Finite Reinsurance Finite Reinsurance Discussion and Discussion and DemonstrationDemonstration

Casualty Actuarial SocietyCasualty Actuarial Society

2003 Spring Meeting2003 Spring Meeting

Marco Island, FloridaMarco Island, Florida

May 18 - 21, 2003May 18 - 21, 2003

Douglas A. CarloneDouglas A. Carlone

Senior Vice PresidentSenior Vice President

What Is Buyer’s What Is Buyer’s Motivation?Motivation?• Is buyer looking to disguise unprofitable results Is buyer looking to disguise unprofitable results

or other financial difficulties?or other financial difficulties?

• Is buyer looking for traditional reinsurance at a Is buyer looking for traditional reinsurance at a finite reinsurance price?finite reinsurance price?

• Neither situation attractive to the reinsurerNeither situation attractive to the reinsurer

Due Diligence - Retroactive Due Diligence - Retroactive CoversCovers

• Claims auditClaims audit

• Quality of underwritingQuality of underwriting

• Ceded reinsurance programCeded reinsurance program

• IBNR reserving philosophyIBNR reserving philosophy

• Data distortionsData distortions

Due Diligence - Due Diligence - Prospective CoversProspective Covers• Same as for retroactive covers, plus ...Same as for retroactive covers, plus ...

• Planning processPlanning process

• Pricing philosophyPricing philosophy

• Changes in claims handling, underwriting, Changes in claims handling, underwriting, ceded reinsuranceceded reinsurance

Actuarial AnalysisActuarial Analysis

Microsoft Excel Worksheet

Pricing ModelPricing Model

• Parameters (loss pick, payout pattern, volatility) Parameters (loss pick, payout pattern, volatility) are entered into a simulation modelare entered into a simulation model

• Simulation can be implemented via macros or Simulation can be implemented via macros or via add-in software (e. g., @Risk)via add-in software (e. g., @Risk)

• Trial and error approach until pricing targets Trial and error approach until pricing targets are reachedare reached

• Typical pricing targets (alone or in Typical pricing targets (alone or in combination): minimum return on capital, combination): minimum return on capital, minimum absolute return, maximum probability minimum absolute return, maximum probability of loss, maximum downside risk, etc.of loss, maximum downside risk, etc.

Capital Allocation Can Be Capital Allocation Can Be Based on …Based on …• Regulatory capital requirements (e. g., RBC)Regulatory capital requirements (e. g., RBC)

• Rating agency capital requirementsRating agency capital requirements

• Distribution of PV profit from simulation outputDistribution of PV profit from simulation output

• Unfunded limit (limit minus premium) Unfunded limit (limit minus premium)

Adverse Development Adverse Development CoverCover• Attachment point: $1,386 million (carried Attachment point: $1,386 million (carried

reserves as of 12/31/2002)reserves as of 12/31/2002)

• Limit: $250 millionLimit: $250 million

• Guaranteed cost premium: $100 millionGuaranteed cost premium: $100 million

Aggregate Stop Loss Aggregate Stop Loss CoverCover• 2003 subject premium assumed to be $700 2003 subject premium assumed to be $700

millionmillion

• Attachment point: $630 million (90% of subject Attachment point: $630 million (90% of subject premium)premium)

• Limit: $140 million (20% of subject premium)Limit: $140 million (20% of subject premium)

• Guaranteed cost premium: $45.5 million (6.5% Guaranteed cost premium: $45.5 million (6.5% of subject premium)of subject premium)

Guaranteed CostGuaranteed Cost

• Low up-front costLow up-front cost• No profit sharingNo profit sharing• Upside is retained by reinsurerUpside is retained by reinsurer• Similar to traditional reinsuranceSimilar to traditional reinsurance• Rarely used for stop loss coversRarely used for stop loss covers• Occasionally used for adverse development Occasionally used for adverse development

coverscovers• More commonly used for loss portfolio transfersMore commonly used for loss portfolio transfers

Profit SharingProfit Sharing

• Higher up-front cost compared to guaranteed Higher up-front cost compared to guaranteed costcost

• Reinsurer’s upside consists only of a relatively Reinsurer’s upside consists only of a relatively small marginsmall margin

• Since reinsurer’s upside is capped, need to Since reinsurer’s upside is capped, need to overfund to reduce the reinsurer’s downsideoverfund to reduce the reinsurer’s downside

• Most of profit goes to ceding companyMost of profit goes to ceding company• Lower economic cost compared to guaranteed Lower economic cost compared to guaranteed

costcost• Pricing model needs to track funding premium, Pricing model needs to track funding premium,

margin, funded losses, unfunded losses, and margin, funded losses, unfunded losses, and interest accrual on experience account balance interest accrual on experience account balance (EAB)(EAB)

Profit Sharing (cont.)Profit Sharing (cont.)

• EAB can be either held by reinsurer (funds EAB can be either held by reinsurer (funds transferred) or held by cedant (funds withheld)transferred) or held by cedant (funds withheld)

• Funds transferred: EAB crediting rate usually Funds transferred: EAB crediting rate usually linked to risk-free ratelinked to risk-free rate

• Funds withheld is similar to debt (reinsurer Funds withheld is similar to debt (reinsurer loans reinsurance premium back to cedant)loans reinsurance premium back to cedant)

• Therefore, EAB crediting rate is higher for funds Therefore, EAB crediting rate is higher for funds withheld than for funds transferred (should withheld than for funds transferred (should approximate cedant’s cost of debt)approximate cedant’s cost of debt)

• Funds transferred: higher up-front costFunds transferred: higher up-front cost• Funds withheld: lower up-front costFunds withheld: lower up-front cost

Other Structural Features:Other Structural Features:Additional PremiumsAdditional Premiums• Generally used only for prospective coversGenerally used only for prospective covers• Lowers the deposit premium requirementLowers the deposit premium requirement• Contingent upon experienceContingent upon experience• Can take many formsCan take many forms• Reinsurer is subject to credit risk with regard to Reinsurer is subject to credit risk with regard to

future AP payments (offset provisions can future AP payments (offset provisions can mitigate this risk, however)mitigate this risk, however)

• Pricing model needs to project premium inflows Pricing model needs to project premium inflows in addition to loss outflowsin addition to loss outflows

Other Structural Features:Other Structural Features:SublimitsSublimits• Retroactive covers: used for types of losses that Retroactive covers: used for types of losses that

are difficult to quantify (e. g., asbestos, are difficult to quantify (e. g., asbestos, pollution, other mass torts)pollution, other mass torts)

• Prospective covers: used for shock losses (e. g., Prospective covers: used for shock losses (e. g., property catastrophes)property catastrophes)

Multiyear Aggregate Stop Multiyear Aggregate Stop Loss CoversLoss Covers• Single year: get benefit of discountingSingle year: get benefit of discounting

• Multiyear: get benefit of discounting and temporal Multiyear: get benefit of discounting and temporal smoothingsmoothing

• Analysis is largely the same as for a single year coverAnalysis is largely the same as for a single year cover

• Need to investigate cedant’s growth plansNeed to investigate cedant’s growth plans

• Need to project loss ratios more than one year into Need to project loss ratios more than one year into the futurethe future

• Pricing model needs to simulate multiple future yearsPricing model needs to simulate multiple future years

MonitoringMonitoring

• Need to monitor for changes that increase Need to monitor for changes that increase losses or speed up loss payoutslosses or speed up loss payouts

• ““Change in Administrative Practices” clause Change in Administrative Practices” clause calls for adjustment if a change should alter calls for adjustment if a change should alter deal economicsdeal economics

• Commutations (both inwards and outwards) can Commutations (both inwards and outwards) can also affect deal economicsalso affect deal economics

• Actuarial input critical to quantifying the impact Actuarial input critical to quantifying the impact of changes and adjusting for such changesof changes and adjusting for such changes

ReservingReserving

• Unique characteristics of each deal preclude a Unique characteristics of each deal preclude a portfolio reserving approachportfolio reserving approach

• Finite re deals usually reserved individuallyFinite re deals usually reserved individually

• Periodic update of reserve analysis done as part Periodic update of reserve analysis done as part of the pricing exerciseof the pricing exercise

ConclusionConclusion

• Pricing is largely driven by actuarial modellingPricing is largely driven by actuarial modelling

• Actuarial input also essential in monitoring and Actuarial input also essential in monitoring and reservingreserving

• Therefore, the actuary plays a key role Therefore, the actuary plays a key role throughout the entire life cycle of a finite re throughout the entire life cycle of a finite re transactiontransaction