CAS Casualty Loss Reserve Seminar September 13-15, 2004

1
CASCasualty Loss Reserve Seminar September
13-15, 2004

• Reserving for Title Insurance
• and
• Residual Value Coverage
• Alan Hines, FCAS
• PwC LLP

2
Overview of Residual Value Coverage

• Insured Exposure
• Protects the owner of an asset against a severe
  reduction in the market value at a fixed point in
  time.
• Definitions
• Asset Expiration Fixed Point in Time
• Insured Value fcn (Expected Residual Value)
  anticipates depreciation greater than expected
  depreciation.
• Residual Value fcn (Market Value or Book Value)
  defined by policy terms
• Insured Loss (Residual Value lt Insured Value)
  at Asset Expiration
• Attachment Ratio Insured Amount / Original
  Value
• Coverage Ratio Insured Amount / Current Value

3
Overview of Residual Value Coverage

• Assets Insured
• Vehicles
• Real Estate
• Aircraft
• Commercial Equipment special machinery,
  construction equipment, railroad locomotives,
  computers electronics

4
Overview of Residual Value Coverage

• Who Purchases Coverage
• Automobile Dealerships
• Banks and Finance Companies
• Credit Tenant Lease Arrangers (guarantying the
  balloon payment on the note)
• Commercial Equipment Manufacturers with leasing
  programs

5
Overview of Residual Value Coverage

• Competitors in Market
• Active ??? AIG, Great American, Chubb, RVI,
  QBE, Mitsui Sumoto, and a few small specialty
  insurers
• Inactive??? Gulf (Travelers), St. Paul,
  Reliance, Philadelphia, Royal Sun Alliance (FSL),
  Swiss Re (North American Specialty), Hartford,
  ACE
• Difficulty assessing since there is no annual
  statement line for this coverage. Usually under
  Aggregate Write-in or Financial Guaranty

6
Overview of Residual Value Coverage

• Material Risk Factors
• Economic Downturn
• Excess Production (supply)
• Market Trends (demand)
• Innovations Rendering Asset Obsolete

7
Overview of Residual Value Coverage

• Two Types of Products
• Asset Value Risk protects the residual value at
  lease termination.
• FASB 13 Risk - This is residual value insurance
  to allow for the lessee and lessor to use the
  most favorable accounting treatment for the lease
  

8
FASB 13 Risk

• Accounting Treatment for Leases
• - Finance lease accounting lessor can
  smooth earnings over the term of the lease
• - Operating lease accounting earnings are
  realized at the latter part of the lease
• To Qualify for financing lease treatment
• PV (Lease payments guaranteed residual
  value)
• must be gt 90 fair value of leased
  asset at lease inception
• Lessee and Lessor need not use same treatment
  when 3rd party guarantees the residual value.
• - Lessee can use operating lease treatment
  with off-balance sheet financing that results in
  delayed expense recognition

9
FASB 13 Risk

• Insured value established to meet 90 test
• Low risk of loss
• Do policies meet FAS 113 risk transfer
  requirements?

10
Establishing Insured Values

• Establishing Insured Values
• 90 rule for FASB13
• Auto Leasing Guide - Percentage thereof
• Residualized MSRP
• Underwriting Models to Project Residual Value

11
Establishing Market Value at Expiration

• PV Black Book, Auction Value
• RE Appraisal Value defined approach
• CE Green Book
• Aircraft Blue Book
• Specific policy provisions regarding return
  conditions and which value/method to use.

12
Accounting Issues

• Incurred Loss When is a loss incurred?
• At policy (asset) expiration. Accident year is
  asset expiration date.
• Proportionally over the life of asset when
  there is a reasonable expectation that the
  residual value of the asset will be less than the
  insured value at asset expiration, the expected
  value of the earned loss shall be recorded.
  Accident year of paid loss is distributed
  proportional to asset term.
• Must match method for earning premium

13
Accounting Issues

• Earned Premium How is premium earned?
• Expenses earned over policy period, remainder at
  policy (asset) expiration
• Proportionally over the life of policy asset
• Sum of digits method (like rule of 78)
  sometimes used for FASB 13 risk

14
Accounting Issues

• Reserves
• Limited use of Case Basis reserves. Multiple
  asset policies with reporting requirements and
  settlement lag
• IBNR Reserve To match premium recognition
• Premium Deficiency Reserve Testing Required
• Statutory reserves Some states may establish
  statutory reserve requirements

15
Accounting Issues

• US GAAP Accounting Insurance or Derivative?
• FAS 133 Accounting for derivatives and hedging
  activities
• - When the residual value is based on an asset
  appraisal, or proceeds from a sale exception 10
  (e) (2) is met and the contract may be treated as
  insurance.
• - When the residual value is based on reference
  to an asset valuation guide (Black Book, Blue
  Book, Green Book) instead of a specific asset
  appraisal, the contract does not qualify for the
  10 (e) (2) exception and must be accounted for as
  a derivative.
• - When based on a combination of a multiple
  underlyings (ie higher of), accounting based on
  contracts predominant characteristics. Under
  10(e) no exception if residual value of other
  underlyings is highly correlated to guide book!

16
Estimating Loss Reserves

• Loss Ratio Approach
• Aggregate Models
• Frequency Severity Approach
• Development of Coverage Ratios
• Econometric Modeling
• Individual Asset
• Asset Classes

17
Estimating Loss ReservesEconometric Modeling

• Database of Insured Assets
• Original Appraisal Date and Value
• Most recent value and valuation date
• Asset Termination Date and Insured Value
• Asset Characteristics PV - make, model, year,
  VIN
• RE age, construction, location, use
• Policy Parameters deductibles, offset, limits,
  mileage/asset condition charges, settlement terms
  

18
Estimating Loss ReservesEconometric Modeling

• Projection Assumptions
• Probability of reaching full term
• Probability of return to lessor at end of term
• Current book value
• Depreciation

19
Estimating Loss ReservesEconometric Modeling

• Probability of Reaching Full Term Not Constant
• Varies by length of lease
• Varies by type of vehicle
• Function of market value gain or loss

20
Estimating Loss ReservesEconometric Modeling
21
Estimating Loss ReservesEconometric Modeling

• Probability of Vehicle Being Returned to Lessor
• Varies by length of lease
• Varies by type of vehicle
• Function of market value gain or loss

22
Estimating Loss ReservesEconometric Modeling

23
Estimating Loss ReservesEconometric Modeling
24
Estimating Loss ReservesEconometric Modeling

• PV Depreciation Data Sources
• Auto Leasing Guide (ALG)
• Black Book Used Vehicle Guide
• Bureau of Labor Statistics (CPI)
• Global Insight (DRI) economic indices
• Manheim Used Vehicle Indices

25
Estimating Loss ReservesEconometric Modeling

• Modeling Used Vehicle Depreciation
• Vehicle Attributes Make, Segment, Body Style,
  Age Product cycle (age of body style)
• Seasonality
• Supply Competition Index (dealer incentives),
  Used Vehicle Stock Index (by segment), New
  Vehicles Sold (lagged 3-5 years)
• Demand Consumer Confidence, Unemployment
• Economic Factors New and Used Car Price Index,
  New Car Auto Loan Rate, CPI

26
Estimating Loss ReservesEconometric
ModelingEstimating Depreciation
27
Estimating Loss ReservesEconometric
ModelingEstimating Depreciation
28
Estimating Loss ReservesEconometric
ModelingEstimating Depreciation
29
Estimating Loss ReservesEstimating
DepreciationAverage Monthly Depreciation 1999
Vehicles
  Ave. Monthly   Ave. Monthly   Ave. Monthly
Vehicle Type Depreciation Vehicle Type Depreciation Vehicle Type Depreciation
SUV   Luxury   Mid Size  
Ford Explorer 2.16 Lincoln Continental 1.98 Ford Taurus 2.23
Chevrolet Blazer 2.04 Chevrolet Corvette 1.21 Chevrolet Malibu 2.11
Toyota 4Runner 1.23 Lexus GS300 1.43 Toyota Camry 1.42
Honda CRV 1.21 Acura RL 1.57 Honda Accord 1.34
Mitsubishi Montero 1.57 Mitsubishi 300GT 0.96 Mitsubishi Gallant 1.88
30
Monthly Depreciation Rates 00 to 04 (All
Segments)Weighted Average Black Book
Month 2000 2001 2002 2003 2004 Wt. Average
January -1.64 -1.81 -0.67 -1.25 -1.50 -1.26
February -1.62 -1.22 1.52 -1.79 -1.24 -0.84
March -2.97 -1.29 0.44 -1.65 -0.92 -0.90
April -1.41 -1.36 -0.38 -1.66 -0.59 -0.95
May -0.88 -0.79 -1.02 -1.25 0.54 -0.47
June -1.95 -0.88 -1.58 -1.33 -0.35 -0.99
July -2.23 -1.74 -1.45 -0.45  -1.72 -1.26
August -0.54 -1.38 -1.21 -0.55  -2.25 -1.40
September -1.48 -1.80 -1.64 -0.16   -1.69 -1.20
October -0.79 -1.28 -2.50 -0.32   -1.24
November -2.24 -7.92 -4.50 -2.41   -3.75
December -3.06 -1.10 -3.00 -2.27   -2.45
Wt. Average -1.75 -1.91 -1.34 -1.26 -1.07  
31
Estimating Loss ReservesEconometric Modeling

• PV Underwriting Considerations
• Who is insured, Bank or Dealer
• Type of Vehicles
• Mileage and Condition
• Length of Lease
• Market Trends
• Optional Equipment
• Deductibles

32
Estimating Loss ReservesEconometric Modeling

• Real Estate
• Long Term Projections
• Monitor Mark to Market Coverage Ratios
• Monitor Concentration of Risk
• Assess loss of stressed markets by assessing
  relative position of the cycle and cycle delta
  for historical depressions.

33
Estimating Loss ReservesEconometric Modeling

• Real Estate Depreciation Data Sources
• National Real Estate Index - Global Real
  Analytics
• Standard Poors
• Cushman Wakefield and SIOR Market Reports
• Property Portfolio Research, Inc (ppr.info)
• CB Richard Ellis (cbre.com)
• Torto Wheaton Research (trw.com)

34
Estimating Loss ReservesEconometric Modeling

• Modeling Real Estate Depreciation
• Property Type Office, Retail, Industrial,
  Hotel/Motel, Other
• Location Standard Metropolitan Statistical
  Areas, State Average, National Average
• Supply/Demand Average Market Rent, New Starts,
  Completions, Vacancy Rates, Net Absorption, Total
  Occupancy
• Economic Factors Market Capitalization Rates,
  Interest rates, Employment

35
Estimating Loss ReservesEconometric
ModelingReal Estate Depreciation
36
Estimating UPR ReservesThree NAIC Tests

• Test 1 Best estimate of the amounts refundable
  to contract holders.
• Test 2 Gross premium multiplied by the ratio
  of gross losses and expenses incurred during the
  unexpired term to the total gross losses and
  expenses under the contract (nominal basis).
• Test 3 The present value of the expected
  future losses and expenses.

37
Estimating UPR Reserves

• Test 1 Not applicable

38
NAIC Tests 2 3 for UPR Reserves
      Proportion Back-End
      Company Company
1 1 GWP 100 100
2 2 EP 35 10
3 3 UEP 65 90
4 4 Tot Expense 28 28
5 5 Incurred 22 22
6 6 Remaining 6 6
7 7 Projected Loss 110 110
8 8 Incurred 38.5 0
9 9 Remaining 71.5 110
Test 2 Test 2 Test 2    
10 10 Ratio (96)/(47) 56.2 84.1
11 11 Required UEP 56.2 84.1
Test 3 Test 3 Test 3    
12 Discount Factor Discount Factor 90 90
13 PV (Loss Expense) (12)x(9) (6) PV (Loss Expense) (12)x(9) (6) 69.8 104.4
14 UPR Reserve Max (3), (11), (13) UPR Reserve Max (3), (11), (13) 69.8 104.4
15 Total Reserves (8) (14) Total Reserves (8) (14) 108.3 104.4