1 Finite Reinsurance Casualty Loss Reserve Seminar Chicago, IL September 9, 2003 Bruce D. Fell, FCAS, MAAA, CFA

2 Casualty Loss Reserve Seminar Disclaimer The views expressed in this presentation are those of the individual presenters and in no way represent the opinions of the CAS, the Joint Committee of the CLRS, or the presenters’ respective employers. The presenters take full responsibility for all irrational, incoherent and foolish comments.

3 Casualty Loss Reserve Seminar Agenda Current Market Environment Overview of Finite Structures Overview of SFAS No. 113 and Statutory Issue Paper No. 75

4 Casualty Loss Reserve Seminar Current Market Environment Interest Rate Environment Underwriting Environment Heightened Regulatory Environment

5 Casualty Loss Reserve Seminar Interest Rate Environment Rates have dropped dramatically in last five years Time value of money changes dynamics of some transactions

6 Casualty Loss Reserve Seminar Underwriting Environment Focus on underwriting profit after years of soft market and Sept. 11, 2001 Fewer finite reinsurers  Exits – Centre, Commerical Risk, Gerling, OPL, Scandinavian, Stockton  Refocus – Am Re, Gen Re, St. Paul

7 Casualty Loss Reserve Seminar Underwriting Environment Focus on correlation and aggregation  Risks previously assumed to be independent now recognized as correlated (lesson learned from Sept. 11, 2001)  Natural catastrophe aggregations Focus on credit risk  Cedents focus on quality of reinsurers  Reinsurers focus on quality of cedents

8 Casualty Loss Reserve Seminar Underwriting Environment Constrained Capacity  Reserve charges from 9/11, soft market and latent exposures have depleted capital  Focus limited capital on best profit potential  Increased premium + fewer companies = increased capital leverage  Supply and demand increases cost of capital

9 Casualty Loss Reserve Seminar Heightened Regulatory Environment Rating agencies – capital levels and underwriting profit Auditors – increased disclosures and “truth in reporting” Stock analysts – redemption from “technology bubble” State regulators – debate over federal versus state regulation

10 Casualty Loss Reserve Seminar Finite Structures Retroactive Reinsurance  Loss Portfolio Transfer (LPT)  Adverse Loss Development Cover (ALDC) Prospective Reinsurance  Finite Quota Share  Aggregate Excess of Loss (Stop Loss)  Traditional contracts with “finite” features  Combination of coverage

11 Casualty Loss Reserve Seminar Common Contract Provisions Experience accounts Profit commissions Aggregate limits Loss ratio corridors Cancellation provisions Delays in payments Adjustable premium, limit or commission

12 Casualty Loss Reserve Seminar LPTs & ALDCs Reinsurer accepts ceding company’s reserve uncertainty in exchange for a fixed premium Pricing based on:  Reserve level  Expected payment pattern of reserves  Variability of reserves and payment pattern  Expected interest rate  Reinsurer’s capital costs and risk margin

13 Casualty Loss Reserve Seminar LPTs & ALDCs

14 Casualty Loss Reserve Seminar Loss Portfolio Transfer Contract provisions  Aggregate limit  Experience account refunds  Commutation provisions Benefits  “Transfer” existing reserves to reinsurer (reduce reserve leverage)  May protect from adverse development  Establish “fixed” current price for uncertain future reserves

15 Casualty Loss Reserve Seminar Loss Portfolio Transfer Example Premium = $120 million Limit = $150 million Reinsurer’s Margin = 3% ($3.6 million) Crediting Interest Rate = 2.0% Experience account commutation = Premium - Margin - Losses + Interest

16 Casualty Loss Reserve Seminar Adverse Loss Development Contract provisions  Aggregate limit  Possible experience account refunds  Commutation provisions Benefits  Protection from adverse development  Establish “fixed” current price for uncertain future reserves

17 Casualty Loss Reserve Seminar Adverse Loss Development Example Premium = $40 million Limit = $50 million excess of $100 million Reinsurer’s margin = 5% ($2.0 million) Crediting Interest Rate = 2.5% Experience account commutation = Premium - Margin - Losses + Interest

18 Casualty Loss Reserve Seminar Finite Quota Share Reinsurer accepts percentage of cedent’s premiums and losses in exchange for ceding commission Contract Provisions  Sliding scale commission  Loss ratio corridor  Aggregate limit

19 Casualty Loss Reserve Seminar Finite Quota Share Pricing based on:  Expected loss ratio  Size of slide, corridor and aggregate limit  Reinsurer’s capital charge Benefits  Surplus relief from ceding commission  “Transfer” premium to reinsurer (reduce premium leverage)

20 Casualty Loss Reserve Seminar Finite Quota Share Example Provisional ceding commission = 35% minimum = 70% loss ratio maximum = 55% loss ratio Loss corridor between 70% and 75% loss ratio Reinsurer’s margin = 5% between 55% loss ratio and 75% loss ratio Aggregate Limit = 100% loss ratio

21 Casualty Loss Reserve Seminar 50% Finite Quota Share Example

22 Casualty Loss Reserve Seminar Aggregate Excess of Loss Reinsurer provides corridor of protection over cedent’s expected results in exchange for fixed premium Contract Provisions  Aggregate limit  Experience account refunds

23 Casualty Loss Reserve Seminar Aggregate Excess of Loss Pricing based on:  Expected loss ratio results  Variability of loss ratio  Size of experience account refund  Interest rates Benefits  Aggregate protection of underwriting results

24 Casualty Loss Reserve Seminar Aggregate Excess of Loss Example 10 loss ratio points in excess of a 65% loss ratio (maximum of $9 million) Maximum subject premium = $90 million Reinsurance premium = $6 million Reinsurer’s Margin = 10% ($600,000) Crediting Interest Rate = 2.5% Experience account commutation = Premium - Margin - Losses + Interest

25 Casualty Loss Reserve Seminar Aggregate Excess of Loss Example

26 Casualty Loss Reserve Seminar Traditional and Combination Coverage Many “traditional” reinsurance contracts include “finite” features:  Corridors, Aggregate limits, Adjustable commissions, etc. Some finite contracts include traditional coverage to add risk  Section A = finite quota share  Section B = excess occurrence (cat) coverage

27 Casualty Loss Reserve Seminar GAAP and Statutory Reinsurance Accounting SFAS No. 113  Effective 1993 Statutory Issue Paper No. 75  Effective 1995 Both outline determination of whether contract is reinsurance and if so, the appropriate accounting treatment

28 Casualty Loss Reserve Seminar SFAS No. 113 Decision Tree Does contract indemnify cedant against loss/liability? Is contract short duration or long duration? Is contract Prospective or Retroactive? Use deposit accounting AICPA: SOP 98-7 Account for as long duration based on FAS No. 97 Account for as Retroactive Reinsurance based on FAS No. 113 Account for as Prospective Reinsurance based on FAS No. 113 No Yes Long Short Prospective Retroactive

29 Casualty Loss Reserve Seminar Indemnification Against Loss Reinsurer assumes significant insurance risk under reinsured portions of the underlying insurance contracts It is reasonably possible that the reinsurer may realize a significant loss from the transaction Risk must not be remote with regard to timing and amount

30 Casualty Loss Reserve Seminar Evaluation of Risk Transfer Present value of all cash flows under reasonably possible outcomes (premiums, losses & commissions) No regard to how cash flows are characterized Same interest rate for all tested outcomes Exception: If substantially all insurance risk relating to reinsured portions of underlying contract has been assumed by reinsurer!

31 Casualty Loss Reserve Seminar Prospective versus Retroactive Prospective – assumption of future events Retroactive – assumption of past events Contract having both elements must be accounted for separately or as retroactive Retroactive also includes:  Claims-made reinsurance of occurrence insurance  Prospective reinsurance not finalized within 9 months of inception

32 Casualty Loss Reserve Seminar Statutory Exceptions to Retroactive Reinsurance Structured settlements Novations Termination of/reduced participation in reinsurance treaties Inter-company reinsurance arrangements, as long as no “surplus creation”

33 Casualty Loss Reserve Seminar Contact Information Bruce D. Fell, FCAS, MAAA, CFA Senior Vice President JLT Re Solutions, Inc Lenox Drive P.O. Box 6400 Lawrenceville, NJ ext. 402