Risk Transfer Testing

1
Risk Transfer Testing

• Rob Downs, FCAS
• Actuary, Research and Development
• American Agricultural Insurance Company

2
Risk Transfer Testing

• "If it looks like duck, walks like duck, and
  quacks like a duck, .... it's probably a duck"...
  

But how do you prove it is a duck?"
3
Agenda

• Overview of Attestation Requirement
• Reasonably Self Evident
• Scenario Testing
• Simulation Testing
• Risk Transfer Metrics Criteria
• Example of Risk Transfer Analysis
• Responsibilities and Controls
• May 26, 2006 - FASB Bifurcation I.T.C.

4
Reinsurance Attestation

• CEO and CFO shall attest, under penalties of
  perjury, with respect to all reinsurance
  contracts for which the reporting entity is
  taking credit on its current financial statement,
  that to the best of their knowledge and belief
  after diligent inquiry
• Consistent with SSAP 62, there are no separate
  written or oral agreements between the reporting
  entity and the assuming reinsurer that would,
  under any circumstances, reduce, limit, mitigate
  or otherwise effect any actual or potential loss
  to the parties under the reinsurance contract
• For each reinsurance contract entered into, ,
  for which risk transfer is not reasonably
  considered to be self-evident, documentation
  concerning the economic intent of the transaction
  and the risk transfer analysis evidencing the
  proper accounting treatment,, is available for
  review
• The reporting entity complies with all the
  requirements set forth in SSAP 62
• The reporting entity has appropriate controls in
  place to monitor the use of reinsurance and
  adhere to the provisions of SSAP 62.

5
Summary of Attestation

• No separate arrangements
• Risk Transfer analysis is available
• Contracts meet SSAP 62
• Appropriate controls in place

6
SSAP 62 - Paragraph 12

• Indemnification of the ceding company against
  loss or liability relating to insurance risk in
  reinsurance requires both of the following
• The reinsurer assumes significant insurance risk
  under the reinsured portions of the underlying
  insurance agreements and
• It is reasonably possible that the reinsurer may
  realize a significant loss from the transaction.

7
Key SSAP 62 Concept

• Significant Loss Is Reasonably Possible

8
Risk Transfer Decision Flow
Reasonably Self Evident?
Yes
No
Document Contract File That it is Self Evident
Risk Transfer Analysis
9
AAA Practice NoteReasonable Self Evident

• Straight Quota Share
• no risk-limiting features other than a loss ratio
  cap with negligible effect on the economics of
  the transaction.
• Single Year Property Catastrophe
• little or no risk limiting features apart from a
  reinstatement premium common to these types of
  contracts.
• Treaty Per Risk Excess of Loss
• arrangements with rates on line well below the
  present value of the limit of coverage, or
  without aggregate limits, sub-limits, or
  contingent features.

10
AAA Practice NoteNOT Reasonable Self Evident

• Aggregate excess of loss contracts
• most of these contracts either contain
  significant risk-limiting features, and/or attach
  in an expected layer of loss so that the premium
  approaches the present value of the coverage
  provided.
• Contracts with experience provisions
• experience accounts, experience rating refunds,
  or similar provisions if such provisions have a
  significant impact on the contracts economics.
• Multiple year contracts
• many of these have provisions that protect the
  reinsurer from changes in exposure over the
  contract period and make the analysis
  complicated, and/or have features that adjust the
  terms of later years explicitly or implicitly
  based on results in earlier years
• Quota share contracts with risk limiting features
• loss retention corridors, sliding scale
  commissions, loss ratio caps and/or sub-limits
  that significantly impact the amount of risk
  being transferred.

11
Risk Transfer Options
Reasonably Self Evident?
Yes
No
Document Contract File That it is Self Evident
Risk Transfer Analysis
Non-Stochastic Scenario Testing
Stochastic Simulation Testing
Or
Analysis goes into U/W File
Analysis goes into U/W File
12
Risk Transfer Analysis Complexity
Reasonably Self Evident
Non-Stochastic Scenario Testing
Stochastic Simulation Testing
13
Risk Transfer Cash Flow Testing Overview

• Analysis Requirements
• Understand the substance of the contract.
• All significant contract provisions are
  considered.
• Develop appropriate loss model for subject
  losses.
• Focus on all cash flows between parties.
• Investment income needs to be considered. (NPV)
• Measure the following Ratio
• NPV Reinsurer Net Result
• NPV Total Premium
• Applies to both Simulation and Scenario Testing
  approaches.

14
Scenario Testing

• Non-Stochastic / Scenario Testing
• Chalk board approach
• Identifying reasonably possible scenarios
• Demonstrating that a significant loss would occur
• When I ask an actuary what time it is, they
  always answer the question by telling me how to
  build a clock. David Glover, AAIC

15
Scenario Testing

• Reasonable Scenarios
• Prior Results
• Common Sense Reasonable Possible
• Simulation isnt a requirement
• Requirements
• Investment Income needs to be considered
• Reasonable and Significant criteria
• 10 / 10 criteria implicitly met
• Document !

16
Scenario TestingExample Surplus Share Contract

• Property Surplus Share Contract
• 1 Year Accident Year Contract
• 10 Million in Est. Subject Premium
• Provisional Commission of 25
• Commission is Adjustable /- 5
• Occurrence Limit is 10 million
• Sliding Scale Commission
• Commission 25 at LR of 65
• Commission 20 at LR of 75 or Greater
• Commission 30 at LR of 55 or Less
• Sliding Commission for LR between 55-75 (1 point
  for 2 points of LR)

17
Scenario TestingHistorical Results of Contract
18
Scenario TestingExample Surplus Share Contract

• Memo to Contract File
• 1994 Reinsurer result would be 95 LR plus 20
  commission for an combined ratio of 115.
  Investment income impact would be about 3.
  Reinsurer Result of 12 loss to premium.
• 2000 Reinsurer result would be 130 LR plus 20
  commission for an combined ratio of 150.
  Investment income impact would be about 3.
  Reinsurer Result of 47 loss to premium.
• Based on this we believe reasonably possible
  that the reinsurer could have a significant loss
  and thus this contract satisfies risk transfer
  for SSAP 62.
• Risk Transfer Analysis Completed !

19
Risk Transfer Metrics Criteria

• 10 / 10 Rule
• Tail Value at Risk (TVAR)
• Expected Reinsurer Deficit (ERD)
• Paragraph 15 exception

20
Criteria 10 / 10

• 10/10 Rule
• This was the initial rule of thumb used by
  auditors for risk transfer and has been highly
  criticized for being too simplistic, and not
  broad enough.
• 10 probability of a loss to the reinsurer of at
  least 10 loss relative to premium.
• Inertia keeps this very relevant

Handout Missing Page
21
Criteria TVAR

• Tail Value at Risk (TVAR)
• Tail Value at Risk is the average result above a
  certain threshold, not just the result at that
  percentile.
• Criteria comparable to the 10 / 10 Rule for TVAR
  would be TVAR value greater than 10 at the 10th
  percentile
• Better than 10 /10, but ERD is even better.

22
Criteria ERD

• Expected Reinsurer Deficit (ERD)
• Accounts for the probability and severity of a
  loss.
• The ERD is calculated by multiplying the
  probability of a reinsurer loss by the average
  reinsurer loss.
• Proposed by the Casualty Actuarial Society
  working group. Better criteria to the 10/10
  rule.
• Criteria of ERD of 1 would be close to 10/10
  rule. (1 10 x 10)
• Criteria of ERD of 2 is being suggested.

23
Simulation Testing

• Stochastic / Simulation Modeling
• Contract Loss Model Generator
• Contract Terms Modeling
• Cash Flow Discounted Quarterly
• Distribution of Reinsurer Results are captured
• Risk Metrics are Summarized for 10,000
  simulations
• Actuarial Work Product
• Judgment in Loss Model Construction
• Two different actuaries could do the analysis and
  produce different distribution of results
• No single right way of modeling
• Documentation Standards of Assumptions

24
Loss Modeling

• Aggregate Losses Model
• Log-Normal Loss Ratio Model
• Reasonable for Quota Share and Aggregate Stop
  Loss Contracts.
• Frequency-Severity Models
• Simulate How Many Losses (if any)
• Simulate Size of Each Loss
• Used for Excess Contracts
• Combination Model
• Aggregate Model for Normal Losses
• Frequency-Severity Model for Shock Losses
• Used in Property Quota Share Contracts

25
Contract Modeling

• Need to be modeled
• Contract Losses (from loss model)
• Upfront Premium
• Contingent Additional Premium
• Commissions (Flat or Variable)
• Contract features that mitigate risk transfer
• Loss Limitations (unless not significant)
• Not modeled
• Reinsurance underwriting expenses
• Tax Impacts

26
Discounted Cash Flow

• Quarterly Cash Flow
• Contractual Premium Timing
• Loss Payout Patterns
• Commission Adjustments
• Discount Rate
• SSAP 62 does not have a specific requirement
  other than single interest rate to reflect time
  value of money.
• Duration match Treasury bond yield.
• Duration match AAA Municipal bond yields.
• Variations in Cash Flow
• Fast, Medium, or Slow payout patterns that
  are randomly generated.
• Timing Risk is required, but often not a true
  issue.

27
Loss Model Parameter Selection

• Drawn from
• Historical Results of the results subject to the
  contract
• Other Sources
• Pricing Analysis
• Judgment
• Parameter Uncertainty
• Extreme Scenarios are more likely than history
• Shock Loss Potential
• Correlation of Losses
• Calibrate likelihoods to reinsurers expected
  results
• -20 Average result isnt reasonable
• 60 Average result isnt reasonable either
• Suggest 5 to 40 Average depending on contract
  type

28
Risk Transfer AnalysisSimulation Analysis

• Risk Transfer Analysis Output Page
• Chart Section
• Percentile Values
• TVAR Calculations
• ERD Calculation
• Documentation of Analysis
• Numerical Values
• Contract Description
• Modeling Description

29
Example Surplus ShareLoss Modeling Details
30
Example Surplus ShareLoss Modeling Details

• Two part Loss Model Simulation
• Normal Losses using a Log-Normal
• Cat Losses using Frequency/Severity
• Commission
• Provisional Paid
• Adjustment made at end of year.
• Occurrence Cap
• 10 million event limit
• Cap is applied to the Catastrophe Events
• Reinsurer Result
• Premium less Commission less Losses
• Dollars and as percent of Premium

31
Distribution of Reinsurance ResultsGraphical
Display
See Back Exhibit for Complete Example
32
Percentile Ranking of ScenariosRanked on
Reinsurers Result
Nominal Real or Undiscounted Amount NPV -
Net Present Value or Discounted Amount
See Back Exhibit for Complete Example
33
Tail Value at Risk (TVAR)Ranked on Reinsurers
Result
TVaR- Tail Value at Risk, is the average outcome
above a certain probability threshold. Thus,
the TVaR _at_ 10 -59.4 which represents the
average of the 10 worst scenarios
See Back Exhibit for Complete Example
34
Expected Reinsurer Deficit (ERD)Calculation
ERD (Probability of a Reinsurer Deficit) X
(Average Reinsurer Deficit)
See Back Exhibit for Complete Example
35
Risk Transfer ResponsibilitiesCeding Company and
Reinsurer

• Risk Transfer requirements applies to both
  ceding company and reinsurer.
• Ultimate responsibility for reinsurance
  accounting is the individual entity.
• AAIC will share our Risk Transfer analysis, but
  companies responsibility to accept analysis as
  reasonable and draw there own conclusions risk
  transfer.
• Auditors will likely be looking if risk transfer
  analysis is available, documented, and
  reasonable.

36
Risk Transfer ResponsibilitiesControls and
Monitoring

• Controls and Monitoring is a Attestation
  requirement.
• Risk transfer review should be done at contract
  inception.
• Risk transfer review needs to be done every
  year.
• Auditors will likely be looking if risk transfer
  analysis is available, documented, and monitored.
• Documentation of risk transfer controls and
  company guidelines is good idea.

37
Reinsurance Risk Transfer Suggested Decision Tree
Contract Negotiation
Risk Transfer Self Evident
Contract pass 10/10 Rule
Risk Transfer Analysis
N
Y
Y
N
Contract pass ERD 2
Y
N
Will Auditors agree with with Risk Transfer
Reinsurance Treatment
N
Y
Reinsurance Accounting and Document Contract File
Deposit Accounting or Renegotiate Terms
38
Risk Transfer AnalysisFuture Developments

• Risk Transfer Criteria will likely become better
  defined as time goes on.
• FASB heading where?
• Requirement wont go away, must manage the
  process, maintain documentation, and controls.

39
Future is NowFASB Invitation to Comment

• Bifurcation of Insurance and Reinsurance
  Contracts for Financial Reporting
• Released May 26, 2006
• Interested Parties Comments by August 24, 2006
• Discussion of Issues and Practice
• Proposals for Bifurcation
• 11 Issues to Comment on
• How will industry respond?

40
FASB Bifurcation DocumentMay 26, 2006

• Insurance and Reinsurance contracts
• Insurance and Non-Insurance companies
• Unequivocally insurance test
• Risk transfer is still required
• Multiple approaches to bifurcation
• Question of which contracts?
• Three suggested bifurcation methods
• Expected Loss Method (Dollar Trading)
• Proportional Method
• Cash Flow Yield Method

41
FASB ITC ProposalRisk Transfer and Bifurcation
Passes Risk Transfer
N
Y
Exempt from Bifurcation?
Y
N
Bifurcation of Contract Based on Risk
Deposit Component
Insurance Component
Reinsurance Accounting
Deposit Accounting
42
(No Transcript)