Part 27 (Klann) (***)

Question 1

What is a commutation

Answer 1

An agreement between a ceding company and reinsurance company that completely discharges all obligations of a particular reinsurance contract

Question 2

Key features of a commutation are

Answer 2

• The reinsurer makes a premium payment to the ceding company
• In return, reinsurer is no longer responsible for the claims or policies covered by the agreement

Question 3

Why would they want to do a commutation

Answer 3

• Reinsurer or insurer may wish to exit a line of business
• There may be concerns about the other party’s solvency
• The parties may wish to end a troubled relationship
• Each side may believe that they are benefiting from the commutation

Question 4

Pricing a commutation, first step of determining what

Answer 4

• Each party will determine its range of pricing

Question 5

What is the range for commutation pricing based on

Answer 5

• future claim payments from reinsurer to the ceding
• timing of the payments
• discount rate that account for both the time value of money and risk
• unique tax treatment
• motivation for entering into the commutation

Question 6

Accounting treatment for Ceding company in commutation

Answer 6

• Record the premium as a recovery of paid losses
• Eliminate the reserves ceded to the reinsurer

Question 7

Accounting treatment for reinsurer in commutation

Answer 7

• Record the premium as paid losses
• eliminate the associated loss reserves

Question 8

Commutation Distortion in Financial Statements, Primary

Answer 8

• Downward development of paid losses
• Ceded Reserves fall to 0
• Net ultimate losses increase, despite a constant gross ultimate

Question 9

When do these distortions in financial statements occur from commutations

Answer 9

Immediately, like @ 36 months for year 2023

Question 10

Commutation Distortion in Financial Statements, Reinsurer

Answer 10

• Jump in paid losses
• Ultimate Loss decrease
• Jump in claims closure count

Question 11

Assume primary has a discount factor of .875 and reinsurance .85

Marginal Tax rate is 35%

Reinsurer pays 400 to commutate, Primary had ceded 500 of reserves, reinsurer had set those with reserves of 550

Calculate the tax impact to each party

Answer 11

Primary:
Income: +400 - 500 * .875 = -37.5
Tax benefit = 35% * 37.5

Reinsurance:
Income: -400 + 550 * .85 = 67.5
Tax increase = 35% * 67.5