Residual Commission Contract by qfi14777

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									Finite Reinsurance

Casualty Loss Reserve Seminar
         Chicago, IL
      September 9, 2003
Bruce D. Fell, FCAS, MAAA, CFA



             1
    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 aggregation
         Risks previously assumed to be independent
          now recognized as correlated (lesson learned
          from Sept. 11, 2001)
         Natural catastrophe aggregations
     • Focus on credit risk
         Cedents 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 Reinsurance
          Loss Portfolio Transfer (LPT)
          Adverse Loss Development Cover (ALDC)

     • Prospective Reinsurance
          Finite 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
        150
                    Reinsured
        125         Retained


        100

         75

         50

         25

          0
              Carried Reserves    LPT   ALDC


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    Loss Portfolio Transfer
     • Contract provisions
          Aggregate limit
          Experience account refunds
          Commutation provisions
     • Benefits
          “Transfer” existing reserves to reinsurer (reduce
           reserve leverage)
          May protect from adverse development
          Establish “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 provisions
          Aggregate limit
          Possible experience account refunds
          Commutation provisions

     • Benefits
          Protection 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

     • Benefits
          Surplus 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 ratio
        maximum = 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
                   100
                   90
                   80
                   70
      Loss Ratio




                   60                                Slide
                   50                                Reinsured
                   40                                Retained
                   30
                   20
                    10
                    0
                         Retained        Reinsured


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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
                   100
                   90
                   80
                   70
      Loss Ratio




                   60
                                           Reinsured
                   50
                                           Retained
                   40
                   30
                   20
                    10
                    0
                                Retained


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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 risk
         Section 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                  No               Use deposit accounting
                 against                                         AICPA: SOP 98-7
              loss/liability?
                           Yes


                         Is contract short              Long         Account for as long duration
                         duration or long
                                                                        based on FAS No. 97
                             duration?

                                         Short

   Account for as                            Is contract                             Account for as
    Prospective      Prospective             Prospective        Retroactive           Retroactive
 Reinsurance based                                or                               Reinsurance based
  on FAS No. 113                             Retroactive?                           on FAS No. 113




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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 Drive
        P.O. Box 6400
        Lawrenceville, NJ 08648
        609-896-0555 ext. 402
        bdf@jltre.com




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