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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
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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?
James Marta & Company, CPAs 4
Funding Your Claims
In risk financing your learn you can fund claims at different points
Before the loss During the loss After the loss
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Risk financing and sharing allows pools to smooth losses
Among members Through fiscal years This smoothes costs over time
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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
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Discounting
Recognizes that you could pay $1 of claims with 80 cents.
Contemplates payout patterns Should contemplate default risk Should only discount the claim liabilities, not assume
future earnings on the entire portfolio.
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History of Discounting
Casualty loss and loss adjustment reserves were not discounted except in narrowly defined circumstances.
1986, with tax reform act, IRS prescribed discounting claim liabilities for tax purposes
The National Association of Insurance Commissioners (NAIC) has been opposed to discounting except in specific circumstances
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How sensitive is your equity to your discount assumption?
Exhibit 1
Rate 0.0% 1.0% 2.0% 3.0% 3.5% 4.0% 5.0%
Funding needed (M) 81.30$ 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
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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
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Will you ever be able to catch up?
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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
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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
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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
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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
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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
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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
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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
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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
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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
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Actuary Role
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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.
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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.
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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.
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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%
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Actuary recommends not to discount
Most conservative May be preferred if there are more volatile factors.
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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 $
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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?
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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?
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Are you putting your pool at risk?
Low rates Dividends Lower confidence levels Is your discount rate achievable?
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Conclusions
Remember: be conservative think long-term stability don’t fall behind by
ratcheting down rates overtime
don’t get caught off guard
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Questions?
What will you do now?
James Marta CPA, ARPMPrincipal James Marta & CompanyCertified Public Accountants916-993-9494 [email protected] www.jpmcpa.com