Freihuat & Vendetti - RiskTransfer

Question 1

Describe 2 condistions for a contract

to recevice reinsurance accounting treatment

Answer 1

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

Question 2

Identify items requiring CEO/CFO’s confimation regarding transfer of risk

Answer 2

• no oral/written agreements btw cedent & reinsurer
• detialed docs available for review when risk transfer not self-evident
• Statutory accounting principles (SAP) compliance by cedant
• Controls on Reinsurer

Question 3

“Substantially All” Exception

Answer 3

Definition:

• If significant loss NOT reasonaly possible,
• but reinsurer assumes “substantially all” risk,
• then risk transfer may still exist through quota-share contracts with a high % (50+%) transferred.

Reason for the exception:

• to maintain access to reinsurance for profitable books of business

Common Examples:

• Quota share contract with high % ceded
• Individual riks contracts without LR cap and other risk limiting feature

Question 4

Expected Reisurer Deficit (ERD)

Answer 4

ERD = Freq * (re loss - re Prem)/re prem

ERD > 1% then risk transfer exists

Question 5

4 methods to tell if risk tansfer exists

Answer 5

1. self - evident?
   
   • if reinsurance permium is very low or potential loss is very high
2. Substantially All exception?
3. ERD > 1%
4. 10 - 10 rule:
   
   • if reinsurer has >=10% change of suffering >=10% loss

Question 6

Pitfalls in a risk transfer test

Answer 6

Hint - PRICE - P

• Profit commission
  
  • do NOT include - usually don’t occur if loss occurs to reinsurer
  • Amount of prem may be charged higher, carry forward in multi-yr contracts
• Reisurer expenses
  
  • do NOT include - not involved CF with ceding company (e.g. borker/operating expense, fees rated to LOC, taxes)
• Interest rates
  
  • do NOT Vary with scenario/CFs
  • only consider insurance risk (U/W & timing)
  • NOT consider - credit, investment, currency
• Commutation timing
  
  • do NOT use prescribled payment pattern
  • DO include commutation fees
• Evaulation Date
  
  • risk transfer test should be based on circumtances at evaluation date
  • ie. if known of loss at the time
• Premiums
  
  • use PV of GROSS premiums
  • apply prem adjustments to UNdiscounted prems

Question 7

Practial considerations in risk tansfer test

Answer 7

• Parameter selection
  
  • interest rate,
  • ceding payment pattern
  • loss distribution
• Parameter risk
  
  • Implicitly consider:
    
    • higher expected loss selection & volatility
    • being conservative when selecting
  • Explicity consider:
    
    • give parameters a prob distribution & simulate them
• Reinsurance Pricing assumptions
  
  • Adv: more in line with reinsurer’s view on risk transfer & incorportate market view of the risk
  • Disadv: assumptions are market-driven - simulation testing for risk transfer should NOT varies by market force
• Commutation clause
  
  • financial consideration: amount&timing, discount rate, payment pattern
  • non-financial consideration: court decisions, mortality& morability of claimant, quality of renisurer

Question 8

Selection of interest rate

Answer 8

Floor

• risk - free rate
• could higher (below 1 & 2)
  
  • since reinsurer’s avg rate of return > r-free
  • Argument: result of risk transfer test shold NOT depend on quaility of reinsurer’s inverstment strategies

Methods:

1. selection should be reasonable, appropriate
   
   • risk-free rate with duration mathching with reinsurer’s CFs
2. reinsurer’s expected investement rate is irrelevant in a risk transfer test

Comparison 1 vs 2:

• PV losses higher using 1, since risk free rates < expected inverstment rate, so 1 makes existences of risk transfer more likely (less conservative)
• 2 is more relfective of reinsurer operations, so more accurate prediction on whether siginicant risk of significant loss

Question 9

Difference in expected loss for Pricing vs Risk transfer analysis

Answer 9

Pricing:

• conservative approvach sightly higher expected losses and risk load
• projection of all potential results

Risk transfer test:

• conservative approvach involves lower expected losses and variability
• focus on the dist’n’s right tail