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

2. 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. Agenda Current Market Environment Overview of Finite Structures
Overview of SFAS No. 113 and Statutory Issue Paper No. 75

4. Current Market Environment
Interest Rate Environment
Underwriting Environment
Heightened Regulatory Environment

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

6. 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. 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. 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. 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. Finite Structures Retroactive Reinsurance Prospective 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. Common Contract Provisions
Experience accounts
Profit commissions
Aggregate limits
Loss ratio corridors
Cancellation provisions
Delays in payments
Adjustable premium, limit or commission

12. 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. LPTs & ALDCs

14. 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. 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. 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. 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. 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. Finite Quota Share Pricing based on: Benefits 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. 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. 50% Finite Quota Share Example

22. 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. 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. 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. Aggregate Excess of Loss Example

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

29. 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. 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. 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. 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. 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