Proposed Revision of ASOP No. 30 – Profit Margins and Contingency Provisions in Property/Casualty Risk Transfer and Risk Retention

Profit Margins and Contingency Provisions in
Property/Casualty Risk Transfer and Risk Retention

June 2024

TRANSMITTAL MEMORANDUM

TO: Members of Actuarial Organizations Governed by the Standards of Practice of the Actuarial Standards Board and Other Persons Inter­ested in Profit Margins and Contingency Provisions in Property/Casualty Risk Transfer and Risk Retention

FROM: Actuarial Standards Board (ASB)

SUBJECT: Actuarial Standard of Practice No. 30

This document contains the exposure draft of a proposed revision of ASOP No. 30, now titled Profit Margins and Contingency Provisions in Property/Casualty Risk Transfer and Risk Retention. Please review this exposure draft and give the ASB the benefit of your comments and suggestions. Each written comment letter or email received by the comment deadline will receive consideration by the drafting committee and the ASB.

The ASB appreciates comments and suggestions on all areas of this proposed standard. The ASB requests comments be provided using the Comments Template that can be found here and submitted electronically to comments@actuary.org. Include the phrase “ASOP No. 30 COMMENTS” in the subject line of your message. Also, please indicate in the template whether your comments are being submitted on your own behalf or on behalf of a company.

The ASB posts all signed comments received on its website to encourage transparency and dialogue. Comments received after the deadline may not be considered. Anonymous comments will not be considered by the ASB nor posted on the website. Comments will be posted in the order that they are received. The ASB disclaims any responsibility for the content of the comments, which are solely the responsibility of those who submit them.

Deadline for receipt of comments: November 1, 2024

History of the Standard

The current standard took effect in July 1997 and was updated for deviation language in May 2011. While the scope of the current standard includes risk retention (self-insurance), the purpose focuses on estimating the cost of capital and evaluating underwriting profit and contingency provisions. The current standard distinguishes contingency provisions from profit provisions. Sections 3.1–3.6 provide guidance on profit provisions for risk transfer between unrelated entities (insurer and insured), with all estimates of future costs based on expected future values, and where an underwriting profit provision, expected investment income from insurance operations, and expected investment income on capital will separately contribute to the insurer’s total return on capital. This distinction between underwriting income and investment income evolved historically in U.S. statutory financial reporting for property and casualty insurers and is commonly used when a given state’s rating laws or regulations are applicable.

State rate regulation typically does not apply to property and casualty coverage provided by reinsurers, excess or surplus lines insurers, self-insurance arrangements, or captive insurers. Certain pools, associations, or government entities provide specialized property and casualty coverage using rates that may or may not be regulated. The current standard acknowledges that “evaluation of whether the cost of capital is appropriately recognized does not necessarily require these distinctions.” To perform actuarial services in such other circumstances, including treatment of profit margins, risk margins, or contingency provisions, an actuary must apply judgment more broadly than the current guidance in ASOP No. 30.

In addition, actuarial modeling techniques have evolved significantly since the standard took effect, and it is now common in some contexts to include explicit or implicit risk margins in the future cost estimation process. ASOP No. 30 currently requires the actuary to use expected future values for every component of an actuarially determined rate. If the actuary uses a different intended measure to meet legal or regulatory requirements, the actuary should “disclose any material difference between the rate so developed and the actuarially determined rate to the client or employer.” ASOP No. 53, Estimating Future Costs for Prospective Property/Casualty Risk Transfer and Risk Retention, which took effect in 2018, directs the actuary to determine the intended measure of the future cost estimate based on the purpose or use of the estimate and disclose the intended measure in an appropriate actuarial communication.

This proposed revision of ASOP No. 30 allows ASOP No. 53 to govern with respect to appropriate intended measures.

Notable Changes from the Existing Standard

Notable changes from the existing standard are below. Notable changes are changes other than those made to improve readability, clarity, or consistency.

1. In section 1.2, the scope was broadened from estimating the cost of capital and evaluating the underwriting profit and contingency provisions to developing overall profit margins and contingency provisions.
2. In section 2, definitions of profit margin, risk margin, risk retention, and risk transfer were added, and several definitions were deleted. In addition, the difference between a profit margin and a contingency provision was clarified.
3. Sections 2.5 and 3.3 make it clear that guidance regarding development, review, or evaluation of underwriting profit provisions is included in the larger context of overall profit margins.
4. Section 3.3 clarifies that the profit margin may be reflected in multiple components of the future cost estimate, including in risk margins in the provisions for loss and loss adjustment expenses, in other risk margins, and in the underwriting profit provision.
5. In section 3.3, the guidance clarifies that the cost of capital is to be taken into account when developing the profit margin.
6. In section 3.3.5, references to ASOPs No. 7, Analysis of Life, Health, or Property/Casualty Insurer Cash Flows, and No. 20, Discounting of Property/Casualty Claim Estimates, were added for guidance when selecting appropriate investment income assumptions.
7. In section 3.4, guidance regarding reliance on another party was added.
8. In section 3.5, the documentation section was updated to coordinate with ASOP No. 41 rather than the repealed ASOP No. 9.
9. Section 4 was expanded to align with the new guidance in section 3.

Request for Comments

The ASB appreciates comments and suggestions on all areas of this proposed standard submitted through the Comments Template. Rationale and recommended wording for any suggested changes would be helpful.

In addition, the ASB would like to draw the readers’ attention to the following questions:

1. Are the distinctions and relationships among contingency provision, risk margin, underwriting profit margin, and profit margin clear? If not, please explain and suggest language.
2. In the context of a contingency provision (both in the definition in section 2.2 and the guidance in section 3.2), is the difference between modeled expected losses and actual expected losses clear? If not, please explain and suggest language.
3. Is the level of disclosure required appropriate?

The ASB voted in June 2024 to approve this draft for exposure.

 

ASOP No. 30 Task Force
Mary Frances Miller, Chairperson
David E. Heppen	Robert J. Walling
Joyce A. Hwu	Robert F. Wolf
Margaret Tiller Sherwood

 

Casualty Committee of the ASB
Gordon K. Hay, Chairperson
Stacey C. Gotham	Norman Niami
David E. Heppen	Margaret Tiller Sherwood
Michelle L. Iarkowski	Jane C. Taylor
Daniel A. Linton	Geoffrey T. Werner

 

Actuarial Standards Board
Kevin M. Dyke, Chairperson
Laura A. Hanson	Gabriel R. Schminovich
Richard A. Lassow	Judy K. Stromback
David E. Neve	Alisa L. Swann
Christopher F. Noble	Patrick B. Woods

 

The Actuarial Standards Board (ASB) sets standards for appropriate actuarial practice in the United States through the development and promulgation of Actuarial Standards of Practice (ASOPs). These ASOPs describe the procedures an actuary should follow when performing actuarial services and identify what the actuary should disclose when communicating the results of those services.

 

PROPOSED REVISION OF 

ACTUARIAL STANDARD OF PRACTICE NO. 30

PROFIT MARGINS AND CONTINGENCY PROVISIONS IN PROPERTY/CASUALTY RISK TRANSFER AND RISK RETENTION

STANDARD OF PRACTICE

 

Section 1: Purpose, Scope, Cross References, and Effective Date

1.1 Purpose

This actuarial stan­dard of practice (ASOP or standard) provides guidance to actuaries when performing actuarial services with respect to developing or reviewing profit margins and contingency provisions that are included in future cost estimates for all forms of property/casualty risk transfer and risk retention.

1.2 Scope

This standard applies to actuaries when performing actuarial services with respect to developing or reviewing profit margins and contingency provisions that are included in future cost estimates for all forms of prospective property/casualty risk transfer and risk retention.

ASOP No. 53, Estimating Future Costs for Prospective Property/Casualty Risk Transfer and Risk Retention, ASOP No. 7, Analysis of Life, Health, or Property/ Casualty Insurer Cash Flows, and ASOP No. 20, Discounting of Property/Casualty Claim Estimates, provide guidance that may be helpful to the actuary when developing or reviewing profit margins and contingency provisions and the cost of capital associated with future cost estimates for prospective property/casualty risk transfer and risk retention.

If the actuary determines that the guidance in this standard conflicts with ASOP Nos. 7, 20, or 53, this standard governs.

If the actuary determines that the guidance in this standard conflicts with an ASOP that applies to all practice areas, this standard governs.

If the actuary is performing actuarial services that involve reviewing profit margins and contingency provisions, the actuary should follow the guidance in this standard to the extent practicable within the scope of the actuary’s assignment.

If a conflict exists between this standard and applicable law (statutes, regulations, and other legally binding authority), the actuary should comply with applicable law. If the actuary departs from the guidance set forth in this standard in order to comply with applicable law, or for any other reason the actuary deems appropriate, the actuary should refer to section 4.

1.3 Cross References

When this standard refers to the provisions of other documents, the reference includes the referenced documents as they may be amended or restated in the future, and any successor to them, by whatever name called. If any amended or restated document differs materially from the originally referenced document, the actuary should follow the guidance in this standard to the extent it is applicable and appropriate.

1.4 Effective Date

This standard is effective for future cost estimates developed or reviewed on or after four months after adoption by the Actuarial Standards Board.

Section 2: Definitions

The terms below are defined for use in this standard and appear in bold throughout the ASOP. The actuary should also refer to ASOP No. 1, Introductory Actuarial Standard of Practice, for definitions and discussions of common terms, which do not appear in bold in this standard.

2.1 Capital

The funds intended to assure payment of obligations from risk transfer or risk retention, in excess of the funds backing the liabilities.

2.2 Contingency Provision

A provision for the difference between the actuary’s modeled expected losses and the actual expected losses that cannot be eliminated by changes in other components of the ratemaking process. A contingency provision is a component of the expected losses and is therefore not expected to be earned as profit.

2.3 Cost of Capital

The rate of return that capital could be expected to earn in alternative investments of equivalent risk; also known as opportunity cost.

2.4 Investment Income

Proceeds (other than the return of principal) derived from the investment of assets, minus investment expenses.

2.5 Profit Margin

The difference between all expected cash inflows and all expected cash outflows in the future cost estimate of the risk transfer or risk retention. The profit margin is also equal to the underwriting profit margin, plus the provision for investment income, less expected income taxes, plus any risk margins in the future cost estimate. Profit margin is also known as total return.

2.6 Risk Margin

A provision that reflects the risk that future cash flows will deviate from expected cash flows associated with a risk transfer or risk retention. A risk margin is typically not a component of the expected losses and is therefore expected to be earned as profit. A risk margin may be implicit or explicit. A risk margin is sometimes referred to as a risk load.

2.7 Risk Retention

A risk-management and risk-control strategy for the assessment, management, or financing of retained risk associated with the specific coverage. Examples of risk retention include individual and group self-insurance, and large deductible programs.

2.8 Risk Transfer

A risk-management and risk-control strategy, involving legally binding agreements, that shifts responsibility from one party to another or indemnifies one party by another party for the financial obligations associated with the coverage. Examples of risk transfer include insurance, reinsurance, and loss portfolio transfers.

2.9 Underwriting Profit Margin

An explicit provision for profit in the future cost estimate. An underwriting profit margin may be referred to as an underwriting profit provision in certain contexts.

Section 3: Analysis of Issues and Recommended Practices

3.1 Overview

Profit margins, contingency provisions, and the cost of capital are used by actuaries when developing or reviewing future cost estimates for property/casualty risk transfer or risk retention. The profit margin includes the provision for the cost of capital. A contingency provision, if appropriate, is a component of the expected losses and is not part of the profit margin.

3.2 Contingency Provision

If the actuary reasonably believes that there is a material difference between the modeled expected losses and the actual expected losses that cannot practicably be eliminated by changes in other components of the future cost estimate process, the actuary should include a contingency provision in the future cost estimate. For example, in the event the modeled expected losses do not adequately capture the tail of the loss distribution, a contingency provision may be appropriate.

3.3 Profit Margin

The actuary should include an appropriate profit margin in the future cost estimate associated with the risk retention or risk transfer. When providing for the profit margin, the actuary should take into account the relationship between risk and return, the cost of capital, the intended measure for the future cost estimate, and characteristics of the risk transfer or risk retention. These characteristics may include insurance risk, investment risk, inflation risk, and regulatory risk, as well as diversi­fication, debt structure, leverage, reinsurance, market structure, and other relevant aspects of the social, economic, and legal environments.

3.3.1 Development of the Profit Margin

When developing the profit margin, the actuary may use any appropriate method that is consistent with the guidance in this standard and should take into account the following as appropriate:

1. 1. the intended use of the future cost estimate;
   2. the structure of the risk transfer or risk retention, including features such as deductibles, limits, insured response behaviors (such as take-up rates and persistency), dividend or return of premium plans, or reinsurance;
   3. the type of entity that is accepting the risk transfer or retaining the risk, such as a commercial insurance company, government insurance program, risk pool, or self-insurance program; a for-profit vs. nonprofit entity; or a publicly traded vs. privately held entity;
   4. the amount of capital, whether available, allocated, or notional;
   5. the risk tolerance of the entity that is accepting the risk transfer or retaining the risk;
   6. the legal and regulatory environment; and
   7. any risk margins included in the overall calculation.

3.3.2 Profit Margin Components

The actuary should ensure that the total profit margin is appropriate for the intended use. When doing so, the actuary should identify and evaluate the components of the profit margin included in the future cost estimate, including any explicit or implicit risk margins, the underwriting profit margin, expected investment income and expected income taxes.

3.3.3 Benchmarking Cost of Capital

When the actuary uses cost of capital to develop the profit margin, the actuary may benchmark against other entities or industries. When doing so, the actuary should make any necessary adjustments so that the costs of capital developed under different accounting rules can be properly compared.

3.3.4 Use of Projected Future Costs

When developing cost of capital, investment income, income taxes, cash flows, leverage factors, and other assumptions used for the profit margin, the actuary should base estimates on projected future costs relating to the prospective period of time to which the future cost estimate applies, which may differ from historical costs.

3.3.5 Investment Income

When developing the profit margin, the actuary should take into account both investment income from the cash flows related to the risk transfer or risk retention and investment income on any capital supporting the transaction. The actuary should refer to ASOP Nos. 7 and 20 for guidance in selecting appropriate investment income assumptions.

3.3.6 Income Taxes

When developing the profit margin, the actuary should take into account the effect of income taxes.

3.3.7 Use of Basis

The actuary may use any appropriate basis to present the profit margin or its components, such as a per­centage of capital, a percentage of assets, or a percentage of premium.

3.4 Reliance on Another Party

When relying on another party and thereby disclaiming responsibility

1. for data and other information relevant to the use of data, the actuary should refer to ASOP No. 23, Data Quality.
2. for a model, the actuary should refer to ASOP No. 56, Modeling.
3. for assumptions and methods prescribed by another party, the actuary should review the assumption or method for reasonableness and consistency to the extent practicable and appropriate within the scope of the actuary’s assignment.
4. for assumptions and methods not prescribed by another party, or for any other item not addressed above, the actuary should review the item for reasonableness and consistency to the extent practicable and appropriate within the scope of the actuary’s assignment. In addition, the actuary should be reasonably satisfied that the reliance is appropriate, taking into account the following, as applicable:

1. 1. when the other party is an actuary, whether the actuary knows that the other party is appropriately qualified and has followed applicable ASOPs;
   2. whether the actuary knows that the other party has expertise in the applicable field;
   3. whether the actuary knows the other party’s stated purpose for the item and the extent to which it is consistent with the actuary’s intended purpose; and
   4. whether the actuary knows of differences of opinion within the other party’s field of expertise that are material to the actuary’s use of the item.

3.5 Documentation

The actuary should prepare and retain documentation to support compliance with the requirements of section 3 and the disclosure requirements of section 4. The actuary should prepare such documentation in a form such that another actuary qualified in the same practice area could assess the reasonableness of the actuary’s work. The amount, form, and detail of such documentation should be based on the professional judgment of the actuary and may vary with the complexity and purpose of the actuarial services. In addition, the actuary should refer to ASOP No. 41, Actuarial Communications, for guidance related to the retention of file material other than that which is to be disclosed under section 4.

Section 4: Communications and Disclosures

4.1 Required Disclosures in an Actuarial Report

When issuing an actuarial report, the actuary should refer to ASOP Nos. 7, 20, 23, 41, 53, and 56. In addition, the actuary should disclose the following in such actuarial reports:

1. a description of and the rationale for any contingency provision (section 3.2);
2. the intended use of the future cost estimate (section 3.3.1);
3. the methodology and assumptions used in determining the profit margin (section 3.3, 3.3.1, 3.3.2, and 3.3.4);
4. any investment income assumptions reflected in the profit margin (section 3.3.5);
5. any income tax assumptions reflected in the profit margin (section 3.3.6);
6. the basis or bases for the profit margin or its components (section 3.3.7); and
7. any reliance on information provided by another party (section 3.4).

4.2 Additional Disclosures in an Actuarial Report

The actuary also should include disclosures in an actuarial report in accordance with ASOP No. 41 for any of the following circumstances:

1. if any material assumption or method was prescribed by applicable law;
2. if the actuary states reliance on other sources and thereby disclaims responsibility for any material assumption or method selected by a party other than the actuary; or
3. if in the actuary’s professional judgment, the actuary has deviated materially from the guidance of this standard.

4.3 Confidential Information

Nothing in this standard is intended to require the actuary to disclose confidential information.

Appendix

Background and Current Practices

Note: This appendix is provided for informational purposes and is not part of the standard of practice.

Background

Historical Procedures

Until the 1970s, it was common practice to include in rate calculations a standard underwriting profit and contingency provision of 2.5% for workers compensation insurance and 5% for other property/casualty lines of insurance (6% for some property lines). These provisions did not ex­plicitly reflect investment income, since there was general agree­ment at the time that these standard provisions implicitly reflected investment income and insur­ance risk in a reasonable fashion. However, economic and structural changes in the insurance industry over time began to lead to the explicit recognition of in­vestment income in calculating insurance rates.

In 1997, ASOP No. 30 was adopted to address a number of considerations that arise in the development of profit provisions and separate contingencies provisions:

1. how to measure risk and reflect it in the underwriting profit provision;
2. how or whether to measure any systematic variation from expected losses and reflect it in the contingency provision;
3. which accounting rules should be used to measure insurance returns and to compare them with returns in other industries;
4. how or whether to allocate investment income and capital; and
5. how to relate underwriting profit provisions in rates to the cost of capital.

The growth of risk financing mechanisms that are alternatives to rate regulated insurance, such as risk retention, captive insurance, pools, and associations, have required different approaches. Available capital, risk tolerance, and risk financing goals differ significantly across the spectrum of risk-transfer and risk-retention mechanisms.

Role of Capital

The primary role of capital in risk transfer and risk retention is to assure payment of future costs, over and above those funds backing the liabilities.

Capital has a value, even if the capital is notional, and its use has a cost. The cost is the expected return the capital could earn in alternative investments of equivalent risk. Judicial decisions dealing with the cost of capital and profit margins (see, for example, Federal Power Commission v. Hope Natural Gas, 320 U.S. 591 [1944]) provide background and definitions for the determination of the cost of capital in a regulatory setting. Outside a regulatory setting, the determination of the amount and return on capital is influenced by the type of risk transfer or risk retention and the goals and risk tolerance of the entity receiving or retaining the risk.

Role of The Profit Margin

The profit margin, which may be reflected in various components of the future cost estimate, provides the risk taker with an expected total return.

Role of The Contingency Provision

A common assumption underlying property/casualty insurance ratemaking is that the modeled expected losses included in the rate calculations will equal the actual expected losses. If not, then this difference may be incorporated in the future cost estimate by including a contingency provision.

Current Practices

A method commonly used to develop or test the profit margin in insurance rates is to estimate the cost of capital and translate that cost into a profit margin. Profit margins can also be developed using models that do not directly relate the cost of capital to the profit margin. A profit margin may or may not include an explicit underwriting profit margin. This is particularly true, for example, in funding studies that are targeted to provide funding at a specified percentile of the loss distribution, which reflects a risk margin as a component of the profit margin.

A contingency provision may be included in the future cost estimate, for example, when the modeled expected losses do not adequately capture the tail of the loss distribution in the future cost estimate, resulting in a high level of uncertainty around the actual expected losses.