This blog post addresses the issues of capital adequacy and surplus policy for specialized risk bearing entities (RBE). These can include captive insurance companies, public entity pools, and qualified self insurance plans. The term Surplus is not common among all RBEs. The excess of assets over liabilities is sometimes called Member Equity. The terms Fund Surplus and Net Assets are also used. For sake of consistency, the term Surplus will be used in this article to identify the difference in assets and liabilities.
This post will pose a number of questions that should be asked by RBEs when considering surplus. SIGMA has developed a forecasting and consulting model that supports the development and measurement of surplus policy. That model is called SIGMA’s Strategic Risk Analysis (SRA). The use and output of the SRA is demonstrated throughout this post.
Why does an RBE need a surplus policy?
RBEs are not regulated in the same way as commercial carriers. In most domiciles, they are not required to maintain solvency that is formally measured by IRIS ratios or Risk Based Capital. However there is still a need for solvency; not to protect policyholders, but to stabilize the cost of risk.
If a commercial carrier experiences poor underwriting results in a line of coverage, or in a geographic territory, they can either raise rates or cease to underwrite that line. RBEs do not have that flexibility. They have to be more committed than a commercial carrier. Surplus will be needed to withstand the poor underwriting results until loss control or gradual price increases can rectify the issue.
Regardless of the need for a surplus policy, the most important question is:
Will the surplus policy serve the insureds now and in the future?
A surplus policy should be created based on a consensus of the RBE management and the Board. With that consensus, the policy can support the stabilization of costs and will be supported by stakeholders.
The proposed policy must be quantified to assure that it will serve the members when costs, especially retained claims, vary from the norm. The forecasts should be done using input from the entity’s management and from actuarial forecasts of retained losses and the variability of those claims based on the risk profile. The forecasts should be critically reviewed to determine the effect of adverse losses and expenses. If the target solvency measures are not achieved, some changes in the retentions and expense structures should be considered.
The forecasts should become a flexible document that can be easily revised as the risk profile evolves.
SIGMA’s SRA satisfies all these criteria. A sample SRA is located at:
Who are the stakeholders?
Management and the board will have primary input for the surplus policy. What data will they use to quantify and test the proposed policy? Does the board want to maximize the return of available surplus? Do they want to retain surplus to invest in loss control and growth?
The policy can be based on a consistent return of premiums. Alternatively, the surplus can be used to stabilize cost of risk. Which philosophy will serve best?
How can surplus policy be used to communicate financial strength to the stakeholders?
Many RBEs have better measures of solvency than regulated carriers. These can be used to counter the argument against the RBE as an alternative to commercial markets.
Do regulators have any interest in the surplus position? If the RBE is at least as strong as a regulated carrier, regulators do not have to be concerned about the ability to pay claims.
Solvency of the underlying carrier is a part of the underwriting process. A strong surplus position could be a factor in obtaining better terms and conditions for reinsurance. The broker and management can use this in negotiations with reinsurers.
These issues should be understood before formulating the surplus policy and before forecasting. Since RBEs are not regulated in the same way as licensed companies, it is important to build support for surplus policy from all stakeholders. This “pre-forecast” work will help build a sound policy that will have the consensus of the stakeholders.
How has the current surplus been created?
If the RBE has experienced a consistent underwriting profit, can it expect to maintain its premium and loss levels? If so, this can buffer the variability of investment income and operating expenses. Are premiums competitive with the commercial market place? If so, this source of surplus should continue. If the RBE exceeds its surplus goals, it can subsidize premiums during recessionary periods.
Without consistent underwriting profits, the following could endanger surplus:
- Underwriting losses in one or more years
- Decrease in investment income
- Adverse loss development
If underwriting profit needs to be strengthened, price increases or more stringent underwriting standards might be needed.
Has investment income contributed to the current surplus? How does that compare to underwriting income? If the RBE is dependent on investment income, unrealized investment losses could reduce surplus albeit temporarily.
If current fixed income investments mature in the near future, can they be replaced with similar yields? If not, how will the reduced interest income affect the surplus forecast?
It is important to understand the relative contributions of underwriting and investment income to anticipate their future effect on surplus.
Changes in outstanding loss reserves
If loss reserving policies, both case and book, have been conservative, surplus could be “created” by reducing reserves. While this will be an addition to surplus in the fiscal year, is it really indicative of operating results?
Has surplus been reduced by reserve increases? If so, will the reserving practices be changed to reduce unexpected calls on surplus?
After determining the source of historical surplus, the next step is to set surplus goals.
What are the options for setting surplus goals?
- IRIS ratios
- Current and or historical standards
- Peer group comparisons
- - What will appeal to the Board and insureds?
- - How can this monitored and measured?
- - How can this be communicated to stakeholders?
What is the process for forecasting surplus?
Forecasts of the surplus position will require considerable time and input about assumptions for retained losses, operating expenses and risk profile. Time spent on these assumptions will develop realistic scenarios that will create a real planning document, not just an academic forecast.
The following issues should be addressed when developing the assumptions for the forecast.
- Assumptions for exposure bases
Renewal rates should include both the number of members and the anticipated change in exposure bases. If market share is expected to change, this should be included in the assumptions.
A line of coverage might be added if surplus and market conditions warrant additional assumption of risk. If a line of coverage has been consistently unprofitable, the RBE might consider transferring that risk. The transfer might be temporary until loss control measures can make it an attractive line of coverage. These changes in risk profile and operating expenses should be an integral part of the forecasts.
- Assumptions for expense components
As the RBE grows, staff changes should be anticipated. Supplier contracts could also change. For example, if the RBE assumes the responsibility for claims management, those changes in staff and expenses should be a part of the forecast.
Costs for excess/reinsurance should also be addressed in the assumptions. Are the current rates influenced by recent bad underwriting experience? Will that change in the foreseeable future? If the loss experience is good and consistent, can those rates be reflective of the loss experience? If so, that should be a part of the forecasting model.
- Retained claims
The most important element of the forecast, by large measure, is the retained claims. The variability in retained claims and funding of those claims will have the greatest effect on surplus. The actuarial forecast can measure the potential variability over a period of several years. That forecast should include the variability of retained losses, by line, and in total. That forecast includes probability distributions based on the frequency and severity of claims. The following chart shows the retained losses at three percentiles used in the sample forecasts.
Losses will vary by year, by line, creating realistic scenarios with which to make decisions about the surplus policy.
The claims cost scenarios will be chosen from these probability distributions. These distributions can also be used to set the loss funding level for the forecast.
If changes in retentions are contemplated, the distributions should be run for all proposed retentions.
If the lines of coverage include highly variable lines like property or sexual misconduct, losses should be funded to be at a higher confidence level. If the assumed risks are not variable, like auto physical damage or workers compensation for office workers, the funding can be less conservative.
Results of the forecasts
The forecasts should compare the estimated surplus levels to the established benchmarks. The following graphs are examples of summary results of the forecasts. Adapted Risk Based Capital (RBC) was used as the benchmark for surplus accumulation in this example.
This chart shows that the surplus exceeds the Adapted RBC goal in each year of the forecast. The accumulation of the remaining underwriting profit and investment income allows surplus to grow and exceed the goal.
The forecasts can, and should, be critically reviewed to be sure they are realistic. If goals are not met, the assumptions should be reviewed to be sure they are reasonable. For example, if surplus consistently falls short of the goal, should loss funding be increased? If the goals are exceeded by a large margin, are the claims cost assumptions too low? If not, should the RBE consider some return of surplus through a dividend plan? The forecast can be revised to test the effects of the proposed dividend.
How will calamities events affect surplus?
The probability distributions described above create scenarios of what is likely to happen. Events that are possible but not probable should also be considered in the strategic planning process. Examples of these calamities could include:
- Claims that exceed the highest confidence intervals
- Reinsurance problems
- - Loss of coverage through insolvency of carrier
- - Coverage disputes
- - Exhaustion of aggregate excess coverage
- - Investment in excess carriers
- Legal decisions that are not contemplated when setting premium levels
- Large investment losses
These events can, and probably will, cause a pool to temporarily miss its benchmarks. The Board can use these forecasts for financial disaster planning. The forecasts should show whether the problem can be overcome in a reasonable time frame or whether more overt action is necessary to assure the pool’s solvency.
The following chart is an example of quantifying a calamity.
This chart shows the estimated surplus in the Calamitous scenario compared to losses at the 95th percentile Variable and the Adapted RBC goal.
How can you use forecasts to manage surplus policy?
The descriptive statistics for pure loss and frequency rates and key expense ratios can be compared to peers. This will help the board understand whether its supplier contracts, and risk management activities should be revised.
If high loss or calamities cause the RBE to miss its benchmarks, how long should it take to recover? The forecasts can, and should, be done using a variety of loss and expense scenarios so the Board has a range of data from which to make decisions.
How will policy and quantitative work be communicated to stakeholders?
The forecasts are a good communication tool. They are a realistic, moving picture of surplus position. All stakeholders need to know how the loss and expense structure will affect surplus. The forecasts provide a platform for understanding, planning and proactively managing the surplus policy.
Surplus policy should be based on:
- Understanding of the current and future risk profile of the RBE
- Consensus of all stakeholders regarding the use of surplus
- Forecasts that include the variability of retained claims and expenses
Please comment or email your thoughts to Lloyd@SIGMAactuary.com
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