Reinsurance

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Based on past exams, the main things you need to know (in rough order of importance) are:

• 10-10 rule for testing risk transfer
• ERD method for testing risk transfer
• reinsurance accounting - determining if a contract qualifies
• discount rate selection considerations
• practical considerations in risk transfer analysis: parameter selection & risk, pricing assumptions, commutation clause
• pitfalls in risk transfer analysis: profit commission, reinsurer expenses,... [PRICE – P]
• general concepts in risk transfer testing: determining most appropriate test, determining whether risk transfer is self-evident

reference	part (a)	part (b)	part (c)	part (d)
E (2018.Spring #26)	10-10 rule: - test risk transfer	'substantially all' rule: - test risk transfer	ERD method: - test risk transfer
E (2017.Spring #27)	ERD method: - test risk transfer	pitfalls: - in risk transfer test	discount rate: - selection considerations
E (2016.Fall #25)	any method: - test risk transfer	any method: - test risk transfer	any method: - test risk transfer
E (2016.Spring #26)	10-10 rule: - test risk transfer	see Odomirok.19-RBC	ERD method: - test risk transfer
E (2015.Fall #26)	self-evident?: - test risk transfer	reinsurance accounting: - conditions to qualify	pitfalls: - in risk transfer test
E (2015.Spring #25)	10-10 rule: - test risk transfer	don't use 10-10 rule: - test risk transfer	see Odomirok.19-RBC
E (2014.Spring #27)	describe 2 tests: - for risk transfer	is 1 test better: - in a certain scenario	required data: - for risk transfer test	(d) practical considerations in a risk transfer test (e) reinsurance accounting vs risk transfer
E (2013.Fall #28)	10-10 rule: - test risk transfer	reinsurance accounting: - conditions to qualify	practical considerations: - in risk transfer test
E (2012.Fall #31)	Scenario: - risk transfer concerns	discount rate: - selection considerations

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In Plain English!

Intro

This is a well-organized paper, and I'd suggest reading Section 1. It's short, but provides a nice introduction. The main question that's addressed is:

How can an actuary determine when risk transfer has (or has not) occurred?

But even before trying to answer that, another reasonable question is:

Why do we care whether risk transfer has taken place?

• One obvious reason is that a reinsurer cannot properly price a reinsurance contract without knowing how much risk they've taken on.
• Another reason is that when a contract qualifies as reinsurance, the cedant may use reinsurance accounting treatment, which is more favorable than the alternative (deposit accounting)

Question: identify 2 conditions for a contract to receive reinsurance accounting treatment

1. requires that significant insurance risk is assumed by reinsurer (under reinsured portion of contract)
2. requires that a significant loss to the reinsurer is reasonably possible

A related concept concerns the components of insurance risk. It's generally understood that insurance risk must include:

• U/W risk (there must be uncertainty in the $-value of loss)
• timing risk (refers to timing of claims payments - there should not be any sort of predetermined payment schedule)

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Explanation of 2016.Fall #16a

Background

I like this problem! It requires you to apply some of the basic tests for determining risk transfer. In other words, how can you tell whether the 2 conditions in the table above are satisfied? Below, I've summarized a few of the methods from the reading. (There are lots of other pitfalls and considerations to think about, but this is a good place to start.)

Method 1: Qualitative

• Is transfer of risk self-evident? (Maybe the reinsurance premium is very low, or the potential loss is very high, like with hurricanes or earthquakes - either way, it should be obvious that the cedant's financial interests are protected.)
• See also example of reasonably self-evident in CIA.Reins. (In that paper, they required 2 specific conditions for reasonably self-evident: (i) transaction is done at arms-length, (ii) no risk-limiting features. See also | here in the forum for user chrisboersma's detailed explanation.)

Method 2: Qualitative

• "Substantially All" exception: IF (significant loss NOT reasonably possible) BUT (reinsurer assumes "substantially all" risk) THEN (risk transfer may still exist)
• (Often applies to quota-share contracts with a high % transferred)

Method 3: Quantitative

• Calculate ERD (Expected Reinsurer Deficit): ERD = prob(of NPV reinsurer loss) x NPV(reinsurer loss) / (reinsurance premium)
• If ERD > 1% then there has been transfer of loss
• click for ERD Example.

Method 4: Quantitative

• 10-10 rule: IF reinsurer has a 10% chance of suffering a 10% loss THEN the contract is deemed to have transferred risk

You can access the question & answer with the link to the right or in the next section or in the mini BattleQuiz. E (2016.Fall #16a)

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Part i

• Given the following info, explain whether there is risk transfer.

excess of loss treaty	$2M excess of $1M
aggregate limit	$2M
aggregate deductible	$1M
reinsurance premium	$1M

• Let's step through the methods in order:

• Is risk transfer self-evident?

• If you have to think about this for more than just a few seconds, then it is not self-evident.
• (Method 1 inconclusive.)

• Does the "substantially all" rule apply?

• No, this doesn't apply either because the maximum reinsurer liability is only $2M, and the deductible and premium together sum to $2M. (It seems closer to "substantially nothing" than substantially all!)
• (Method 2 inconclusive.)

• Calculate ERD

• We don't have any data on frequency and severity, but we can still deduce the ERD from the given info:

• max loss = 3M THEREFORE max reinsurer payout = 1M (because retention = 1M and deductible = 1M) THEREFORE max reinsurer loss = 1M - (premium of 1M) = 0
• BINGO! The reinsurer can't lose. Therefore there has been no transfer of risk.

• (Method 3 provided the answer.)

• Note: The reasoning for Method 3 came from the examiner's but user danielle4nan noticed that if there was a second loss of 3m, the insurer would then suffer a loss of 1m. The reasoning is that for the second 3m loss, 1m is retained by the insured as before, but the aggregate deductible of 1m was reached on the first loss and there's still 1m left in the aggregate limit. So, the insurer would have to pay 1m. The answer to whether there has been true transfer of risk is not so clear now. (Thx danielle4nan!)

Part ii

• Given the following info, explain whether there is risk transfer.

quota share %	50%
ceding commission	20%
ERL (expected LR)	40%
reinsurance expenses	5%

• If you remember that the "substantially all" rule applies to quota-share reinsurance, then you can immediately conclude that there is risk transfer under this contract. (Method 2 provided the answer.)
• (The text says that the "substantially all" applies to quota-share with a high percentage transfer. Actually, 50% doesn't seem high, but the examiner's report accepted this as an explanation.)

Part iii

• Given the following info, explain whether there is risk transfer.

excess of loss (earthquake)	$300M excess of $50M
reinsurance premium	$5M
100-year PML	$50M
200-year PML	$200M
500-year PML	$350M

• This is the easiest of the 3 problems. It's tempting to try to calculate ERD because we're given information about both the frequency and severity, but since it's earthquake reinsurance, there is potential for a catastrophic loss in any year.
• We can immediately invoke Method 1 to conclude that there is self-evident risk transfer under this contract.

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Section 3ab & 4: Pitfalls & Practical Considerations in Reinsurance

The first thing you should do is study the 2 examples in the source reading at the beginning of Section 3.

Contract 1 is an example of a quota-share contract:

• quota share contract (with profit commission LR @ 66%) and one-for-one profit swing up to 5% below an LR of 66%.

Contract 2 is an example of an excess-of-loss contract:

• excess-of-loss (with optional commutation after 5 yrs) and swing-rated where provisional the reinsurance premium rate of 8.5% varies between 6%-11% based on LR of 75%

These examples are used to illustrate the pitfalls and practical considerations discussed in this section, but also that if you get another problem like (2016.Fall #16a), you'll be familiar how quota-share, and excess-of-loss reinsurance contracts work. This section is fairly straightforward memorization.

There first list must memorize is:

Question: identify the pitfalls in a risk transfer test [Hint: PRICE – P]

Profit commission

Reinsurer expenses

Interest rates

Commutation timing

Evaluation date

    –

Premiums

See details in mini BattleQuiz.

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There second list must memorize is:

Question: identify the practical considerations in a risk transfer test [Hint: parameter(selection, risk).Pr(ass).Comm]

Parameter selection (interest rate, payment-pattern, loss distribution)

Parameter risk

Pricing assumptions

Commutation clause

See details in mini BattleQuiz.

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Note :There is a lot to memorize in these sections, but it's usually not a high point-value reading, 1.0 - 1.5 points. The broad topic of reinsurance, however, covers 3 readings. (See also CIA.ReIns & BK.ReIns) These 3 readings together account for more than 3.0 points per exam, and you never know where the reinsurance questions are going to come from.

Final Thoughts

There have not been any exam questions that ask you simply to list the 6 pitfalls or 4 practical considerations in risk transfer. I'm a little surprised by that - it seems like a standard type of question. In fact, there haven't been questions of any sort on the pitfalls. (I think it's only a matter of time before one appears.) Rather, old exam questions have focused on the practical considerations.

• A question asking for the advantages & disadvantages of using pricing assumptions in a risk transfer analysis has appeared twice, both very recently: (2017.Spring #17b), (2015.Fall #15b)
• The answer is covered in the BattleCards, so I won't reproduce it here.
• I think the reason this question on pricing assumptions is important is that if you're doing a risk transfer analysis, it's very easy just to ask the pricing department to give you their assumptions. It saves you the trouble of having to make your own assumptions. But if you're going to use someone else's assumptions, you should do so with full knowledge of the advantages & disadvantages.

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BattleCodes

Memorize:

Conceptual:

Calculational: