Spring 2016 #27 (b)

us_beta_071us_beta_071
in Klann.ReinsComm

Hi,

I am a bit confused about how commutation impact insurer. Based on part (a) of this question, insurer will benefit from commutation if price is greater than 1.7M. So when the comm price is 2M, should PHS increase rather than decrease in the standard answer?

Comments

  • grahamgraham
    edited March 2019

    This is a very tricky question and I wish they had explained it better in the examiner's report.

    The trick is this:

    • when you calculate the 1.7m in part (a), you're using discounted reserves (this is the economic benefit of the commutation to the insurer)
    • but in part (b), the IRIS 1 ratio is a statutory ratio so you have to use undiscounted reserves to calculate the statutory benefit

    The undiscounted reserves are given as 3m so without the discounting, and ignoring taxes the statutory insurer benefit is:

    • 2m - 3m = -1m

    The surplus decreases by 1m and IRIS 1 increases. I will add this explanation to the wiki. (This question can be interpreted different ways but the above explanation should receive credit considering how short the sample answer in the examiner's report was.)

  • us_beta_071us_beta_071

    Thank you, Graham! It is more clear now.

    Not related to this question but in general, is there any difference of the income tax calculation under statutory and GAAP accounting? The tax accounting is more close to GAAP rule but the calculated tax is used in income statement for statutory reports?

  • grahamgraham

    I'm not sure if this will answer your question, but here's how I think about it:

    • Tax accounting is separate from SAP and GAAP.
    • Tax accounting is a set of rules from the IRS. It looks at your assets, liabilities, and income to determine your taxes.
    • Your assets, liabilities, and income can be different under SAP and GAAP due to differences in timing and recognition of assets and liabilities.
    • This is because statutory accounting is generally cash-accounting (income is recognized when cash changes hands, like when the policyholder pays the premium) while GAAP is accrual-accounting (income is recognized as the service is completed, like the earning of a policy)
    • In summary, there is no SAP tax accounting or GAAP tax accounting, there is just tax accounting according to a set of IRS rules.

    I should say however that I'm not an expert on taxes. I hope that explanation helps.

  • us_beta_102us_beta_102
    edited April 2019

    This maybe a stupid question but what is the difference between the commutation prices in Fall2017 Q27 and Spring2016 Q27?

    The way I interpret the solution is that either one of the party will be beneficial in the case of Fall2017 Q27 problem. And we use change to taxable income = Price - Reserve ceded x Discount factor (of primary). No need to use economic discount here.

    In Spring 2016 Q27, we try to get a mutual benefit price for both parties. So we need to change the commutation price formula to include the economic discount on loss reserve and tax impact? The tax benefit calculation makes sense, but I am confused why we use the economic discount on ceded losses of primary (and gross losses of reinsurer) ?

    I just try to understand the connection between the two problems and your formulas.

  • grahamgraham

    This is not a stupid question at all. I wondered about it myself when I first looked at it, and maybe I should have been more clear in the wiki article.

    The concept of "economic discounting" was discussed more fully in a reading that is not longer on the syllabus. But the material in that discontinued reading is so similar to the material in the Klann reading, that I was afraid to label it as outdated and eliminate it completely from the discussion in the wiki.

    So, there are basically 2 types of discounting: economic and statutory. Economic discounting is the discounting the "market" considers appropriate. Statutory discounting is dictated by SAP, and that's the discounting you use in the 2017 problem because the goal is no tax, which is a statutory consideration.

    Economic discounting is used in the 2016 problem because they ask about a "mutually beneficial" price. This would include both statutory AND non-statutory economic considerations, but you wouldn't know that just from the Klann reading.

    They really should not ask a problem like the 2016 problem. (But, who knows for sure?)

  • jasonchwjasonchw

    Hi Graham, i understand you ignored tax effect for simplicity in your explanation and there is no difference for the answer of this question. However, technically should we also consider the change in taxable income when we estimate the change in surplus (i suppose change to net income is reflected by the 2mil - 3mil) ?

  • Staff - ACStaff - AC

    What Graham described above isthe change to taxable income, which is in turn the change to surplus.

    Since the writing of this thread, we added some more explanation on commutation pricing to the Wiki here, which you may find helpful:

    https://battleacts6us.ca/wiki6us/Klann.ReinsComm#:~:text=Here%27s%20the%20quick,margin%20to%20price.

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