Financial Reporting Misc Flashcards
legislative response to criticism of rating agencies
law now requires extensive disclosure of rating agencies’ methods to help users understand ratings
importance of financial strength ratings to buyers of insurance
- help buyers assess insurer’s ability to pay claims
- some buyers must place business with highly rated insurers or reinsurers
how rating agencies ensure consistency across insurers
- info-gathering: be consistent in info-gathering, assessment guidelines
- economic capital: relate financial ratings to economic capital
- separation: the analysis & final rating should be issued by separate bodies
shortcomings of rating agencies
- conflict of interest: rating agencies are paid by the companies they rate
- reliability: rating agencies gave high ratings to companies that went bankrupt
define interactive rating
an independent assessment of an insurer’s ability to pay claims based on a comprehensive qualitative & quantitative analysis
advantages of interactive rating
- best’s ratings are widely reviewed & likely reliable
- without an interactive ratings an insurer may:
-> remain unrated
-> given a public rating where insurer has less control over info used
disadvantages of interacitve rating
- time-consuming: requires extensive meetings with senior management
- intrusive: insurer must provide detailed operational info
- expensive: insurer must pay for rating agencies to do the interactive rating
briefly describe 5 steps in interactive ratings by rating agencies
- research: by rating analysts + insurer submits proprietary info
- meetings: between rating analysts & insurer’s senior management for presentations
- proposal: lead ratings analyst prepares proposal + insurer may submit further info
- decision: by rating committee
- publication: to public & fee-paying subscribers
identify examples where a high financial rating is particualrly important
- reinsurance: if downgraded, a reinsurer may not be able to renew treaties
- low-frequency/high-severity lines: harder to assess risk and a high rating proves insurer can pay claims
- mortgage insurance: lenders may require mortgage insurance from a highly-rated company
why do insurers maintain credit ratings with rating agencies
- unrated insurers: agents are wary of unrated insurers
- solvency assessment: 3rd party rely on ratings
- efficiency: agents, underwriters & regulators don’t have expertise to do their own rating
identify best, moody, s&p rating or capital standard models
- A.M.Best: expected policyholder deficit
- moody’s: use stochastic cash flows to model economic capital
- standard & poor’s: principles-based models & ERM practices
describe best’s rating model: expected policyholder deficit
method:
- EPD = P/V (pure premium / market value of reserves)
selection:
- choose required capital so that EPD = 1%
describe moody’s rating model: stochastic CF
method:
- model is based on repeated simulations of loss distributions of separate risks
time horizon:
- project cash flows until liabilities are settled
describe S&P’s rating model: principles-based
method:
- evaluate insurer’s ERM & internal capital model
rating:
- weighted average of S&P insurer capital assessment
what is the usual definition of ENID
low-probability, high-severity events often not in the historical data
what is the proposed definition of ENID or purpose of ENID
the balancing amount required to bring the best estimate before ENID up to an amount allowing for all possible future outcomes
describe how ENID can be identified
- bring together parties who understand the insurer’s exposure
- their discussion should include factors affecting:
-> future settlements of past events
-> potential future claims relating to current exposure - specific events to consider may include:
-> catastrophes, court awards, legislative changes
an example of ENID with an unfavorable outcome
- catastrophic event in an area where the insurer has material exposure
- a court ruling against the insurer
an example of ENID with an favorable outcome
- withdrawal from market of a major competitor
- a court ruling for the insurer
why might it be beneficial of insurers to attempt to identify ENIDs
- may increase awareness of potential risks by senior management
- may assist in calculation of loading using frequency/severity methods
- may increase regulator confidence in company’s risk management due to insights gleaned
benefit to cedant when contract qualifies as reinsurance
cedant may use reinsurance accounting treatment on the contract
2 conditions for a contract to receive reinsurance accounting treatment
- requires the significant insurance risk is assumed by reinsurer under reinsured portion of contract
- requires that a significant loss to the reinsurer is reasonable possible
the components of insurance risk
U/W risk, timing risk
items requiring CEO, CFO confirmation regarding transfer of risk
- that there are no separate oral/written agreenments between cedant and reinsurer
- detailed docs available for review when risk transfer not self-evident
- SAP compliance by cedant
- controls
4 methods for assessing the existence of risk transfer and state whether each is qualitative or quantitative
method 1: self-evident?
- qualitative
method 2: substantially all exception
- qualitative
method 3: ERD rule (expected reinsurer deficit)
- quantitative
method 4: 10-10 rule
- quantitative
describe the ‘self-evident’ method for assessing the existence of risk transfer
- when it’s obvious that cedant’s financial interest are protected by the reinsurance contract
- may apply if reinsurance premium is low and/or the potential loss is high
describe the ‘substantially all’ exception method for assessing the existence of risk transfer
if significant loss is not reasonablly possible but reinsurer assumes ‘substantially all’ risk then risk transfer may still exist
what is the reason for the ‘substantially all’ exception in testing risk transfer
to maintain access to reinsurance for profitable books of business
substaintially all common examples
- quota share contracts with high % ceded
- individual risk contracts without LR caps, other risk limiting features
describe the ERD method for assessing the existence of risk transfer
ERD = prob(NPV loss) * NPV(avg severity of loss as a % of premium)
- if ERD > 1% then risk transfer has occurred
ERD is basically frequency*severity as a % of premium
describe the 10-10 rule for assessing the existence of risk transfer
if reinsurer has a 10% chance of suffering a 10% loss then the contract is deemed to have transferred risk
describe the pitfalls of risk transfer test
- profit commission: do not include in risk transfer test
- reinsurance expenses: do not include in risk transfer test
- interest rates: do not vary with scenario
- commutation timing: do not use prescribed payment patterns but do include commutation fees
- evaluation date: risk transfer test should be based on circumstances at evaluation date
- premiums: use PV(gross premiums) and apply premium adjustments to undiscounted premiums
describe 2 methods for selecting interest rate in a risk transfer test
- selection should be reasonable, appropriate: risk-free rate with duration matching reinsurer’s cash flows
- reinsurer’s expected investment rate
compare 2 methods for selecting interest rate in a risk transfer test
risk free rate vs. expected investment rate:
- using the risk free rate -> PV(losses) higher because risk free rate < expected investment rate
- PV(losses) higher -> risk transfer test is more likely to pass
describe the practical considerations in a risk transfer test
- parameter selection: interest rate, payment pattern, loss distribution
- parameter risk
- pricing assumptions
- commutation clause
why is risk free rate the lowest allowed in a risk transfer test
if selected interest rate < risk free rate
-> PV(losses) higher)
-> over-detect risk transfer
identify an alternate to the risk free in a risk transfer test & identify an advantage
reinsurer’s expected investment return
-> more reflective of reinsurer operations
-> more accurate estimate of reinsurer loss
identify a problem with using an interest rate greater than the risk free rate in a risk transfer test
alternate rate may not be available to ceding company doing risk transfer test, result of risk transfer test shouldn’t depend on quality of reinsurer’s investment strategy
describe the implicit & explicit methods for accounting for parameter risk in a risk transfer test
- implicit: higher expected loss selection & volatility
- explicit: give parameters a probability distribution & incorporate the into simulation
advantages of using pricing assumptions in a risk transfer test & identify a relevant situation
- a properly priced reinsurance agreement is based on appropriate expected loss, risk load, payment pattern
- may work well for small or inmmature books of business
disadvantages of using pricing assumptions in a risk transfer test
- reinsurance pricing assumptions are market-driven (may not reflect true expected loss)
- pricing assumptions were derived for a different purpose
identify 2 financial & 2 non-financial considerations regarding cash flows in a reinsurance commutation
financial:
- amount & timing of cash flows
- discount rate applied to cash flows
- payment pattern of cash flows
non-financial:
- court decisions
- life expectancy of claimant
- quality of reinsurer
SAP vs. GAAP - objective
- SAP: measure ability to pay claims
- GAAP: measurement of earnings
SAP vs. GAAP - intended user
- SAP: regulators
- GAAP: general audience (policyholders, investors, public)
SAP vs. GAAP - asset recognition
- SAP: asset recognized when expense incurred
- GAAP: may defer recognition of asset for asset/revenue matching with expenses
SAP vs. GAAP - treatment of resinsurance in loss reserves
- SAP: loss reserves net of reinsurance
- GAAP: loss reserves gross of reinsurance
SAP vs. GAAP - deferred income taxes
- SAP: no, doesn’t defer
- GAAP: yes, does defer
contrast liquidation, going-concern
liquidation:
- runoff of assets/liabilities
- of interest to regulators for satisfying policyholder obligations
going-concern:
- continued normal operations
- of interest to investors
contrast fair value, historical cost
fair value:
- value in open market
- more accurate
historical cost:
- original cost minus depreciation
- easier to calculate
contrast principle-based, rule-based accounting system
principle-based:
- accounting approach requiring interpretation to apply
- more flexible
rule-based:
- specific guidance
- easier to apply, but less flexible
what is solvency 2
solvency 2 is a:
- principles-based insurance regulatory system
- for capital levels of insurance companies
- in the European Union
what are the 3 pillars of solvency 2
- quantitative: sets SCR & MCR (solvency&minimum capital requirement)
- uses a total balance sheet strength
- SCR is defined as 99.5% VaR meaning that the probability of ruin is <0.5% - governance: supervisory activities (internal control&risk management, supervisory review process)
- requires adequate governance for the functions: internal audit/actuarial/risk management/compliance
- supervisor identifies high-risk companies and may intervene
- note that companies are required to perform ORSA - transparency: supervisory reporting & public disclosure
- information from pillars 1&2 is given to the supervisor & financial markets
- purpose is to increase market discipline because companies know their decisions are public
what happens if total capital falls below SCR, below MCR
- below SCR, regulatory intervention
- below MCR, company not permitted to operate
method for calculating SCR
SCR is set using a total balance sheet approach
methods:
- standard/regulator model
- spproved internal model (more costly than standard model but gives lower capital requirements)
identify conditions that must be addressed
fitness & propriety, outsourcing, internal control
describe functions that must be addressed
- internal audit (annual report to BoD on deficiencies)
- actuarial (reasonability of methods & assumptions)
- risk management (monitor)
- compliance (with law)
describe the ‘windows&walls’ approach of the US solvency modernization initiative as it applies to solvency 2
gives windows for state insurance regulators to look into group-wide operations:
- enhanced communication between state&group regulators
- enforcement tools if violations occur
but maintains the walls at the statutory legal entity level
- capital cannot be shared between legal entities
what’s commutation agreement in the context of reinsurance
an agreement between a ceding insurer and the reinsurer that provides fro the valuation, payment, and complete discharge of all obligations between the parties under a particular reinsurance contract
(basically the reinsurer gives the ceded claims back to the original insurer)
advantages of (or reasons for) commutation - from reinsurer point-of-view
- increases stability for long-tailed lines
- decreases claims expenses
- decreases U/W leverage
- to exit market quickly
advantages of (or reasons for) commutation - from primary insurer point-of-view
- removes reinsurance credit risk
- insurer receives benefit of favorable loss development
- decreases expense costs
- more efficient claims handling
- receives immediate cash flow
