C - Freihaut and Vendetti Flashcards
FREIHAUT AND VENDETTI
2 criteria to determine the existence of risk transfer?
1 exemption to the requirements?
The reason for this exemption?
2 examples of this exemptions?
1) reinsurer assumes significant INSURANCE RISK under reinsured portion
AND
2) reasonably possible that reinsurer realizes a significant loss
When reinsurer assumes “substantially all” INSURANCE risk of the REINSURED PORTION
Because it allows reinsurers to reinsure a profitable book where it may NOT BE REASONABLY POSSIBLE that reinsurer will have SIGNIFICANT LOSS
1) straight quota-share
2) individual contract with no loss ratio cap
FREIHAUT AND VENDETTI
When is documentation required for risk transfer?
For reinsurance contract where the risk transfer is not “REASONABLY SELF EVIDENT”.
FREIHAUT AND VENDETTI
Contrast the requirement of RAS vs the recommendation CAS and AAA about documentation of “reasonably self-evident” risk transfer.
RAS requirement : document every contract for which transfer is not reasonably self evident
AAA and CAS : document every contract whether or not found reasonably self evident.
FREIHAUT AND VENDETTI
4 confirmations that CEO and CFO need to make when attesting risk transfer in reinsurance transaction.
1) NO SEPARATE WRITTEN OR ORAL AGREEMENT.
2) There is DOCUMENTATION AVAILABLE FOR REVIEW for every reinsurance contract for which risk transfer is NOT REASONABLY SELF-EVIDENT.
3) compliance with SSAP62
4) Appropriate controls to MONITOR the use of REINSURANCE.
FREIHAUT AND VENDETTI
Contrast the roles of the CFO and CEO versus actuaries’ role in risk transfer analysis
CEO and CFO : to ATTEST to risk transfer in reinsurance transaction
Actuaries : qualified to QUANTIFY risk transfer and to provide required DOCUMENTATION
FREIHAUT AND VENDETTI
2 components of insurance risk required for risk transfer to be present
UW risk
Timing Risk
If both are not present, then insurance risk has not been transferred
FREIHAUT AND VENDETTI
6 common pitfalls in risk transfer analysis
1) Profit Commission
2) Reinsurer Expenses
3) Interest Rates and Discount Rates
4) Premiums
5) Evaluation Date
6) Commutation and Timing of Payments
FREIHAUT AND VENDETTI
Discuss PROFIT COMMISSION as a common pitfall in risk transfer analysis.
Profit commission should NOT BE INCLUDED in risk transfer analysis (as usually not triggered during a reinsurer loss)
P.Comm may have indirect impact through a higher premium
Carryforwards from previous years affecting losses for reinsurer then should be incorporated into cash flow model.
FREIHAUT AND VENDETTI
Discuss REINSURER EXPENSES as a common pitfall in risk transfer analysis.
Only CF between insurer and reinsurer should be considered in a risk transfer analysis.
This means that broker expenses, operating expenses, fees from letter of credit, taxes should have no impact on the analysis.
FREIHAUT AND VENDETTI
Discuss INTEREST RATES AND DISCOUNT FACTOR as a common pitfall in risk transfer analysis.
Requirement to use :
- constant interest rate for discounting across all simulated scenarios
- reasonable and appropriate interest rate (recommend risk free rate and duration of net cash flows)
Risk transfer analysis should only consider INSURANCE RISK, so interest rate for discounting should not vary by scenario.
Non-insurance risks should not be included (investment risk, currency risk, credit risk) .
FREIHAUT AND VENDETTI
Discuss PREMIUM as a common pitfall in risk transfer analysis
GROSS Premium should be used in Risk Transfer Analysis
Same interest rate used to discount losses and PV(premium)
FREIHAUT AND VENDETTI
Discuss EVALUATION DATE as a common pitfall in risk transfer analysis.
Risk transfer assessment is made at the inception date based on facts known at the time.
Any PARAMETER affected by the evaluation date should be considered from the inception date.
FREIHAUT AND VENDETTI
Discuss COMMUTATION and TIMING OF PAYMENTS as a common pitfall in risk transfer analysis.
In order to have risk transfer in a reinsurance contract, there must be U/W RISK and TIMING RISK.
PRESCRIBED PAYMENTS PATTERNS remove the timing risk : no risk transfer.
Commutation maintenance fees : contract automatically commuted after 5 yrs unless the ceding cie pays the fee to reinsurer. The fee is a cash flow between insurer and reinsurer thus should be considered as premium and be included in risk transfer analysis.
FREIHAUT AND VENDETTI
Discuss PARAMETER SELECTION as a practical consideration in risk transfer analysis.
Any parameter not given by contract must be selected after some reflection.
(eg. interest rates, payment patterns, loss distributions used for projecting Cash Flows)
FREIHAUT AND VENDETTI
Discuss INTEREST RATE as a practical consideration in risk transfer analysis.
Recommended to use risk-free rate with duration matching of reinsurer’s CFs.
Required same rate to apply to all CFs, including premium and losses.
FREIHAUT AND VENDETTI
Why should the risk free rate be the lowest possible choice when selecting an interest rate for a risk transfer analysis?
A lower rate would produce higher PV(losses) and could over-detect risk transfer.
FREIHAUT AND VENDETTI
Advantage and Drawback of using an interest rate above the risk free rate in risk transfer analysis
Could use the reinsurer’s expected investment return.
Advantage : more reflective of reinsurer’s operations and more accurate estimate of reinsurer’s loss.
Drawback : result of risk transfer should NOT depend on quality of reinsurer’s investment strategy.
FREIHAUT AND VENDETTI
Discuss PAYMENT PATTERNS as a practical consideration in risk transfer analysis.
Often based on past experience and industry benchmark.
When constant payment patterns are applied to a loss distribution, result will not recognize potential impact of quicker than expected payments.
This will have significant impact on tails of distribution, which is the portion of interest in risk transfer analysis.
FREIHAUT AND VENDETTI
Discuss LOSS DISTRIBUTION as a practical consideration in risk transfer analysis.
Loss distribution are often based on experience, industry benchmarks, pricing info or judgment.
Having an ADEQUATE LEVEL OF COMFORT WITH THE TAIL RESULTS produced by the selected distribution is crucial.
FREIHAUT AND VENDETTI
Discuss how PARAMETER RISK can be accounted for IMPLICITLY and EXPLICITLY in risk transfer analysis
important to account for the risk that the selected parameters or models are incorrect.
Implicit : reflected in higher expected loss selection or in increase in expected volatility of losses.
Explicit : probability distribution assigned to key parameters and simulate them.
FREIHAUT AND VENDETTI
Advantage / Disadvantage of using PRICING ASSUMPTION in risk transfer analysis
A: in line with how reinsurer and market sees the contract
D: may be influenced by hard/soft market, which should not matter in risk transfer analysis
FREIHAUT AND VENDETTI
Discuss COMMUTATION CLAUSE as a practical consideration in risk transfer analysis.
Any mandatory fees to delay a required commutation should be included when determining if risk transfer is present.
Commutation requirement does not restrict the amount of risk transferred.
FREIHAUT AND VENDETTI
10-10 rule in risk transfer
If there’s AT LEAST 10% CHANCE OF A 10% OR GREATER LOSS for the reinsurer
Then: contract exhibit risk transfer
–10% (reasonable chance) of a 10% significant loss–
FREIHAUT AND VENDETTI
2 examples of contracts posing significant risk to reinsurer but failing the 10-10 rule.
1) XOL contract can fail if loss only above 90th percentile. Loss could reach high levels at higher percentiles
2) QS contract can fail if reinsurer have high percentage of exposure on profitable book of business. Because of profitability, reinsurer can only reach 10% loss above the 90th percentile.
FREIHAUT AND VENDETTI
1 shortcoming of the 10-10 rule.
The rule focuses on only 1 point, the 90th percentile, and ignores possibility that significant risk may be transferred at higher percentiles
FREIHAUT AND VENDETTI
Define ERD, mathematically.
What is the threshold of ERD to be considered risk transfer?
ERD: Expected Reinsurer Deficit
ERD : P(NPV UW loss) * NPV avg severity of UW loss
A contract shows risk transfer if ERD >= 1%
-to be consistent with the 10-10 rule (10% loss multiplied by 10% chance equivalent to 1% ERD)
