Freihaut - Risk Transfer Analysis

Question 1

Benefit to cedant when contract qualifies as reinsurance.

Answer 1

The cedant may use reinsurance account treatment on the contract.

Question 2

Describe 2 conditions for a contract to receive reinsurance account treatment.

Answer 2

• requires that significant insurance risk is assumed by reinsurer (under reinsured portion of contract)
• requires that a significant loss to the reinsurer is reasonably possible

Question 3

Identify the components of ‘insurance risk’ (conceptual - not specific). (2)

Answer 3

• U/W Risk

- Timing Risk

Question 4

Identify items requiring the CEO/CFO confirmation regarding transfer of risk. (4)

Answer 4

• that there are no separate ORAL/WRITTEN agreements between the cedant and the reinsurer
• detailed DOCS are available for review WHEN the risk transfer is not self-evident
• SAP (Statutory Account Principles) compliance by the cedant
• appropriate CONTROLS to monitor reinsurance

Question 5

List 4 methods for assessing the existence of risk transfer and state whether each is qualitative or quantitative.

Answer 5

1) self-evident? - qualitative
2) ‘substantially all’ exception - qualitative
3) ERD rule (Expected Reinsurer Deficit) - quantitative
4) 10-10 rule - quantitative

Question 6

Describe the ‘self-evident’ method for assessing the existence of risk transfer. (2)

Answer 6

• sometimes risk transfer is so self-evident that no further analysis is needed
• may apply if reinsurance premium is very low or potential loss is very high

Question 7

Describe the ‘substantially all’ exception method for assessing the existence of risk transfer.

Answer 7

IF a significant loss is NOT reasonably possible, BUT the reinsurer assumes ‘substantially all’ risk, THEN risk transfer may still exist.

Question 8

What is the reason for the ‘substantially all’ exception method in testing risk transfer?

Answer 8

To maintain access to reinsurance for profitable books of business.

Question 9

‘Substantially all’ - 2 common examples.

Answer 9

QUOTA SHARE contracts where a high % is ceded.

INDIVIDUAL RISK CONTRACTS without LR caps or other risk limiting features

Question 10

Describe the ERD (Expected Reinsurer Deficit) method for assessing the existence of risk transfer.

Answer 10

ERD = Prob(NPV loss) * NPV(avg severity of loss as a % of premium)
- if ERD > 1%, then a risk transfer has occured

ERD is basically (freq * severity as a % of premium)

Question 11

Describe the ‘10-10’ rule for assessing the existence of risk transfer.

Answer 11

IF reinsurer has a 10% chance of suffering a 10% loss, THEN the contract is deemed to have transferred risk.

Question 12

How is the risk transfer analysis done?

Answer 12

Calculated ERD based on Monte-Carlo Simulation.

Question 13

Describe the pitfalls in a risk transfer test. (1-3)

Answer 13

i) Profit commission: don’t include
ii) Reinsurer expenses: don’t include
iii) Interest rates: do NOT vary with scenario, should only consider insurance risk (U/W & timing risk)

Question 14

Describe the pitfalls in a risk transfer test. (4-6)

Answer 14

iv) Commutation timing: no NOT use prescribed payment patterns, DO include commutation fees
v) Evaluation date: risk transfer test should be based on circumstances at evaluation date
vi) Premiums: use PV of GROSS premium, apply premium adjustment to UNDISCOUNTED premiums

Question 15

Should profit commission be incorporated into risk transfer test?

Answer 15

DO NOT INCORPORATE because the results of the CEDANT should not be included in the risk transfer analysis.

Question 16

What is the impact of reinsurer’s expenses on ERD?

Answer 16

NO IMPACT: only cash flows between the cedant and the reinsurer should be considered in ERD calculations.

Question 17

Describe 2 methods for selecting the Interest Rate in a risks transfer test.

Answer 17

• selection should be REASONABLE and APPROPRIATE: risk-free rate with duration MATCHING reinsurer’s cash flows
• reinsurer’s expected investment rate is irrelevant in a risk transfer test

Question 18

Compare 2 methods for selecting the Interest Rate in a risk transfer test.

Answer 18

• risk-free rate vs expected investment rate: PV(losses) are higher using the risk-free rate since the risk-free rate < expected investment rate
• make existence of risk transfers more likely; i.e.: less conservative

Question 19

Describe the practical considerations in a risk transfer test. (4)

Answer 19

• parameter selection (interest rate, payment pattern, loss distribution)
• parameter risk
• pricing assumptions
• commutation clause

Question 20

Why is the risk-free rate the lowest allowed in a risk transfer test?

Answer 20

• if the selection is lower than the risk-free rate -> PV(losses) will be higher -> over-detection of risk transfer
• note: risk-free rate should always be known

Question 21

Identify an alternative to the risk-free rate in a risk transfer test and identify an advantage.

Answer 21

Reinsurer’s Expected Investment Return
- more reflective of the reinsurer’s operation, SO it is a more accurate prediction on whether there is significant risk of significant loss

Question 22

Identify a problem with the use of an interest rate greater than the risk-free rate in a risk transfer test.

Answer 22

• the alternative rate may not be available to the ceding company doing the risk transfer test
• result of the risk transfer test should NOT depend on quality of reinsurer’s investment strategy

Question 23

Describe the implicit & explicit methods for accounting for parameter risk in a risk transfer test.

Answer 23

IMPLICIT: higher expected loss selection & volatility
EXPLICIT: give parameters a probability distribution & incorporate into simulation

Question 24

Advantage of using pricing assumptions in a risk transfer test, and identify a relevant situation.

Answer 24

FOR small and immature BOOKS of business:

property priced reinsurance agreement likely based on appropriate expected loss, risk load, payment pattern

Question 25

Disadvantage of using pricing assumptions in a risk transfer test.

Answer 25

• reinsurance pricing assumptions are market driven -> do NOT necessarily reflect true expected loss
• pricing assumptions were derived for a different purpose

Question 26

Who has the final say in risk transfer test?

Answer 26

CEO or CFO.

- the actuary does an analysis that they use as an input in their final decision

Question 27

Identify 2 financial and 2 non-financial considerations regarding cash flows in a reinsurance commutation.

Answer 27

FINANCIAL: amount & timing, discount rate, payment pattern
NON-FINANCIAL: court decisions, life expectancy of claimant, quality of reinsurer