Risk Transfer – Actuarial Perspective
Casualty Actuarial Society – Washington, D.C.
September 18-19, 2008
Ian Sterling, FCAS, MAAA

Agenda
►
►
►
►
FAS 113/SSAP 62
Methods of Testing
Metrics
Next Steps
Page 2 Presentation title

Reinsurance Accounting Guidance
►
GAAP
►
FASB Statement No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts
►
Statutory
►
SSAP No. 62, Property and Casualty Reinsurance
►
Similar to FAS 113
Page 3 Presentation title

Short-Duration Risk Transfer – FAS 113
►
Risk Transfer Conditions:
►
►
►
Paragraph 11 Test:
►
The reinsurer assumes “substantially all” of the insurance risk relating to the reinsured portion of the underlying insurance contracts, or
Paragraph 9 Test:
►
(a) The reinsurer assumes “significant” insurance risk under the reinsured portions of the underlying insurance policies.
►
–

Transfer of insurance risk refers to:
Ultimate amount of net cash flows between parties, and

Timing of the receipt of cash
(b) It is “reasonably possible” that the reinsurer may realize a significant loss from the transaction.
Risk factors do not include recognition of reinsurance costs, investment risk, taxes, or credit risk
Page 4 Presentation title

SSAP 62
►
Risk Transfer Conditions:
►
Indemnification of the entity company against loss or liability relating to insurance risk in reinsurance requires both of the following:
►
► a. The reinsurer assumes significant risk under the reinsured portions of the underlying insurance agreements; and b. It is reasonably possible that the reinsurer may realize a significant loss from the transaction
Page 5 Presentation title

Reinsurance Attestation Supplement 20-1
►
Risk Transfer Testing Practice Note
►
American Academy of Actuaries Committee on Property and Liability Financial Reporting – November 2005
Page 6 Presentation title

Methods of Testing
►
(1) Reasonably “Self-Evident”
►
►
►
►
Purpose
Need to Document
Considerations
►
Substance of the arrangement
►
►
Existence, impact and role of risk-limiting factors
Use of professional judgment
Contract Terms to make this less likely?
Page 7 Presentation title

Methods of Testing
►
(1) Reasonably “Self-Evident”
►
Examples of Safe Harbors:
►
►
►
A straight QS with no risk-limiting features other than a loss ratio cap with negligible effect on the economics of the transaction
Single year property cat and casualty clash contracts with little or no risk limiting features apart from a reinstatement premium common to these types of contracts
Most facultative and treaty per risk excess of loss arrangements with rates on line well below the present value of the limit of coverage, or without aggregate limites, sub-limits, or contingent features
Page 8 Presentation title

Methods of Testing
►
(1) Reasonably “Self-Evident”
►
Examples of contracts not reasonably self-evident:
►
►
►
►
Aggregate excess of loss contracts
Contracts with experience accounts, experience rating refunds, or similar provisions, if such provisions have a significant impact on the contract’s economics
Multiple year contracts
QS contracts with risk limiting features
Page 9 Presentation title

Page 10
Yes
Document
Reasonably Self-Evident
No
Risk Transfer Analysis
Scenario Testing
Presentation title
Simulation/Modeling Techniques

Methods of Testing
►
(2) Scenario Testing
►
►
►
Historical results by year
Comparison of All Underwriting Downside Scenarios
Comparison of Cedent and Reinsurer Expected Underwriting
Deficits
Page 11 Presentation title

Methods of Testing
►
Historical Results by Year
AY
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Loss Ratio Commission
70%
65%
20%
20%
40%
95%
55%
75%
80%
120%
75%
70%
20%
20%
20%
20%
20%
20%
20%
20%
Reinsurer
Combined
Ratio
90%
85%
60%
115%
75%
95%
100%
140%
95%
90%
Investment
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
Reinsurer
Result
15%
20%
45%
-10%
30%
10%
5%
-35%
10%
15%
Page 12 Presentation title

Methods of Testing
►
Comparison of All U/W Downside Scenarios
Loss Ratio
30%
40%
50%
60%
70%
80%
90%
100%
Cedent
Expense Ratio Cedent Margin
20%
20%
50%
40%
20%
20%
20%
20%
20%
20%
30%
20%
10%
0%
-10%
-20%
Reinsurer
Ceding
Commission
40%
40%
40%
30%
30%
20%
20%
20%
Reinsurer
Margin
30%
20%
10%
10%
0%
0%
-10%
-20%
Page 13 Presentation title

Methods of Testing
►
Comparison of Cedent and Reinsurer Expected
Underwriting Deficits (EUD)
Cedent
Reinsurer
Difference
Breakeven
Loss Ratio
80%
80%
0%
Prob (Loss)
12%
11%
1%
U/W Loss
8%
9%
-1%
EUD
0.960%
0.990%
-0.030%
Page 14 Presentation title

Methods of Testing
►
(3) Simulation Testing
►
►
Types of Models
►
►
Aggregate Loss Models
Frequency-Severity Models
►
Combination Models
Considerations
Page 15 Presentation title

Methods of Testing
►
Modeling Considerations
►
►
Need to model:
►
►
►
►
►
Contract losses
Contingent Premium
Commissions
Other Contract Features
Reinsurance Underwriting Expenses
Potentially not considered:
►
Tax impacts
Page 16 Presentation title

Metrics
►
(1) “10-10” Rule (Value at Risk)
►
►
►
►
Initial rule of thumb, and still somewhat used today
Definition
Shortcomings
Unintended Consequences
Page 17 Presentation title

Metrics
►
(2) Tail Value at Risk (TVaR)
►
►
►
►
►
Definition
Criteria similar to “10-10” = TVaR > 10% at 10 th percentile
Advantages
Disadvantages
Does this solve the shortcomings of VaR?
Page 18 Presentation title

Metrics
►
Var and TVaR Example
Confidence
Level
Percentile
10%
20%
30%
40%
50%
60%
70%
80%
90%
95%
VaR NPV
Reinsurer's
Profit Ratio
45.0%
35.0%
28.0%
20.0%
10.0%
5.0%
0.0%
-4.0%
-8.0%
-20%
TVaR NPV
Reinsurer's
Profit Ratio
15.0%
10.0%
2.0%
0.0%
-4.0%
-10.0%
-15.0%
-20.0%
-35.0%
-100%
Page 19 Presentation title

Metrics
►
(3) Expected Reinsurer Deficit (ERD)
►
►
►
►
►
Definition
How relates to previous methods
►
►
Criteria of ERD > 1% similar to “10-10” (1% = 10% x 10%)
Avg Loss Severity = TVaR at the economic breakeven LR
Advantages
Does this solve “Shortcoming 2”?
Similar to Financial?
Page 20 Presentation title

Metrics
►
(4) Other Methods
►
►
►
Other methods:
►
1. Right Tail Deviation (RTD) - Wang
►
►
►
2. Mean Square Adverse Deviation
3. Conditional Expected Downside
4. Some combination of (2) and TVaR
Advantage
Disadvantage
Page 21 Presentation title

Summary
►
►
►
►
Can a bright-line test be used?
►
Advantage
►
Disadvantage
Guides
►
“10-10”, TVaR, ERD, RTD, etc.
Methods of Testing Risk Transfer
►
“Reasonably Self-Evident”, Scenario Testing, Simulation
Next Steps
Page 22 Presentation title