2014.Spring 8 part a. - regarding Reinsurer Facility

This questions asks
"Describe how switching from an ARP to a RF might impact the size of the residual market?"

One of the answers provided in the examiner's report (in the battle cards as well) is "insurer's have more freedom to set rates where there is a RF (versus an ARP)."

I don't understand this answer. Why does the insurer have more freedom to set rates for an RF versus an ARP?


  • The first thing to notice about the 5 answers in the examiner's report is that the first and last state the size of the residual market will increase and the middle 3 state that it will decrease. So there is no single correct answer.

    To get credit on this problem (or any "fuzzy" interpretation problem) you have to state 1 or 2 relevant facts, then provide a half-way intelligent reason to support your conclusion. The examiners are looking to see whether you understand the question, know the relevant fact(s), and can draw a logical conclusion. That's why such a range of answers was accepted.

    But getting back to this particular problem about ARPs and RFs:

    • The source text does not really explain how rates are set in a RF because rules differ by state. Some are probably strict and some are probably lax so you can't say anything very specific. The rates on policies ceded to RF are the insurer's rates and must satisfy "normal" state regulations. It's just that "normal" regulation likely doesn't let insurers charge enough for some of these high-risk policies so insurers don't have total freedom. That's why they cede policies to the RF. Still, in the RF the rates for identical policies can vary by insurer, so there is some degree of freedom.
    • The source text does say however that in an ARP, the regulator sets uniform rates across all insurers. So in a state with an ARP, the insurer sets rates for policies it takes on voluntarily, but must use uniform rates for any policies assigned to it through the ARP. Identical policies will always be charged the same rate even if they are assigned to different insurers. No freedom at all.

    Now you could go on arguing back and forth about whether the size of residual market would increase or decrease, but this question was worth only 0.5pts. If you get one like this on the exam, don't overthink it. As I mentioned above, just make sure to state 1 or 2 relevant facts and provide a brief logical argument to support your conclusion.

  • Thanks that makes sense.

  • I think I'm confused on what it means to "cede a policy to the Reinsurance Facility." The RF is still a residual market mechanism, right? Why would the size of the residual market decrease if insurers start using an RF instead of an ARP (since they are both residual markets)?

  • This question doesn't have a single correct answer and can be argued either way. The idea is that ARPs, RFs, and JUAs create different environments with the auto insurance market within a state and this can have indirect effects of the size and composition of the residual market.

    In this exam question, they ask what might happen if a state switches from the residual market mechanism of an ARP to a RF. If this happens, it wouldn't be that every person formerly insured in the ARP would suddenly get transferred to the RF. There are a lot of other moving parts when such a change occurs and that's what the question is getting at. The whole environment would change and insurers would likely make different many business decisions based on that new environment. The size and composition of the residual market would almost certainly change. Whether the size increases or decreases (or maybe even stays about the same) is open to debate. You just had to show you knew the basic facts and provide a reasonable argument either way.

    When an insurer cedes a policy to the RF they are taking a policy they wrote voluntarily but then essentially getting rid of it by dumping it into the "pot" with all the other high-risk drivers that all the other auto insurers in a state have ceded to the RF. Then everyone shares in the losses according to their share of the market for policies they didn't cede.

  • Thanks Graham!

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