C - Freihaut and Vendetti

Question 1

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?

Answer 1

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

Question 2

FREIHAUT AND VENDETTI

When is documentation required for risk transfer?

Answer 2

For reinsurance contract where the risk transfer is not “REASONABLY SELF EVIDENT”.

Question 3

FREIHAUT AND VENDETTI

Contrast the requirement of RAS vs the recommendation CAS and AAA about documentation of “reasonably self-evident” risk transfer.

Answer 3

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.

Question 4

FREIHAUT AND VENDETTI

4 confirmations that CEO and CFO need to make when attesting risk transfer in reinsurance transaction.

Answer 4

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.

Question 5

FREIHAUT AND VENDETTI

Contrast the roles of the CFO and CEO versus actuaries’ role in risk transfer analysis

Answer 5

CEO and CFO : to ATTEST to risk transfer in reinsurance transaction

Actuaries : qualified to QUANTIFY risk transfer and to provide required DOCUMENTATION

Question 6

FREIHAUT AND VENDETTI

2 components of insurance risk required for risk transfer to be present

Answer 6

UW risk
Timing Risk

If both are not present, then insurance risk has not been transferred

Question 7

FREIHAUT AND VENDETTI

6 common pitfalls in risk transfer analysis

Answer 7

1) Profit Commission
2) Reinsurer Expenses
3) Interest Rates and Discount Rates
4) Premiums
5) Evaluation Date
6) Commutation and Timing of Payments

Question 8

FREIHAUT AND VENDETTI

Discuss PROFIT COMMISSION as a common pitfall in risk transfer analysis.

Answer 8

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.

Question 9

FREIHAUT AND VENDETTI

Discuss REINSURER EXPENSES as a common pitfall in risk transfer analysis.

Answer 9

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.

Question 10

FREIHAUT AND VENDETTI

Discuss INTEREST RATES AND DISCOUNT FACTOR as a common pitfall in risk transfer analysis.

Answer 10

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) .

Question 11

FREIHAUT AND VENDETTI

Discuss PREMIUM as a common pitfall in risk transfer analysis

Answer 11

GROSS Premium should be used in Risk Transfer Analysis

Same interest rate used to discount losses and PV(premium)

Question 12

FREIHAUT AND VENDETTI

Discuss EVALUATION DATE as a common pitfall in risk transfer analysis.

Answer 12

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.

Question 13

FREIHAUT AND VENDETTI

Discuss COMMUTATION and TIMING OF PAYMENTS as a common pitfall in risk transfer analysis.

Answer 13

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.

Question 14

FREIHAUT AND VENDETTI

Discuss PARAMETER SELECTION as a practical consideration in risk transfer analysis.

Answer 14

Any parameter not given by contract must be selected after some reflection.

(eg. interest rates, payment patterns, loss distributions used for projecting Cash Flows)

Question 15

FREIHAUT AND VENDETTI

Discuss INTEREST RATE as a practical consideration in risk transfer analysis.

Answer 15

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.

Question 16

FREIHAUT AND VENDETTI

Why should the risk free rate be the lowest possible choice when selecting an interest rate for a risk transfer analysis?

Answer 16

A lower rate would produce higher PV(losses) and could over-detect risk transfer.

Question 17

FREIHAUT AND VENDETTI

Advantage and Drawback of using an interest rate above the risk free rate in risk transfer analysis

Answer 17

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.

Question 18

FREIHAUT AND VENDETTI

Discuss PAYMENT PATTERNS as a practical consideration in risk transfer analysis.

Answer 18

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.

Question 19

FREIHAUT AND VENDETTI

Discuss LOSS DISTRIBUTION as a practical consideration in risk transfer analysis.

Answer 19

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.

Question 20

FREIHAUT AND VENDETTI

Discuss how PARAMETER RISK can be accounted for IMPLICITLY and EXPLICITLY in risk transfer analysis

Answer 20

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.

Question 21

FREIHAUT AND VENDETTI

Advantage / Disadvantage of using PRICING ASSUMPTION in risk transfer analysis

Answer 21

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

Question 22

FREIHAUT AND VENDETTI

Discuss COMMUTATION CLAUSE as a practical consideration in risk transfer analysis.

Answer 22

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.

Question 23

FREIHAUT AND VENDETTI

10-10 rule in risk transfer

Answer 23

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–

Question 24

FREIHAUT AND VENDETTI

2 examples of contracts posing significant risk to reinsurer but failing the 10-10 rule.

Answer 24

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.

Question 25

FREIHAUT AND VENDETTI

1 shortcoming of the 10-10 rule.

Answer 25

The rule focuses on only 1 point, the 90th percentile, and ignores possibility that significant risk may be transferred at higher percentiles

Question 26

FREIHAUT AND VENDETTI

Define ERD, mathematically.

What is the threshold of ERD to be considered risk transfer?

Answer 26

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)