Freihaut: Common Pitfalls & Practical Considerations in Risk Transfer Analysis

Question 1

2 criteria to classify a transaction as having risk transfer:

Answer 1

1. Reinsurer assumes significant insurance risk
2. It is reasonably possible that the reinsurer may realize a significant loss

***Contract can still be considered reinsurance if substantially all of the insurance risk related to the reinsured portion has been retained by the reinsurer.

Question 2

GAAP and SAP both require insurance risk. What are the two components of insurance risk?

Answer 2

1. Underwriting risk

2. Timing Risk

Question 3

What must the CEO/ CFO confirm in the Reinsurance Attestation Supplement:

Answer 3

• There are no separate written or oral agreements between the two parties
• There is documentation for every reinsurance contract where risk transfer is not self evident that describes the economic purpose of the transaction & discloses that documentation proving risk transfer is available for review
• The reporting entity complies with all requirements of SSAP62
• The appropriate controls are implemented to monitor the use of reinsurance

Question 4

10-10 Rule

Answer 4

The 10-10 rule is a benchmark to determine if risk transfer exists: There needs to be at least a 10% chance of a 10% or greater loss.

Question 5

Formula for Expected Reinsurer Deficit (ERD):

Answer 5

ERD = Probability (NPV U/W loss to reinsurer) x Avg Severity (U/W loss)

** Risk transfer can be assumed to exist if this is greater than 1% of premium

Question 6

Describe why profit commissions need to be excluded from the risk transfer analysis:

Answer 6

Risk transfer analysis only focuses on scenarios that would generate a loss to the reinsurer, in which case a profit commission will not be required.

Question 7

Describe why reinsurer expenses need to be excluded from the risk transfer analysis:

Answer 7

They do not constitute a cash flow that takes place between ceding company & reinsurer.

Question 8

How should premium be treated in the risk transfer analysis when it is dependent on future events:

Answer 8

• Initial deposit premium: intuitive & simple, but does not include future payments, and can therefore be easily manipulated.
• Expected premium: also intuitive. may over detect risk transfer: in the iterations with the highest losses, the premium should be higher as well.
• Actual premium: based on the losses simulated.

Question 9

2 reasons that the selected interest rate should at least exceed the risk free rate:

Answer 9

1. Very unlikely that a lower rate will be reasonable

2. A lower rate would over detect risk transfer

Question 10

2 issues with using a rate higher than risk free if the reinsurer has a higher expected investment yield:

Answer 10

1. The reinsurers yield is most likely not known by the ceding company
2. It will generate the situation where risk transfer is more likely to be triggered when dealing with reinsurers with poorer investment yields

Question 11

Why cant a yield curve be used to discount cash flows in a risk transfer analysis:

Answer 11

Not consistent with the accounting standards, as it would produce different interest rates in each iteration of the simulation when the timing of cash flows differed, which is against the standard that interest rates can not vary by scenario.

Question 12

What factors can be used to derive the projected loss payment patterns:

Answer 12

• Previous experience of the ceding insurer
• Industry benchmarks
• Combination of the two

Question 13

What is parameter risk

Answer 13

the risk that the selected parameters are incorrect. This increases the chance that risk transfer is indicated.

Question 14

2 ways to reflect parameter risk in the risk transfer analysis:

Answer 14

1. Implicitly: via slightly higher expected loss input, or increased expected volatility
2. Explicitly: the parameters would be variable. This is more scientific, but there is more judgment involved.