Risk Transfer Analysis

September 30, 2018 0 By c.boersma

Definition

1. The reinsurer assumes significant insurance risk under the reinsured portion of the underlying insurance agreement; and

2. It is reasonably possible that the reinsurer may realize a significant loss from the transaction.

Because the terms “significant insurance risk,” “reasonably possible,” and “significant loss” are
not defined in either accounting standard, the challenge is to appropriately interpret and apply the
accounting standards to each reinsurance transaction.

Reinsurance Attestation Supplement (CEO & CFO)

  1. There are no separate written or oral agreements between the reporting entity and assuming reinsurer.
  2. There is documentation for every reinsurance contract for which risk transfer is not reasonably self-evident that details the transaction’s economic intent and that documentation evidencing risk transfer is available for review.
  3. The reporting entity complies with all requirements set forth in the Statement of Statutory Accounting Principles No. 62, “Property and Casualty Reinsurance” (SSAP 62).
  4. The appropriate controls are in place to monitor the use of reinsurance.

Substantially All

This is meant to exempt a very narrow definition of contracts where the reinsurer assumes “substantially all of the insurance risk relating to the reinsured portions of the underlying insurance contracts.” The most common examples are straight quota share or individual risk contracts with no loss ratio caps or other risk limiting features.

Reasonably Self-Evident

The AAA Practice Note followed the introduction of the RAS and laid out some general guidelines for establishing when the presence of risk transfer is reasonably self-evident.

Why are these guidelines not specified?  I guess we just need to know that this is a “option”.  Not clear what this paper thinks should be included here.  Reasonably Self-Evident seems like a bad excuse for no documentation.

Expected Reinsurer Deficit

ERD can be viewed as the probability of a net present value (NPV) underwriting loss for the reinsurer multiplied by the NPV of the average severity of the underwriting loss.

ERD can be viewed as the probability of a net present value (NPV) underwriting loss for the reinsurer multiplied by the NPV of the average severity of the underwriting loss.

ERD = \frac{\sum_{i=1}^{n} \max\left(-profit_i,0\right)}{n\times premium}

for scenario i.

Example

Scenario Loss Premium Profit
1 (25%) $100,000 $120,000 $20,000
2 (25%) $80,000 $120,000 $40,000
3 (25%) $145,000 $120,000 -$25,000
4 (25%) $125,000 $120,000 -$5,000

It’s pretty obvious the ERD on this one is greater than 1%.  But just to check: -$30,000/4 = 6.25% = ERD

Note: The expected profit = $60,000 – $30,000 = $30,000 (or 25% of premium).

Risk Transfer Thresholds

1% (Some think 2% would be better)

Pitfalls

Profit Commissions

Profit commissions generally should not be considered in risk transfer analysis… and focus on reinsurer loss scenarios.

Carryforwards

Carryforwards may be used in multi-year contracts where the profits or losses from prior years may affect the results of the future years. A contract for periods of more than one year usually requires further testing for risk transfer and any carryforwards that may impact a loss position for the reinsurer would need to be incorporated into the model.

Reinsurer Expenses

Only cash flows between the ceding company and the reinsurer should be considered in a risk transfer analysis.

Interest Rates and Discount Factors

SSAP 62 requires a constant interest rate to be used for discounting across all simulated scenarios.

Note: should only consider insurance risk (not credit or interest rate)

Premiums

While its importance is clear, what the premium should include is not nearly as straightforward.

  1. gross premiums.
  2. present value of
  3. same interest rate used
  4. model the actual functioning of the contract
  5. model the actual functioning of the contract (based on nominal amounts)

Fees

It is not uncommon for a reinsurance contract to include fees other than premium. When there are fees that depend upon future events, the impact of these events should be included in the model.

Evaluation Date

risk transfer assessment is made at the inception date based on facts and circumstances known at the time

Commutations

In order to have risk transfer in a reinsurance contract, there must be timing risk as well as underwriting risk.

If a fee is required to avoid an early forced commutation, this fee should be considered as part of the expected premium paid