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

Risk Transfer – Actuarial Perspective

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Agenda

► FAS 113/SSAP 62► Methods of Testing► Metrics► Next Steps

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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

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► 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

Short-Duration Risk Transfer – FAS 113

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► 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

SSAP 62

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► Risk Transfer Testing Practice Note► American Academy of Actuaries Committee on

Property and Liability Financial Reporting – November 2005

Reinsurance Attestation Supplement 20-1

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► (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?

Methods of Testing

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► (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

Methods of Testing

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► (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

Methods of Testing

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Methods of Testing

Reasonably Self-Evident

Yes No

Document Risk Transfer Analysis

Scenario Testing Simulation/Modeling Techniques

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► (2) Scenario Testing► Historical results by year► Comparison of All Underwriting Downside Scenarios► Comparison of Cedent and Reinsurer Expected

Underwriting Deficits

Methods of Testing

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► Historical Results by Year

Methods of Testing

AY Loss Ratio Commission

Reinsurer Combined

Ratio InvestmentReinsurer

Result1999 70% 20% 90% 5% 15%2000 65% 20% 85% 5% 20%2001 40% 20% 60% 5% 45%2002 95% 20% 115% 5% -10%2003 55% 20% 75% 5% 30%2004 75% 20% 95% 5% 10%2005 80% 20% 100% 5% 5%2006 120% 20% 140% 5% -35%2007 75% 20% 95% 5% 10%2008 70% 20% 90% 5% 15%

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► Comparison of All U/W Downside Scenarios

Methods of Testing

Loss RatioCedent

Expense Ratio Cedent Margin

Reinsurer Ceding

CommissionReinsurer

Margin30% 20% 50% 40% 30%40% 20% 40% 40% 20%50% 20% 30% 40% 10%60% 20% 20% 30% 10%70% 20% 10% 30% 0%80% 20% 0% 20% 0%90% 20% -10% 20% -10%

100% 20% -20% 20% -20%

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► Comparison of Cedent and Reinsurer Expected Underwriting Deficits (EUD)

Methods of Testing

Breakeven Loss Ratio Prob (Loss) U/W Loss EUD

Cedent 80% 12% 8% 0.960%Reinsurer 80% 11% 9% 0.990%

Difference 0% 1% -1% -0.030%

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► (3) Simulation Testing

► Types of Models► Aggregate Loss Models► Frequency-Severity Models► Combination Models

► Considerations

Methods of Testing

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► Modeling Considerations► Need to model:

► Contract losses► Contingent Premium► Commissions► Other Contract Features► Reinsurance Underwriting Expenses

► Potentially not considered:► Tax impacts

Methods of Testing

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

Metrics

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► (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?

Metrics

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► Var and TVaR Example

Metrics

Confidence Level

Percentile

VaR NPV Reinsurer's Profit Ratio

TVaR NPV Reinsurer's Profit Ratio

10% 45.0% 15.0%20% 35.0% 10.0%30% 28.0% 2.0%40% 20.0% 0.0%50% 10.0% -4.0%60% 5.0% -10.0%70% 0.0% -15.0%80% -4.0% -20.0%90% -8.0% -35.0%95% -20% -100%

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► (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?

Metrics

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► (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

Metrics

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► 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

Summary