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Loss Portfolio Transfer
LOSS PORTFOLIO TRANSFER by Al Rhodes A loss portfolio transfer (LPT) is one of the few transfers that can be a winning deal for buyer and seller. An LPT allows you to transfer claims to another party for a fixed sum. An LPT program involves past claims, but not future claims, as with a traditional insurance program. The main steps in an LPT are the claims review; actuarial analysis; and accounting for the transferred portfolio. The transaction involves the portfolio value of the liabilities, which is discounted to net present value; the investment value of risk capital; and issues such as administration, accounting, and taxes. SELLER'S ADVANTAGES: Eliminating uncertainty over the cost of losses, pay-out patterns, and interest-rate risks, including unreported losses. Reducing administrative duties. Eliminating accumulated collateral. Freeing up escrow funds used for claims handling from the TPA or the carrier. Seeing a positive effect on the balance sheet. Getting an accelerated tax benefit. SELLER'S DISADVANTAGES: Immediately paying the claim reserves' net-present value may reduce cash flow and investment opportunities if the value of cash increases. Losses may be lower than anticipated. The loss pay-out may be longer than anticipated. The seller may lose control of claims handling. The seller has to pay a fee for transferring the risk and administration. Losses might not be properly accrued or accounted for on current books. BUYER'S ADVANTAGES: The buyer gets a fee and may be able to manage losses and administration better. Losses may be lower than anticipated. The loss pay-out pattern may be longer than anticipated. The transaction could be a relationship builder, bringing additional business from the seller. The buyer might be able to use the cash for better investment opportunities or other uses. The buyer might want to add claims reserves in good years to maintain a rate structure. BUYER'S DISADVANTAGES: The increase in claims reserves binds surplus and must be priced accordingly. Losses may be higher than expected (ultimate claims cost risk). Losses may pay out faster than expected (timing risk). Investment opportunities may not be there for the anticipated period. EVALUATING AN LPT When considering an LPT, it's wise to look at the following components: The value of losses and their pay-out pattern.* The portfolio's net present value or discounted value.* Loss risks that are greater for the buyer or paid out faster by the buyer.* The charges for administration and risk that the buyer assumes. The security of the buyer - whether they'll be around to pay. The value of the risk that the seller transfers. The value of the seller's reduced administration costs. Collateral or escrow funds that may be freed up. How RMLs, state assessments, taxes, and other issues are handled. Accounting of the transaction, tax implications, capital costs, and investment costs for both parties. The aggregate limit, if any.* Who will handle the claims and how this will affect the seller's relationships. * always limited to the attachment point below actual risk transfer of past programs During an LPT transaction, you'll need the following information: Copies of all policies (including excess) and rating plans. The latest rating-plan adjustments. A recent individual claim review detailing whether they include plans for closure or settlement. The most current and accurate loss data - by individual claim and in the aggregate. The most accurate historical loss triangles (loss development) by year for all years in the portfolio and prior years. TPA or carrier averages and industry averages for similar risks. The TPA's or carrier's reserving practices (ultimate or net present value). Any of your company's organizational changes and strategies that may affect claim reserves. Anticipated or actual changes in legal and regulatory issues. Tax and accounting implications. You can get a good handle on the technical aspects of the portfolio by getting a full review for all claims. Make sure that the claims are as accurate as possible and try to bring them to early closure. Track the each plan period's retention level and your insurance or risk transfer attachment points during every stage of the process. Next, you may need to have an actuarial analysis done to estimate the portfolio's ultimate value. Look at several assumptions, including the expected case, the worst case, and the best case scenarios. You'll be getting the market's estimate later, so you'll need this information for comparison. Compare your estimate of the portfolio's worth to your financials. If the price isn't lower than what's on your books, you'll have to justify the deal to your management or show the advantages or disadvantages of a particular accounting method for these losses, including tax implications. Once you have this key benchmark, you can determine the appropriate areas for proposals. Be prepared to identify your program's retention levels, aggregates, insurance and attachment points, and collateral by period. Review all of the components and assumptions in the proposals, and compare them to your own analysis. Question any assumptions you can't rationalize or components that don't apply, especially if they could have a negative effect on the transfer. Also be sure to evaluate the other party thoroughly: What's their ability to pay the claims? What's in the deal for them? The cash is obviously worth more to them, but why? Can they earn more? Will they delay the pay-out to make more money? Will they close claims faster and be able to save money because they can manage the portfolio better? Do they have a tax advantage that you don't? Is there a special purpose vehicle that makes the difference - perhaps an off- shore captive? As you go through the process, ask yourself, "Why can't we do this? or "Why aren't we doing this now?" CONCLUSION When considering an LPT, people look at the value of a block of losses (risk) and discount it to a net present value. An LPT could make sense if the cost is less than the client's net-present-value cost. You also need to consider other factors, such as accelerated tax issues, the value of cash, and pay-out patterns. For more information, check the Internet for broker's sites, contact reinsurers, or check with insurance companies. A number of carriers are willing to quote LPTs. The price and conditions vary widely, so look around for several proposals. Don't take the first one that comes across your desk. Al Rhodes, ACAS, MAAA, is president of SIGMA Actuarial Consulting Group, Nashville, TN. He can be reached at (615) 352-3944, fax (615) 352-7555, or e-mail alrhodes@aol.com.