Frei.RskTrans

Question 1

benefit to cedant when contract qualifies as reinsurance

Answer 1

cedant may use reinsurance accounting treatment on the contract

Question 2

describe 2 conditions for a contract to receive reinsurance accounting treatment / requirements of risk transfer

Answer 2

• significant insurance risk is assumed by reinsurer under the reinsured portion of contract
• a significant loss to the reinsurer is reasonably possible

Question 3

identify the components of ‘insurance risk’

Answer 3

• uw risk
• timing risk

Question 4

identify items requiring CEO and CFO confirmation regarding transfer of risk

Answer 4

• there are no separate oral/written agreements between cedant and reinsurer
• detailed docs available for review when risk transfer is not self evident
• SAP (Statutory Accounting Principles) compliance by cedant
• controls

Question 5

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

Answer 5

1) self-evident?: qualitative
2) “substantially all” exception: qualitative
3) ERD rule (Expected Reinsurer Deficit): quantitative
4) 10-10 rule: quantitative

Question 6

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

Answer 6

• when it is 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 7

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

Answer 7

if significant loss is not reasonably possible, but reinsurer assumes substantially all risk, then risk transfer may still exist

Question 8

what is the reason for the substantially all exception in testing risk transfer?

Answer 8

to maintain access to reinsurance for profitable books of business

Question 9

2 common examples for “substantially all”

Answer 9

• quota share contracts with high % ceded
• individual risk contracts without LR caps, other risk limiting features

Question 10

describe ERD method for assessing the existence of risk transfer

Answer 10

ERD = P(NPV loss) * NPV(avg severity of loss as a % of premium)
if ERD >1%, then risk transfer has occurred
ERD is basically frequency * severity as a % of premium

Question 11

describe the 10-10 rule for assessing the existence of risk transfer

Answer 11

if reinsurer has a 10% chance of suffering a 10% loss, then the contract is deemed to have transferred risk

Question 12

if there is a 5% probability of 25% loss, does risk transfer exist?

Answer 12

• by 10 10 rule, no
• by ERD, ERD = 5% * 25% = 1.25% >1%, yes

Question 13

F2017 Q17
F2016 Q16

Question 14

steps of analyzing risk transfer

Answer 14

1) understand reinsurance contract terms and conditions
2) determine reporting and premium due dates
3) analysis completed using monte carlo simulation
3) calculate ERD

Question 15

describe the pitfalls in a risk transfer test

Answer 15

PRICE-P
- Profit Commission (N)
- Reinsurance Expense (N)
- Interest Rate (donot vary with scenario, only consider insurance risk)
- Commutation timing: (donot use prescribed payment pattern)
- Evaluation Date: test based on circumstances at evaluation date
- Premiums: use PV(present value) of gross premiums, apply premium adjustments to undiscounted premiums

Question 16

should profit commission be incorporated into risk transfer test?

Answer 16

No, because the results of the ceding company should not be considered in the analysis.
The analysis focuses only on the scenarios resulting in a loss for the reinsurer. Profit commissions can affect the economic results of a treaty, usually not triggered during a reinsurer loss.

Question 17

what is the impact of reinsurer’s expenses on ERD calculation?

Answer 17

No impact, only cash flows between cedant and reinsurer should be considered in ERD calculation

Question 18

describe 2 methods for selecting interest rate in a risk transfer test

Answer 18

• selection should be reasonable and appropriate: risk free rate with duration matching reinsurer’s cash flow
• reinsurer’s expected investment rate

Question 19

compare 2 methods for selecting interest rate in a risk transfer test

Answer 19

Risk free rate VS. Expected investment rate
- using the risk free rate -> PV(losses) higher because risk free rate < expected investment return
- PV( losses) higher -> risk transfer test is more likely to pass

Question 20

describe the practical considerations in a risk transfer test

Answer 20

• parameter selection (interest rate, payment pattern, loss distribution)
• parameter risk
• pricing assumptions
• commutation clause

Question 21

why is the risk free rate the lowest allowed in a risk transfer test?

Answer 21

if selected interest rate < risk free rate, then
- PV (losses) higher
- over detect risk transfer

Question 22

identify an alternate to the risk-free rate in a rate transfer test and identify an advantage

Answer 22

reinsurer’s expected investment return
- more reflective of reinsurer operations
- more accurate estimate of reinsurer loss

Question 23

identify a problem with using a interest rate greater than the risk free rate in a risk transfer test

Answer 23

• alternate rate may not be available to ceding company, doing risk transfer test
• result of risk transfer test should not depend on the quality of reinsurer’s investment strategy

Question 24

describe the implicit and explicit methods for accounting for parameter risk in a risk transfer test

Answer 24

• implicit: higher expected loss selection and volatility
• explicit: give parameters a probability distribution & incorporate this into simulation

Question 25

advantages of using pricing assumptions in a risk transfer test and identify a relevant situation

Answer 25

• a properly priced reinsurance agreement is based on appropriate expected loss, risk load and payment pattern
• may work well for small or immature book of business

Question 26

disadvantages of using pricing assumptions in a risk transfer test

Answer 26

• reinsurance pricing assumptions are market driven, so it may not reflect the true expected loss
• pricing assumptions are derived for a different purpose

Question 27

who has the final say in risk transfer test?

Answer 27

CEO or CFO

Question 28

identify 2 financial and 2 non-financial considerations regarding cash flows in a reinsurance commutation

Answer 28

financial :
- amount and 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