Freihaut - Reinsurance Risk Transfer

Question 1

Why is important to the ceding company to show that risk transfer has occurred?

(ie what are the implications?)

Answer 1

In case of no risk transfer: The insurer cannot show reserves as ‘net’ of reinsurance recoverables (in other words, they get no capital credit for having reinsurance)….would have to use deposit accounting

Also: reinsurer cannot properly price a reinsurance contract without knowing how much risk they’ve taken on.

Question 2

Identify 2 conditions for a contract to receive reinsurance accounting treatment

Answer 2

1. Requires that significant insurance risk is assumed by reinsurer (under reinsured portion of contract). Remember insurance risk includes
   
   1. UW Risk - ie uncertainty in value of loss
   2. Time Risk - uncertainty in when a loss may occur
2. Requires that a significant loss to the reinsurer is reasonably possible.

Question 3

What are 2 qualitative methods for determining risk transfer has occurred?

Answer 3

1. Reasonable Self Evident:
   
   2. Maybe the premium is very low or the potential of loss is very high like with hurricanes or earthquakes
   3. Tranaction done at “arms length”, no risk limiting features (ie loss ratio caps).
2. Substantially All Exception
   
   5. IF (significant loss NOT reasonably possible) BUT (reinsurer assumes “substantially all” risk) THEN (risk transfer may still exist)
   6. Think a quota share arrangement on a profitable book of business

Question 4

What are 2 quantitative methods for determining risk transfer has occurred?

Answer 4

• Calculate ERD (Expected Reinsurer Deficit): ERD = prob(NPV reinsurer loss) x NPV(reinsurer loss) / NPV(reinsurance premium)
  
  • If ERD > 1% then there has been transfer of risk
• 10-10 rule: IF reinsurer has ≥10% chance of ≥10% U/W loss THEN the contract has transferred risk
  
  • If NPV(loss) at 90th percentile > 110% x NPV(reinsurance premium)
  • Remember to discount if given discount rate and check for any capping

Question 5

How do you calculate the ERD %

Answer 5

Given scenarios i=1 to n
∑_{(i=1 to n)} Prob(i) x max{(NPV(Loss_i) - NPV(Prem) + NPV(Cash Flow_i))},0] / NPV(Prem)

Where:
* Prob(i) is the probability of scenario/event i occurring
* NPV(Loss_i) is net present value of ceded loss in scenario i
* NPV(Cash Flow_i) is the net present value of cash flows such commutations, ceding commissions (per Appendix A) maintenance fees etc. that occur in scenario i
* NPV(Prem) is the net present value of the ceding premium paid to the reinsurer

Do not include profit commissions though.

Note only include if the NPV of a scenario is greater than 0. If less than 0, set equal to 0

Question 6

Should profit commissions be considered when calculating ERD?

Answer 6

Profit commissions should generally NOT be considered in risk transfer analysis (because they are not usually triggered during a reinsurer loss). That being said, profit commissions affect risk transfer in 2 ways:

• Profit commissions may have an impact on premium. If there are profit commissions then reinsurer may want higher premium
• profit/loss from prior years may affect future results

Note if ERD fails, can try removing profit commissions to lower premium.

Question 7

Should reinsurer expenses be considered in risk transfer test?

Answer 7

No, as they are not a cash flow between cedant and reinsurer

Question 8

Should the interest rate vary in risk transfer test?

Answer 8

NO: because risk transfer analysis should consider only insurance risk not credit risk.
NOTE: yield curves (which imply higher yields for longer durations) are NOT permitted

Should use best estimate of interest rate at evaluation date.

Question 9

What are some considerations for the selection of the interest rate for ERD?

Answer 9

• should be reasonable & appropriate (per SSAP 62)
• may use risk-free rate
• duration of risk-free rate should MATCH reinsurer’s cash flows
• use SAME rate for all cash flows

Note that reinsurer’s expected investment rate is IRRELEVANT in a risk transfer test)

Question 10

How can the selection of the interest rate have an impact on risk transfer tests?

Answer 10

• if discount rate higher, then
  ==> PV(losses) lower
  ==> risk transfer less likely
  ==> risk transfer is UNDER-detected
• if discount rate lower, then
  ==> PV(losses) higher
  ==> risk transfer more likely
  ==> risk transfer is OVER-detected

Question 11

What are important considerations regarding premiumn for ERD?

Answer 11

• Should be the reinsurer’s gross premiums before any ceding commission.
• Premiums should be discounted back to the evaluation date using the same interest rates used for losses.
• However, for contract features such as loss ratio caps and experience adjustments should be done at nominal premium amounts (losses as well)
  
  • Discounting is done after
• When premium is dependent on future events, premium modeling is more complicated (page 14)
  
  • Can use expected premium or actual premium from each scenario

Commutaions should be included.

expected premium may overstate risk transfer as actual premiums would tend to be higher with poor experience

Question 12

What is the evaluation date as it pertains to evaluating risk transfer?

Answer 12

The evaluation date is the point in time at which the risk transfer assesment is made.

Per SSAP 62 “risk transfer assessment is made at the inception date based on facts and circumstances known at the time”

Even if facts change over time, this is irrelevant to risk transfer test. Only need to retest if there are material changes to the contract

Question 13

If there is prescribed payment plan in a reinsurance contract is there risk transfer

Answer 13

No, because this removes the “timing risk” that is necessary for risk transfer.

Reinsurer must make “timely reimbursement payments.” to qualify.

Question 14

What are 3 important paramter selections to simulate / calculate an ERD?

Answer 14

• Interest Rate
• Payout Pattern
• Loss Distribution

Question 15

What are some considerations regarding interest rate selection?

Answer 15

Based on SSAP 62, a risk free rate matching the duration of liabilies is accepted, but some other considerations are:

• An interest rate less than risk free, though seemingly conservative, actually gives higher PV’s of loss and leads to overstating risk transfer
• **Higher than risk free **/ reinsurer expected return - Not likely be known and should risk transfer be determined by how well reinsurer invests?
• A yield curve is tempting, but SSAP 62 requires a single interest rate to be used —-> not measuring interest rate risk.

Risk free rate is the way to go!

Question 16

Why is the payment pattern an important paratmeter selection for ERD?

Answer 16

• More difficult to measure than loss distribution
• However, a constant loss payment pattern will not recognize the impact of quicker than expected payments.
• This can have a significant impact on the tail of the loss disitrbution, which has a lot of influence on risk transfer test.

Question 17

What are some important considerations regarding loss distribution selection?

Answer 17

• Selected based some combination of company experience, industry benchmarks, pricing information, and judgement.
• For small-to-mid size books this is difficult to use company data due to lack of data in the tail, especially on long-tail lines. However, industry data may not fully represent the book.
• Important to test tail results
• In the case of selecting a generally accepted distribution, still must contemplate the variance (size of book, type of business/coverage)

Remember the tail has big impact on ERD calc, as these are the larger losses.

Question 18

What is paramater risk and how it is contemplated in risk transfer analysis

ERD

Answer 18

Parameter risk is the the risk that the selected parameters
or model are incorrect (loss distribution, payment pattern, etc).

• Contemplate either explicitly or implicitly.
  
  • Explicit: Provide probability distributions for key parameters and then simulate those as well.
  • Implicit: Choose a higher expected loss selection or increase the expected variance of losses

Note the problem with explicit selection is depends on judgment and requires the selection of more distributions and parameters