Testing Risk Transfer

Question 1

2 Conditions for a contract to receive reinsurance accounting treatment

Answer 1

1. Requires that significant insurance risk is assumed by the reinsurer
2. Requires that a significant loss to the reinsurer is reasonably possible

Question 2

2 Components required to satisfy the condition of significant insurance risk

Answer 2

1. U/W risk
2. Timing risk

Question 3

4 Risk Transfer Tests

Answer 3

1. Self-Evidence
2. “Substantially All”
3. ERD (Expected Reinsurer Deficit)
4. 10-10 Rule

Question 4

Self-Evidence Test

Answer 4

Qualitative Test

If the reinsurance premium is very low or potential loss is very high (like with hurricanes and earthquakes) the presence of risk transfer may be self evident

Reasonably self-evident
- transaction is done at arms-length
- no risk-limiting features

Question 5

“Substantially All” Exception

Answer 5

Qualitative Test

If significant loss is NOT reasonably possible, BUT the reinsurer assumes “substantially all” risk, then risk transfer may still exist.

This often applies to quota share contracts with high % transferred

Question 6

Expected Reinsurer Deficit (ERD)

Answer 6

Quantitative Test

ERD = prob(NPV reinsurer loss) * NPV(reinsurer loss) / (reinsurance premium)

If ERD > 1% then there has been transfer of risk

Question 7

10-10 rule

Answer 7

If reinsurer has >10% chance of >10% U/W loss THEN contract has transferred risk

Question 8

Pitfalls in a risk transfer test

Answer 8

PRICE-P
- Profit commission
- Reinsurer expenses
- Interest rates
- Commutation timing
- Evaluation date
- Premiums

Question 9

Profit commissions (Pitfall)

Answer 9

• Payment from reinsurer to cedant (if ceded LR < specified LR)
• Do NOT include in risk transfer test (focus only on reinsurer losses, not results of cedant)
• Indirect effects of profit commissions
  ○ Higher premiums (because profit commissions are a payment from reinsurer to cedant)
  ○ Carry-forwards: profit/loss from prior years may affect future results

Question 10

Interest/Discount Rates (Pitfall)

Answer 10

• Rate should not vary with the scenario in a test because risk transfer analysis should only consider insurance risk (yield curves are NOT permitted)
• Considerations for selecting rate
  ○ Should be reasonable & appropriate
  ○ May use risk-free rate
  ○ Duration of risk-free rate should MATCH reinsurer’s cash flows
  ○ Use SAME rate for all cash flows
• Risk transfer is UNDER-detected with a discount rate HIGHER than risk-free rate
  ○ PV(losses) lower
  ○ Risk transfer less likely

Question 11

Commutation Timing (Pitfall)

Answer 11

• Do not use prescribed payment patterns in risk transfer test
• INCLUDE commutation fees

Question 12

Evaluation Date (Pitfall)

Answer 12

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

Question 13

Premiums (Pitfall)

Answer 13

• Use GROSS premium of all payments before any returns like ceding commission
• Use PV, but LR caps and experience adjustments are applied to nominal amounts then discounted
• INCLUDE non-premium fees like maintenance fees because they are cash flows between cedant and reinsurer

Question 14

Practical Considerations in risk transfer test

Answer 14

• Parameter selection (payment-pattern, loss distribution)
• Parameter risk
• Pricing assumptions
• Commutation clause

Question 15

Parameter Selection (Risk Transfer Test)

Answer 15

• Important because cash flow simulation for a risk transfer test needs appropriate input parameters
• Any parameters not given in a contract (e.g. interest rate, payment pattern, loss distributions) require judgement

Question 16

Parameter Selection: Interest Rate (Risk Transfer Test)

Answer 16

• Risk-free rate is lowest rate allowed because otherwise risk transfer is OVER-detected
• Alternative to risk-free rate: reinsurer’s Expected Investment Return
  ○ More reflective of reinsurer operations
  ○ More accurate estimate of reinsurer loss
• Problem with using Expected Investment Return
  ○ Rate may not be available to ceding company doing the risk transfer test
  ○ Result of risk transfer test should NOT depend on reinsurer’s investment strategy

Question 17

Parameter Selection: Payment Patterns (Risk Transfer Test)

Answer 17

• Uncertainties are difficult to measure
• Pay attention to tail of distribution because this is where ceded losses are likely to fall

Question 18

Parameter Selection: Loss Distribution (Risk Transfer Test)

Answer 18

• Most important part of distribution is reasonableness of tail results
• e.g. especially important for high excess-of-loss contracts

Question 19

Parameter Risk (Risk Transfer Test)

Answer 19

• Methods for accounting for parameter risk in risk transfer test
  ○ Implicit: higher expected loss selection & volatility
  ○ Explicit: give parameters a probability distribution & incorporate this into simulation
• Relative impact of parameter risk on:
  ○ Premium: small impact
  ○ Loss: large impact
  ○ Discounting: small impact
• Key elements of discounting risk
  ○ Payment patterns: should be included because it’s timing risk which is part of insurance risk
  ○ Interest rate risk: should not be part of risk transfer test
• Parameter risk need not be explicitly modeled but SHOULD be included in some manner of the test and documentation

Question 20

Pricing Assumptions: Advantages and Disadvantages (Risk Transfer Test)

Answer 20

• Advantages of using pricing assumptions
  ○ Properly priced reinsurance agreement is based on appropriate expected loss, risk load, payment pattern
  ○ May work well for small or immature books of business
• Disadvantages of using pricing assumptions
  ○ Reinsurance pricing assumptions are market-driven (may not reflect true expected loss)
  ○ Pricing assumptions were derived for a different purpose

Question 21

Commutation Clause: Financial and Non-financial Considerations (Risk Transfer Test)

Answer 21

• If there are rules for determining value at commutation, this complicates risk transfer test
• Financial Considerations
  ○ Amount & timing of cash flows
  ○ Discount rate applied to cash flows
  ○ Payment pattern of cash flows
• Non-financial considerations
  ○ Court decisions
  ○ Life expectancy of claimant
  ○ Quality of reinsurer