Reserve Adequacy, Solvency, and a Large Engineering Risk
Northstar Insurance, a non-life insurer, reports 31 December gross written premiums of P480,000,000. Of that, P120,000,000 was written on 1 October and P60,000,000 on 1 December; the remaining P300,000,000 was written evenly through the year at P25,000,000 per month. Northstar uses the 1/24th method for unearned premium reserve. It carries outstanding loss reserves of P95,000,000 and IBNR of P8,000,000; reinsurance recoverables are P25,000,000 on paid claims and P15,000,000 on outstanding claims. Admitted assets are P1,200,000,000, including P30,000,000 due from agents, of which P18,000,000 is over 90 days. Liabilities other than UPR and loss reserves are P280,000,000. The Insurance Commission's minimum net worth for this insurer is P500,000,000. The board wants to declare a P40,000,000 dividend and accept a P1,000,000,000 engineering risk with a P100,000,000 retention.
1. Compute the UPR under the 1/24th method and the insurer's net worth after non-admitted assets. Show the treatment of reinsurance recoverables.
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1/24th method: for premiums written evenly through the year, the unexpired fractions at 31 December are 1/24 for January, 3/24 for February, ... 23/24 for December. Their sum is 144/24 = 6. The P300,000,000 evenly written therefore produces 25,000,000 × 6 = P150,000,000 of UPR. October 1 writings: 9 months unexpired = 120,000,000 × 9/12 = P90,000,000. December 1 writings: 11 months unexpired = 60,000,000 × 11/12 = P55,000,000. Total UPR = P295,000,000.
Non-admitted assets: P18,000,000 of agents' balances over 90 days are excluded, so admitted assets = P1,200,000,000 − P18,000,000 = P1,182,000,000. Net loss reserves = P95,000,000 + P8,000,000 − P15,000,000 reinsurance recoverable on outstanding = P88,000,000. Total liabilities = UPR P295,000,000 + net loss reserves P88,000,000 + other liabilities P280,000,000 = P663,000,000. Net worth = P1,182,000,000 − P663,000,000 = P519,000,000. (Assumes the P25,000,000 paid-claim recoverable is already included in admitted assets and is collectible.)
2. Assess whether the board can declare the P40M dividend and accept the engineering risk. Consider IBNR adequacy and retention.
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The dividend would reduce net worth from P519M to P479M, below the P500M minimum. A dividend that leaves the insurer below the required net worth should not be declared; the board must preserve capital. The engineering risk is also too large on a P100M retention: a single loss equals about 19% of current net worth, and the P1B limit is nearly twice net worth. Reinsurance is essential, but reinsurance does not eliminate counterparty and liquidity risk. The IBNR of P8M looks thin for a growing book with late-year writings; a P20M strengthening would cut net worth to P499M even before the dividend. The board should: (a) defer the dividend; (b) commission an actuarial review of IBNR; (c) accept the engineering risk only with a much lower retention, facultative or treaty support, and a detailed PML study; and (d) monitor the aggregate CAT exposure.
3. What underwriting and rating conditions should Northstar impose before accepting the engineering risk?
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Before accepting, Northstar should obtain the contractor's design and soil reports, the project schedule, the PML/EML study, and the contractor's loss history. It should check the policy's defects-in-design exclusion and make sure resulting damage is covered only as intended; add testing and commissioning sub-limits, a maintenance/defects liability period exclusion, and a suitable deductible. The rate must load for typhoon, flood, and earthquake and for the long construction period; a rate based only on fire loss costs would be inadequate. Retain only what capital supports; cede the balance through the surplus treaty and, if needed, facultative reinsurance. Include a coinsurance or engineering deductible and progress-report conditions. Finally, set aggregate limits per project and per event, and require the insurer's engineers to inspect at key stages. If the contractor refuses these conditions, decline the risk.