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1
CAS
Casualty Loss Reserve Seminar September 13-15, 2004
CAS
Casualty Loss Reserve Seminar September 13-15, 2004
Reserving for Title Insurance
and
Residual Value Coverage
Alan Hines, FCAS
PwC LLP
Reserving for Title Insurance
and
Residual Value Coverage
Alan Hines, FCAS
PwC LLP
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Overview of Residual Value CoverageOverview 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 < Insured Value) at Asset
Expiration Attachment Ratio – Insured Amount / Original Value Coverage Ratio – Insured Amount / Current Value
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 < Insured Value) at Asset
Expiration Attachment Ratio – Insured Amount / Original Value Coverage Ratio – Insured Amount / Current Value
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Overview of Residual Value CoverageOverview of Residual Value Coverage
Assets Insured
Vehicles
Real Estate
Aircraft
Commercial Equipment – special machinery, construction equipment, railroad locomotives, computers & electronics
Assets Insured
Vehicles
Real Estate
Aircraft
Commercial Equipment – special machinery, construction equipment, railroad locomotives, computers & electronics
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Overview of Residual Value CoverageOverview 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
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
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Overview of Residual Value CoverageOverview 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
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
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Overview of Residual Value CoverageOverview of Residual Value Coverage
Material Risk Factors
Economic Downturn
Excess Production (supply)
Market Trends – (demand)
Innovations – Rendering Asset Obsolete
Material Risk Factors
Economic Downturn
Excess Production (supply)
Market Trends – (demand)
Innovations – Rendering Asset Obsolete
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Overview of Residual Value CoverageOverview 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
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
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FASB 13 RiskFASB 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 > 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
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 > 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
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FASB 13 RiskFASB 13 Risk
Insured value established to meet 90% test
Low risk of loss
Do policies meet FAS 113 risk transfer requirements?
Insured value established to meet 90% test
Low risk of loss
Do policies meet FAS 113 risk transfer requirements?
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Establishing Insured ValuesEstablishing Insured Values
Establishing Insured Values 90% rule for FASB13 Auto Leasing Guide - Percentage thereof Residualized MSRP Underwriting Models to Project Residual Value
Establishing Insured Values 90% rule for FASB13 Auto Leasing Guide - Percentage thereof Residualized MSRP Underwriting Models to Project Residual Value
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Establishing Market Value at ExpirationEstablishing 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.
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.
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Accounting IssuesAccounting Issues
Incurred Loss – When is a loss incurred?A. At policy (asset) expiration. Accident year is asset
expiration date.B. 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.
C. Must match method for earning premium
Incurred Loss – When is a loss incurred?A. At policy (asset) expiration. Accident year is asset
expiration date.B. 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.
C. Must match method for earning premium
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Accounting IssuesAccounting Issues
Earned Premium – How is premium earned?A. Expenses earned over policy period, remainder at
policy (asset) expirationB. Proportionally over the life of policy assetC. Sum of digits method – (like rule of 78) sometimes
used for FASB 13 risk
Earned Premium – How is premium earned?A. Expenses earned over policy period, remainder at
policy (asset) expirationB. Proportionally over the life of policy assetC. Sum of digits method – (like rule of 78) sometimes
used for FASB 13 risk
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Accounting IssuesAccounting 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
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
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Accounting IssuesAccounting 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 contract’s predominant characteristics. Under 10(e) no exception if residual value of other underlyings is highly correlated to guide book!
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 contract’s predominant characteristics. Under 10(e) no exception if residual value of other underlyings is highly correlated to guide book!
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Estimating Loss Reserves Estimating Loss Reserves
Loss Ratio Approach
Aggregate Models
– Frequency Severity Approach
– Development of Coverage Ratios
Econometric Modeling
– Individual Asset
– Asset Classes
Loss Ratio Approach
Aggregate Models
– Frequency Severity Approach
– Development of Coverage Ratios
Econometric Modeling
– Individual Asset
– Asset Classes
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Estimating Loss ReservesEconometric Modeling
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
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
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Estimating Loss ReservesEconometric Modeling
Estimating Loss ReservesEconometric Modeling
Projection Assumptions Probability of reaching full term
Probability of return to lessor at end of term
Current book value
Depreciation
Projection Assumptions Probability of reaching full term
Probability of return to lessor at end of term
Current book value
Depreciation
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Estimating Loss ReservesEconometric Modeling
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
Probability of Reaching Full Term Not Constant
Varies by length of lease
Varies by type of vehicle
Function of market value gain or loss
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Estimating Loss ReservesEconometric Modeling
Estimating Loss ReservesEconometric Modeling
Probability of a PV Lease Reaching Full Term
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
-25% -20% -15% -10% -5% 0% +5% +10% +15% +20% +25%
Market Value Gain as % of MSRP
Pro
ba
bil
ity
of
Fu
ll R
etu
rn
24 36 48 60
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Estimating Loss ReservesEconometric Modeling
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
Probability of Vehicle Being Returned to Lessor
Varies by length of lease
Varies by type of vehicle
Function of market value gain or loss
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Estimating Loss ReservesEconometric Modeling
Estimating Loss ReservesEconometric Modeling
Probability of a PV Lease Being Returned to Lessor Full Term
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
-25% -20% -15% -10% -5% 0% +5% +10% +15% +20% +25%
Market Value Gain as % of MSRP
Pro
ba
bil
ity
of
Fu
ll R
etu
rn
24 36 48 60
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Estimating Loss ReservesEconometric Modeling
Estimating Loss ReservesEconometric Modeling
Probability of Return, 5-Year Leases by Segment
20%
25%
30%
35%
40%
45%
50%
-20% -15% -10% -5% 0% +5% +10% +15% +20%
Market Value Gain as % of MSRP
Pro
ba
bil
ity
of
Fu
ll R
etu
rn
LUXURY VEHICLE PASSENGER CAR SUV TRUCK VAN
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Estimating Loss ReservesEconometric Modeling
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
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
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Estimating Loss ReservesEconometric Modeling
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
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
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Estimating Loss ReservesEconometric Modeling:Estimating Depreciation
Estimating Loss ReservesEconometric Modeling:Estimating Depreciation
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Estimating Loss ReservesEconometric Modeling:Estimating Depreciation
Estimating Loss ReservesEconometric Modeling:Estimating Depreciation
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Estimating Loss ReservesEconometric Modeling:Estimating Depreciation
Estimating Loss ReservesEconometric Modeling:Estimating Depreciation
75
80
85
90
95
100
105
110
115
Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03
Compact Luxury Midsize Sports SUV
75
80
85
90
95
100
105
110
115
Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03
Compact Luxury Midsize Sports SUV
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Estimating Loss ReservesEstimating Depreciation
Average Monthly Depreciation – 1999 Vehicles
Estimating Loss ReservesEstimating Depreciation
Average 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 2.16Lincoln 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
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Monthly Depreciation Rates ’00 to ’04 (All Segments)Weighted Average Black Book
Month 2000 2001 2002 2003 2004Wt.
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
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Estimating Loss ReservesEconometric Modeling
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
PV Underwriting Considerations
Who is insured, Bank or Dealer
Type of Vehicles
Mileage and Condition
Length of Lease
Market Trends
Optional Equipment
Deductibles
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Estimating Loss ReservesEconometric Modeling
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.
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.
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Estimating Loss ReservesEconometric Modeling
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)
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)
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Estimating Loss ReservesEconometric Modeling
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
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
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Estimating Loss ReservesEconometric Modeling
Real Estate Depreciation
Estimating Loss ReservesEconometric Modeling
Real Estate Depreciation
National Average
0
50
100
150
200
250
1985
Q4
1986
Q4
1987
Q4
1988
Q4
1989
Q4
1990
Q4
1991
Q4
1992
Q4
1993
Q4
1994
Q3
1995
Q1
1995
Q3
1996
Q1
1996
Q3
1997
Q1
1997
Q3
1998
Q1
1998
Q3
1999
Q1
1999
Q3
2000
Q1
2000
Q3
2001
Q1
2001
Q3
2002
Q1
2002
Q3
2003
Q1
2003
Q3
2004
Q1
Pri
ce
ps
f Industrial
Office
Retail
Suburban Office
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Estimating UPR ReservesThree NAIC Tests
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.
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.
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Estimating UPR ReservesEstimating UPR Reserves
Test 1: Not applicable Test 1: Not applicable
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NAIC Tests 2 & 3 for UPR ReservesNAIC Tests 2 & 3 for UPR Reserves
Proportion Back-End
Company Company
1 GWP 100 100
2 EP 35 10
3 UEP 65 90
4 Tot Expense 28 28
5 Incurred 22 22
6 Remaining 6 6
7 Projected Loss 110 110
8 Incurred 38.5 0
9 Remaining 71.5 110
Test 2
10 Ratio (9+6)/(4+7) 56.2% 84.1%
11 Required UEP 56.2 84.1
Test 3
12 Discount Factor 90% 90%
13 PV (Loss & Expense) = (12)x[(9) +(6)] 69.8 104.4
14 UPR Reserve = Max [(3), (11), (13)] 69.8 104.4
15 Total Reserves (8) + (14) 108.3 104.4