Klann Reinsurance

Question 1

Commutation definition

Answer 1

A commutation agreement between a ceding insurer and the reinsurer that provides for the valuation, payment, and complete discharge of all obligations between the parties under a particular reinsurance contract.

Question 2

Functions of reinsurance

Answer 2

F-cat-SWIPLES
* Fronting arrangements
* catastrophe protection
* Surplus relief & capital efficiency
* Withdrawal from market
* Internal reinsurance transactions
* Pools - mandatory & voluntary
* Large line capacity
* Enter market and/or U/W guidance
* Stabilize results

Question 3

Motivations for commutations

Answer 3

SEDR
* Solvency: primary & reinsurer may have concerns about each other’s solvency
* Exit: commutation provides a way for the reinsurer (& primary insurer) to exit a particular market
* Disputes: primary & reinsurer may want to end their relationship because of disputes (e.g. over contract provisions)
* Reserves: primary & reinsurer may disagree over the value of the ceded/assumed reserves (both may think they’re getting a good deal under the commutation)

Question 4

Commutation - loss triangle changes

Answer 4

Primary insurer:
* Ceded paid loss increases by commutation price (because of the payment the reinsurer made)
* Net paid loss decreases by commutation price
* Ceded reserves go to 0 (this is the point of a commutation!)
* Net reserves increase by amount that ceded reserves decreased (to balance)

Reinsurer:
* Gross paid loss increases by the commutation price
* Gross reserves go to 0 (this is the point of a commutation!)

Question 5

Change in taxable income after commutation formulas

Answer 5

Primary insurer = price - (pR-c) x dp
Reinsurer = (reR-g) x dre - price

price = commutation price
dp = discount factor for primary insurer
dre = discount factor for reinsurer
pR-c = undiscounted reserve amount that primary insurer cedes to reinsurer
reR-g = undiscounted reserve amount that reinsurer assumes from primary insurer

Question 6

Hard commutation notation

Answer 6

• pR-g
• pU-g
• pR-c
• reR-g
• pP-n
• pP-c = reP-g
• reU-g
• reU+g

P, R, U = Paid, Reserve, Ultimate

Question 7

Commutation price calculation steps

Answer 7

• Commutation price = reU+g - reP-g
• reP-g = pP-g x qs% = (pU-g - pR-g) x qs%
• reU+g = reU-g x (1 + increase in reinsurer’s ultimate after commutation)
• reU-g = reR-g + reP-g
• reR-g = pR-g x (1 + increase in reinsurer’s carried) x qs%

Question 8

Steps in pricing a commutation

Answer 8

EDTU
1. Estimate the claim payments that would be made in the absence of a commutation
For the insurer, these payments are reinsurance recoverables
For the reinsurer, these payments are loss reserves
2. Discount the estimates (losses are booked on nominal basis, but commutation price uses discounted values)
Need a payment pattern and discount factor – probably different for two sides
3. Tax effects: would try to agree on a price that is mutually beneficial
4. Unique considerations: for example, reinsurer may be desperate to exit the market and may accept a higher selling price

Question 9

Pricing a commutation for mutual benefit formulas

Answer 9

Primary insurer benefit = price - (economic-discounted pR-c) + (pT) > 0
Reinsurer benefit = - price + (economic-discounted reR-g) + (reT) > 0

pT is tax benefit to primary insurer =
= (tax rate for primary insurer) x (decrease in taxable income for primary insurer)
= (tax rate for primary insurer) x (tax-discounted pR-c - P)

reT is tax benefit to reinsurer =
= (tax rate for reinsurer) x (decrease in taxable income for reinsurer)
= (tax rate for reinsurer) x (-reR-g + P)

Question 10

Solvency motivation for commutation

Answer 10

If primary insurer is weak:
* Commutation provides a CASH INFUSION to primary insurer
* Reinsurer also avoids liquidation issues if primary insurer goes insolvent

If reinsurer is weak:
* Commutation ELIMINATES CREDIT RISK for primary insurer

Question 11

Exit motivation for commutation

Answer 11

Commutation allows reinsurer to exit LOB immediately
Commutation is 1st step in exiting for primary insurer:
* 2nd step is a loss portfolio transfer
* Easier to execute if they own 100% of claims without reinsurance overlay

Question 12

Disputes motivation for commutation

Answer 12

If there are serious disputes between primary insurer & reinsurer…a single negotation over commutation price may be preferable

Question 13

Reserves motivation for commutation

Answer 13

If there is a big difference in reserve estimates between primary insurer & reinsurer…a commutation price between their reserve estimates may leave each believing they got the better deal