Risk Transfer
CAS Seminar on Reinsurance
June 6th, 2005
Lisa Walsh FCAS MAAA CPCU
lisa.walsh@us.benfieldgroup.com
Outline

Risk Transfer Background

Risk Transfer Analysis

Reasonable Level of Risk Transfer

Bifurcation

Conclusions
The information contained in this document is strictly proprietary and confidential.
2
Risk Transfer Background
Relevant Regulations

FASB 113

SSAP 62
The information contained in this document is strictly proprietary and confidential.
3
Risk Transfer Background
FAS 113 and SSAP 62

The reinsurer assumes significant insurance risk



Amount and timing of reinsurer payments vary directly with
those of the cedant
Determination based on examination of contract wording
The reinsurer has a reasonable probability of a
significant loss



Measured using present value of cash flows
“10/10” rule generally accepted although not documented
Actuarial analysis required
The information contained in this document is strictly proprietary and confidential.
4
Risk Transfer Background
10-10 Rule

Not codified, but applied in practice

Not applicable to all contracts

e.g. catastrophe excess

Provides framework for an analysis

Probability of some loss is greater than 10%

Losses are on a continuum


“remote” probability events have been observed
losses greater than 10% should be considered
The information contained in this document is strictly proprietary and confidential.
5
Risk Transfer Background
Simple Example of Cash Flow Analysis
Does Qualify as Sufficient Transfer of Risk
Reinsurance

10% chance of 83.7% loss ratio

Loss of 13.7%
Type
Property Quota
Share
Cede Commission
30%

Loss Cap
100%

Ceded Premium
$100


Premium:
Loss:
Cede Commission:
Net:
100
(83.7)
(30)
(13.7)
Subject Loss Parameters
Average
60%
Standard Deviation
18%
Distribution
Lognormal
In a full analysis the cash flows would be
discounted using an appropriate interest rate.
This has little impact on short-tail business
such as a property book
The information contained in this document is strictly proprietary and confidential.
6
Risk Transfer Background
Simple Example of Cash Flow Analysis
Does Not Qualify as Sufficient Transfer of Risk
Reinsurance

10% chance of 83.7% loss ratio

Loss of 5%
Type
Property
Quota Share
Cede Commission
30%

Loss Cap
75%

Ceded Premium
$100


Premium:
Loss:
Cede Commission:
Net:
100
(75)
(30)
(5)
Subject Loss Parameters
Average
60%
Standard Deviation
18%
Distribution
Lognormal
The information contained in this document is strictly proprietary and confidential.
7
Risk Transfer Analysis
Documentation
The file should include some explanation of:
1. Client data was available
2. Assumptions made based on that data
3. Supplementary data used and why
4. Summary of conclusions
The information contained in this document is strictly proprietary and confidential.
8
Risk Transfer Analysis
Analytical Requirements

Model reflective of all contract features

Actuarial analysis consisting of


Subject loss distribution, and
Subject loss payment pattern
The information contained in this document is strictly proprietary and confidential.
9
Risk Transfer Analysis
Criteria

10/10 rule still generally acceptable



Specifics of ratio




Some auditors now want to see a definite growth in reinsurer loss
above the 90th percentile
If loss probability is “remote” (e.g. catastrophe excess), amount
must be greater than 10% of premium
Present values of all cash flows should be taken utilizing a single
duration matched treasury yield rate
The “duration” can be reflective of the time between premium
receipts and loss payment
Denominator needs to reflect present value of gross premium
(cede commission nor brokerage may not be netted out)
Based on facts available at inception

Hindsight is 20/20
The information contained in this document is strictly proprietary and confidential.
10
Reasonable Level of Risk Transfer
Average P&C Company
Loss and LAE Ratio:
74.6%
Expense Ratio:
24.9%
Average Life of Loss Payments:
2 years
2003 National Underwriter Insurance Services including
over 2,000 public companies.
The information contained in this document is strictly proprietary and confidential.
11
Reasonable Level of Risk Transfer
Underwriting Margin
Combined Ratio:
99.5%
Nominal Underwriting Margin:
0.5%
Present Value Underwriting Margin:
4.3%
(PV Premium less PV expenses less PV losses) / (PV Premium) =
(98.3% - 24.5% - 69.6%) / (98.3%) = 4.3%
The information contained in this document is strictly proprietary and confidential.
12
Reasonable Level of Risk Transfer
Reinsurance Capital
It is in the best interest of the consumer to require a
company to maintain sufficient capital.

A widely considered benchmark is to hold enough
to cover a 99th percentile loss position.

Using 2003 industry results and a lognormal
distribution, the 99th percentile loss ratio is 105.0%
nominal loss ratio; 97.9% present value.

The resulting Present Value Underwriting Margin is 24.5% = (98.3% - 24.5% - 97.9%) / (98.3%).


Capital would be allocated at 24.5% of premium.
Note: the loss distribution predicts that there is a 32% chance that the reinsurer will have a loss. In
2003, 28% of P&C companies reported an operating loss supporting the validity of the assumptions.
The information contained in this document is strictly proprietary and confidential.
13
Reasonable Level of Risk Transfer
Industry Loss Curve
Industry Loss Ratio Curve by Percentile
120.0%
110.0%
99th
loss ratio
100.0%
90.0%
90th
80.0%
70.0%
60.0%
50.0%
40.0%
1
11
21
31
41
51
61
71
81
91
percentile
The information contained in this document is strictly proprietary and confidential.
14
Reasonable Level of Risk Transfer
ROE

ROE = Expected profit / allocated capital

ROE = 65% of 4.3%/24.5% = 11.4%

Actual historical P&C returns:
1997
1998
1999
2000
2001
2002
2003
2004
11.9%
9.2%
6.6%
6.3%
-2.7%
1.0%
9.4%
10.5%
source: Insurance Information Institute
The information contained in this document is strictly proprietary and confidential.
15
Reasonable Level of Risk Transfer
Reinsurance Capital
 Matrix of ROE results with 10/10 alternatives
Chance of loss
Size of
loss
10%
15%
20%
10%
11.40%
7.70%
5.70%
15%
8.10%
5.40%
3.90%
20%
5.60%
3.50%
2.30%
 Average US stock market return 1990-1999 = 18%
 Average US stock market return 1926-1999 = 11%
 Higher risk thresholds will restrict availability
The information contained in this document is strictly proprietary and confidential.
16
Bifurcation
Proposed SSAP No. 62 Revisions
N2 – Paragraphs 9-16 only applicable to the portion
of the transaction transferring insurance risk,
remainder deposit accounted

N3
– List exceptions that need not be considered
Excess
per risk
Excess
per occurrence treaties (property cat)
Fronting
arrangements
Facultative
Where
All
contracts
annual premium is less than XX% of the max payable loss
others that don’t meet N4 conditions
The information contained in this document is strictly proprietary and confidential.
17
Bifurcation
Proposed SSAP No. 62 Revisions
– Lists conditions where bifurcation required (if
not exempt)
N4
Contractual
limits where the annual premium is greater than XX%
of the max payable
Aggregate
Loss
loss ratio limits
corridors, including the existence of deductibles
Retrospective
Sliding
Profit
premium adjustments
scale or other adjustable comissions
sharing formulas
Mandatory
reinstatement premiusm
Commutation
clause allowing refund of premium
The information contained in this document is strictly proprietary and confidential.
18
Bifurcation
Proposed SSAP No. 62 Revisions
– Lists conditions where bifurcation required (if
not exempt) - continued
N4
Limited
or conditional cancellation provision
Reporting
Funds
requirements less than quarterly
held accounts
Retroactive
Coverage
agreements
periods greater than one year
The information contained in this document is strictly proprietary and confidential.
19
Bifurcation
Proposed SSAP No. 62 Revisions
– Accounting for Bifurcation of Reinsurance
Agreements
N5
Insurer
shall estimate the portion of the layer of coverage
provided for in the agreement for which there is > 90% probability
that the ceding insurer will be indemnified for the losses in that
layer.
The information contained in this document is strictly proprietary and confidential.
20
Bifurcation
Proposed SSAP No. 62 Revisions

SAP today recognizes economic substance of reinsurance
- when properly applied

NY proposal moves away from economic substance
- valid quota shares may be deposit accounted
- contracts now deposited may be treated as reinsurance

Implementation issues will be substantial

Economic penalties
- disproportionate penalty for smaller insurers
- increase in cost of insurance to consumers
The information contained in this document is strictly proprietary and confidential.
21
Bifurcation
Proposed SSAP No. 62 Revisions
Layers where there is a 90% probability of indemnification
shall be deposit accounted


Will be differing views of:
90%
Loss Level
Payout
Pattern
Discount
Rate
Premium
Allocation - Circular

All estimates that will change over time

Ceding commission deposit accounted?
The information contained in this document is strictly proprietary and confidential.
22
Bifurcation
Proposed SSAP No. 62 Revisions
N4 would encourage elimination of the reinsurance features
increasing the cost of reinsurance and/or reducing availability,
negatively impacting the ultimate insurance consumer

Divergent accounting treatments could distort figures and
ratios used to assess a company’s financial strength

Many features in N4 are beneficial to a buyer and this would
discourage their use

The information contained in this document is strictly proprietary and confidential.
23
Conclusions
Reported problems with risk transfer are willful
misrepresentations

Further rules would not affect those ignoring them
in the first place

The current guidance regarding risk transfer is
adequate and appropriate to support an essential
reinsurance marketplace for the benefit of the
consumers

Changes including bifurcation and bright line rules
will complicate and confuse statutory accounting

The information contained in this document is strictly proprietary and confidential.
24