Cedar.ReinsAccting

Reading: Reinsurance Accounting & Strategy for the Actuary (January 2020)

Author: Derek Cedar, FCAS, CERA & Andrew Thompson, FCAS

Study Tips

This reading by Cedar & Thompson, new for 2021.Spring, is one of my favorite readings. It's very organized and it replaces an older reinsurance reading by Blanchard & Klein. This older reading was #47 on the Ranking Table which means it was not heavily tested. The percentage weights for Exam 6 topics listed in the syllabus have not changed so I'm assuming Cedar & Thompson will not be heavily tested going forward, unless of course the syllabus weightings change. You can see from the current Ranking Table that there are 3 other reinsurance readings that are heavily tested. There are a total of 6 reinsurance readings and they are highlighted in orange in the rankings so you can easily find them.

Anyway, the ranking is important because studying this reading thoroughly would take a significant amount of time. Based on past exams, it's more strategic to do the following:

• if you have 30 minutes: study the 'Intro' section of this wiki article - functions of reinsurance
• if you have 2 hours: add the 'Simplified Examples' section - one example for each of the functions of reinsurance
• if you have 2-3 days: add a detailed study of the all the examples - you will need the source text for this - Cedar & Thompson explain the examples very well

Some of the examples are easier than others, and not all of them involve calculations. The first 6 examples have calculations showing the financial impacts of reinsurance but #7, 8, 9 do not. Also, some of the calculations overlap with other syllabus readings so it won't all be completely new although some of it is quite involved. But remember that it has historically been a low-ranked reading so if you decide to take the time to study this material thoroughly, make sure you've already covered all the higher-ranked readings first.

Even if you don't have time to study this reading thoroughly, you could still probably take a pretty good guess if a calculation problem appeared on the exam. That's because if you generally understand how reinsurance works, and you're solid on the financial accounting chapters of Odomirok, you just need to put those 2 things together.

Here's a direct link to the source text on the CAS site, valid as of Jan 14, 2021:   Reinsurance Accounting & Strategy for the Actuary

Estimated study time: 30 minutes - 3 days depending on the level of detail (not including subsequent review time)

BattleTable

No past exam questions are available for this reading. This reading however is a replacement for Blanchard and Klein - Reinsurance so you can scan the old BattleTable for that reading to see the kinds of questions that are likely to be asked.

reference	part (a)	part (b)	part (c)	part (d)
see Blanchard & Klein

In Plain English!

Functions of Reinsurance

Let's start with the most important memory item from this reinsurance reading.

Question: identify 9 functions of reinsurance [Hint: F-cat-SWIPLES]

(9)   →   Fronting arrangements

–

(2)   →   catastrophe protection

–

(3)   →   Surplus relief & capital efficiency

(6)   →   Withdrawal from market

(8)   →   Internal reinsurance transactions

(7)   →   Pools - mandatory & voluntary

(1)   →   Large line capacity

(5)   →   Enter market and/or U/W guidance

(4)   →   Stabilize results

The numbers preceding the bullet points refer to the numbering used in the Cedar & Thompson source text. I changed the order so the hint, F-cat-SWIPLES, would spell a word, sort of. Sometimes people post better hints in the forum. If you come up with something better, please go ahead and post! I will link to it from here. This reordering doesn't change the content of course, but it might be slightly confusing if you try to read the source text.

Aside from being able to list the 9 functions, you must also be able to give a brief explanation for each. There's an easy little web-based problem in the quiz to help you solidify your basic understanding but let's first quickly go through each function in the correct order. These descriptions are all common sense and once you've read through them once, I think you'll remember them.

(1) Large line capacity - insurer can write higher limit policies but then offload some of the risk to the reinsurer

(2) Catastrophe risk protection - cats are a significant risk to solvency because they generate a large number of simultaneous claims

(3) Surplus relief and capital efficiency - insurer cedes losses to reinsurer to reduce liabilities and strengthen surplus relative to net liabilities

(4) Stabilize results - reinsurance mitigates adverse loss volatility

(5) Enter market and/or underwriting guidance - reinsurers may have expertise in new market where the primary insurer is inexperienced

(6) Withdrawal from market - insurer may wish to eliminate an entire business segment and focus on new, more profitable market segments

(7) Pools - mandatory & voluntary - risks that insurers don't want to underwrite are ceded to reinsurance pools (ensures all customers have access to coverage)

(8) Internal reinsurance transactions - individual business units with lower tolerance than overall company may cede their losses internally (within the same legal entity)

(9) Fronting arrangements - to issue policies on behalf of clients with no access to properly licensed insurance companies

Front Arrangements

Just a quick note on number (9), fronting arrangements. In miniBattleQuiz 1 of Odomirok.14-F, we touched on the concept of fronting carrier:

• an insurer that cedes a large portion of its business (>75%) so the reinsurer can avoid regulatory oversight
• may occur when the reinsurer is not authorized to conduct business in the ceding insurer's jurisdiction

For some reason, it took me a moment to wrap my head around how a fronting arrangement works but Cedar & Thompson have a good example:

Business Issue:

• a U.S. insurer wants to insure a multinational company that has a small number of properties in Japan (most of the multinational's properties are in the U.S. so there's no problem with those)
• the U.S. insurer is not licensed to write business in Japan

Reinsurance Solution:

• a Japanese insurer issues the policy to the multinational company for the properties located in Japan (the Japanese insurer is the fronting carrier)
• the Japanese insurer then cedes 100% of the risk to the original U.S. insurer (the U.S. insurer is considered the reinsurer for these risks)

This cooperative effort between the Japanese and U.S. insurers is a fronting arrangement. It's perfectly valid because the U.S. insurer isn't attempting to enter the Japanese market in any serious way. They merely want to provide a convenient service for their existing U.S. client who just happens to have a small number of properties in Japan.

mini BattleQuiz 1

Simplified Examples

1. Large Line Capacity

Business Issue:

• an attractive opportunity to underwrite high value properties is presented
• but underwriting authority / risk appetite is $100 million for a single policy

Reinsurance Solution:

• purchase per-risk insurance to limit individual account exposure

Discussion:

treaty

- all individual losses above $100 million are ceded to reinsurer

negative effects

- net premium, losses, COR (Combined Operating Ratio) are HIGHER with reinsurance

positive effects

- net expenses are lower

- net income is HIGHER (the source text provides a numerical example to illustrate this)

- reinsurance made premium growth possible

2. Catastrophic Risk Protection

Business Issue:

• company writes 10 billon of property insurance along the coast of Florida
• but one large hurricane could cause the company to become insolvent

Reinsurance Solution:

• purchase annual aggregate excess-of-loss treaty covering losses from hurricanes

Discussion:

treaty

- company is responsible for the first $500 million of losses from each hurricane

- company must then meet its $2 billion deductible before reinsurance kicks in

negative effects

- low severity hurricane season → balance sheet surplus is lower with reinsurance (the reinsurance premium was higher than the recoverables)

positive effects

- medium & high severity hurricane seasons → balance sheet surplus is HIGHER with reinsurance (the reinsurance recoverables were higher than the premium)

comments

- the text example considered specific balance sheet items to calculate the surplus positions both with and without reinsurance

- balance sheet items included assets: cash & invested assets, reinsurance recoverables, liabilities: LAE, unearned premium

(similar to the analysis for Example 5 - Market Entrance and Underwriting Guidelines)

3. Surplus Relief and Capital Efficiencies

Business Issue:

• a certain minimum capital is required to write a certain insurance policy
• therefore the insurer would like to optimize the cost of obtaining capital

Reinsurance Solution:

• issue equity or debt to raise capital
• purchase reinsurance (this option essentially uses the reinsurer's surplus to underwrite a portion of the primary insurer's risks)

Discussion:

treaty

- net cost of treaty   =   $45 - $15   =   $30

- but the treaty provides a $500 reduction in capital requirements for the primary insurer

negative effects

- without reinsurance, the cost-of-capital is 9.6%

positive effects

- with reinsurance, the cost-of-capital is reduced to 8.9%

comments

- the text calculates the cost-of-capital as a weighted average of the costs for 3 items: equity, debt, reinsurance

- the %-costs of equity & debt are same both with and without reinsurance, but the amount of equity & debt required is lower when reinsurance is used

- the overall weighted average for the scenario WITH reinsurance turns out to be lower as stated above (8.9%)

4. Stabilization of Results

Business Issue:

• large year-to-year volatility in earnings
• this volatility impacts the investment community's valuation of the company stock

Reinsurance Solution:

• evaluates various reinsurance retention levels to improve earnings stability

Discussion:

treaty

- scenario 1: low-retention treaty that kicks in a $4 billion and provides $8 billion in coverage (treaty costs $3.2 billion)

- scenario 2: HIGH-retention treaty that kicks in a $8 billion and provides $4 billion in coverage (treaty costs $1.0 billion)

(the scenario of "no reinsurance" is not considered)

negative effects

- low-retention treaty has lower earnings over a 5-year time horizon

- HIGH-retention treaty has a HIGHER standard deviation with respect to earnings over a 5-year time horizon

positive effects

- low-retention treat has lower standard deviation with respect to earnings over a 5-year time horizon

- HIGH-retention treaty has a HIGHER earnings over a 5-year time horizon

comments

- low-retention treaty does indeed reduce volatility of earnings (if earnings are measure by standard deviation)

- the insurer sacrifices higher earnings for greater stability by choosing the low-retention treaty

further key comments

- stability can means different things for different situations

- therefore stability should be defined by specifying the metric to be stabilized and the time horizon over which stability is required

- examples of metrics: COR, earnings

- examples of time horizon: quarterly, annual, longer-term such as 5 years

5. Market Entrance and Underwriting Guidelines

Business Issue:

• a U.S. based company is interested in writing a new cyber risk product

Reinsurance Solution:

• use quota share reinsurance to facilitate market entrance

Discussion:

treaty

- 80% quota-share → primary insurer cedes 80% of premium and loss on new cyber-liability business

- reinsurer pays a ceding commission of 20% to cover the primary insurer's cost of writing new business

negative effects

- without reinsurance, NWP is lower for the primary insurer

positive effects

- with reinsurance, NWP-to-surplus ratio is lower (less pressure on surplus)

- the primary insurer can also be more confident that the new cyber-liability policies are properly priced

- the primary insurer has a "safe space" to build a credible database of cyber experience

comments

- the text example considered specific balance sheet items to calculate the surplus positions both with and without reinsurance

- balance sheet items included assets: cash & invested assets, reinsurance recoverables, liabilities: LAE, unearned premium

(similar to the analysis for Example 2 - Catastrophic Risk Protection)

6. Withdrawal from a Market Segment

Business Issue:

• new management wants to exit the workers compensation market
• instead: focus on growing its home and auto market

Reinsurance Solution:

• purchase retroactive reinsurance for the balance sheet WC reserves (removes liabilities from the balance sheet)
• discontinue writing new and renewal business prospectively

Discussion:

treaty

-purchase retroactive reinsurance agreement, effective December 31st, 2016, to reinsure all legacy WC balance sheet liabilities

- cost of treaty is $2 million

- liabilities to be transferred is $2.47 million

negative effects

- without reinsurance, it may take many years for the WC liabilities to be "run off"

- with reinsurance, there is a cost for this retroactive reinsurance policy

positive effects

- with reinsurance, primary insurer gets rid of WC liabilities immediately

comments

- this example is the most complex of the 9 examples in the Cedar & Thompson reading

- the point of the example is really to demonstrate the difference between SAP and GAAP accounting

- retroactive policies require the insurer to use retroactive accounting as covered in NAIC.SSAP-62R

- GAAP: the retroactive reinsurance rules attempt to align earnings in order to provide insight to the investment community

- GAAP: prevents insurers from artificially boosting earnings via retroactive reinsurance (by unlocking and recognizing the discount embedded in the reserves at the onset of a deal)

- More information: click the link Odomirok.22-23-GAAP – 2017.Fall Q12 for more details on SAP vs GAAP retroactive reinsurance accounting

7. Pools - Manadatory and Voluntary

Public Policy Issue:

• a state wants to ensure that property insurance is available for all residents

(including those not desired by the voluntary market)

• note that this is not a business issue - it is a public policy issue (that's why Alice used a different color for the little box above!)

Reinsurance Solution:

• insurance companies must participate in a state FAIR Plan ← click link to review FAIR plans

(a FAIR plan insures homes not able to obtain insurance in the voluntary market)

Discussion:

types of pools

- mandatory: carriers must participate in the mandatory pools to provide insurance for these "uninsurable" risks

- voluntary: often used to share risks too large for a single insurer / or reinsurer to cover alone (Ex: nuclear, aircraft, or energy risks)

negative effects

- insurers may have a slightly worse balance sheet by having to participate in mandatory pools

positive effects

- mandatory pools ensure coverage is available to everyone

- voluntary pools allow insurers to share large risks

comments

- auto insurance and homeowners insurance pools are discussed further in Cook.Personal

8. Internal Reinsurance Transactions

Business Issue:

• business unit appetite is only $20 million dollars per exposure
• corporate appetite is $50 million dollars per exposure

Reinsurance Solution:

• purchase internal reinsurance as an alternative to buying reinsurance externally

(allows the business unit to leverage the higher risk appetite of the whole company)

Discussion:

treaty

- business unit purchases internal reinsurance that kicks in at $20 million and provides $30 million reinsurance cover (to the $50 million corporate limit)

- premiums and losses are pooled among business units within the same legal entity

negative effects

- none

positive effects

- corporate entity retains (hopefully!) profitable business rather than ceding it to an external reinsurer

comments

- don't forget that the business units must be within the same legal entity

(this strikes me as a fact that might be important)

9. Fronting Arrangements

• Fronting Arrangements was discussed at the beginning of this wiki article. Just click the link to go to it.

Summary

As I said in the Study Tips, this material has historically been low-ranked and hasn't appeared very often on exams. That doesn't mean it won't appear more often in the future but if you're playing the odds, there is a lot of other material we know is likely to appear on the exam so you should study all of the higher-ranked material first.