Risk Transfer – Actuarial Perspective

1. Risk Transfer – Actuarial Perspective Casualty Actuarial Society – Washington, D.C. September 18-19, 2008 Ian Sterling, FCAS, MAAA

2. Agenda • FAS 113/SSAP 62 • Methods of Testing • Metrics • Next Steps

3. Reinsurance Accounting Guidance • GAAP • FASB Statement No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts • Statutory • SSAP No. 62, Property and Casualty Reinsurance • Similar to FAS 113

4. Short-Duration Risk Transfer – FAS 113 • Risk Transfer Conditions: • Paragraph 11 Test: • The reinsurer assumes “substantially all” of the insurance risk relating to the reinsured portion of the underlying insurance contracts, or • Paragraph 9 Test: • (a) The reinsurer assumes “significant” insurance risk under the reinsured portions of the underlying insurance policies. • Transfer of insurance risk refers to: • Ultimate amount of net cash flows between parties, and • Timing of the receipt of cash • (b) It is “reasonably possible” that the reinsurer may realize a significant loss from the transaction. • Risk factors do not include recognition of reinsurance costs, investment risk, taxes, or credit risk

5. SSAP 62 • Risk Transfer Conditions: • Indemnification of the entity company against loss or liability relating to insurance risk in reinsurance requires both of the following: • a. The reinsurer assumes significant risk under the reinsured portions of the underlying insurance agreements; and • b. It is reasonably possible that the reinsurer may realize a significant loss from the transaction

6. Reinsurance Attestation Supplement 20-1 • Risk Transfer Testing Practice Note • American Academy of Actuaries Committee on Property and Liability Financial Reporting – November 2005

7. Methods of Testing • (1) Reasonably “Self-Evident” • Purpose • Need to Document • Considerations • Substance of the arrangement • Existence, impact and role of risk-limiting factors • Use of professional judgment • Contract Terms to make this less likely?

8. Methods of Testing • (1) Reasonably “Self-Evident” • Examples of Safe Harbors: • A straight QS with no risk-limiting features other than a loss ratio cap with negligible effect on the economics of the transaction • Single year property cat and casualty clash contracts with little or no risk limiting features apart from a reinstatement premium common to these types of contracts • Most facultative and treaty per risk excess of loss arrangements with rates on line well below the present value of the limit of coverage, or without aggregate limites, sub-limits, or contingent features

9. Methods of Testing • (1) Reasonably “Self-Evident” • Examples of contracts not reasonably self-evident: • Aggregate excess of loss contracts • Contracts with experience accounts, experience rating refunds, or similar provisions, if such provisions have a significant impact on the contract’s economics • Multiple year contracts • QS contracts with risk limiting features

10. Methods of Testing

11. Methods of Testing • (2) Scenario Testing • Historical results by year • Comparison of All Underwriting Downside Scenarios • Comparison of Cedent and Reinsurer Expected Underwriting Deficits

12. Methods of Testing • Historical Results by Year

13. Methods of Testing • Comparison of All U/W Downside Scenarios

14. Methods of Testing • Comparison of Cedent and Reinsurer Expected Underwriting Deficits (EUD)

15. Methods of Testing • (3) Simulation Testing • Types of Models • Aggregate Loss Models • Frequency-Severity Models • Combination Models • Considerations

16. Methods of Testing • Modeling Considerations • Need to model: • Contract losses • Contingent Premium • Commissions • Other Contract Features • Reinsurance Underwriting Expenses • Potentially not considered: • Tax impacts

17. Metrics • (1) “10-10” Rule (Value at Risk) • Initial rule of thumb, and still somewhat used today • Definition • Shortcomings • Unintended Consequences

18. Metrics • (2) Tail Value at Risk (TVaR) • Definition • Criteria similar to “10-10” = TVaR > 10% at 10th percentile • Advantages • Disadvantages • Does this solve the shortcomings of VaR?

19. Metrics • Var and TVaR Example

20. Metrics • (3) Expected Reinsurer Deficit (ERD) • Definition • How relates to previous methods • Criteria of ERD > 1% similar to “10-10” (1% = 10% x 10%) • Avg Loss Severity = TVaR at the economic breakeven LR • Advantages • Does this solve “Shortcoming 2”? • Similar to Financial?

21. Metrics • (4) Other Methods • Other methods: • 1. Right Tail Deviation (RTD) - Wang • 2. Mean Square Adverse Deviation • 3. Conditional Expected Downside • 4. Some combination of (2) and TVaR • Advantage • Disadvantage

22. Summary • Can a bright-line test be used? • Advantage • Disadvantage • Guides • “10-10”, TVaR, ERD, RTD, etc. • Methods of Testing Risk Transfer • “Reasonably Self-Evident”, Scenario Testing, Simulation • Next Steps