Frei.RskTrans

Question 1

Describe 2 conditions for a contract to receive reinsurance accounting treatment

Answer 1

Requires that:

1. Significant insurance risk is assumed by reinsurer
2. Significant loss to the reinsurer is reasonably possible

Question 2

Identify 4 items requiring CEO/CFO confirmation regarding transfer of risk

Answer 2

• that there are no separate ORAL / WRITTEN agreements between cedant and Reinsurer
• detailed DOCS available for review WHEN risk transfer not self-evident
• SAP (Statutory Accounting Principles) compliance by cedant
• CONTROLS

Question 3

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

Answer 3

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

Question 4

Describe the “self-evident” method for assessing the existence of risk transfer

Answer 4

• 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

Question 5

Describe the “substantially all” exception method for assessing the existence of risk transfer

Answer 5

IF significant loss is NOT reasonably possible

BUT reinsurer assumes ‘substantially all’ risk

THEN risk transfer may still exist

Question 6

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

Answer 6

to maintain access to reinsurance for profitable books of business

Question 7

‘substantially all’ - 2 common Exs

Answer 7

QUOTA SHARE contracts with high % ceded

INDIVIDUAL RISK CONTRACTS without LR caps and other risk limiting features

Question 8

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

Answer 8

ERD = Prob(NPV loss) x NPV(avg severity of loss as a % of premium)

If ERD > 1% –> Risk transfer has occurred

ERD is basically (frequency) x (severity as a % of premium)

Question 9

Describe the “10-10” rule for assessing the existence of risk transfer

Answer 9

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

Question 10

Describe the 6 pitfalls in a risk transfer test

Answer 10

1. Profit commission NOT included in risk transfer test
2. Reinsurer expenses NOT included in risk transfer test
3. Interest rates:
   Do NOT vary with scenario
   Only consider insurance risk (U/W & timing risk)
4. Commutation timing:
   Do NOT use prescribed payment patterns
   DO include commutation fees
5. Based on circumstances at evaluation date
6. Premiums:
   Use PV (Present Value) of GROSS premiums
   Apply premium adjustments to UNDISCOUNTED premiums

Question 11

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

Answer 11

Risk Free Rate vs Expected Investment Rate:
• using the risk-free rate → PV(losses) higher
[ this is because (risk-free rate) < (expected investment rate) ]
• PV(losses) higher → risk transfer test is more likely to pass

Question 12

Identify the 4 practical considerations in a risk transfer test

Answer 12

1. Parameter Selection: (interest rate, payment pattern, loss distribution)
2. Parameter Risk
3. Pricing Assumptions
4. Commutation Clause

Question 13

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

Answer 13

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

Question 14

Identify advantages of using pricing assumptions in a risk transfer test (& identify a relevant situation)

Answer 14

A properly priced reinsurance agreement is based on appropriate expected loss, risk load, payment pattern.

May work well for small or immature books of business

Question 15

Identify 2 disadvantages of using pricing assumptions in a risk transfer test

Answer 15

• reinsurance pricing assumptions are market-driven (may not reflect true expected loss)
• pricing assumptions were derived for a different purpose

Question 16

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

Answer 16

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