Reinsurance Structures and On Level Loss Ratios

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Reinsurance Structures and On Level Loss Ratios

• Reinsurance Boot Camp July 2005

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Agenda

• Reinsurance Structures
• Calculating an On Level Loss Ratio
• Adjustments to Premium
• Adjustments to Losses
• Adding in a Catastrophe/Shock load
• Dealing with a change in mix of business
• Filling in the gaps when data is unavailable

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Reinsurance Structures

• Standard Structures
• Pro Rata
• Excess of Loss
• NonStandard Structures
• Stop Loss
• Loss Portfolio Transfer

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What is a Pro Rata Treaty?

• The cedant agrees to share x of the premium and
  x of the losses of a book of business.
• The reinsurer returns some of the premium to the
  cedant in the form of a ceding commission.
• One Pro Rata Structure, a Quota Share, cedes the
  same percentage on all risks.
• A Variable Quota Share may cede different
  percentages for different limits.
• A Surplus Share allows the cedant to retain a
  given amount, called a line, on any one risk
  and cede the remaining lines to reinsurers.

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Variable Quota Share
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Surplus Share
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Uses for Pro Rata Treaties

• Surplus Relief
• Pro Rata Structures reduce net premium which
  improves (decreases) the cedants net-premium-to
  surplus ratio
• The ceding commission increases the cedants
  surplus, also improving (decreasing) the
  net-premium-to-surplus ratio.
• Combined Ratio Improvement, in some cases
• Although straight Pro Rata Structures do not
  improve loss ratios, the cedants actual overall
  results can improve if the ceding commission
  received exceeds the cedants actual expenses (an
  override).
• Cedants overall portfolio results COULD be worse
  if they end up ceding out very profitable
  business instead of keeping it net.

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What would I care about if I were pricing a Pro
Rata Treaty?

• Expected Loss Ratio for the covered business
• Volatility of Loss Ratio/Loss Sensitive Features
• Cedants actual expenses
• Alignment of Interests

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Other concerns -

• Variable QS
• Do I have the appropriate data to estimate a loss
  ratio by limit?
• Surplus Share
• Do I have surplus share data that represents the
  current line guide?

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What is an Excess of Loss Treaty?

• For any loss, the cedant retains the first x
  dollars and cedes out the next y dollars, in
  exchange for premium.
• Per Risk
• Per Occurrence
• Example 9M x 1M per occurrence
• For a loss sustained on any given occurrence, the
  cedant keeps the first 1M and the reinsurer picks
  up the next 9M.

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Uses for Excess of Loss Treaties

• Stabilize loss experience
• Catastrophe Protection
• Increased Risk Capacity

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What would I care about if I were pricing an
Excess of Loss Treaty?

• Frequency of Layer Losses
• Severity of Layer Losses
• Volatility of Loss Ratio/Loss Sensitive Features
• Alignment of Interests

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What is a Stop Loss Treaty and what is it used
for?

• The cedant retains the first x of aggregate
  losses and cedes out the next y of aggregate
  losses to a reinsurer in exchange for premium.
• X can either be a percentage or a fixed dollar
  amount
• Stabilizes net results
• Example 10 excess of a 70 net loss ratio in
  exchange for 3 premium.

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What would I care about if I were pricing a Stop
Loss Treaty?

• Expected Loss Ratio for the covered business
• Volatility around the Loss Ratio
• Special Funding features
• Alignment of Interests
• Accounting considerations

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What is a Loss Portfolio Transfer and what is it
used for?

• The cedant gives a block of loss reserves to a
  reinsurer in exchange for premium.
• Premium considers the discounted value of those
  reserves along with a risk charge.
• Enables the cedant to cleanly exit a line of
  business and focus on their going concern
  portfolio.

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What would I care about if I were pricing a Loss
Portfolio Transfer?

• Loss Reserve Adequacy
• Latent Liabilities
• Interest Rate Assumptions
• Alignment of Interests

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Calculating an On Level Loss Ratio

• Essential for pricing almost any prospective
  reinsurance structure.
• Historical years of premium are adjusted to the
  prospective periods rate and dollar levels.
• Historical years of losses are adjusted to an
  ultimate settled basis and trended to the
  prospective periods dollar levels.
• Adjusted losses are ratio-ed to adjusted premium
  for an on level loss ratio.

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Data Needs - Premium

• Historical Premium
• Earned Premium if Losses Occurring treaty
• Written Premium if Risks Attaching treaty
• Historical Rate Changes
• Premium/Exposure Trend if Exposure Base is
  Inflation Sensitive

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Data Needs - Losses

• Historical Paid a/o Incurred Losses and ALAE
• Accident Year if Losses Occurring treaty
• Policy Year if Risks Attaching treaty
• Loss Development Triangle
• Loss Trend
• Catastrophe/Shock losses separately

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Adjustments to Premium

• Rate On Level Factors
• Parallelogram method
• Premium at Present Rates
• Premium/Exposure Trend
• Yes if exposure base is insured value, sales,
  revenues, etc.
• No if exposure base is square feet, per vehicle,
  per employee, per doctor, etc.

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Rate On Level Factors

• Rate Changes should consider changes to base
  rates, schedule credits and debits, tier rating,
  LCMs. They should also be adjusted for changes in
  limits and attachment points on the underlying
  policies.
• Parallelogram method uses geometry to calculate
  on level factors.
• Premium at Present Rates re-rates all historical
  policies using prospective rates.

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Rate On Level Factors
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Premium/Exposure Trend

• Trend from
• Average Earned Date of experience period for
  Losses Occurring
• Average Written Date of experience period for
  Risks Attaching
• Trend to
• Average Earned Date of prospective period for
  Losses Occurring
• Average Written Date of prospective period for
  Risks Attaching

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Adjustments to Losses

• Catastrophe/Shock losses should be separated out.
• NonCat Incurred Losses need to be adjusted to
  ultimate, settled basis.
• Use cedants own loss development triangle
• Supplement with industry/peer data if necessary
• Ultimate, settled noncat losses need to be
  trended to prospective period.
• Trend from average date of loss of experience
  period
• Trend to average date of loss of prospective
  period

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Incurred Loss Development Triangle (in thousands)
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Loss Development (contd)
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Developing Incurred Losses
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Loss Trend
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On Level Loss Ratios Making a Selection

• Select for Stability?
• Select for Responsiveness?
• Somewhere in the middle?

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Stability versus Responsiveness
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Adding a Catastrophe Load

• Catastrophe Load
• By definition, catastrophes are low frequency,
  high severity.
• Your experience period may not even have had such
  a lossyet
• There are plenty of catastrophe exposure models
  available for property however.
• Catastrophe experience should be reviewed, but
  given little weight due to its inherently
  volatile nature.

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Adding a Shock Load

• Loss Experience versus Loss Exposure
• Calculate a limited loss ratio at low stable
  level.
• Add a load for larger losses that you are exposed
  to, but havent experienced yet.
• Use exposure curves to add an excess charge above
  that limited level
• Amortize in some large but possible loss

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Dealing with a Shift in Business Mix

• A loss ratio analysis done on an all lines
  combined basis will miss shifts in the business
  mix.
• Should analyze each line of business separately
  and then weight results on prospective premium by
  line.

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Dealing with Start-Ups and No Data

• New line of business for a company
• New company altogether

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What to think about in no data situations

• Competitor experience or rate comparisons, but
  consider
• Growing pains/distractions in new line
• Competitive advantage?
• Position in the market cycle?
• Burning your way in
• Track record at prior carriers
• Rating of current carrier/current paper
• Company infrastructure established?
• Smaller but growing book and volatility