Risk Transfer

Question 1

Why determining risk transfer is important (for both pricing and accounting)

Answer 1

Pricing: reinsurer can’t properly price a contract unless they know level of risk they have assumed

Accounting Treatment: if risk transfer to reinsurer has occurred, can use reinsurance accounting treatment which is more favorable than the alternative (deposit accounting)

Question 2

Conditions for contract to receive reinsurance accounting treatment

Answer 2

Reinsurer must assume significant insurance risk
Reinsurer must have a reasonable chance of suffering a significant loss

Question 3

Components of insurance risk

Answer 3

Timing risk and UW risk

Question 4

Implications to balance sheet if reinsurance accounting not used

Answer 4

Must use deposit accounting -> reserves can’t be shown net of reinsurance

Question 5

Who performs risk transfer test

Answer 5

actuary since CEO and CFO don’t have expertise

Question 6

Who has final say on risk transfer test

Answer 6

CEO or CFO (but they rely on actuary’s analysis as part of final decision)

Question 7

4 methods of assessing existence of risk transfer

Answer 7

Qualitative:
- Self-evident
- Substantially All exception
Quantitative
- Expected Reinsurer Deficit (ERD)
- 10-10 rule

Question 8

Self-evident method

Answer 8

• sometimes risk transfer is so self-evident that no further analysis is needed
• may apply if reinsurance premium is very low or potential loss is very high

Question 9

Substantially all exception method

Answer 9

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

Usually fits for quota-share reinsurance with high % ceded or independent risk contracts without risk-limiting features

Question 10

Reason for substantially all exception

Answer 10

to maintain access to reinsurance for profitable books of business

Question 11

Expected Reinsurer Deficit (ERD) formula

Answer 11

ERD = prob(NPV loss) * NPV(average loss) / Reinsurance Prem
if ERD > 1% -> risk transfer has occurred

Question 12

10-10 rule

Answer 12

If reinsurer has >= 10% chance of >= 10% UW loss then contract has transferred risk

Question 13

Facts about ERD

Answer 13

• Done with Monte Carlo Simulation
• Considers both frequency & severity
• Considers TVM
• More flexibility

Question 14

10-10 Rule facts

Answer 14

• Might miss a low frequency/high severity event
• Simpler than ERD & easier to understand
• More conservative
• Fewer assumptions

Question 15

Pitfalls of risk transfer test (PRICE-P)

Answer 15

• Profit Commissions
• Reinsurer Expenses
• Interest/Discount Rate
• Commutation/Timing
• Evaluation Date
• Premiums

Question 16

Should profit commissions be included in risk transfer test?

Answer 16

No (focus only on reinsurer losses, not results of cedant)

Question 17

Indirect effects of profit commissions

Answer 17

Higher premiums: bc profit commissions are a payment from reinsurer to cedant
Carryforwards: profit/loss from prior years may affect future results

Question 18

Should reinsurer expenses be included in risk transfer test?

Answer 18

No (not a cash flow btwn insurer and reinsurer)

Question 19

Should interest rate vary with the scenario in risk transfer test?

Answer 19

No (not measuring interest rate risk, consider only insurance risk)

Question 20

Considerations for selecting discount rate

Answer 20

• should be reasonable and 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

Question 21

Considerations with prems

Answer 21

• use gross premium (all payments to reinsurer before any returns like ceding commission)
• use present value but any adjustments applied to nominal amounts before discount
• include non-prem fees like maintenance fees bc they are cash flows btwn insurer and reinsurer

Question 22

Importance of Evaluation Date

Answer 22

risk transfer test done at evaluation date based on facts and circumstances known at the time

Question 23

Should prescribed payment patterns be used?

Answer 23

No because it eliminates timing risk

Question 24

Should commutation fees be included in risk transfer test?

Answer 24

Yes

Question 25

Should foreign exchange rates and potential for reinsurer default be included in risk transfer test?

Answer 25

No. Foreign exchange risk and credit risk aren't included (not part of insurance risk)

Question 26

Practical considerations for risk transfer test

Answer 26

- Parameter Selection - Parameter Risk - Pricing Assumptions - Commutation Clause

Question 27

Parameter selection importance

Answer 27

cash flow simulation requires appropriate input parameters any parameters not given in contract require assumptions

Question 28

Interest rate considerations

Answer 28

- risk free rate is lowest allowed, otherwise PV(losses) is higher and over-detects risk transfer - alternative: reinsurer's expected investment return - advantages: more reflective of reinsurer's operations and more accurate estimate of reinsurer loss - disadvantage: risk transfer should not rely on quality of reinsurer's investment strategy

Question 29

How uncertainties in payment patterns handled

Answer 29

uncertainties difficult to measure, pay attention to the tail bc this is where ceded losses likely to fall

Question 30

Most important aspect of a loss distribution in risk transfer test

Answer 30

most important part is the tail (especially for XOL treaties), need reasonable tail results

Question 31

Parameter risk aspects in risk transfer tests

Answer 31

Should be included explicitly or implicitly Implicit: higher expected loss selection & volatility Explicit: give parameters probability distribution & incorporate into simulation Should incorporate payment patterns because it is a timing risk, don't include interest rate risk Large impact on losses, small impact on prem and discounting

Question 32

Pricing assumptions in risk transfer tests advantages and disadvantages

Answer 32

Advantages: - a properly priced reins agreement based on appropriate expected loss, risk load, and pmt pattern - may work well for small or immature books of business Disadvantages: - reins pricing assumptions are market driven (may not reflect true expected loss) - pricing assumptions were derived for a different purpose

Question 33

Commutation clause - how fee is determined

Answer 33

mutually agreed value in contract if there are rules for determining value at commutation, complicates risk transfer test

Question 34

Financial and non-financial considerations regarding cash flows at commutation

Answer 34

Financial - Payment pattern - Discount applied to cash flows - Amount and timing of cash flows Non-Financial - Life expectancy of claimant - Quality of reinsurer - Court decisions