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Commutation
Definition: Process where the future value of an unpaid claim(s) and associated expenses is 'current valued, taking into account financial and non-financial aspects, to accelerate payment and close the case(s)
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Buyer / Primary Ceding Company's Attraction To A Commutation
- 1. Accelerated settlement of the obligation
- 2. Improvement in current "wealth" using entity's perception of value of cash over non-cash assets
- 3. Cash flow for reinvestment or liquidity to deploy for other purposes
- 4. Certain immediate amount is substituted for an uncertain future amount
- 5. Possible admin cost saving associated with monitoring and collection efforts
- 6. Creating a marginal underwriting loss and federal income tax marginal adjustment
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Seller / Reinsurer's Attraction To A Commutation
- 1. Accelerated settlement, often times ending relationship with buyer
- 2. Improvement in perceived "wealth" when considering financial and non-financial aspects
- 3. Limited attractive cash flow alternatives
- 4. A certain result, not subject to future events such as contract remediation or retroactive legislation or judicial results
- 5. LAE administrative expense savings
- 6. Creating a marginal underwriting gain with a probable adverse current tax consequence
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Ambivalence Point
- 1. Definition: Point estimate monetary figure representing the highest value the seller is willing to pay the buyer
- 2. Formula: AP = (AP - Tax Basis Reserve) * Tax Rate + NPV Booked Reserve
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Steps to Reach US Ambivalence Point
- 1. Calculate PV of loss
- 2. Calculate tax basis reserve as total loss * tax basis discounting factor
- 3. Calculate amount of unwind = Step 1 - Step 2
- 4. Calculate PV of Step 3
- 5. Calculate PV of the unwinding of the discount times the US tax rate
- 6. Calculate basis of seller's ambivalence point, i.e., cost not to commute = Step 1 - Step 5
- 7. US Ambivalence Point = (Step 6 - Step 2 * r) / (1 - r) where r = US Tax Rate
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Steps to Reach Canadian Ambivalence Point
- 1. Calculate PV of Loss
- 2. Calculate Tax Basis Reserve = min(Booked Reserve, Step 1 + Provision for Adverse Deviation) * 95%
- 3. Marginal Taxable Income = Step 2 - Step 1
- 4. After Tax Income Generated = Step 3 * r
- 5. Canadian Ambivalence Point = (Step 1 - Step 3 * r) / (1 - r), where r = Canadian Tax Rate
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