CAS Exam 6 Notes - Part II - Actuarial Outpost

99 Pages·2007·0.46 MB·English

CAS Exam 6 Notes - Part II
Contents
Reinsurance 1
Harrison - Ch. 1: Introduction to reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Harrison - Ch. 2: Types of reinsurance and reinsurance program design . . . . . . . . . . . . . . . 4
Harrison - Ch. 4: Common reinsurance treaty clauses . . . . . . . . . . . . . . . . . . . . . . . . . 7
Harrison - Ch. 8: Property per risk excess of loss treaties . . . . . . . . . . . . . . . . . . . . . . . 10
Harrison - Ch. 9: Casualty excess of loss treaties . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Harrison - Ch. 10: Catastrophe reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Clark: Basics of reinsurance pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Ludwig: Exposure rating approach to pricing property XOL reinsurance . . . . . . . . . . . . . . . 30
Steeneck: Commutation of claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Patrik: Reinsurance loss reserving . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Accounting 42
Blanchard: Accounting concepts for the actuary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
Blanchard: Premium accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
FAS 5: Accounting for contingencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
FIN 14: Reasonable estimation of the amount of a loss . . . . . . . . . . . . . . . . . . . . . . . . . 56
FAS 60: Accounting and reporting by insurance enterprises . . . . . . . . . . . . . . . . . . . . . . 57
Myhr & Markham: Differences between SAP and GAAP accounting . . . . . . . . . . . . . . . . . 60
IFRS 4: Insurance contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
IASA - Ch. 11: Reinsurance accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
FAS 113: Reinsurance accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
CAS VFIC: Considerations in risk transfer testing . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
Harrison - Ch. 1: Introduction to reinsurance
Introduction
• Reinsurance: The transfer of insurance risk from one insurer to another through a contractual
agreement under which one insurer (the reinsurer) agrees, in return for a reinsurance premium, to
indemnify another insurer (the primary insurer) for some or all of the financial consequences of certain
loss exposures covered by the primary insurer’s policies
• Insurance risk: Uncertainty about the adequacy of insurance premiums to pay losses
• Thereinsuranceagreementdoesnotalterthetermsoftheunderlyinginsurancepoliciesortheprimary
insurer’s obligations to honor them
• Retrocession: A reinsurance agreement whereby one reinsurer (the retrocedent) transfers all or part
of the reinsurance risk it has assumed to another reinsurer (the retrocessionaire)
Reinsurance functions
1. Increase large line capacity
• The line is the maximum amount of insurance or limit of liability on a single loss exposure
• The primary insurer’s line is influenced by:
– Insuranceregulationswhichprohibitaninsurerfromretaining(netofreinsurance)morethan
10% of its surplus on any loss exposure
– The size of a potential loss that can be safely retained
– The specific characteristics of a particular loss exposure
– The amount, types and cost of available reinsurance
• Reinsurers provide primary insurers with large line capacity by accepting liability for loss expo-
sures that the primary insurer is unwilling or unable to retain
– Allows insurers to participate more fully in the insurance market place
– Allows primary to increase market share while limiting financial consequences of losses
2. Provide catastrophe protection
• Primaryinsurersuse reinsurancetoprotectthemselvesfromthe financialconsequencesofasingle
catastrophe event causing multiple losses
3. Stabilize loss experience
• Volatile loss experience may
– Affect the stock value of a publicly traded insurer
– Alter an insurer’s financial rating
– Cause abrupt changes in managing u/w, claim and marketing depts.
– Undermine the confidence of the sales force
– Possibly lead to insolvency
• A primary insurer can stabilize loss experience by obtaining reinsurance to do any, or all of:
– Limits its liability for a single loss exposure
– Limits its liability for several loss exposures affected by a common event
– Limits its liability for loss exposures that aggregate claims over time
• Stabilizing loss experience is a major function of reinsurance because it aids financial planning
and supports growth. It may also encourage capital investments
4. Provide surplus relief
• Insurers that are growing rapidly may have difficulty maintaining a desirable capacity ratio be-
cause of how they must account for their expenses to acquire new policies
• Immediately recognizing expenses combined with gradually recognizing revenue causes an in-
surer’s surplus to decrease and the capacity ratio to increase
• Reinsurance provides surplus relief because the ceding commission replenishes the primary in-
surer’s surplus, lowering its capacity ratio
5. Facilitate withdrawal from market segment
• When withdrawing from a market segment, the primary insurer can:
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– Stop selling policies and continue in-force insurance until all policies expire (“run-off”)
– Cancel all policies (if permitted) and refund the unearned premiums
– Purchase portfolio reinsurance
• Portfolio reinsurance reinsures the loss exposures of an entire type of insurance, class of busi-
ness, or geographic area
– The reinsurer accepts all of the liability for some exposures covered by the primary’s policies
– However, the primary must continue to fulfill its obligations to its insured, and continues to
pay claims to (or on behalf of) its insureds covered by the underlying insurance
– In many states, portfolio reinsurance must be approved by the state insurance department
• Novation: An agreement in which one insurer or reinsurer is substituted for another
– The substitute insurer assumes the direct obligations to insureds covered by the underlying
insurance (e.g. claim administration)
– Either regulators or insured’s approval is required
6. Provide underwriting guidance
• A reinsurer’s understanding of insurance operations and the insurance industry can assist other
insurers,e.g. inexperiencedprimaryinsurersenteringontonewmarketsandofferingnewproducts
• Reinsurers that provide underwriting assistance to primary insurers must respect the confiden-
tiality of their client’s proprietary information
Definitions
• Policyholders’ surplus: An insurer’s net worth as reported on the financial statement prescribed
by state insurance regulators
• Net written premiums: Grosspremiumchargedtopolicyholdersminuspremiumspaidtoreinsurers
plus reinsurance premiums assumed
• Capacity ratio: the ratio of net written premiums to policyholders’ surplus
• Ceding commission: An amount paid by the reinsurer to the primary insurer to cover part or all of
the primary insurer’s policy acquisition expenses
Reinsurance transactions
1. Treaty reinsurance: A reinsurance agreement that covers an entire class or portfolio of loss expo-
sures and provides that the primary insurer’s individual loss exposures that fall within the treaty are
automatically insured
2. Facultative reinsurance: Reinsurance of individual loss exposures in which the primary insurer
chooses which loss exposures to submit to the reinsurer, and the reinsurer can accept or reject any loss
exposures submitted
Treaty reinsurance
• Usually used as the foundation of a reinsurance program
• Treaties are tailored to the primary insurer’s individual requirements
• The price and terms of each reinsurance treaty are individually negotiated
• Usually long-term relationships
• Requires the primary to cede all eligible loss exposures to the reinsurer, avoiding adverse selection
Facultative reinsurance
• The primary negotiates a separate reinsurance agreement for each loss exposure to reinsure
• Facultative certificate of reinsurance: An agreement that defines the terms of the facultative reinsur-
ance coverage on a specific loss exposure
• Facultative reinsurance serves the following four functions
1. Provides large line capacity for loss exposures exceeding the limits of treaty reinsurance
2. Reduces the primary insurer’s exposure in a given geographic area
3. Insures a loss exposure with atypical hazard characteristics and thereby maintain the favorable
loss experience of the primary reinsurer’s treaty reinsurance and any associated profit-sharing
4. Insures particular classes of loss exposures that are excluded under treaty reinsurance
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• Facultative reinsurance is usually priced to reflect the likelihood of adverse selection
• Primary insurers use facultative for fewer of their loss exposures than they use treaty
• The expense of facultative reinsurance can be high for both primary insurer and reinsurer
– The primary insurer must provide extensive information about each loss exposure
– The primary insurer must devote a significant amount of time to complete each cession and to
notify the reinsurer of any endorsement, loss notice, or policy cancellation
– Likewise, the reinsurer must underwrite and price each facultative submission
Hybrids of treaty and facultative reinsurance
• Facultative treaty
– Insurer and reinsurer agree on how subsequent individual facultative submissions will be handled
– Used when a class of business has insufficient loss exposures to justify treaty reinsurance, but has
a sufficient number of loss exposures to determine details of future individual placements
• Facultative obligatory treaty
– Although the primary insurer has the option of ceding loss exposures, the reinsurer is obligated
to accept all loss exposures submitted to it (aka semi-obligatory treaty)
Reinsurance sources
1. Professional reinsurers: An insurer whose primary business purpose is serving other insurers’ rein-
surance needs
• Direct writing reinsurer
– A professional reinsurer whose employees deal directly with primary insurers
– Primary insurers using direct writing reinsurers often use fewer reinsurers in their program
• Reinsurance intermediary
– Broker who negotiates reinsurance agreements between the primary insurer and reinsurers
– Reinsurance intermediaries often use more than one reinsurer to develop the reinsurance
program for a primary insurer
– Intermediaries can often help secure high coverage limits and catastrophe coverage
– Reinsurance intermediaries usually have access to various reinsurance solutions, and they can
usually obtain reinsurance under favorable terms and at a competitive price since they know
the prevailing market conditions
• In evaluating the primary insurer as well as the losses being ceded, the reinsurer gathers in-
formation about the financial strength of the primary insurer, its experience, reputation, and
management
• The primary insurer should evaluate the reinsurer’s claim paying ability, reputation, and man-
agement competence
2. Reinsurance departments of primary insurers
3. Reinsurance pools, syndicates and associations: groups of insurers that share the loss exposures
of the group, usually through reinsurance
Reinsurance associations
1. Intermediaries and Reinsurance Underwriters Association (IRU)
• Publishes the “Journal of Reinsurance”
• Conducts claim seminars, sponsors internships and holds conferences
2. Brokers & Reinsurance Markets Association (BRMA)
• Represents intermediaries and reinsurers in U.S. treaty reinsurance business
• Benchmark for treaty reinsurance contract wording
3. Reinsurance Association of America (RAA)
• Nonprofit trade association of professional reinsurers and intermediaries
• Provides information on reinsurance issues, analyzes aggregate data, conducts seminars
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Harrison - Ch. 2: Types of reinsurance and reinsurance program design
Pro rata reinsurance
• A type of reinsurance in which the primary insurer and reinsurer proportionately share the amounts
of insurance, policy premiums, and losses (including LAE)
• Usually identified as one of two types: quota share or surplus share
Ceding commission
• The reinsurer usually pays the primary insurer a ceding commission for the loss exposures ceded, in
order to reimburse the primary insurer for policy acquisition expenses
• Flat commission: A ceding commission that is a fixed percentage of the ceded premiums
• Profit-sharing commission: A ceding commission that is contingent on the reinsurer realizing a
predetermined percentage of excess profit on ceded loss exposures
• Sliding scale commission: A ceding commission based on a formula that adjusts the commission
according to the profitability of the reinsurance agreement
Quota share reinsurance
• A type of pro rata reinsurance in which the primary insurer and the reinsurer share the amounts of
insurance, policy premiums, and losses (including LAE) using a fixed percentage
• More frequently used in property insurance
• The retention is expressed as a percentage and there is usually a maximum dollar limit. E.g., a “55%
quota share” implies that the reinsurer accepts 55% of the liability
• Often, a per occurrence limit, stated as an aggregate dollar amount or as a loss ratio cap, restricts the
primary insurer’s recovery for losses originating from a single occurrence
• Observations
– The dollar amounts of the retention and cession change as the amount of insurance changes. On
policies with higher amounts of insurance, the primary insurer has a higher dollar retention
– Even policies with low AOI that the primary insurer could safely retain are reinsured
– Quota share treaties are straightforward to administer
– The reinsurer is usually not subject to adverse selection. The loss ratio for the reinsurer is the
same as that of the primary insurer for the ceded loss exposures
• Variable quota share treaty: A quota share reinsurance treaty in which the session percentage
retention varies based on specified predetermined criteria such as the amount of insurance needed
Surplus share reinsurance
• A type of pro rata reinsurance in which the policies covered are those whose amount of insurance
exceeds a stipulated dollar amount, or line
• Typically used only with property insurance
• The primary insurer’s share of the policy premiums and losses is that proportion that the line bears
to the total amount of insurance
• The reinsurer’s share is that proportion that the amount ceded bears to the total AOI
• The reinsurance limit (the total limit or capacity) of a surplus share treaty is often expressed in
multiples of the primary insurer’s line
• Observations
– Surplus share treaties do not cover policies with AOI less than the primary insurer’s line
– The percentage of policy premiums and losses varies for each loss exposure ceded
– Surplus share treaties are most costly to administer than quota share . primary insurers must
keep records that contain a history of all loss exposures reinsured
– Surplus share treaties usually provide surplus relief to the primary insurer due to the ceding
commission (less than with a quota share since not all exposures are reinsured in surplus share)
• Line guide: A document that provides the minimum and maximum line a primary insurer can retain
on a loss exposure
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Excess of loss (XOL) reinsurance
• Reinsurance in which the primary insurer is indemnified for losses exceeding a specified $$$ amount
– Per risk XOL and catastrophe XOL are generally used with property loss exposures
– Per policy XOL and per occurrence XOL are generally used with liability loss exposures
– Aggregate excess of loss is used for both property and liability loss exposures
• Unlike pro-rata reinsurance, in which the reinsurance pricing follows that of the primary insurer’s
pricing, the premium for excess of loss reinsurance is usually stated as a percentage (aka a rate) of the
policy premium charged by the primary insurer (subject premium)
• Generally, reinsurers do not pay ceding commissions under excess of loss reinsurance agreements.
However, the reinsurer may reward the primary insurer for favorable loss experience with a profit
commission or by reducing the rate
• Attachment point (AP): The dollar amount above which the reinsurer responds to losses
• Subject premium: Thepremiumtheprimaryinsurerchargesonitsunderlyingpoliciesandtowhich
a rate is applied to determine the reinsurance premium
• Working cover: An excess of loss reinsurance agreement with a low attachment point
• Co-participation provision: A provision in a reinsurance agreement that requires the primary
insurer to retain a specified percentage of the losses that exceed its attachment point
• Three ways to handle LAE
1. Prorate the loss adjustment expenses between the primary insurer and the reinsurer based on the
same percentage share that each is responsible for the loss (pro rata)
2. Add the loss adjustment expenses to the amount of loss when applying the attachment point of
the XOL reinsurance agreement (on top)
3. Exclude loss adjustment expenses
• LAE are usually prorated for property insurance and most types of liability insurance. For lines with
substantial litigation (malpractice, E&O, D&O), LAE are added to the amount of losses
Per risk excess of loss reinsurance
• A type of excess of loss reinsurance that covers property insurance and that applies separately to each
loss occurring to each risk
• Usually includes a per occurrence limit restricting the amount that the reinsurer pays as the result of
a single occurrence affecting multiple risks
Catastrophe excess of loss reinsurance
• A type of excess of loss reinsurance that protects the primary insurer from an accumulation of retained
losses that arise from a single catastrophic event
• Usually purchased in conjunction with per risk excess of loss reinsurance
• Loss occurrence clause: A reinsurance agreement clause that defines the scope of a catastrophic
occurrence for the purposes of the agreement. Usually 72h for hurricanes and 168h for earthquakes
• Often includes a provision that requires the primary insurer to pay an additional premium to reinstate
the limits of the agreements after a loss
Per policy excess of loss reinsurance
• A type of excess of loss reinsurance that applies the attachment point and the reinsurance limit
separately to each insurance policy issued by the primary insurer regardless of the number of losses
occurring under each policy
• Used primarily with liability insurance
Per occurrence excess of loss reinsurance
• A type of excess of loss reinsurance that applies the attachment point and the reinsurance limit to the
total losses arising from a single event affecting one or more of the primary insurer’s policies
• Usually used for liability insurance, with an attachment point that is less than the highest liability
policy limit offered by the primary insurer
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• Clash cover
– A type of per occurrence excess of loss reinsurance for liability loss exposures that protects the
primary insurer against aggregations of losses from one occurrence that affects several insureds
or several types of insurance
– Clash covers have an AP higher than any of the limits of the underlying policies. The clash cover
retention is not in addition to the retention of any other applicable per occurrence excess of loss
reinsurance, it is net of those retentions
– Useful for lines with high LAE, such as professional liability and environmental liability
– Also used for protection against extra-contractual damages and excess of policy limits losses
• Extra-contractual damages
– Damages awarded to an insured as a result of an insurer improperly handling a claim
– Usually not subject to indemnification by a reinsurer
• Excess of policy limits loss
– Alossthatresultswhenaninsuredsuesaninsurerforfailingtosettleaclaimwithintheinsured’s
policy limits when the insurer had the opportunity to do so
– The reinsurance agreement specifies whether excess of policy limit losses are subject to indemni-
fication by the reinsurer
Aggregate excess of loss reinsurance
• A type of excess of loss reinsurance that covers aggregated losses that exceed the attachment point
and that occur over a stated period, usually one year
• The attachment point can be stated as a dollar amount of loss or a loss ratio (in which case it is called
stop loss reinsurance, e.g 30% xs 90% loss ratio)
• Can be used for property or liability insurance
• Less common and more expensive than the other types of excess of loss reinsurance. Stabilizing effect,
but limited availability
• Most aggregate excess of loss treaties contain a co-participation provision
• Provides the reinsured with broader protection than catastrophe excess of loss (addressing loss sever-
ity), because it includes catastrophes and unforeseen accumulations of non-catastrophic losses (ad-
dressing both loss severity and loss frequency)
Finite risk reinsurance
• A non traditional type of reinsurance in which the reinsurer’s liability is limited and anticipated
investment income is expressly acknowledge as an underwriting component
• Typically multi-year term, usually designed to cover extremely high severity losses
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Harrison - Ch. 4: Common reinsurance treaty clauses
Common reinsurance treaty clauses
1. Preamble: The introduction to a reinsurance treaty that identifies the parties to the treaty
2. Affiliated companies clause: Clause that broadens the treaty’s scope to include the primary in-
surer’s affiliated companies
3. Reinsuring clause: Clause that establishes the obligatory nature of the cessions under the treaty
and describes the type of reinsurance provided. It may include
• Definition of policies
• Insurance policies covered (e.g. homeowners, property business, ...)
• Basis of attachment for policies:
– Identifieswhichoftheprimaryinsurer’spolicies,accordingtotheireffectivedates,arecovered
(a) Risks attaching basis: Attachment basis that covers policies issued or renewed by the
primary insurer on or after the reinsurance treaty’s effective date
(b) Loss occurring basis: Attachment basis that covers the unearned portion of policies
in force as well as policies issued or renewed by the primary insurer on or after the
reinsurance treaty’s effective date
(c) Policies issued basis: Attachment basis that covers only new policies issued on or after
the reinsurance treaty’s effective date
(d) In-force policies basis: Attachment basis that covers only the unearned portion of
in-force policies
– “Risks attaching” and “loss occurring” are the most common
– “Risks attaching” basis may create gaps in coverage. Can be modified to include in-force,
new and renewed
– “Policies issued” basis used when the primary insurer significantly changes its u/w guidelines
– “In-force policies” basis used for run-off
– Primary insurer’s accounting systems may dictate which attachment basis can be used(e.g.
capability of separating earned and unearned premium for risk attaching basis)
4. Definitions clause: Clause that defines the terms used in the treaty
5. Access to records clause: Clause that gives the reinsurer the contractual right to inspect all of the
primary insurer’s records that pertain to the coverage provided by the treaty
• Who must be given access to the records?
• What is the scope of the investigation of records?
• What material must be made available for review?
• Where must the records be made available for review?
• When must access be made available?
• Is there a time limitation to access?
6. Service of suit clause
• Clause that allows the primary insurer to seek a legal remedy from a court in a convenient
jurisdiction when the treaty involves an international reinsurer that is not licensed or otherwise
authorized to sell reinsurance in the U.S. It also allows the reinsurer to commence suit in any
court in the U.S. that has jurisdiction
• Designates an agent for service of process
• Requires the reinsurer to abide by the final court decision, allowing, however, for an appeal
7. Federal excise tax clause
• Clause that states that the primary insurer is responsible for administering and remitting the
federal excise tax levied against alien reinsurers party to the treaty (reinsurance premiums are
taxed at a rate of 1% on the gross amount ceded without reduction for ceding commissions)
• The federal excise tax is owed when the reinsurance premium payment is made to an alien
reinsurer. The primary insurer also becomes liable when payments are made to a nonresident
agent or intermediary
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• The primary insurer is responsible for recovering any overpayment on the reinsurer’s behalf
• AlienreinsurerswhosepremiumsaresubjecttoU.S.incometaxaregenerallyexemptfromfederal
excise tax. Exemption treaties with Germany, Great Britain, and Bermuda
8. Currency clause: Specifies the base currency and the basis of any conversion to the base currency
9. Governing law clause: Clause that specifies which law governs the treaty
10. Exclusion clauses: Clause containing exclusions that limit the treaty’s coverage, usually applying to
high-hazard loss exposures and losses not customarily covered by reinsurance treaties
• Nuclear incident exclusion clause, (except for specific incidental loss exposures, e.g. radiological
services of hospitals)
• Pollution exclusion clause,
• War risk exclusion clause, (does not apply if (i) the primary’s policy already includes a standard
war risk exclusion clause, or (ii) losses come from general riots, strikes and civil commotion)
• Terrorism exclusion clause,
• Insolvency fund exclusion clause, stating that reinsurers will not indemnify primary insurers for
any assessments that the primary insurers must pay to state guaranty funds because of another
primary insurer’s insolvency. State guaranty funds are nonprofit, unincorporated associations
established in all states to pay the outstanding claims of insolvent primary insurers
11. Arbitration clause: Clause stating that an arbitration process will be used to resolve disputes
between the parties to the treaty. The clause addresses the following items
• Arbitration required
• Time limits
• Arbitrator’s qualifications
• Rules of procedure and evidence
• The decision - It’s binding but the arbitration panel cannot enforce it
12. Insolvency clause∗: Clause stating that the reinsurer agrees to pay its reinsurance obligations if the
primary insurer becomes insolvent, whether or not the primary insurer has paid its obligations to the
underlying policyholders
• Without diminution: The liquidator of an insolvent primary insurer will demand full payment
from a reinsurer despite the primary insurer’s inability to pay all or part of an underlying claim
• Notice requirements: The liquidator must notify the reinsurer of a pending claim
• Right to investigate and to defend: The reinsurer has the right to participate at its own
expense in a claim’s defense
• Reimbursableexpenses: Withcourtapproval,thereinsurer’sexpensestoinvestigateandsettle
a claim can be wholly or partially reimbursable by the insolvent primary insurer. The amount is
limited to the proportionate share of the benefit that accrues to the primary insurer
• Reinsurance proceeds payable: Usually the reinsurer pays claim amount to the liquidator.
The insolvency clause may contain exceptions allowing the reinsurer to pay someone other than
the liquidator
13. Offset clause: Allows the primary insurer and the reinsurer to offset balances due to each other
14. Intermediary clause∗
• Clauserequiredbystateinsuranceregulationthatrequiresthereinsurertoacceptfinancialrespon-
sibility (the credit risk) for funds transferred from the primary insurer to the reinsurer through a
reinsurance intermediary
• Identifies the reinsurance intermediary by name and states that all communications (notices,
statements, premium, commissions, LAE, settlements, ...) must be channeled through the rein-
surance intermediary
• Paymentsmadebytheprimaryinsurertothereinsuranceintermediaryconstitutepaymenttothe
reinsurer. However, payments made by the reinsurer to the reinsurance intermediary constitute
payment to the primary insurer only when actually received
• If the reinsurance intermediary becomes insolvent, the reinsurer takes the credit risk
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