Frei.RskTrans Flashcards
Benefit to cedant when contract qualifies as reinsurance
Cedant may use reinsurance accounting treatment on the contract
Describe the 2 conditions for a contract to receive reinsurance accounting treatement
- Requires that a significant insurance risk is assumed by the reinsurer under reinsured portion of contract
- Requires that a significant loss to the reinsurer is reasonably possible from the transaction
Identify the components of “insurance risk” (conceptual - not specific) (2)
- U/W risk
- Timing risk
Identify items requiring (CEO, CFO) confirmation regarding transfer of risk (4)
- That there are no separate ORAL/WRITTEN agreements between cedant & reinsurer
- Detaied documentation available for review when risk transfer not self-evident that details the transaction’s economic intent and that documents evidencing risk transfer is available for review
- SAP (Statutory Accounting Principles) compliance by cedant
- The appropriate controls are in place to monitor the use of reinsurance
List 4 methods for assessing the existence of risk transfer and state whether each is qualitative of 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
It is intuitively obvious that the contract protects the cedant from future events that would adversely impact the financial condition of the ceding company
- May apply if reinsurance premium is lower and/or the potential loss is high (usually low freq high sev contracts such as EQ or Hurricane)
Describe the “substantially all” exception for assessing the existence of risk transfer
IF (significant loss is NOT reasonably 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
“Substantially all” - 2 common examples
- Quota share contracts with high % ceded
- Individual risk contracts without (LR caps, other risk limiting features)
Describe the ERD method (Expected Reinsurer Deficit) for assessing the existence of risk transfer
ERD = Prob(NPV Loss) x NPV (Avg Severity of loss as a % of premium)
- If ERD is greater than 1%, then risk transfer has occurred
ERD is basically frequency x 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
If ERD = 2.5%, has risk transfer occured?
Yes, since ERD is greater than 1%
5% prob of 25% loss, does risk transfer exist? Provide one response for yes, one reponse for no
Yes: Under ERD, risk transfer has occurred since ERD = 5% x 25% = 1.25% which is greater than the 1% threshold
No: under “10-10” rule, risk transfer has not occurred since our probability of loss is less than 10%
How is the risk transfer analysis done?
Calculated ERD based on Monte Carlo simulation
Describe the pitfalls in a risk transfer test (6)
Profit commission
- do NOT include in risk transfer test
Reinsurer expenses:
- do NOT include in risk transfer test
Interest rates:
- do NOT vary with scenario (should remain stable throughout)
- should only consider insurance risk (U/W & timing risk)
Commutation timing:
- do NOT use prescribed payment patterns (for losses)
- DO include commutation fees
Evaluation date:
- Risk transfer test should be based on circumstances at evaluation date
- In the case of an amendment date that makes a material change to the amount of risk transferred, the amendment date should be treated as the inception date of the contract and the contract should be reviewed again for risk transfer
Premiums:
- Use PV of GROSS premiums
- Apply premium adjustments to UNDISCOUNTED premiums
Should profit commission be incorporated into risk transfer test?
DO NOT INCORPORATE: because results of cedant should not be included in risk transfer analysis
What is the impact of reinsurer’s expenses on ERD (Expected Reinsurer Deficit) calculation
NO IMPACT: only cash flows between cedant & reinsurer should be considered in ERD calculation
(Interest Rates, Discount Factors) - describe 2 methods for selecting Interest Rate in a risk transfer test (2)
- Selection should be (REASONABLE, APPROPRIATE): usually the risk-free rate. Duration matching should be done with reinsurer’s cash flows
- Reinsurer’s expected investment rate (strictly speaking, the reinsurer’s investment rate should not be relevant in a risk transfer test)
(Interest Rates, Discount Factors) - compare 2 methods for selecting Interest Rate in a risk transfer test
Risk Free Rate vs Expected Investment Rate:
- Using the risk-free rate leads to higher PV (losses) (since rf is less than expected investment rate)
- Higher PV of losses means that risk transfer test is more likely to pass
Describe practical considerations in a risk transfer test - abbreviated list (4)
Parameter selection: interest rate, payment pattern, loss distribution
Parameter Risk
Pricing Assumptions
Commutation Clause
Interest rate- why is the risk free rate the lowest allowed in a risk transfer test?
If (selected interest rate) is smaller than risk free rate
- PV(losses) higher
- Over-detect risk transfer
Interest rate - identify an alternate to the risk-free rate in a risk transfer test & identify an advantage
Reinsurer’s expected investment return:
- More reflective of reinsurer operations (reinsurer expected return is higher than rF)
- More accurate estimate of reinsurer loss
Interest rate - Identify a problem with using an interest rate greater than the risk-free rate in a risk transfer test
Investment strategies of different reinsurers should not have an impact on the risk transfer itself as it may result in different conclusions drawn for reinsurers with good or bad investment strategies
Parameter Risk - describe the implicit & explicit methods for accounting for parameter risk in a risk transfer test
IMPLICIT:
- Higher expected loss selection or an increased volatility of losses
EXPLICIT:
- Give parameters a probability distribution & incorporate this into Monte Carlo simulation of each parameter
Pricing assumptions - advantages of using pricing assumptions in a risk transfer test (& identify a relevant situation)
Reinsurer would have more data and experience that may help insured to have better pricing and risk analysis
- More in line with reinsurer’s view on the risk transfer, and incorporates market view of the risk
Pricing Assumptions - disadvantages of using pricing assumptions in a risk transfer test
Reinsurance pricing assumptions are market-driven, meaning they may vary during a soft market vs during a hard market
- Risk transfer should not depend on the state of the market
Who has final say in risk transfer test?
CEO or CFO (they rely on the actuary’s analysis as part of their final decision)
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
- Cost inflation
NON-FINANCIAL:
- Unfavorable court decisions
- Mortality of claimant
- Tort reform
Briefly describe 2 reasons for a reinsurer to commute a claim and 2 reasons for an insurer to commute a claim
Reinsurer:
- Free up capital to lower underwriting leverage
- Savings in claims adjusting and admin costs
Insurer:
- Decrease expense cost
- Susipicious on the creditworthiness of the reinsurer
