Strategic Planning for Captive GrowthA Capital Modelling Perspective

Strategic Planning for Captive Growth

Speakers:

• William Montanez, Director, Risk Management, Ace Hardware

• Jeff Doffing, Director & Actuary, Aon Risk Consulting

• Jim McNichols, Risk Modeling Actuary, Aon Risk Consulting

Moderator:

• Robert Paton, Executive VP, Aon Captive Managers

Strategic Planning for Captive Growth

Ace Hardware Corporation (Ace)

– Founded in Chicago (1924) by local hardware store owners to leverage group purchasing power

– Current Corporate Headquarters in Oak Brook, Illinois• Established Ace Insurance Agency in 1981• Formed Bermuda based captive in 1996

– Largest retailer-owned hardware cooperative in the industry– Each store is independently owned by local entrepreneurs– 4,400 Retailer owned & operated stores worldwide– 4,100 US based locations

Strategic Planning for Captive Growth

Captive Background for New Age Insurance, Ltd (“NAIL”)

– Formed by Ace Hardware in 1996 as a Class 3 (re)insurer with $1 million of capital and several strategic objectives:

• Achieve long term insurance cost savings• Stabilize insurance expenses for corporate and retail• Minimize administrative and operating costs• Attain efficient funding levels for retained risk• Enhance coverage options for retail operations• Increase retail risk program market penetration

Strategic Planning for Captive Growth

• Captive (NAIL) Profile and Performance

– Underwrites WC/GL/Auto/Property exposures (related risk & 3rd party) at varying retentions averaging $500,000/occ.

• 2009 Gross/Net Written Premium = $12.5 MM/10.5 MM• 2000-2009 Average Loss & ALAE ratio = 70%• 2000-2009 Average Expense ratio = 15%• 2009 Year End Loss & ALAE Reserves = $21.0 MM• 2009 Year End Capital & Surplus = $24 MM

Basic Financial Diagnostics

Basic Financial Diagnostics

Basic Financial Diagnostics

Basic Financial Diagnostics

Capital Requirements - Regulatory• Bermuda Statutory Capital / Surplus Requirements

– Requisite statutory capital and surplus must exceed the greater of A or B or C

• A) Class 3 Minimum => $1,000,000• B) Premium Level Test (20% / 5:1) => $2,000,000• C) Loss Reserve Level Test (15% / 6.7:1) => $3,000,000

NAIL Statutory capital & surplus @12/31/2009 = $24,000,000

Bermuda Regulatory Excess Statutory Surplus = $21,000,000

Capital Requirements - Regulatory

Premium to Surplus RatioThe ratio of net written premiums to total capital and surplus has decreased from 2005 to 2009. Bermuda

allows up to a 5:1 ratio. A 2:1 ratio is considered conservative. This measure indicates that NAIL has significant underwriting capacity available. At a 2:1 ratio, NAIL could write an additional $37.1mm of

premium.

The ratio of net written premiums to total capital and surplus has decreased from 2005 to 2009. Bermuda

allows up to a 5:1 ratio. A 2:1 ratio is considered conservative. This measure indicates that NAIL has significant underwriting capacity available. At a 2:1 ratio, NAIL could write an additional $37.1mm of

premium.

Capital Requirements - Regulatory

Reserves to Surplus Ratio

The ratio of loss & ALAE reserves to total capital and surplus has continued to decrease. This measures the degree to which surplus would be impaired if loss & ALAE reserves are undervalued due to inflation or other factors. A typical range is 2:1 to 4:1, so NAIL is now significantly below that range.

The ratio of loss & ALAE reserves to total capital and surplus has continued to decrease. This measures the degree to which surplus would be impaired if loss & ALAE reserves are undervalued due to inflation or other factors. A typical range is 2:1 to 4:1, so NAIL is now significantly below that range.

Historical Underwriting Variability

Historical Loss Reserve Variability

Historical Asset (Bonds & Equities) Variability

Capital Requirements – Liquidation Scenario

NAIL RISK PROFILE*

CONFIDENCE LEVELEXPECTED 65% 70% 95% 99%

(A) EST. RESERVE @ 9/30/09 $18.7 $20.4 $21.9 $34.9 $39.3(B) EST. RESERVE SURPLUS $3.2 $1.4 $0.0 ($13.1) ($17.4)(C) NAIL EQUITY @ 10/31/09 $23.8 $23.8 $23.8 $23.8 $23.8

LIQUIDATION SCENARIO(D) AFTER TAX RESERVE SURPLUS $2.1 $0.9 $0.0 ($8.6) ($11.5)(E) EQUITY LIQUIDATION VALUE $25.9 $24.7 $23.8 $15.2 $12.3

Capital Requirements

• Financial Statement Statutory Surplus = $24,000,000

• Bermuda Regulatory Excess Statutory Surplus = $21,000,000

• Liquidation Scenario Excess Surplus = $12,300,000

Capital Requirements – Risk Based

• Economic Capital/Dynamic Risk Capital/Solvency II Capital– All these terms denote risk based capital approaches which

are designed to better capture the inherent effects from more extreme / Black Swan events. Recent examples would include:

• Mortgage CDO induced banking credit crisis• New Zealand earthquake• Australian & Mississippi floods• Japan earthquake/tsunami/nuclear fallout• Commodities market price bubble• Alabama & Missouri tornados

Capital Requirements – Risk Based

• Economic Capital Modeling– Requires dynamic risk modeling techniques to analyze all

of the key risk exposures, namely;

• Underwriting risk (i.e., in-force premium risk)• Reserve variability (i.e., prior years reserve changes)• Interest rate (primarily within the investment portfolio)• Credit risk (corporate bonds & reinsurance recoverable)• Equity investment volatility (including F/X risks)

Capital Requirements – Risk Based

• Economic Capital Modeling Perspective– 1 year forward time horizon– 1:200 stress level events

Underwriting Risk (Example)• Frequency • Severity • Aggregate claims distribution• Stochastic (i.e., Monte Carlo) simulated outcomes• Stress level thresholds (e.g., Black Swans)• Economic capital contribution

Underwriting Risk – Example (Corp WC-Only)Stochastic Simulation (aka Monte Carlo)

Underwriting Risk – Example (Corp WC-Only)

Monte Carlo Direct Net

Mean 3,246,900 2,997,000

5.0% 1,087,400 1,083,600

15.0% 1,579,700 1,539,700

25.0% 1,977,300 1,910,400

35.0% 2,348,000 2,234,400

45.0% 2,724,200 2,550,200

55.0% 3,130,200 2,916,600

65.0% 3,576,500 3,294,400

75.0% 4,099,400 3,767,600

85.0% 4,938,000 4,444,200

95.0% 6,597,700 5,947,300

98.0% 7,849,600 6,935,200

99.0% 9,154,800 7,973,800

99.5% 9,750,400 8,800,000

Underwriting Risk – Example (Corp WC-Only)

Net

99.5th Percentile Losses 8,800,000

Expected Earned Premium (3,500,000)

Required Risk Capital 5,300,000

Capital Requirements – Risk Based• Economic Capital Modeling Results (U/W Risk variable only)

– Stochastic Simulation of each LOB variable at 1:200 stress

• Work Comp - Corp $ 5.3 MM• Work Comp - Retail 2.1 MM• Gen Liab. - Corp & Retail 1.6 MM• Auto Liab. - Corp & Retail 1.0 MM• Auto PD - Corp & Retail 0.5 MM• Retail Property 2.0 MM• Sum $12.5 MM

Required Economic Capital => $ 8.5 MM** does not equal the sum of the parts due to portfolio effects

Capital Requirements – Risk Based

• Economic Capital Modeling Results (All 5 key risk variables)– Stochastic Simulation at 1:200 stress, 1 yr time horizon

• Underwriting Risk $ 8.5 MM• Reserve Variability 2.0 MM• Interest Rate 3.5 MM• Credit Risk 0.5 MM• Equity Volatility 2.5 MM• Sum $17.0 MM

Required Economic Capital => $14.0 MM* * does not equal the sum of the parts due to portfolio effects

Capital Requirements

• Financial Statement Statutory Surplus = $24,000,000

• Bermuda Regulatory Excess Statutory Surplus = $21,000,000

• Liquidation Scenario Excess Surplus = $12,300,000

• Risk Modeling Based Excess Surplus = $10,000,000

Capital Requirements – Rating AgencyA.M. Best – Best Capital Adequacy Ratio (BCAR) Capital Adequacy Ratio Estimation

B1 Fixed Income Securities 600,000B2 Equity Securities 1,500,000B3 Interest Rate 250,000B4 Credit 200,000B5 Loss & LAE Reserves 5,000,000B6 Net Premiums Written 3,000,000B7 Business Risk -

Unadjusted Required Capital (Sum B1=>B7) 10,550,000Covariance Adjustment (i.e., Portfolio Effect) (4,150,000)Net Required Capital (“NRC”) 6,400,000

Reported Surplus 14,000,000Loss Reserve Equity 2,000,000Adjusted P/H Surplus (“APHS”) 16,000,000

Capital Adequacy Ratio [APHS/NRC] = 2.50

Capital Requirements – Rating Agency

A.M. Best – Best Capital Adequacy Ratio (BCAR)

Capital Adequacy Scale (2009)

RATING MINIMUM SCORE MEDIAN SCORE

A++ 1.75 2.65A+ 1.60 2.60A 1.45 2.50A- 1.30 2.25B++ 1.15 2.00B+ 1.00 1.70

XS Capital Employment Options

• Risk capital DRM analyses demonstrated that NAIL is carrying approximately $10 million in “excess” Capital/Surplus

• ACE/NAIL are considering three strategic growth options

1. Providing additional property coverage to the 350 retailers located in coastal properties.

2. Increasing third party participation from all retailers by lowering BOP rates 10%.

3. Writing Umbrella Excess Coverage for retailers.

XS Capital Employment Options

1. Providing additional property coverage to the 350 retailers located in coastal properties

Incremental Increase in Earned Premium = $3.5 MM

Expected Loss & ALAE = $1.4MM

Expected Underwriting Gain/(Loss) = $2.1 MM

(i.e., Expected U/W Loss Ratio = 40%)

1:200 Adverse Cat Loss & ALAE Projection = $13.5 MM

DRM estimated Capital Charge* = $10.0 MM

* On a stand alone basis – before any reduction from portfolio effect

XS Capital Employment Options

2. Increasing third party participation by all retailers by lowering BOP rates by 10%

Incremental Increase in Earned Premium = $2.5 MM

Expected Loss & ALAE = $2.0 MM

Expected Underwriting Gain/(Loss) = $0.5 MM

(i.e., Expected U/W Loss Ratio = 80%)

1:200 Adverse Loss & ALAE Projection = $4.5 MM

DRM estimated Capital Charge* = $2.0 MM

* On a stand alone basis – before any reduction from portfolio effect

XS Capital Employment Options

3. Writing Umbrella Excess Coverage for retailers

Incremental Increase in Earned Premium = $1.0 MM

Expected Loss & ALAE = $0.1 MM

Expected Underwriting Gain/(Loss) = $0.9 MM

(i.e., Expected Loss Ratio = 10%)

1:200 Adverse Cat Loss Projection = $8.0 MM

DRM estimated Capital Charge* = $7.0 MM

* On a stand alone basis – before any reduction from portfolio effect

XS Capital Employment: $10mm available Capital

Retailer Growth Option

Premium Growth Estimate

Expected U/W Gain

Relative Capital Charge

Business Considerations

Underwrite Coastal Coverage

$3.5 mm $2.1mm $10.0mm • Represents 9% of total stores• Reduce political distractions• Improve cross selling opps.

10% BOP Rate Decrease

$2.5mm $0.5mm $2.0mm • Service more Ace retailers• Provides more pricing flexibility• Minimal capital usage allows for additional captive expansion

Underwrite Umbrella Coverage

$1.0mm $0.9mm $7.0mm • Reduce subsidy of 3rd parties• Customize coverage• Overall program pricing flexibility