1 finite reinsurance casualty loss reserve seminar chicago, il september 9, 2003 bruce d. fell,...

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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 aggregationRisks previously assumed to be

independent now recognized as correlated (lesson learned from Sept. 11, 2001)

Natural catastrophe aggregations

• Focus on credit riskCedents 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 ReinsuranceLoss Portfolio Transfer (LPT)

Adverse Loss Development Cover (ALDC)

• Prospective ReinsuranceFinite 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 company’s 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

Reinsurer’s capital costs and risk margin

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LPTs & ALDCs

0

25

50

75

100

125

150

Carried Reserves LPT ALDC

ReinsuredRetained

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Loss Portfolio Transfer

• Contract provisionsAggregate limitExperience account refundsCommutation provisions

• Benefits“Transfer” existing reserves to

reinsurer (reduce reserve leverage)May protect from adverse developmentEstablish “fixed” current price for

uncertain future reserves

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Loss Portfolio Transfer Example• Premium = $120 million

• Limit = $150 million

• Reinsurer’s Margin = 3% ($3.6 million)

• Crediting Interest Rate = 2.0%

• Experience account refund @ commutation =Premium - Margin - Losses + Interest

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Adverse Loss Development

• Contract provisionsAggregate limit

Possible experience account refunds

Commutation provisions

• BenefitsProtection 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

• Reinsurer’s margin = 5% ($2.0 million)

• Crediting Interest Rate = 2.5%

• Experience account refund @ commutation =Premium - Margin - Losses + Interest

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Finite Quota Share

• Reinsurer accepts percentage of cedent’s 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

Reinsurer’s capital charge

• BenefitsSurplus 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% @ 70% loss ratiomaximum = 40% @ 55% loss ratio

• Loss corridor between 70% and 75% loss ratio

• Reinsurer’s margin = 5% between 55% loss ratio and 75% loss ratio

• Aggregate Limit = 100% loss ratio

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50% Finite Quota Share Example

0

10

20

30

40

50

60

70

80

90

100

Retained Reinsured

Los

s Rat

io

SlideReinsuredRetained

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Aggregate Excess of Loss

• Reinsurer provides corridor of protection over cedent’s 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

• Reinsurer’s Margin = 10% ($600,000)

• Crediting Interest Rate = 2.5%

• Experience account refund @ commutation =Premium - Margin - Losses + Interest

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Aggregate Excess of Loss Example

0

10

20

30

40

50

60

70

80

90

100

Retained

Los

s Rat

io

ReinsuredRetained

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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 riskSection 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?

Is contract short duration

or long duration?

Is contract Prospecti

ve or Retroacti

ve?

Use deposit accounting

AICPA: SOP 98-7

Account for as long duration based on FAS

No. 97

Account for as Retroactive Reinsurance based on FAS

No. 113

Account for as Prospective Reinsurance based on FAS

No. 113

No

Yes

Long

Short

Prospective Retroactive

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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, CFA

Senior Vice President

JLT Re Solutions, Inc.1009 Lenox DriveP.O. Box 6400Lawrenceville, NJ 08648609-896-0555 ext. 402bdf@jltre.com