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Retrospective planning for future profits.

Retrospective Planning For Future Profits

As risk management grew into a discipline, risk managers became increasingly concerned with the cost and payment of insurance premiums. They recognized that insurers nearly always contemplated expected losses in premium calculations and, consequently, retained the use of loss reserves for the insurer's benefit. Insurers, in an effort to compete with the captive movement and to respond to risk management needs, developed a variety of cash flow plans which enabled the insured to share in the benefits of retained loss reserves.

Retrospective or "retro" plans are the major insurance mechanism used to offer cash flow benefits. These plans provide a means for the insured to extend or spread payments for a particular year over a given period of time (usually several years), corresponding to the "tail" or payment profile/schedule of the insured. The existence of these future cash outflows complicates the selection of the optimum insurance program since the time adjusted value of these payments must be considered in the calculation of actual insurance program costs.

Capital budgeting (or discounted cash flow analysis) is the most popular way of considering the time value of a series or "stream" of payments in the future. Retrospective rating plans are particularly sensitive to this technique since their basic nature involves improved cash flow.

Retro Basics

Retrospective rating is a method by which the insurance company calculates premiums based on the insured's actual loss experience during the policy period. Since claims may take a long time to close or reach ultimate value, final premium determination may be delayed for several years. However, adjustments are usually made annually during the program to estimate the final premium. Since the final premium is directly related to loss experience, ultimate program costs could be unlimited. The insured, therefore, usually selects and pays for a minimum and maximum level to lessen the risk associated with higher than expected loss expenses.

Loss experience is the key variable involved in the calculation of the retro premium. Initially, loss experience is based on expected losses. As the program progresses, actual loss experience including a factor for loss development becomes the driving force of the retro premium. Other factors involved in the calculation of retro premiums include the basic premium, loss conversion factor and the tax multiplier. The basic premium provides for insurer expenses and profits (except loss adjustment) along with the charges for a certain level of minimum and maximum premiums. The loss conversation factor is used to modify loss experience to include charges for loss adjustment expenses. The tax multiplier provides a means for reflecting taxes in the retro premium.

The various factors and variables associated with the retro premium are interrelated by the following formula: RP = [BP + (LCF X LE or EL)] X TM.

While loss experience is subject to the retro formula, other expenses and premiums are not. These include non-subject premiums, letter of credit expenses and other miscellaneous expenses. Thus, the final premium is the sum of these charges and the retro premium: FP = RP + NSP + LOC, etc.

Nearly all retro plans use the above formula in one form or another, but there are differences reflecting the cash flow advantages offered by the insurer. Normally, these are related to the types of losses considered in the loss experience or expected loss factor of the retro formula. Under an incurred loss plan, the insurer will pick a very conservative (high) expected loss experience (including fully developed reserves) and will factor this amount into the retro formula. The resulting retro premium along with non-subject expenses will represent the amount the insured must pay for the first year of the program. Annual adjustments will be made to revise this estimate to new expected incurred loss levels, but the insurer will, at all times, retain the use of money reserved for future loss experience. Thus, the insured loses investment opportunity on these funds.

Conversely, in the case of a paid loss plan loss experience is only considered as it is paid. First year costs will include taxes, basic premiums, non-subject expenses and a reserve escrow for the payment of initial claims. Actual losses, converted to include loss adjustment and tax expenses, will be billed as they are incurred. Thus, the insured, not the insurer, retains the use of money reserved for future losses.

Another type of retro plan, an expected loss plan, is based on a more reasonable estimate of the insured's loss experience. Operation is similar to an incurred loss plan, but since a lower loss estimate is used, first year costs are normally lower. Consequently, the insured retains more money reserved for future losses. Because of the similarity to an incurred loss program, this plan will not receive any further attention.

Cash Flow Analysis

The basic approach to analyzing the cost of various retro programs is to select the plan which has the lowest after-tax net present value. This involves the identification of annual differential cash flows occurring over the expected life of the program. It should also consider the effect of taxes on these flows. These after-tax cash flows are discounted to the present value using an appropriate interest rate, and then summed to generate the net present value of the program. The most important--and difficult--step in the process is the identification of differential cash flows.

The following example clearly defines the steps in this process: Table A of Figure 1 illustrates the facts of two alternative rating programs. Except for differences relating to cost, cash flow and the like, all other aspects such as coverage and financial security are assumed to be identical and not differential to the selection process. Thus, the objective is to select the program with the lowest after-tax net present value.

A close look at Table A reveals that there may be a substantial advantage in favor of the incurred loss alternative. Specifically, the premium at the expected loss level of $1,300,000 is about $383,000 lower than the paid loss program. If the decision is made on these facts alone, the obvious choice would be the incurred loss plan. However, consideration has not been given to cash flow or, more importantly, interest income on loss reserves.

The first step is to define and identify the cash flows associated with each program. These cash flows can be classified as "given" or "calculated." Given cash flows are generally nonvariable fixed items normally occurring in the first year. Calculated cash flows are variable, related directly to actual or expected loss experience, and continue year after year. In the example under consideration, given cash flows have been defined by the insurance carrier and include basic premium (including taxes), reserve escrows, non-subject premiums, letter of credit costs and standard premium. Calculated cash flows for this example include converted paid losses (including taxes), and incurred loss retro adjustments. Investment income derived from the paid loss program is also a cash flow, but it is implicitly considered when cash flows are discounted to present value. That is, it is not considered as an independent cash flow since the difference between the plans at any point reflects the paid loss reserve advantage and the discount rate develops the interest income.

Since the given cash flows are defined by the insurance carrier, their values are easily obtained. For this example, these values are determined from Table A of Figure 1 and are listed in the appropriate column of the work sheet in Figure 2. Calculated cash flows, on the other hand, must be developed by the insured based on a projected loss experience profile showing expected future losses in terms of loss development and payout. The calculation of this data is largely an actuarial concern. Suffice it to say that the information can be determined from past experience, industry averages, insurance carriers or insurance brokers. Table B of Figure 1 represents the experience profile for this example as determined from historical data.

The first calculated cash flow is converted paid losses (including taxes). These cash flows are based on a payout schedule derived from historical statistics along with a forecast of future loss experience. The source of this information was defined earlier with the derivation of other loss experience data. Converted paid losses are obtained by multiplying appropriate tax multipliers and loss conversion factors by the annual expected paid losses. Table B of Figure 1 illustrates the converted paid losses defined for this example.

The final calculated cash flow is the retro adjustment process associated with the incurred loss plan. The adjustments are directly related to loss experience in terms of loss development. Specifically, data defining the total ultimate incurred losses at various valuation points is needed so that earned premium can be calculated via the retro formula. For this example, the necessary loss development statistics are displayed in Table B of Figure 1.

The retro adjustments are calculated by computing earned premium (using the incurred loss factors) at a particular valuation date (usually 18, 30 or 42 months after policy inception) using the corresponding estimate of ultimate incurred losses. The difference between current earned premiums and those of the prior period is the retro adjustment that must be made. These adjustments could be inflows or outflows. Table C of Figure 1 illustrates this computation for the example under consideration. A reference section is included in the Table to explain the derivation/source of the tabular values. Notice that the adjustments in this example are based on groups of 12 month values, but are credited/payable at 18, 30, 42, 54 and 66 month periods after policy inception. This method was chosen to simplify the presentation, but more accurate results can be obtained by using ultimate incurred loss estimates at the 18, through 66 month period after policy inception.

Once all cash flows have been identified, the second step of the cash flow analysis is to organize them in a manner to reflect the timing of the cash flows. Figure 2 is a possible way of presenting this information. Appropriate references and formulas are included to define the computation process. All of the individual cash flows are listed in the left column and entries are made in the following columns for corresponding cash flows at six month intervals (12 to 66 months). Cash inflows are denoted as positive values (increased resources) while outflows are designated as negative (decreased resources).

The various cash flows are added vertically to obtain a pre-tax cash flow. A 40 percent tax effect is considered for each pre-tax cash flow to obtain an after-tax cash flow. Generally, this effect is considered an inflow since taxes are decreased by this amount, but the first incurred loss adjustment reflects an outflow since excess deductions were claimed in the first year. A relatively conservative tax posture was assumed in this example.

As mentioned earlier, it is difficult to define and identify cash flows. The last step is fairly mechanical, but necessary to properly account for the present value of the after-tax cash flows. Cash flows must be adjusted to reflect values as if all were occurring at today's dollar value. This is accomplished by discounting each after-tax cash flow through the use of present value factors reflective of the age of the cash flow. The sum of these discounted flows is the after-tax net present value. The program with the lowest cost would be the choice. Thus, the incurred loss program would be the recommendation since its after-tax net present value is $103,000 lower than the paid loss program. Notice, however, that the initial $383,000 difference between the plans has now been reduced to about $103,000. This illustrates the investment income opportunity of the paid loss program which cannot be factored until a cash flow analysis is performed.

This example reflects the opposite ends of a spectrum ranging from incurred loss to paid loss retrospective rating plans. In between there are numerous modifications involving payment deferrals, paid loss conversions, loss payment schedules, etc. Although these variations were not illustrated, they are equally adaptable to the cash flow analysis method described above. In general, the types of cash flows associated with these programs do not vary much from those presented in this example. The key difference, however, is in the timing and, sometimes, the amount of the cash flows. Since these differences can be clearly identified, they can easily be factored into the analysis.

When it comes to cost, cash flow analysis or capital, budgeting is the best method of comparing alternative insurance programs, especially when the rating plans involve degrees of cash flow benefits. While the method can be reduced to the selection of the program with the lowest after-tax net present value, the most critical step is the identification of differential cash flows. These cash flows should not only be reflective of payments to be made, but should also consider the timing at which they are made. [Figures 1 to 2 Omitted]

Stephen E. Johnson is a risk manager for Mosler Inc. in Hamilton, OH.
COPYRIGHT 1989 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1989 Gale, Cengage Learning. All rights reserved.

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Author:Johnson, Stephen E.
Publication:Risk Management
Date:Apr 1, 1989
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