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Conditions required for a contract to receive reinsurance accounting treatment (SAP and GAAP)
- Reinsurer assumes significant insurance risk under reinsured portion of contract
- Reasonably possible that reinsurer will realize a significant loss from this transaction
- if not, risk transfer can still exist if reinsurer assumes substantially all of the risk under reinsured portion.
- e.g. QS or individual risk contracts with no LR caps or other risk limiting features -> to allow purchase of reinsurance on inherently profitable books where reinsurer may not realize a significant loss.
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Contracts that are not always reasonably self-evident:
- Individual risk contracts that do not qualify for 'substantially all' exemption
- XOL contracts example: a single doctor paying $1M for a $1M xs $5M MM treaty with a $2M agg limit. This contract passes the established criteria for the risk transfer to be reasonably self-evident, but clearly not enough risk is transferred for it to qualify as reinsurance.
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Risk Measuring Method for risk transfer analysis
- '10-10' rule: risk transfer if >= 10% chance of >= 10% loss for reinsurer.
- Expected Reinsurer Deficit (ERD): Probability of NPV UW loss for reinsurer * NPV of avg severity of reinsurer UW losses. risk transfer if ERD > 1%
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Steps in risk transfer analysis
- Understand terms that affect amount of risk transferred (incl when those terms will be triggered)
- Determine reporting dates and premium due dates
- MC simulation
- Model direct loss payments and cessions (discounted to effective date).
- Determine final premium based on nominal treaty results. Premium payments discounted to effective date.
- Reinsurer P/Ls for each iteration of simulation based on NPV of all payments made from and to ceding. Consider all CFs btw 2 parties (premiums, fees, or experience adjustments). Reinsurer expenses not included (not btw 2).
- Calculate ERD
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Risk transfer analysis example - QS with a loss ratio cap of 100% and profit commission if LR <66%; No pre-defined loss payment schedule
- LR cap: potential to affect risk transfer (does not always indicate a lack of risk transfer. LR caps at 200%-300% can result in a significant loss to reinsurer)
- Profit provision swings on a one-to-one basis with LR, which could have an impact on risk transfer
- Not reasonably “self-evident” that risk transfer exists due to low LR caps
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Risk transfer analysis example - XOL WC with Swing rated premium, 5 year Commutation Clause & No pre-defined loss payment schedule
- Both features are potentially risk limiting.
- Not reasonably 'self-evident' that risk transfer exists due to swing-rated premiums
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Common pitfalls that can affect a risk transfer
- Profit Commissions
- Reinsurer Expenses
- Interest Rates
- Discount Factors
- Premiums
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How to consider profit commissions in ERD
should not be considered in risk transfer analysis - focus is 'reasonable chance of significant loss' to reinsurer, so results of ceding should not be considered in a risk transfer analysis
- would increase premium as reinsurance contracts are priced considering all expected payments paid and received by reinsurer. Profit commissions increase future expected payments by reinsurer to ceding -> higher premium for contract
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Risk transfer analysis - How does Reinsurer Expenses affect risk transfer
- Only CFs between ceding and reinsurer should be considered in a risk transfer analysis <-> broker expenses, operating expenses, fees related to
- LOC, taxes should not impact the analysis
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Risk transfer analysis - How does Reinsurer Expenses affect risk transfer
- Only CFs between the ceding and the reinsurer should be considered in a risk transfer analysis
- All the following have no impact:
- Broker expenses
- Operating expenses
- Fees related to LOC
- Taxes
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Risk transfer analysis - How does Interest Rates / Discount Factors selected affect risk transfer
Should only consider insurance risk so Interest rate should not vary by scenario - Non-insurance risks (investment, currency, credit risks) should not be included
- Same interest rate for all CFs (prem/loss)
- risk-free rate is a reasonable choice, as investment abilities of reinsurer shouldn't be considered ("good investors -> less risk transferred")
- Duration used to select interest rate should be based on net CFs to reinsurer (to be invested by reinsurer)
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Risk transfer analysis - How to select interest rate
- Determine duration of premium payments
- Calculate loss duration using industry payment pattern
- Duration of net CFs is difference btw the two, used to select an interest rate based on years of maturity and yield curve rates from U.S. Treasury
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Risk transfer analysis - Considerations for Premiums, types of premiums (and drawbacks)
- all loss scenarios are compared against premium to calculate P/L. considerations:
- use gross (before getting back ceding commission)
- Use PV for P/L, but still model actual functioning of contract (payment schedule, future events) -> apply LR caps and experience adj's based on nominal and then discount
- Types for CF simulation:
- Initial deposit premium
: does not account for future payments from ceding - Expected premiums: potential over detection as premium depends on losses, high when experience is poor. If reinsurer’s % of total loss is calculated using avg expected premium, likely reinsurer LR will be a larger negative than reasonable.
- Actual premiums: developed along with losses for each scenario (and % of reinsurer loss) -> ERD can be calculated. incl fees that depend on future events.
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Practical considerations in risk transfer analyses
- Parameter Selection
- Parameter Risk
- Use of Pricing Assumptions
- Commutation Clauses
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Parameter selection in risk transfer analyses - Interest rate, flaws with above risk free
- Risk-free rate is most preferred.
- < risk-free lead to higher losses -> over-detecting -> reasonable to treat risk-free as lowest possible
- > risk-free (flaws)
- Not likely available to primary insurer
- Exhibit risk transfer for reinsurer with poor investment strategy, and not for superior investment <- CFs not btw ceding and reinsurer should not be considered
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Parameter selection in risk transfer analyses - Payment pattern
- Timing of payments can affect amount of risk transferred. e.g., constant won't recognize potential impact of quicker than expected payments.
- Most significant impact on tails of distribution
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Parameter selection in risk transfer analyses - Loss distribution
- Previous company experience, industry benchmarks, pricing info, or judgment.
- Companies can experience significantly higher variance in their loss than industry (select variance based on size of book, type of coverage, type of business)
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Parameter Risk - Defin, impact on risk transfer, how to account for it
- Defn: risk that parameters or model are incorrect (impact simulation)
- Impact on risk transfer:
- Increase likelihood of risk transfer being present; same parameter risk for reinsurer.
- Affect premium and discounting (timing risk in inaccurate payment pattern - part of insurance risk in risk transfer analysis)
- How to account for it:
- Implicitly
: increase parameter by a PfAD or be conservative when selecting parameter - Explicit: probability distribution for key parameters and simulate -> variability to parameters to account for parameter risk
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Advantages and disadvantages in using (reinsurance) Pricing Assumptions in risk transfer analyses
- Advantages:
- Reinsurers have more data that will help to have better analysis
- Market-driven; reflect how market sees the contract
- Disadvantages:
- pricing assumptions may overdetect risk transfer
- Market-driven; hard/soft market could impact pricing assumptions, but shouldn't affect risk transfer (insurance risk). hence:
- Data behind pricing assumptions more useful
- To apply pricing assumptions, account for risk load and consider risk load when selecting loss distribution
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Pricing info vs. risk transfer testing
Both try to determine expected future losses but for dif reasons: - dif approaches: conservative means:
- Pricing: higher expected losses and risk load (volatility in losses)
- risk transfer: lower expected losses and variability. pricing approach may over-detect risk transfer
- Loss models
- Pricing: optimized based on projections of all potential results.
- Risk transfer: optimized on right tail
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How does Commutation Clauses affect risk transfer analyses
- Mandatory fees to delay commutation should be considered
- can limit risk transfer. common to pre-set date for commutation based on unpaid claim estimates at that time (limit risk transferred in original transaction)
- If future commutation based on agreed upon value, payment pattern used to discount losses may not need to be adjusted. While commutation may result in an earlier payment than anticipated by reinsurer for o/s claims, payment should reflect PV of expected payments at that time and impact on original payment pattern assumption should be minimal.
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