Funding Your Pool During Difficult Times: How Payout Patterns and Investment Earnings are Affecting...

Funding Your Pool During Difficult Times:

How Payout Patterns and Investment Earnings are Affecting Your Bottom

Line

Presented by

James Marta CPA, ARPM

James Marta & Company Certified Public Accountants

Accounting, Auditing, Consulting, and Tax

James Marta & Company, CPAs 2

Our current environment Economy Interest rates Benefit costs


How is your JPA facing tough times? Is your pool cutting its

funding margin? Is your discount rate your

using much larger than what you will be earning in the next few years?

Are you returning net assets?

Are your members cutting back on risk management?


Funding Your Claims

In risk financing your learn you can fund claims at different points

Before the loss During the loss After the loss


Risk financing and sharing allows pools to smooth losses

Among members Through fiscal years This smoothes costs over time


Facing declining rates

CalPERS discounts at 7.75% Cuts its rate to 7.50% through vote of the board. It earned 1.1% in 2011 and 1% in 2012


Discounting

Recognizes that you could pay $1 of claims with 80 cents.

Contemplates payout patterns Should contemplate default risk Should only discount the claim liabilities, not assume

future earnings on the entire portfolio.


History of Discounting

Casualty loss and loss adjustment reserves were not discounted except in narrowly defined circumstances.

1986, with tax reform act, IRS prescribed discounting claim liabilities for tax purposes

The National Association of Insurance Commissioners (NAIC) has been opposed to discounting except in specific circumstances


How sensitive is your equity to your discount assumption?

Exhibit 1

Rate 0.0% 1.0% 2.0% 3.0% 3.5% 4.0% 5.0%

Funding needed (M) 81.30$ 75.00$ 69.70$ 65.20$ 63.20$ 61.30$ 58.00$

Equity (M) (37.90)$ (17.90)$ (4.20)$ 4.20$ 8.10$ 10.00$ 13.30$ (M) = Millions


Effect of lower current earning ratesExhibit 2

A B C D EPeriod(s)

1 1.00% 1.00% 1.00% 1.00% 1.00%2 1.00% 1.00% 1.25% 1.50% 2.00%3 2.00% 2.00% 1.75% 2.00% 3.00%4 2.00% 2.00% 2.25% 2.50% 4.00%5 2.00% 3.00% 2.75% 3.00% 5.00%6 3.00% 3.00% 3.25% 3.50% 5.00%7 3.00% 4.00% 3.75% 4.00% 5.00%8 3.00% 4.00% 4.25% 4.50% 5.00%

9-36 8.86% 8.25% 8.16% 7.66% 5.77%

Earnings Rate future pattern

Periods 9-36; rate you must earn over the remaining 27 years to fund claims


Will you ever be able to catch up?


Remaining investment balances

Investment Balances

0

10,000,000

20,000,000

30,000,000

40,000,000

50,000,000

60,000,000

70,000,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37

Years

Per

cen

t

Balance


Payments and Liabilities

Summary of Liabilities and Cummulative Paid

-10,000,00020,000,00030,000,00040,000,00050,000,00060,000,00070,000,00080,000,00090,000,000

Years

Do

llar

s

Cummulative Paid

Liabilities


Investment earningsRolling 3 Year - Yield to Maturity Comparison

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

BAML Government 1-5 Year Index BAML Government 1-10 Year Index BAML Corp/Gov 1-5 Year, A & Above Index

BAML Treas, Current 5 Year BAML Treas, Current 10 Year

Contributed by Martin Castle, Chandler Asset Management


Yields over time

Yield to Maturity

0

2

4

6

8

10

12

Dat

e

12/3

1/88

10/3

1/89

08/3

1/90

06/3

0/91

04/3

0/92

02/2

8/93

12/3

1/93

10/3

1/94

08/3

1/95

06/3

0/96

04/3

0/97

02/2

8/98

12/3

1/98

10/3

1/99

08/3

1/00

06/3

0/01

04/3

0/02

02/2

8/03

12/3

1/03

10/3

1/04

08/3

1/05

06/3

0/06

04/3

0/07

02/2

9/08

12/3

1/08

10/3

1/09

08/3

1/10

06/3

0/11

Yld to Mat

5 year government and corporate note yieldsContributed by Martin Castle, Chandler Asset Management


What have been your recent rates?

Analysis of Investment Earnings

0

1

2

3

4

5

6

7

8

9

2004 2005 2006 2007 2008 2009 2010 2011

Fiscal Year

Per

cen

t

Rate of return incl. change FMV

Rate of return excl. change in FMV


What assumptions should you use?

A. You could average the past 10 years B. Assume yields will improve C. Assume yields will continue to erode D. Assume yields will stay the same. E. Don’t discount your claim liabilities


Financial Statement Affect

Earnings GAAP: if you assume you will earn 5% and you only earn 2% then that difference will hit the financial statements as follows.

you will have less earnings your claim liabilities for the older years will increase.

This is known as “Unwinding of the discount” and gets buried in the claims development.

Everything else being normal, you would have a reduction of net assets


Why discount?

Rewards: Contemplates the time value of

money Allows the pool to efficiently

price claims and coverage Improves stated financial

position Future earnings contribute to the

expected cash flows and claim funding

Competitive rates Attract and maintain members


Why you shouldn’t discount?

Risks: Ruin

You are fired Assessment Increase in rates Decrease in ability to compete Variability Members leave Adverse risk pool Give back money when you shouldn’t Set rates too low Based on assumptions you maintain too

little capital Failure in ability to match rates with costs

on an incurred or accrued basis


Actuary Role


Client picks a rate assumption, the actuary disclaims any opinion on it

Really? How can the actuary disclaim on such an important component of the estimate factors?

Actuary: Well, because we have limited background in finance and investments. And, the same reason that accountants and risk managers do not opine on IBNR reserves.


Actuary provides a range of claim valuations at various discount rates

Starts the discussion Gives you information to value using different

assumptions. You could use this information along with other advisor’s

information.


Actuary recommends a particular discount rate

Industry experience and an understanding of the long-term cash flows.

However, you don’t always have sufficient information on the actual investment portfolio and how the planned investments will affect earnings.

Actuary: we have told clients that their discounts are too high. But no, we cannot pick it for them.


Actuary recommends or uses a risk free rate

Roger G. Ibbotson and Rex. A . Sinqefiled analyzed treasury bills, long-term bonds and corporate notes and found that the inflation adjusted returns: Treasury near zero Long-term government bonds near zero Long-tem corporate notes .5%


Actuary recommends not to discount

Most conservative May be preferred if there are more volatile factors.


Example disclosure

The board has elected to discount claims liabilities at the 3.0% rate. The discounting assumption contemplates that if the value of discounted claim liabilities are invested at the assumed rate, earnings will be sufficient to provide for funding the claims at full value. The current portfolio has been yielding between 1% and 2% and near 1% for new investments. The actual earnings rate may vary from the assumed rate. The chart below shows the claim valuation at different assumptions and the resulting affect on net assets.

Discount Factor 0% 1% 2% 3%

Claims Liabilities 15,031,258 $ 15,020,265 $ 14,007,515 $ 13,152,596 $

Net Asset Balance 7,177,556 $ 7,188,549 $ 8,201,299 $ 9,056,218 $


Should we discount?

Variables: Claim experience Claim cost drivers Legislation Timing of payments Are your claims and

payments predicable enough to throw in another significant variable?


What your auditor might say

We are concerned about the achievability of the discount rate assumptions included in the actuary report.

We will consider the factors and your supporting data when evaluating the interest rate assumptions implicit in the discount rates applied to your claim liabilities.

Changes in these assumptions could be material to your financial statements.

Are your financial statements fairly stated?


Are you putting your pool at risk?

Low rates Dividends Lower confidence levels Is your discount rate achievable?


Conclusions

Remember: be conservative think long-term stability don’t fall behind by

ratcheting down rates overtime

don’t get caught off guard


Questions?

What will you do now?

James Marta CPA, ARPMPrincipal James Marta & CompanyCertified Public Accountants916-993-9494 [email protected] www.jpmcpa.com

Funding Your Pool During Difficult Times: How Payout Patterns and Investment Earnings are Affecting...

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