Common Pitfalls - Gross Premium
I’m confused about the statement that gross premium should be used in the risk transfer analysis, and how F&V describes this as not including ceding commission (top of pg14 of paper). They state this comes from SSAP 62, which I was able to track down in the question 14, (pg 29 of SSAP62), however this contradicts their example contract #1. The calculation shown in appendix A incorporates the ceding commission when doing the ERD calculation. Is this part of the point made with the statement in the preceding paragraph “what the premium should include is not nearly as straightforward”?
Comments
You are correct. This is a contradiction. The text says that ceding commission should not be included in a risk transfer analysis, but then in the example in appendix they do including ceding commission.
It isn't possible to resolve this based on information on the syllabus, but note that the syllabus states that the F&V appendices are for informational purposes only, whatever the hell that means! So the safest assumption is that ceding commissions are not included since that is specifically stated in pages that are on the syllabus.
This is a great point and I will note it in the wiki (and give you a shout-out!)
The manual says "Gross premiums entail all premium paid to the reinsurer before the consideration of any payments back such as ceding commissions."
When you say 'not included', does this mean we just basically use Gross Premium Paid instead of Gross Premium Paid - Ceding Commission to Insurer?
Somehow the wording is confusing to me.
Sorry, I see how my wording is confusing. I should have said ceding comissions should not be subtracted from gross premiums. But in the appendix they do subtract ceding commissions.
I hope that's clearer.
Great point about the appendices being informational! Thanks Graham!
I also find this topic confusing. At first it made more sense in my mind to subtract ceding commissions, since for example if the reinsurance premium were 100 and the ceding commission were 30, then really the insurer has only ceded 70 to the reinsurer. And we only care about "cash flows between the ceding and assuming companies under reasonably possible outcomes, without regard to how the individual cash flows are described or characterized"
But my guess is that, if you use Gross Premiums, then manipulating a contract to have an unusually high ceding commission would only serve to under recognize risk transfer, which the insurer would not be incentivized to do. It wouldn't make sense to send a bunch of extra money to the reinsurer, only to get it returned right back to you, if the only thing that would accomplish is to make the contract ineligible for reinsurance accounting. So by including the ceding commission, there is no risk of over detecting risk transfer.
And it does seem consistent with the idea of not treating different reinsurance contracts differently based on the expenses or expected returns of the assuming entity.
Although Freihaut says,
I've read SSAP 62 and I don't know which line they are referring to. I didn't see this "specifically pointed out" anywhere.
I think the part of SSAP 62 they're talking about is the Q&A, specifically Q14, which is on page 29 of the SSAP 62 doc. The problem is that they don't define what they mean by gross premiums. So we have to go back to Freihaut where they say in the text to not subtract ceding commissions.
To the other points you made, it does seem more reasonable to indeed subtract the ceding commission from the gross premium because that certainly is a cash flow between the insurer and reinsurer.
Let's say the gross premium is really high, high enough to significantly offset reinsurer losses and we don't subtract commissions:
But if there's a very high ceding commission in the background, let's say almost as much as the original gross premium, then there's a high chance of reinsurer loss so risk transfer really would exist. In other words, as you said, using only gross premiums leads to under-detection of risk transfer.
Just as a heads-up on this, but this exact question came up on Spring 2019, and the Exam Committee expected that candidates would have considered at least commissions as part of the original premium transaction to be included as part of a risk transfer analysis. I think it's probably safest to conclude that, based on the rough rule that whatever constitutes a cash flow between the insurer and the reinsurer, commissions should be included as part of the risk transfer analysis, although caveat this by stating profit commissions specifically are excluded (since risk transfer analysis does not focus on situations where a profit could be made; only losses).
Yes, I was aware of that question from the 2019.Spring exam and I've discussed this issue with a few other people outside of this forum. Friehaut just flat-out contradicts itself between the text and the example in the appendix so there's no good way to resolve it from the syllabus readings alone.
But as you said, it appears from the answer in the examiner's report to this question that they do expect you to subtract ceding commissions. You make a good point about ceding commissions versus profit commissions (which should not be included in the risk transfer test.)
If this comes up on the exam, you should include a brief explanation so the examiner's know you understand the concept. Then it might be an idea to submit a note to the CAS about a defective question. You should do this RIGHT AFTER THE EXAM. If you wait until the appeals window opens, you'd have a far smaller chance of being successful. They would prefer to make any adjustments to their grading rubrik before they start grading.
I am trying to understand the contradiction on the ceding commission.
In 2015 F 26, I am confused about provisional ceding commission, profit commission and ceding commission. Based on your definition of profit commission (a payment from reinsurer when ceded LR < specified), it seems like the provisional ceding commission in contract #1 is one type of profit commission. But in contract #2, it gives a condition of profit commission which does not align with your definition.
In 2019 S 23 part a ii gives answer "Depends, profit commissions should be excluded but commissions as a part of original premium transactions are included". Does this mean different treatment to different ceding commission is possible?
No matter of which type of commission they throw out, is the safest saying " ceding commission should not be included in risk transfer test, which means no subtraction of ceding commission from premium"?
Unfortunately there is no way to give a conclusive answer based on the source text.
In general, a profit commission is way of sharing the profit (if any) from a reinsurance contract. The purpose of the profit commission is to encourage the primary insurer to practice good underwriting and management. The usual way of profit-sharing is to adjust the ceding commission based on the loss ratio of the ceded business. That is what's done in contract 1, although here it's called a provisional ceding commission that can be adjusted later, depending on the loss ratio of the ceded business.
In contract 2, they describe the profit commission differently. It isn't based directly on the loss ratio of the ceded business. Instead, a profit commission is paid if the reinsurer exceeds its target profit margin of 12.5%. In practice however, this is closely tied to the loss ratio of the ceded business because if the ceded business has a low (good) loss ratio, it will be more likely that the reinsurer will exceed the target profit margin.
So on an exam question, I would say something similar to 2019 Spring Q23:
But keep in mind there is a grey area and you may have to modify the above statement based on whatever information you're given in the problem.
About your final question, the source text specifically states that ceding commissions should not be subtracted (even though the example in the Appendix does subtract ceding commissions, but the syllabus says the Appendix is for informational purposes only, so I would go by what it says in the main part of the source text. In other words, do not subtract ceding commissions.)
My 2-cents:
a) When calculating the NPV of Reinsurer UW Gain/Loss, include all cash flows between the cedent and reinsurer, including ceded commissions, profit commissions, etc. This just makes sense.
b) When assessing the significance of the loss (i.e. dividing by reinsurance premium to get a %), use the gross premium. This is the specific context of Question 14 in SSAP 62: "In evaluating the significance of a reasonably possible loss, should the reasonably possible loss be compared to gross or net premiums?"
Unfortunately, this still contradicts what Freihaut does in Appendix A: The percentage in column 9 is divided by net premium rather than gross premium.
Hey @pbolgert,
Thanks for the comment. You really dug down to find that. As you said, it really doesn't resolve the issue however. I've pasted the reference below: