An Introduction to Reserving and Financial Reporting Issuesfor Non-Traditional Reinsurance

Casualty Loss Reserving SeminarSeptember 14, 2004

Derek Jones, FCAS, MAAA

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Finite Re BasicsFinite Re Basics

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OverviewOverview

Customized deals to address specific Customized deals to address specific issues of cedantissues of cedant

Limited risk transferred by cedantLimited risk transferred by cedant

Limited upside for reinsurerLimited upside for reinsurer

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Common UsesCommon Uses

Deferral of taxesDeferral of taxes Discounting Discounting Earnings stabilizationEarnings stabilization Risk management Risk management Surplus protectionSurplus protection

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Types of DealsTypes of DealsRetroactiveRetroactive Adverse development coverAdverse development cover Loss portfolio transferLoss portfolio transfer

ProspectiveProspective Aggregate stop-lossAggregate stop-loss Finite quota shareFinite quota share Spread loss Spread loss

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Loss Portfolio TransferLoss Portfolio Transfer

Covers prior written businessCovers prior written business Move reserves off balance sheetMove reserves off balance sheet Premium = PV (reserves) + provision Premium = PV (reserves) + provision

for potential adverse developmentfor potential adverse development Tends to cover smaller segmentsTends to cover smaller segments

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Adverse Development CoverAdverse Development Cover

Cedant retains portfolioCedant retains portfolio Premium is based on potential for Premium is based on potential for

adverse development and related adverse development and related timing of future paymentstiming of future payments

Tends to cover larger groupings of Tends to cover larger groupings of business than LPTsbusiness than LPTs

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Aggregate Stop-LossAggregate Stop-Loss

Stabilize earningsStabilize earnings Typically multi-year dealsTypically multi-year deals Loss ratio corridor above plan ratioLoss ratio corridor above plan ratio Fixed premiumFixed premium

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Finite Quota ShareFinite Quota Share

Primary benefit = surplus reliefPrimary benefit = surplus relief Differences from traditional QSDifferences from traditional QS

Loss ratio capLoss ratio cap Loss corridor Loss corridor Lower net costLower net cost

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Common FeaturesCommon Features

Time value of money (via experience Time value of money (via experience account)account)

Cedant participationCedant participation Sub-limits of liabilitySub-limits of liability Multiple yearsMultiple years Cancellation, commutation provisionsCancellation, commutation provisions

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Reserving IssuesReserving Issues

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Understand Deal StructureUnderstand Deal Structure

Line(s) of business, coverage typeLine(s) of business, coverage type Limits, sub-limits for reinsurerLimits, sub-limits for reinsurer Reinsurance or deposit accountingReinsurance or deposit accounting Loss reserve discountingLoss reserve discounting Experience accountExperience account Commutation provisionCommutation provision

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Experience AccountExperience Account

EAB = premium – margin – loss EAB = premium – margin – loss payments + interest creditpayments + interest credit

What if EA is exhausted?What if EA is exhausted?

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Monitor EmergenceMonitor Emergence

Issue 1: temporary speed-upIssue 1: temporary speed-up– Could exhaust EA too quicklyCould exhaust EA too quickly

Issue 2: actual > expectedIssue 2: actual > expected– Initial estimate of nominal loss may be Initial estimate of nominal loss may be

understatedunderstated– Under-reporting will delay triggering Under-reporting will delay triggering

additional premiumadditional premium

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Interest CreditInterest Credit

Based on risk-free rate (e.g., U.S. Based on risk-free rate (e.g., U.S. Treasury spot rates)Treasury spot rates)

Spread is larger for deals on a funds Spread is larger for deals on a funds withheld basiswithheld basis

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Sensitivity TestingSensitivity Testing

Both magnitude and timing of Both magnitude and timing of reinsurer payment are keyreinsurer payment are key

Nominal loss amountsNominal loss amounts– Retroactive: usually use more simplistic Retroactive: usually use more simplistic

approach to produce rangeapproach to produce range– Prospective: stochastic simulationProspective: stochastic simulation

Use alternative payout patterns to Use alternative payout patterns to evaluate impact of timingevaluate impact of timing

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Bulk ReservesBulk Reserves

Law of large numbers doesn’t applyLaw of large numbers doesn’t apply

How is best estimate determined How is best estimate determined (mode, mean, confidence level)?(mode, mean, confidence level)?

Not commonly used in practiceNot commonly used in practice

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Financial Reporting Financial Reporting IssuesIssues

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Type of AccountingType of Accounting

Reinsurance treatment is based on Reinsurance treatment is based on SFAS 113 or SSAP 62SFAS 113 or SSAP 62

– Reinsurer must assume significant riskReinsurer must assume significant risk– It must be It must be reasonably possiblereasonably possible to realize to realize

a a significant losssignificant loss Deposit accounting is required unless Deposit accounting is required unless

both conditions are metboth conditions are met

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Prospective vs. Retroactive Prospective vs. Retroactive ReinsuranceReinsurance

The following exceptions should be The following exceptions should be treated as prospective reinsurancetreated as prospective reinsurance

Structured settlementsStructured settlements NovationsNovations Reduced participation in reinsurance Reduced participation in reinsurance

treatiestreaties Intercompany agreements that do not Intercompany agreements that do not

produce gain in surplusproduce gain in surplus

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Deposit AccountingDeposit Accounting

No initial impact on balance sheet or No initial impact on balance sheet or income statement for cedant or income statement for cedant or reinsurerreinsurer

Emerges in financial statements as Emerges in financial statements as actual payments are made/receivedactual payments are made/received

Note: deposit liabilities are not part of Note: deposit liabilities are not part of lines 1 or 3 on statutory balance lines 1 or 3 on statutory balance sheetsheet

http://www.casact.org/pubs/forum/04fforum/04ff073.pdf

derek.jones@milliman.com

646.473.3416