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Finite Reinsurance Discussion and Demonstration

Casualty Actuarial Society 2003 Spring Meeting Marco Island, Florida May 18 - 21, 2003 Douglas A. Carlone Senior Vice President. Finite Reinsurance Discussion and Demonstration. What Is Buyer’s Motivation?. Is buyer looking to disguise unprofitable results or other financial difficulties?

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Finite Reinsurance Discussion and Demonstration

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  1. Casualty Actuarial Society 2003 Spring Meeting Marco Island, Florida May 18 - 21, 2003 Douglas A. Carlone Senior Vice President Finite Reinsurance Discussion and Demonstration

  2. What Is Buyer’s Motivation? • Is buyer looking to disguise unprofitable results or other financial difficulties? • Is buyer looking for traditional reinsurance at a finite reinsurance price? • Neither situation attractive to the reinsurer

  3. Due Diligence - Retroactive Covers • Claims audit • Quality of underwriting • Ceded reinsurance program • IBNR reserving philosophy • Data distortions

  4. Due Diligence - Prospective Covers • Same as for retroactive covers, plus ... • Planning process • Pricing philosophy • Changes in claims handling, underwriting, ceded reinsurance

  5. Actuarial Analysis

  6. Pricing Model • Parameters (loss pick, payout pattern, volatility) are entered into a simulation model • Simulation can be implemented via macros or via add-in software (e. g., @Risk) • Trial and error approach until pricing targets are reached • Typical pricing targets (alone or in combination): minimum return on capital, minimum absolute return, maximum probability of loss, maximum downside risk, etc.

  7. Capital Allocation Can Be Based on … • Regulatory capital requirements (e. g., RBC) • Rating agency capital requirements • Distribution of PV profit from simulation output • Unfunded limit (limit minus premium)

  8. Adverse Development Cover • Attachment point: $1,386 million (carried reserves as of 12/31/2002) • Limit: $250 million • Guaranteed cost premium: $100 million

  9. Aggregate Stop Loss Cover • 2003 subject premium assumed to be $700 million • Attachment point: $630 million (90% of subject premium) • Limit: $140 million (20% of subject premium) • Guaranteed cost premium: $45.5 million (6.5% of subject premium)

  10. Guaranteed Cost • Low up-front cost • No profit sharing • Upside is retained by reinsurer • Similar to traditional reinsurance • Rarely used for stop loss covers • Occasionally used for adverse development covers • More commonly used for loss portfolio transfers

  11. Profit Sharing • Higher up-front cost compared to guaranteed cost • Reinsurer’s upside consists only of a relatively small margin • Since reinsurer’s upside is capped, need to overfund to reduce the reinsurer’s downside • Most of profit goes to ceding company • Lower economic cost compared to guaranteed cost • Pricing model needs to track funding premium, margin, funded losses, unfunded losses, and interest accrual on experience account balance (EAB)

  12. Profit Sharing (cont.) • EAB can be either held by reinsurer (funds transferred) or held by cedant (funds withheld) • Funds transferred: EAB crediting rate usually linked to risk-free rate • Funds withheld is similar to debt (reinsurer loans reinsurance premium back to cedant) • Therefore, EAB crediting rate is higher for funds withheld than for funds transferred (should approximate cedant’s cost of debt) • Funds transferred: higher up-front cost • Funds withheld: lower up-front cost

  13. Other Structural Features:Additional Premiums • Generally used only for prospective covers • Lowers the deposit premium requirement • Contingent upon experience • Can take many forms • Reinsurer is subject to credit risk with regard to future AP payments (offset provisions can mitigate this risk, however) • Pricing model needs to project premium inflows in addition to loss outflows

  14. Other Structural Features:Sublimits • Retroactive covers: used for types of losses that are difficult to quantify (e. g., asbestos, pollution, other mass torts) • Prospective covers: used for shock losses (e. g., property catastrophes)

  15. Multiyear Aggregate Stop Loss Covers • Single year: get benefit of discounting • Multiyear: get benefit of discounting and temporal smoothing • Analysis is largely the same as for a single year cover • Need to investigate cedant’s growth plans • Need to project loss ratios more than one year into the future • Pricing model needs to simulate multiple future years

  16. Monitoring • Need to monitor for changes that increase losses or speed up loss payouts • “Change in Administrative Practices” clause calls for adjustment if a change should alter deal economics • Commutations (both inwards and outwards) can also affect deal economics • Actuarial input critical to quantifying the impact of changes and adjusting for such changes

  17. Reserving • Unique characteristics of each deal preclude a portfolio reserving approach • Finite re deals usually reserved individually • Periodic update of reserve analysis done as part of the pricing exercise

  18. Conclusion • Pricing is largely driven by actuarial modelling • Actuarial input also essential in monitoring and reserving • Therefore, the actuary plays a key role throughout the entire life cycle of a finite re transaction

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