolios of pure reinsurers, following the implementation of
the European Reinsurance Directive 2005/68/EC.4 For example
under German law, a transfer may be effected by German direct and
reinsurance companies that are authorized in the EU or EEA, subject
to the approval of the German (and other) supervisor(s). In the case of
a transfer of direct insurance, German regulatory law also requires that
the interests of the policyholders be protected as a further condition of
authorization. It should be noted, however, that under German law, such
a transfer does not in and of itself imply the transfer of any reinsurance or
retrocessional cover along with the transferred portfolio.
Looking toward the United Kingdom
The German and other continental European markets are familiar
with the more traditional exit routes such as commutation and
merger, but they are less familiar with solvent schemes and
portfolio transfers. Over the coming years, it is possible that
additional German companies will start to utilize a solvent scheme
for German books of business that have sufficient connection
to the United Kingdom or another country that has passed exit
legislation similar to that available in the U.K. (See below.)
The EU Reinsurance Directive allows for the transfer of business
from the continent to the U.K., so that a company may take
advantage of the U.K.’s solvent scheme legislation to achieve a full
and final exit for all stakeholders. In October 2007, and with the
help of Milliman, Deutsche Rück transferred a German portfolio
into its U.K. subsidiary, a transaction that was similar to what is
known in the U.K. as a Part VII transfer,5 and was the first to be
carried out under German law.6 Following on from this, a solvent
scheme was approved at a creditors’ meeting in May 2009 and
sanctioned in June 2009 by the High Court of Justice of England
and Wales. More recently, many are anticipating the launch of
Global Re’s proposed solvent scheme (GLM Pool), which was
sanctioned by the High Court in July of 2009. The GLM Pool
is the first German solvent scheme to use a claim of sufficient
connection to the U.K.
There is no fixed formula defining what constitutes sufficient
connection. However, the U.K. Court will look at a number of
factors to determine whether it would be appropriate for the Court
to exercise its jurisdiction to sanction a solvent scheme. Some of
the factors to be considered are whether:
• The business was written through a U.K. branch or London
market brokers
• Some of all of the policyholders are based in the U.K.
• The insurance contracts were subject to English law
• The company’s assets are based in the U.K.
• The reinsurers are based in the U.K.
Conclusion: How should a runoff insurer
prepare for Solvency II?
To prepare for Solvency II, runoff insurers (and those considering
this option) need to take several steps that will help them meet
the requirements of the new regime:
• use the standard model as defined in QIS4 in order to
quantitatively assess the likely impact of the new regime on
regulatory capital requirements
• decide proactively whether or not to develop an internal model
(or partial internal model) that captures the risk profile of the
business in a robust way, including the addition of stress tests
and stochastic methods to quantify the uncertainty in the held
reserve estimates with detailed treatment of commutations and
reinsurance credit risk
• complete a gap analysis to identify areas where risk measurement
and risk governance (systems and controls) need to be enhanced
and documented
• implement a plan to address the gaps identified
• allocate resources to undertake the project
Jeffrey A. Courchene is a principal and senior consultant with
the Munich, Germany, office of Milliman and can be reached at
[email protected].
3 Provided for under British law by s895 of the U.K. Companies Act 2006.
4 http://eur-lex.europa.eu/LexUriServ/site/en/oj/2005/l_323/l_32320051209en00010050.pdf
5 Part VII transfers are a technique by which insurers or reinsurers in the U.K. can transfer all of part of their business to another approved insurer.
6 Paragraph 121f of the Versicherungsaufsichtsgesetz (Insurance Oversight Law, or VAG) is new German legislation that enables portfolio transfers. The law came into force when
Germany implemented the EU Reinsurance Directive.
12 :: OCTOBER 2009
P&C PERSPECTIVES
Current Issues in Property and Casualty
Forecasting asbestos claims in the aviation industry
By Carl X. Ashenbrenner, FCAS, MAAA
For the past 20 years, asbestos claims have represented a
significant drain on the earnings of many commercial casualty
insurance companies. Reserve valuations are complicated by the
long latency of asbestos-related illnesses such as mesothelioma,
asbestosis, and pleural plaques. Complicating these issues
are the various legal rulings, favorable legal jurisdictions, and
bankruptcies, which distort the normal progression of claim
payments. Estimating claims from general liability policies is
difficult for many reasons, including identifying the responsible
parties, products versus premises coverage issues (and limits
included within), and identifying the universe of possible claimants
that may be exposed to asbestos.
Despite the difficulty of estimating the costs of future
asbestos claims, most commercial insurers have developed
methodologies to estimate the exposures. However, many of
the claims filed to date for the insurance industry relate to
companies that mined or produced asbestos-related products
(primary targets) as well as workers at a specific location who
worked with products containing asbestos. In more recent
years, asbestos claims are being brought against industries
with peripheral exposure to asbestos. This in turn, has
brought about the need to estimate the ultimate claims liability
associated with asbestos for these industries.
The following pages describe a ground-up model to estimate
ultimate asbestos losses for the aviation industry.
Asbestos claims and the aviation industry
The aviation industry was a latecomer to asbestos-related
claims. In other industries, losses began to materialize during
the 1970s, but claims within the aviation industry only became
significant during the late 1990s. This is true despite the fact
that some asbestos-related injuries traced their causes back
as far as the Korean War, when mechanics were exposed to
asbestos when repairing aircraft. These mechanics later went
to work in private aviation and subsequently filed claims.
In 1985–1986, the property and casualty (P&C) insurance
industry adopted the practice of adding an absolute asbestos
exclusion clause in its policies. In contrast, aviation insurers did
not start adopting asbestos exclusion clauses until 2003–2004.
Only a handful of companies and underwriting pools write policies
for the aviation business, but in addition to insuring airlines and
aircraft manufacturers such as Boeing and Lockheed, they find
themselves involved with companies whose primary product
markets are in industries other than aviation. Liability associated
with aviation is generally excluded from typical general liability
insurance policies pertaining to general manufacturing, which
means that companies supplying products such as seats, wire,
and lavatories for airplanes must purchase separate productliability insurance for their aviation business. Goodyear, which
makes aircraft tires and brakes, is a prime example of a company
that purchases aviation liability insurance in addition to its general
product liability.
Asbestos valuation model
A Milliman team has developed a stochastic model for valuating
ultimate asbestos-related claims for the aviation industry. The
model generates probabilistic future outcomes using a sequence
of four processes that estimate claim frequency and claim severity,
allocate the total value of the claims to the exposure years, and
calculate the insurer share of the allocated claim values. While the
following discusses the approach taken for the aviation industry,
a similar process has been used to estimate ultimate asbestos
claims for many other insurers and individual companies.
Claim frequency. The model starts by estimating the ultimate
number of asbestos claims over all of the insurance policies
exposed. The model makes assumptions about how many claims
might occur, how long it could take the claims to emerge, and
how long it will take to settle the claims once they are filed.
The universe of possible claimants within the aviation insurance
industry is assumed to comprise the number of persons working
as aircraft mechanics, the population most heavily exposed to
asbestos. Data useful for estimating the numbers of aircraft
mechanics is available from the U.S. Bureau of Labor Statistics
(for the civilian aviation industry) and the Department of Defense
(for the military sector). For estimating the number of claims, data
on asbestos-related illnesses and deaths is available from the U.S.
Centers for Disease Control and Prevention.
Claim severity. Next, the model estimates the average severity
of claims to be settled in the future, based on existing claim
information trended for future inflation costs. The valuations take
into account both indemnity and the associated legal expenses to
settle the claims (allocated loss adjustment expenses, or ALAE).
Allocation. After estimating the total value of all future claims,
the next step is to allocate those values to the years during which
the exposure took place. The model follows the current allocation
procedure and standard practice in the aviation insurance
market. This allocation process applies the triple-trigger theory
used in legal cases involving asbestos claims. Typically a claim
is allocated uniformly from first exposure date until either the
claimant’s death or the report date. In legal cases, the application
of the triple-trigger theory dates asbestos injuries back to the
moment of an individual’s first exposure, for example, the date on
which workers first took the job that exposed them to asbestos
OCTOBER 2009 :: 13
P&C PERSPECTIVES
Current Issues in Property and Casualty
fibers—even though the illness might not manifest, nor the claim
be filed, until 20 or 30 years later.
Aviation asbestos claims are generally filed in cases of very
serious illness or death, often by the children of the deceased.
The claims are hard to defend, and multiple parties are named in
the suit. Significant expenses can be incurred in assessing liability
to the various claimants, as well as in defending the claim itself.
Insurer share. The final process is to estimate the share of the
total projected claims for one or more insureds by adjusting the
projected values to match the specific policy terms (participation,
limits, date of exclusion) for each account. Again, it is important to
consider both indemnity and ALAE.
The outcome of these procedures is a range of probabilities for
the unpaid claim liabilities by insured, by policy year for future
years. The model can also provide an estimate of the future cash
flows by year.
Conclusion
The aviation insurance industry is a niche market that has
experienced a wave of asbestos-related claims arising much
later than the initial rounds of asbestos claims that arose in the
larger liability market. Because the aviation asbestos claims are
being reported much later than the general insurance industry’s
asbestos claims, ratios associated with general asbestos claims
may underestimate the liability for the aviation market.
Stochastic modeling can yield a range of probable results that give
reasonably accurate ranges for reserve valuation. More than just
an educated guess, the ranges can help insurers feel confident
that their reserve base is sufficient to cover likely future claims
and educate them to differentiate between a trend and a blip.
Such knowledge can also help a company approach commutation
negotiations better prepared to achieve favorable terms.
Carl X. Ashenbrenner is a principal and consulting actuary with
the Milwaukee office of Milliman and can be reached at
[email protected].
14 :: OCTOBER 2009
P&C PERSPECTIVES
Current Issues in Property and Casualty
OCTOBER 2009 :: 15
P&C PERSPECTIVES
Current Issues in Property and Casualty
Milliman qualifications: Runoff
At Milliman, we have experience working with almost all segments
of the runoff market in the United States, the United Kingdom, and
Europe. Our recent clients have included:
•
•
•
•
run-off specialists
insolvent insurance and reinsurance companies
insurance and reinsurance companies in voluntary run-off
insurance regulators
The competent review and management of a runoff entity or
portfolio of business requires special knowledge and experience.
It is critical to understand the effect that entering runoff can have
on claim payments (both the amount and timing) and potential
reinsurance recoveries. In our engagements, we have worked with
various company claims departments, third-party administrators
(TPAs), and guaranty associations (GAs), acquiring an extensive
understanding of the critical role they play in the runoff process.
For any engagement involving runoff, we bring not just an actuarial
perspective to our work, but also a business perspective. This
perspective is based on our knowledge of the insurance and
reinsurance markets, which we use to verify the reasonableness of our
results and indications. We have particular expertise in troublesome
blocks of business that are usually part of a runoff portfolio—asbestos,
pollution, and other health hazards (APH); construction defect claims
(CD); and workers’ compensation (WC) liabilities.
P&C Perspectives is published by Milliman’s P&C Editorial Committee as a
Specific recent examples of our work in the runoff area include
the following:
Analysis of unpaid claim liabilities – We have performed
numerous analyses of unpaid claim liabilities for companies or
individual blocks of business in runoff. These analyses have been
performed for purposes of due diligence (working for either the
buyer or seller) and for financial reporting.
Pricing of runoff entities or blocks of business – We have
assisted clients in preparation for due diligence in the valuation of
blocks of business or entire entities. These exercises have included
modeling and analysis of cash-flow projections, required capital, and
expected return on equity.
Commutations – We have worked with both ceding companies
and reinsurers to assist in the pricing of commutations of
reinsurance coverage provided for runoff business. This modeling
has included providing estimates of incurred but not reported
(IBNR) liabilities at high excess layers.
Claims reviews – Claims handling is a key to success in most
runoff operations. We have a dedicated team of claim specialists
that has reviewed the claims management operations of numerous
companies and TPAs to ensure that claims are being handled
properly and consistently with expectations.
Inquiries may be directed to:
service to our clients. Additional copies are available through any of our offices.
Reproduction of any article appearing in this publication requires permission from
P&C Perspectives Editor
the P&C Perspectives Editor and proper credit to the firm and the author.
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Because the articles and commentary prepared by the professionals of our firm
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are often general in nature, we recommend that our readers seek the counsel of
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their attorney and actuary before taking action.
16 :: OCTOBER 2009
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