1
Finite Reinsurance
Casualty Loss Reserve Seminar
Chicago, IL
September 9, 2003
Bruce D. Fell, FCAS, MAAA, CFA
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Disclaimer
• The views expressed in this presentation are those of the individual presenters and in no way represent the opinions of the CAS, the Joint Committee of the CLRS, or the presenters’ respective employers.
• The presenters take full responsibility for all irrational, incoherent and foolish comments.
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Agenda
• Current Market Environment
• Overview of Finite Structures
• Overview of SFAS No. 113 and Statutory Issue Paper No. 75
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Current Market Environment• Interest Rate Environment
• Underwriting Environment
• Heightened Regulatory Environment
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Interest Rate Environment
• Rates have dropped dramatically in last five years
• Time value of money changes dynamics of some transactions
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Underwriting Environment
• Focus on underwriting profit after years of soft market and Sept. 11, 2001
• Fewer finite reinsurers
Exits – Centre, Commerical Risk, Gerling, OPL, Scandinavian, Stockton
Refocus – Am Re, Gen Re, St. Paul
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Underwriting Environment
• Focus on correlation and aggregationRisks previously assumed to be
independent now recognized as correlated (lesson learned from Sept. 11, 2001)
Natural catastrophe aggregations
• Focus on credit riskCedents focus on quality of reinsurers
Reinsurers focus on quality of cedents
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Underwriting Environment
• Constrained Capacity
Reserve charges from 9/11, soft market and latent exposures have depleted capital
Focus limited capital on best profit potential
Increased premium + fewer companies = increased capital leverage
Supply and demand increases cost of capital
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Heightened Regulatory Environment
• Rating agencies – capital levels and underwriting profit
• Auditors – increased disclosures and “truth in reporting”
• Stock analysts – redemption from “technology bubble”
• State regulators – debate over federal versus state regulation
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Finite Structures
• Retroactive ReinsuranceLoss Portfolio Transfer (LPT)
Adverse Loss Development Cover (ALDC)
• Prospective ReinsuranceFinite Quota Share
Aggregate Excess of Loss (Stop Loss)
Traditional contracts with “finite” features
Combination of coverage
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Common Contract Provisions• Experience accounts
• Profit commissions
• Aggregate limits
• Loss ratio corridors
• Cancellation provisions
• Delays in payments
• Adjustable premium, limit or commission
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LPTs & ALDCs
• Reinsurer accepts ceding company’s reserve uncertainty in exchange for a fixed premium
• Pricing based on:Reserve level
Expected payment pattern of reserves
Variability of reserves and payment pattern
Expected interest rate
Reinsurer’s capital costs and risk margin
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LPTs & ALDCs
0
25
50
75
100
125
150
Carried Reserves LPT ALDC
ReinsuredRetained
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Loss Portfolio Transfer
• Contract provisionsAggregate limitExperience account refundsCommutation provisions
• Benefits“Transfer” existing reserves to
reinsurer (reduce reserve leverage)May protect from adverse developmentEstablish “fixed” current price for
uncertain future reserves
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Loss Portfolio Transfer Example• Premium = $120 million
• Limit = $150 million
• Reinsurer’s Margin = 3% ($3.6 million)
• Crediting Interest Rate = 2.0%
• Experience account refund @ commutation =Premium - Margin - Losses + Interest
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Adverse Loss Development
• Contract provisionsAggregate limit
Possible experience account refunds
Commutation provisions
• BenefitsProtection from adverse development
Establish “fixed” current price for uncertain future reserves
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Adverse Loss Development Example
• Premium = $40 million
• Limit = $50 million excess of $100 million
• Reinsurer’s margin = 5% ($2.0 million)
• Crediting Interest Rate = 2.5%
• Experience account refund @ commutation =Premium - Margin - Losses + Interest
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Finite Quota Share
• Reinsurer accepts percentage of cedent’s premiums and losses in exchange for ceding commission
• Contract Provisions
Sliding scale commission
Loss ratio corridor
Aggregate limit
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Finite Quota Share
• Pricing based on:Expected loss ratio
Size of slide, corridor and aggregate limit
Reinsurer’s capital charge
• BenefitsSurplus relief from ceding commission
“Transfer” premium to reinsurer (reduce premium leverage)
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Finite Quota Share Example• Provisional ceding commission =
35% minimum = 25% @ 70% loss ratiomaximum = 40% @ 55% loss ratio
• Loss corridor between 70% and 75% loss ratio
• Reinsurer’s margin = 5% between 55% loss ratio and 75% loss ratio
• Aggregate Limit = 100% loss ratio
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50% Finite Quota Share Example
0
10
20
30
40
50
60
70
80
90
100
Retained Reinsured
Los
s Rat
io
SlideReinsuredRetained
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Aggregate Excess of Loss
• Reinsurer provides corridor of protection over cedent’s expected results in exchange for fixed premium
• Contract Provisions
Aggregate limit
Experience account refunds
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Aggregate Excess of Loss
• Pricing based on:
Expected loss ratio results
Variability of loss ratio
Size of experience account refund
Interest rates
• Benefits
Aggregate protection of underwriting results
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Aggregate Excess of Loss Example• 10 loss ratio points in excess of a 65%
loss ratio (maximum of $9 million)
• Maximum subject premium = $90 million
• Reinsurance premium = $6 million
• Reinsurer’s Margin = 10% ($600,000)
• Crediting Interest Rate = 2.5%
• Experience account refund @ commutation =Premium - Margin - Losses + Interest
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Aggregate Excess of Loss Example
0
10
20
30
40
50
60
70
80
90
100
Retained
Los
s Rat
io
ReinsuredRetained
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Traditional and Combination Coverage•Many “traditional” reinsurance
contracts include “finite” features:Corridors, Aggregate limits,
Adjustable commissions, etc.
• Some finite contracts include traditional coverage to add riskSection A = finite quota share
Section B = excess occurrence (cat) coverage
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GAAP and Statutory Reinsurance Accounting
• SFAS No. 113
Effective 1993
• Statutory Issue Paper No. 75
Effective 1995
• Both outline determination of whether contract is reinsurance and if so, the appropriate accounting treatment
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SFAS No. 113 Decision Tree
Does contract indemnify
cedant against loss/liability?
Is contract short duration
or long duration?
Is contract Prospecti
ve or Retroacti
ve?
Use deposit accounting
AICPA: SOP 98-7
Account for as long duration based on FAS
No. 97
Account for as Retroactive Reinsurance based on FAS
No. 113
Account for as Prospective Reinsurance based on FAS
No. 113
No
Yes
Long
Short
Prospective Retroactive
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Indemnification Against Loss• Reinsurer assumes significant
insurance risk under reinsured portions of the underlying insurance contracts
• It is reasonably possible that the reinsurer may realize a significant loss from the transaction
• Risk must not be remote with regard to timing and amount
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Evaluation of Risk Transfer• Present value of all cash flows under
reasonably possible outcomes (premiums, losses & commissions)
• No regard to how cash flows are characterized
• Same interest rate for all tested outcomes
• Exception: If substantially all insurance risk relating to reinsured portions of underlying contract has been assumed by reinsurer!
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Prospective versus Retroactive• Prospective – assumption of future events
• Retroactive – assumption of past events
• Contract having both elements must be accounted for separately or as retroactive
• Retroactive also includes:Claims-made reinsurance of occurrence
insurance
Prospective reinsurance not finalized within 9 months of inception
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Statutory Exceptions to Retroactive Reinsurance
• Structured settlements
• Novations
• Termination of/reduced participation in reinsurance treaties
• Inter-company reinsurance arrangements, as long as no “surplus creation”
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Contact Information
Bruce D. Fell, FCAS, MAAA, CFA
Senior Vice President
JLT Re Solutions, Inc.1009 Lenox DriveP.O. Box 6400Lawrenceville, NJ 08648609-896-0555 ext. [email protected]