Finite Reinsurance

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Finite Reinsurance

• Casualty Loss Reserve Seminar
• Chicago, IL
• September 9, 2003
• Bruce D. Fell, FCAS, MAAA, CFA

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Disclaimer

• The views expressed in this presentation are
  those of the individual presenters and in no way
  represent the opinions of the CAS, the Joint
  Committee of the CLRS, or the presenters
  respective employers.
• The presenters take full responsibility for all
  irrational, incoherent and foolish comments.

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Agenda

• Current Market Environment
• Overview of Finite Structures
• Overview of SFAS No. 113 and Statutory Issue
  Paper No. 75

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Current Market Environment

• Interest Rate Environment
• Underwriting Environment
• Heightened Regulatory Environment

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Interest Rate Environment

• Rates have dropped dramatically in last five
  years
• Time value of money changes dynamics of some
  transactions

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Underwriting Environment

• Focus on underwriting profit after years of soft
  market and Sept. 11, 2001
• Fewer finite reinsurers
• Exits Centre, Commerical Risk, Gerling, OPL,
  Scandinavian, Stockton
• Refocus Am Re, Gen Re, St. Paul

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Underwriting Environment

• Focus on correlation and aggregation
• Risks previously assumed to be independent now
  recognized as correlated (lesson learned from
  Sept. 11, 2001)
• Natural catastrophe aggregations
• Focus on credit risk
• Cedents focus on quality of reinsurers
• Reinsurers focus on quality of cedents

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Underwriting Environment

• Constrained Capacity
• Reserve charges from 9/11, soft market and latent
  exposures have depleted capital
• Focus limited capital on best profit potential
• Increased premium fewer companies increased
  capital leverage
• Supply and demand increases cost of capital

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Heightened Regulatory Environment

• Rating agencies capital levels and underwriting
  profit
• Auditors increased disclosures and truth in
  reporting
• Stock analysts redemption from technology
  bubble
• State regulators debate over federal versus
  state regulation

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Finite Structures

• Retroactive Reinsurance
• Loss Portfolio Transfer (LPT)
• Adverse Loss Development Cover (ALDC)
• Prospective Reinsurance
• Finite Quota Share
• Aggregate Excess of Loss (Stop Loss)
• Traditional contracts with finite features
• Combination of coverage

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Common Contract Provisions

• Experience accounts
• Profit commissions
• Aggregate limits
• Loss ratio corridors
• Cancellation provisions
• Delays in payments
• Adjustable premium, limit or commission

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LPTs ALDCs

• Reinsurer accepts ceding companys reserve
  uncertainty in exchange for a fixed premium
• Pricing based on
• Reserve level
• Expected payment pattern of reserves
• Variability of reserves and payment pattern
• Expected interest rate
• Reinsurers capital costs and risk margin

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LPTs ALDCs
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Loss Portfolio Transfer

• Contract provisions
• Aggregate limit
• Experience account refunds
• Commutation provisions
• Benefits
• Transfer existing reserves to reinsurer (reduce
  reserve leverage)
• May protect from adverse development
• Establish fixed current price for uncertain
  future reserves

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Loss Portfolio Transfer Example

• Premium 120 million
• Limit 150 million
• Reinsurers Margin 3 (3.6 million)
• Crediting Interest Rate 2.0
• Experience account refund _at_ commutation Premium
  - Margin - Losses Interest

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Adverse Loss Development

• Contract provisions
• Aggregate limit
• Possible experience account refunds
• Commutation provisions
• Benefits
• Protection from adverse development
• Establish fixed current price for uncertain
  future reserves

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Adverse Loss Development Example

• Premium 40 million
• Limit 50 million excess of 100 million
• Reinsurers margin 5 (2.0 million)
• Crediting Interest Rate 2.5
• Experience account refund _at_ commutation Premium
  - Margin - Losses Interest

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Finite Quota Share

• Reinsurer accepts percentage of cedents premiums
  and losses in exchange for ceding commission
• Contract Provisions
• Sliding scale commission
• Loss ratio corridor
• Aggregate limit

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Finite Quota Share

• Pricing based on
• Expected loss ratio
• Size of slide, corridor and aggregate limit
• Reinsurers capital charge
• Benefits
• Surplus relief from ceding commission
• Transfer premium to reinsurer (reduce premium
  leverage)

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Finite Quota Share Example

• Provisional ceding commission 35 minimum
  25 _at_ 70 loss ratiomaximum 40 _at_ 55 loss
  ratio
• Loss corridor between 70 and 75 loss ratio
• Reinsurers margin 5 between 55 loss ratio
  and 75 loss ratio
• Aggregate Limit 100 loss ratio

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50 Finite Quota Share Example
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Aggregate Excess of Loss

• Reinsurer provides corridor of protection over
  cedents expected results in exchange for fixed
  premium
• Contract Provisions
• Aggregate limit
• Experience account refunds

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Aggregate Excess of Loss

• Pricing based on
• Expected loss ratio results
• Variability of loss ratio
• Size of experience account refund
• Interest rates
• Benefits
• Aggregate protection of underwriting results

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Aggregate Excess of Loss Example

• 10 loss ratio points in excess of a 65 loss
  ratio (maximum of 9 million)
• Maximum subject premium 90 million
• Reinsurance premium 6 million
• Reinsurers Margin 10 (600,000)
• Crediting Interest Rate 2.5
• Experience account refund _at_ commutation Premium
  - Margin - Losses Interest

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Aggregate Excess of Loss Example
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Traditional and Combination Coverage

• Many traditional reinsurance contracts include
  finite features
• Corridors, Aggregate limits, Adjustable
  commissions, etc.
• Some finite contracts include traditional
  coverage to add risk
• Section A finite quota share
• Section B excess occurrence (cat) coverage

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GAAP and Statutory Reinsurance Accounting

• SFAS No. 113
• Effective 1993
• Statutory Issue Paper No. 75
• Effective 1995
• Both outline determination of whether contract is
  reinsurance and if so, the appropriate accounting
  treatment

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SFAS No. 113 Decision Tree
Does contract indemnify cedant against
loss/liability?
Use deposit accounting AICPA SOP 98-7
No
Yes
Is contract short duration or long duration?
Long
Account for as long duration based on FAS No. 97
Short
Is contract Prospective or Retroactive?
Account for as Prospective Reinsurance based on
FAS No. 113
Account for as Retroactive Reinsurance based on
FAS No. 113
Retroactive
Prospective
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Indemnification Against Loss

• Reinsurer assumes significant insurance risk
  under reinsured portions of the underlying
  insurance contracts
• It is reasonably possible that the reinsurer may
  realize a significant loss from the transaction
• Risk must not be remote with regard to timing and
  amount

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Evaluation of Risk Transfer

• Present value of all cash flows under reasonably
  possible outcomes (premiums, losses
  commissions)
• No regard to how cash flows are characterized
• Same interest rate for all tested outcomes
• Exception If substantially all insurance risk
  relating to reinsured portions of underlying
  contract has been assumed by reinsurer!

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Prospective versus Retroactive

• Prospective assumption of future events
• Retroactive assumption of past events
• Contract having both elements must be accounted
  for separately or as retroactive
• Retroactive also includes
• Claims-made reinsurance of occurrence insurance
• Prospective reinsurance not finalized within 9
  months of inception

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Statutory Exceptions to Retroactive Reinsurance

• Structured settlements
• Novations
• Termination of/reduced participation in
  reinsurance treaties
• Inter-company reinsurance arrangements, as long
  as no surplus creation

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Contact Information

• Bruce D. Fell, FCAS, MAAA, CFASenior Vice
  President
• JLT Re Solutions, Inc.1009 Lenox DriveP.O. Box
  6400Lawrenceville, NJ 08648609-896-0555 ext.
  402bdf_at_jltre.com