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Reinsurance and Cross-Border Issues August 2007 . Reinsurance Training - Brazil. Bryan Fuller - NAIC Senior Reinsurance Manager. Outline . Purpose and role Financial impact Monitoring and security Insurer failures Contracts and supervision Broader context and references.

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Reinsurance training brazil l.jpg

Reinsurance and Cross-Border Issues

August 2007

Reinsurance Training - Brazil

Bryan Fuller - NAIC Senior Reinsurance Manager


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Outline

  • Purpose and role

  • Financial impact

  • Monitoring and security

  • Insurer failures

  • Contracts and supervision

  • Broader context and references


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Five Functions of Reinsurance

  • 1.Capacity / Spreading Risk

    • Ability to write more premium while maximizing

    • principle of insurance.

  • 2.Loss Control / Catastrophe Protection

  • Minimize financial impact from losses.

  • 3.Financing

  • Providing financial resources for growth.

  • 4.Stabilization

  • Minimize variations in financial results.

  • 5.Services

  • Facilitate operations of insurance companies.


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Capacity

  • Refers to an insurer’s ability to provide a high limit of insurance for a single risk, often a requirement in today’s market.

  • Reinsurance can help limit an insurer’s loss from one risk to a level with which management and shareholders are comfortable.

  • Most states require that the maximum “net retention” from one risk must be less than 10% of policyholders’ surplus.


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Catastrophe Protection

  • Objective is to limit adverse effects on P&L and surplus from a catastrophic event to a predetermined amount.

  • Covers multiple smaller losses from numerous policies issued by one primary insurer arising from one event.


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Financing

  • It is growing and needs additional surplus to maintain acceptable premium to surplus ratios.

  • Unearned premium demands reduce surplus.

  • In a down cycle, underwriting results are bad and reduce surplus.

  • Investment valuation negatively impacts surplus.

  • Marketing considerations dictate that an insurer enter new lines of business or new territories.


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Stabilization

Marketing Consideration

Policyholders and stockholders like to be identified with a stable and well managed company.

Management Consideration

Planning for long term growth and development requires a more stable environment than an insurance company’s book of business is apt to provide.


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Services

1.Claims Audit

2.Underwriting

3.Product Development

4.Actuarial Review

5.Financial Advice

6.Accounting, EDP and other systems

7.Engineering - Loss Prevention


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Process Risk

  • Reinsurance basis risk is the risk that the reinsurance cover might prove insufficient for the risk in question because the need for reinsurance has not been precisely identified. This may occur if theinsurer incorrectly identifies the need for reinsurance or incorrectly describes the need to reinsurers. This might occur if relevant clauses in the reinsurance contract are inappropriate or omitted. Also, the wording of reinsurance contracts may be incompatible with the underlying insurance contracts, particularly in harder reinsurance markets when greater exclusions may be applied.

  • Operational risk is the risk that the people, process, or systems on which the management and execution of the reinsurance process depend will fail or be inadequate.


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Reinsurance Credit Risk

  • Reinsurance credit risk. While the insurer may pass risk to the reinsurer, the insurer takes on some risks, of a different nature, as a consequence. In particular, the insurer takes on the risk that its reinsurer might fail and so void the reinsurance coverage.


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Specialization

  • A given insurer may be a direct insurer for certain risks, but a reinsurer for other risks. This gives rise to the use of the terms outward reinsurance and inward reinsurance (sometimes called reinsurance assumed) to describe the two directions in which the reinsurance arrangement may flow.

  • While insurers may be specialist reinsurers or specialist insurers, it is not uncommon for insurance entities to be involved with both outward and inward reinsurance. From a supervisory perspective, it is important to recognize the different issues relating to whether the entity is seeking or providing reinsurance to other insurers.


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Law of Large Numbers

  • In general, insurance can be viewed as an economic device whereby the individual substitutes a small certain cost (the premium) for a large uncertain financial loss (the contingency insured against) that would exist if it were not for the insurance contract.

  • Capital.

    • The variability of results is reduced, because capital typically must be held to provide support in the case of adverse results—that is, adverse variations from expected results. In practice, capital is in limited supply for insurers and reinsurers. The pooling effect of reducing variability of results translates to reducing the capital requirements, when measured on a per policy basis. Reinsurance can reduce the probability of occasional large losses, reducing the variability of results, thereby potentially reducing the minimum capital that the insurer is required to hold. Alternatively, the need for capital increases at a slower rate than the growth rate of an insurance portfolio (assuming statistically independent and identical risks).


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Law of Large Numbers

  • Homogeneous risks

    • In practice most pools of insured risks are not homogeneous. While homogeneity is a useful assumption for demonstrating the validity of the insurance concept and may be assisted by appropriate underwriting, it does not hold in practice. To the extent that risks are not homogeneous in type, severity, or frequency, the theoretical results are weakened. This highlights the importance of insurers and reinsurers understanding the structure of their insured pools and subpools of risks. In the case of reinsurers who rely, perhaps entirely, on the underwriting of the ceding insurer, there is the added risk of underwriting error or bias of the insurer to consider.

  • Independence of risks

    • The justification for pooling presumes that risks are independent of each other. Again this is rarely true in practice, and there may be correlations, albeit of varying strengths. A clear example of correlations is the level of geographic concentration of risk for, say, hailstone damage to motor vehicles.


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Reinsurance Contracts Basics

Proportional Reinsurance

Non-Proportional Reinsurance

Reinsurance

Contracts

Treaty

Facultative

Semi Automatic

Pro Rata

Excess of Loss

Certificate

OR Automatic

Quota Share

Surplus Share

Per Risk

Per Occurrence

Aggregate

Pro Rata

Excess of Loss

  • Other Considerations:

    • Occurrence vs. Claims Made

    • Prospective vs. Retroactive


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Facultative

Protects individual risks

Offer and acceptance basis.

Reinsurer retains the right to accept or reject each risk.

Supported by a Certificate

Certificate attaches to the conditions on the underlying insurance policy

Cession is optional

Treaty

Protects a large block of business.

The reinsurer does not have the right of rejection on a per risk basis.

Supported by a contract

Pre-agreed conditions

Cession is obligatory

Acceptance is automatic

Reinsurance Forms

Book of

Business

Individual

Risk


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Types of Agreements

Proportional

  • Quota Share

  • Surplus Share

  • Excess of Loss


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Reinsurance Issues

  • Types of Reinsurance Contracts

    • Functions of Reinsurance

      • Why reinsure?

    • Forms of Reinsurance

      • How is reinsurance effected?

    • Reinsurance Markets

      • Who are the reinsurers?

    • Reinsurance Security

      • Where to place the reinsurance?

    • Classes of Business Protected

      • What are we reinsuring?

    • Retentions and Deductibles to be carried

      • When do we reinsure?


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Types of Agreements

Quota Share: Simplest type, reinsurer and reinsured share in every loss and in the premiums at a fixed percentage.

Example: Retention 60% / Reinsurance 40%

Policy Limit

$100,000

$200,000

Retained Amount – 60%

$ 60,000

$120,000

Reinsured Amount – 40%

$40,000

$80,000


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All premiums, losses, loss adjustment expenses, unearned premium reserves and case reserves are shared according to the contract terms from the first dollar of coverage.The reinsurer receives $800.00 in premium and the ceding company retains $200.00.If a loss of $ 100,000 occurs, the reinsurer will pay $80,000 and the cedant pays $ 20,000.

Policy Limit $ 300,000

Premium: $ 1,000

Loss: $100,000

Ignoring any ceding commission.


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Impact of Quota Share


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80% Quota Share


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Types of Agreements

Surplus Share: Greater flexibility. Reinsured selects retention each risk, and cedes multiples of the retention (lines) to the reinsurer.

Compared ceded amount to policy limit. Create a proportion. Reinsurer chares in that proportion of loss and premiums for each loss under that policy.

Policy Limit

$20,000

$40,000

$60,000

Reinsured’s Share

100%

50%

33.33%

Reinsurer’s Share

0

50%

66.66%


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The first $ 200K of each risk is kept net of reinsurance (blue). The first three risks are kept entirely by the reinsured. The ceding insurer then keeps the following percentage of the premiums and losses for each subsequent risk (66.7%, $ 200K/$ 300K), 50%, 40%, 33.3%, 28.6%, and 25% respectively.

Surplus Reinsurance


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Quota Share Vs. Surplus Share

Both Always Pay Proportionate

Share of Any Loss

QS

Surplus

Cession % Varies Based

on Size of each Risk and

ceding company retention

Cession % the Same

for every risk

Protects Cedent’s Entire

Book

Used Mostly for Larger

Risks

Always Obligatory

Can Be Obligatory or

Non-Obligatory


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Excess Of Loss

Reinsured retains a predetermined dollar amount (the retention). The reinsurer then indemnifies loss excess of that retention up to a stated limit.

  • Per risk excess of loss

  • Per risk aggregate excess of loss

  • Per occurrence excess

  • Aggregate Excess of Loss (Catastrophe)


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Excess Of Loss

With excess of loss reinsurance no insurance is ceded and no sharing is involved. The reinsurer promises to reimburse the reinsured company for losses above a set retention in return for a stated premium rather than promising to share premiums and losses based on some proportional basis

Excess of loss reinsurance is frequently provided in layers with the retention at each layer equal to the reinsured company’s retention plus the reinsurance limit of the layer(s) above. As the limits of the layer are exhausted the next layer of excess reinsurance becomes available.


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20

$ 10 M

95% of $ 5M xs $ 5M

Catastrophe Excess of Loss Cover

$ 5 M

95% of $ 4M xs $ 1M

$ 1 M

95% $ 500K xs $ 500K

$ 500 K

Retention


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Impact of Excess of Loss


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Impact of Excess of Loss


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Types of Agreements


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Reinsurance Program Example

Catastrophe

Non-Proportional

2nd Excess

1st Excess

$ Loss

Surplus Share

Proportional

Quota

Share

Retention


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Life vs. Non-Life Reinsurance

  • Several differences have been noted between Life and Non-Life reinsurance:

    • Reinsurance program structure. Life reinsurance treaties tend to cover indefinite periods, and the termination conditions affect new business only, whereas nonlife reinsurance arrangements traditionally last for one year and cover only a specific line of business. This increases the importance, for non-life reinsurance, of ensuring that proper documentation, such as cover notes, is in place.


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Life vs. Non-Life Reinsurance

  • Facultative reinsurance is more common for life insurance. The term “co-insurance” has very different meanings in the context of life and non-life reinsurance, as may the usual order of application of reinsurance cover. The use of layers is common in non-life insurance, but not in life insurance.

  • Product structure. Many life insurance products, especially traditional whole-life and endowment products, have high initial expenses that are expected to be recouped over the later years of the contract. This can lead to initial capital strain for life insurers. Reinsurance may alleviate some of this initial capital strain. This phenomenon is not as pronounced with non-life insurance, in which one-year insurance contracts predominate.


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Life vs. Non-Life Reinsurance

  • Finite risk and alternative risk transfer. While more recent developments in reinsurance can be used in the context of life insurance, they have developed primarily in the non-life context.

  • Supervisory regimes and practices. Legislative requirements, actuarial approaches, and industry practices vary between life and non-life insurance and hence are reflected in reinsurance considerations. This is not surprising given the nature of the risks covered.


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Life vs. Non-Life Reinsurance

  • Retention levels. Industry retention levels, in general, are significantly higher in life insurance than in non-life insurance. This reflects the increased heterogeneity of non-life insurance risks as well as the increased volatility of non-life insurance risks.

  • Credit risk. Reinsurance failures of some type are a significant, although not the most likely, cause of failures of insurers, particularly for non-life insurance.


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Life vs. Non-Life Reinsurance

  • Complexity, volatility, and change. As a general comment, the role of reinsurance is more important, more complex, and more subject to change and volatility in the non-life than in the life insurance industry. The non-life insurance, and so reinsurance, industry is more subject to changes in expectation, legislation, and volatility in potential claims than the life insurance industry. As a specific example, consider the ongoing risks and issues relating to the past use of asbestos.


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Types of Life Reinsurance

  • Indemnity

    • TraditionalSpread or Lessen Risk

    • FinancialMeets Financial Goals

    • Non-ProportionalCatastrophe, Stop Loss

    • RetrocessionReinsurance of Reinsurance

  • Assumption

    • Transfers Business Permanently


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Reasons for Indemnity Reinsurance

  • Transfer Mortality/Morbidity Risk

  • Transfer Lapse or Surrender Risk

  • Transfer Investment Risk

  • Help Ceding Insurer Finance Acquisition Costs


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Reasons for Indemnity Reinsurance

  • Provide Ceding Company

    • Underwriting Assistance

    • Product Expertise

    • Tax Planning

    • Help Manage Capital and Surplus and/or RBC Objectives

  • Limit Adverse Effects of Catastrophic Events

  • Help Enter New Market


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Assumption Reinsurance

  • Sale of a block of business

  • Novation of a contract

  • Reasons For Assumption

    • Divesture

    • Raise Capital

    • RBC Issues

    • Help Ratings

    • Rehabilitation


  • Yearly renewable term yrt insurance l.jpg

    Yearly Renewable Term (YRT) Insurance

    • Only the Mortality Risk is Transferred

      • Premium varies yearly

        • Rates vary by age, sex, duration, smoking

        • Quoted by reinsurer, subject to negotiations

        • Not usually guaranteed, but rarely changed

    • Coverage continues until original policy terminates


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    COINSURANCE

    • Simplest and purest form of reinsurance; all significant risks are transferred

      • Mortality, Investment, Lapse Risk

    • Company receives same share of benefits and expense

      • Premium = Policyholder Premium - Allowances

    • Reinsurer holds its reserves that match with

      Company’s reserve credit


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    MODIFIED COINSURANCE

    • Ceding company retains reinsurer’s share of reserves & related assets

    • Reinsurer pays amount equal to its share of reserve increase to company periodically


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    COINSURANCE WITH FUNDS WITHHELD

    • Company takes reserve credit & reinsurer sets up its share of reserves

    • Assets backing reinsurer’s reserve are withheld & retained with company


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    TYPES OF COINSURANCE


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    Appendix A-791

    • Life & Health Reinsurance Agreements has a table reflecting products and their underlying risk components:

      • Morbidity

      • Mortality

      • Lapse

      • Credit Quality

      • Reinvestment and

      • Disintermediation


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    Life Reinsurance Overview


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    Supervisor’s Perspective

    • At a high level, the process for assessing a reinsurer’s risk profile includes

      • Examining recent compliance issues,

      • Conducting financial analysis and comparing the industry and performance indicators over a recent period (for example, three or five years)

      • Assessing the reinsurer’s current business strategy, assessing the various risks inherent in the reinsurer (in particular, corporate governance matters and “fit and proper” consideration for board and senior management)

      • Judging the effectiveness of risk mitigators, control functions, and capital availability.


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    Supervisor’s Perspective

    • Appropriate powers include matters such as the ability of the supervisor to require:

      • Reinsurance arrangements (changes both in the coverage desired by the insurer and in the treaty conditions),

      • Reinsurance providers (changes in providers, including the power to prohibit a particular reinsurance arrangement),

      • Capital (the power to require the provision of additional capital, technical provisions, or collateral)

      • Information and analysis (regular provision of information regarding reinsurance programs, for example, the power to require reporting and analysis through financial condition reports), and

      • Independent reviews (independent third-party reviews of matters relating to reinsurance and its administration).


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    Supervisor’s Perspective

    • Do any insurers in your jurisdiction have in place reinsurance arrangements with reinsurers who are not supervised within your jurisdiction? If so, how are these arrangements treated in the insurer’s balance sheet?


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    Insurer’s Perspective

    • From the perspective of an insurer, security of reinsurance can be viewed in terms of the appropriateness of placing business with the reinsurer.

      • As noted, the insurer is responsible for conducting appropriate risk assessment and assuring itself of the financial soundness of the reinsurer. The supervisor is responsible for ensuring that such responsibilities are properly carried out.


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    Insurer’s Perspective

    • Consistency of approach.

      • Appropriate and up-to-date board and senior management reinsurance policies must be consistent with the insurer’s risk appetite and approach and be reflected in reinsurance contracts.

    • Legal and statutory framework.

      • Understanding the framework is especially important if the reinsurer is not domiciled in the same jurisdiction as the insurer.


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    Insurer’s Perspective

    • Financial assessment

      • Appropriate and documented criteria are needed to assess the financial condition and credit risk of reinsurers.

    • Management.

      • It is important to evaluate the expertise, quality, and stability of management of the reinsurer.


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    Insurer’s Perspective

    • Business practices

      • It is important to understand the reinsurer’s underwriting and claims practices (understanding the underwriting and claims policies and procedures of the reinsurer and how they will integrate with the insurer’s practices and reporting), the use of alternative risk transfer tools, and the investment policy, including the use of derivatives.


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    Insurer’s Perspective

    • Structural indicators

      • Indicators of importance include ownership structures, affiliates, and group (assessment of any affiliated companies and other members of any group to which the reinsurer belongs). Reinsurers should apply similar criteria when considering retrocessions.


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    Finite Risk, Defined

    • Usually multiple-year

    • Insured (or reinsured) pays significant portion of the losses

    • Time value of money plays an important role in transaction value for both insurer and insured

    • Relatively narrow band between potential profit and potential loss to counterparties

    • Historically, long term budgeting and financial reporting have been key considerations


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    Does the level of risk match the accounting treatment?

    • Crux of the issue because it impacts the solvency of the cedent

    • Can’t always tell by the contract language

    • Need to review and challenge assumptions underlying the cash flow models

    • Are there “side” agreements that undo the initial risk transfer?


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    What is the right amount of risk transfer?

    • “significant” loss (10/10?)

      • Both Underwriting and timing

    • “taking a drop of risk and putting in a loan and calling it insurance is problematic” (Robert Herz, Chairman of FASB)

    • No matter where line is drawn, products will be designed to just get over the minimum.


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    Risk Transfer

    • NAIC Accounting Guidance – Risk is Defined as:

      • Underwriting risk is the possibility that losses and expenses recoverable by the cedent from the reinsurer will exceed the consideration received by the reinsurer, thus resulting in an underwriting loss to the reinsurer.

      • Timing risk exists when anticipated loss payment patterns are not considered during the development of recoverable losses under the reinsurance agreement, and result in a reduction in investment income to the reinsurer as an effect of the accelerated loss payments.


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    FAS 113

    • Establishes the conditions required for a reinsurance contract to be accounted for as reinsurance;

    • Prescribes accounting and reporting standards;

    • While “conditions” and “standards” established, methodology is not.


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    FAS 113 and SSAP 62

    • Test is on reinsurer gaining risk, not on insurer reducing risk

    • Reasonable possibility of significant loss

    • Terms invite informed judgment

    • Provide consistent framework for such judgments


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    Where can retail finite transactions still occur?

    • Uninsurable risks

      • Product recall

      • Catastrophic property

    • Adverse development

      • Asbestos (?)

    • Risks more predictable over 5-10 years than in any one year

    • Basket aggregate transactions

    • Post loss funding


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    Typical Finite Program

    Aggregate Limit

    Aggregate Risk

    Transfer

    Experience Account

    Occurrence Limit

    Timing Risk Transfer

    Premium


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    Income/loss smoothing: The slides that will buy you trouble


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    Income/loss smoothing: The slides that will buy you trouble


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    Example

    • Many of these finite reinsurance arrangements are structured as a series of transactions on a cross-border basis with multiple parties (some may be related) or can be one complex contract, which makes detection and risk assessment difficult for local supervisors. They may involve deceptive behaviour by insurance and other professionals. Effective supervision is enhanced through international cooperation among regulators and sharing of information about the fitness & propriety of the individuals involved in putting the arrangements together.


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    Key Characteristics of Structured Risk

    • Broad Coverage - Tailored to client’s business, including “difficult to protect risks”

    • Aggregate Limit of Liability

      • Allows client to determine amount of coverage purchased

      • Aggregate limit allows reinsurer to provide more attractive terms to client and preserves reinsurer’s ability to pay

    • Multiple Year Term

      • Allows for more accurate determination of limit to be purchased due to reduced volatility of multi year deal

        -Removes uncertainty from planning process since limit is guaranteed

    • Recognition of Time Value of Money

      • Substantial part of overall economics of the transaction

      • With funds withheld, investment income can be generated at a more realistic rate than Reinsurer’s risk free pricing rate

    • Alignment of Interests

      • Potential for substantial profit sharing in the event of favorable experience


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    Profit / Loss Distribution

    Conventional Reinsurance

    Net Reinsurance Cost

    Maximum Profit

    Structured Contract

    Losses

    0

    Maximum Loss

    Structured Contract

    Ultimate Loss


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    Motivations for Purchasing Structured Risk

    • Client motivations for use of structured reinsurance include:

      -Company experience is much better than average, making reinsurance “too expensive”

      -Company experience is much worse than average, making reinsurance unavailable

      -Company wants to exit lines of business

      -Company wants to increase writings or take a larger retention in existing portfolio, but is constrained by limited capital

    • In all these cases, structured reinsurance gives clients options to purchase protection, but also to continue to participate in the underlying economics


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    Specific Types of Structured Risk Transactions

    Structured transactions provide cost effective alternatives to traditional covers. Can be either Retrospective or Prospective. Examples include:

    • Adverse Development Cover / Loss Portfolio Transfer

      -addresses old year liabilities, and permits management to focus on ongoing business. Can include transfer of claims management

    • Structured Quota Share

      -allows access to traditional pro rata protection while allowing the client to retain a share of the positive economics

    • Catastrophe Excess

      - uses multiple years of coverage to reduce reinsurers’ risk charge

    • Aggregate Stop Loss

      -provides whole account protection against both frequency and severity of loss, a.k.a the “Ultimate Cat Cover”


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    The Benefits of Structured Risk Transactions

    • Structured reinsurance provides a number of benefits to client:

      • Cost of reinsurance dictated by client results, not market price

      • Multi year cover gives customer stable term and conditions

      • Potential for profit sharing with favorable experience

      • Funds withheld structure, where only margin is paid to reinsurer, allows for:

        • Reduction in unsecured reinsurance recoverable balances

        • Improved cash flow

        • Recognition of reasonable investment returns in the Funds Withheld Account (FWA), resulting in higher loss payment capacity


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    Risks Contained inStructured Risk TransactionsContinued

    • There are additional risks that are evaluated given the nature of these transactions:

      -Credit Risk – the possibility that the client will default their payment obligations

      -Investment Risk – the potential for asset return to differ from the obligation specified in the contract

      -Regulatory / Accounting Risk – the potential for an Insurance Department or auditors to disapprove a transaction

      -Legal Risk –the chance the contract wording will be interpreted by a court in an unintended way

      -Reputational Risk – the risk of being associated with counterparties of questionable character or writing covers with questionable benefits


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    Risk Transfer Analysis - Simple Example

    • 10% chance of 83.7% loss ratio

    • Loss of 13.7%

      • Premium:100

      • Loss:(83.7)

      • Cede Commission:(30)

      • Net:(13.7)

    In a full analysis the cash flows would be discounted using an appropriate interest rate.

    This has little impact on short-tail business such as a property book


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    Current Risk Transfer Testing


    Practitioner survey l.jpg

    Response 1

    Response 2

    Response 3

    Response 4

    Response 5

    Official Policy?

    No

    No

    Yes

    Don’t know

    Don’t know

    Probability

    5% or 10%

    10% or 20%

    Reasonable worst case chance

    20%

    10%

    Significance

    5% or 10%

    10% or 20%

    10%

    20%

    10%

    Method

    Probability distribution of E[ NPV losses], compare to the present value of premium.

    Compare E[NPV loss] to E[NPV premiums] by scenario

    Scenario testing

    NA

    Net present value of all cash flows.

    Practitioner survey


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    Cat example

    • Hypothetical cat exposure (left)

    • Cat program:

      • $15M retention (1 in 10 years)

      • $50M layer (1 in 100 years)

      • Gross AAL = $6M; ceded layer = $1.625 M

    • Assume 50% target loss ratio

    • Distribution used to calculate the distribution of reinsurer profit/loss

    • NPV calculated at 4%, assuming premiums collected at inception and losses paid at year end


    Cat example78 l.jpg

    Cat example


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    Considerations

    • Burden of proof is on the cedant; “proof” is that the reinsurer can lose money, not that cedant risk is reduced

    • Analysis should include:

      • Distribution of possible results

      • Cash flow estimates

      • Appropriate, common discount rate

      • Thorough understanding of contract terms

    • Analysis does not include:

      • Taxes

      • Reinsurer expenses

    • The 10-10 rule, or VaR tests in general are “sufficient, but not necessary.” Risk assessment could/should consider the whole distribution…other risk metrics can be considered.


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    Risk Transfer Test – Contract 1

    • CONTRACT 1:

    • Cover ~ $1,000,000 of loss per occurrence in excess of $1,000,000

    • Annual Premium ~ $2,000,000

    • Commission ~ 15% of premiums ceded

    • Loss Ratio ~ Ultimate range could range from 75% to 120%

    • Payment Pattern ~ 7 years ranging from “slow” to “fast”

    • STEP 1 – Does contract pass underwriting risk?

    • YES ~ Reasonable potential variability in loss payments (75% to 120%)

    • STEP 2 – Does contract pass timing risk?

    • YES ~ Reasonable variability in timing of loss payments (“slow to “fast” payout patterns over 7 years)

    • STEP 3 – Does reinsurer have reasonable possibility of significant loss?

    • YES ~ See quantitative analysis on next slide

    • CONCLUSION

    • Contract passes – Account for contract as REINSURANCE


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    Risk Transfer Test – Contract 1

    Assumptions:

    Estimated ultimate loss ratio:

    120%

    Estimated payout pattern (medium):

    Year

    1

    2

    3

    4

    5

    6

    7

    Total

    End of Year

    10%

    20%

    30%

    20%

    10%

    6%

    4%

    100%

    Cash Flows:

    Year

    1/1/X1

    12/31/X1

    12/31/X2

    12/31/X3

    12/31/X4

    12/31/X5

    12/31/X6

    12/31/X7

    Total

    Premium

    $

    2,000,000

    $

    2,000,000

    Commission

    (300,000)

    (300,000)

    Loss Payments

    (240,000)

    (480,000)

    (720,000)

    (480,000)

    (240,000)

    (144,000)

    (96,000)

    (2,400,000)

    Net Cash Flows

    $

    1,700,000

    $

    (240,000)

    $

    (480,000)

    $

    (720,000)

    $

    (480,000)

    $

    (240,000)

    $

    (144,000)

    $

    (96,000)

    $

    (700,000)

    Present Value of Cash Flows:

    US Treasury Yield

    0%

    3.525%

    4.374%

    4.872%

    5.383%

    5.893%

    6.140%

    6.386%

    Present Value

    $

    1,700,000

    ($231,828)

    ($440,612)

    ($624,243)

    ($389,188)

    ($180,250)

    ($100,714)

    ($62,241)

    ($329,076)

    Test:

    Total Present Value of Cash Flows

    ($329,076)

    =

    -16.5%

    Loss to Reinsurer

    Present Value of Amounts to be Paid to Reinsurer

    $

    2,000,000

    Gain (Loss) to Reinsurer for ALL Assumptions

    Loss Ratio

    Payout

    75%

    90%

    120%

    Greater than 10% chance that reinsurer will suffer a 10% loss

    Fast

    19.3%

    6.1%

    -20.2%

    Medium

    21.6%

    8.9%

    -16.5%

    Slow

    24.3%

    12.2%

    -12.1%


    Slide82 l.jpg

    Risk Transfer Test – Contract 2

    • CONTRACT 2:

    • Base assumptions same as CONTRACT 1

    • Retrospective rated premium (RPP) based on combined ratio of contract

      • Adjustable from minimum combined ratio of 100% capped at 130%

      • RPP is payable as of the end of Year 5

    • STEP 1 – Does contract pass underwriting risk?

    • YES ~ Reasonable potential variability in loss payments (75% to 120%)

    • RPP somewhat mitigates but significant amount of variability still present

    • STEP 2 – Does contract pass timing risk?

    • YES ~ Reasonable variability in timing of loss payments (“slow to “fast” payout patterns over 7 years)

    • STEP 3 – Does reinsurer have reasonable possibility of significant loss?

    • YES ~ See quantitative analysis on next slide

    • CONCLUSION

    • Contract passes – Account for contract as REINSURANCE


    Slide83 l.jpg

    Risk Transfer Test – Contract 2

    Assumptions:

    Estimated ultimate loss ratio:

    120%

    Estimated payout pattern (medium):

    Year

    1

    2

    3

    4

    5

    6

    7

    Total

    End of Year

    10%

    20%

    30%

    20%

    10%

    6%

    4%

    100%

    Cash Flows:

    Year

    1/1/X1

    12/31/X1

    12/31/X2

    12/31/X3

    12/31/X4

    12/31/X5

    12/31/X6

    12/31/X7

    Total

    Premium

    $

    2,000,000

    $

    2,000,000

    Commission

    (300,000)

    (300,000)

    Loss Payments

    (240,000)

    (480,000)

    (720,000)

    (480,000)

    (240,000)

    (144,000)

    (96,000)

    (2,400,000)

    RPP

    4,000

    96,000

    100,000

    *

    Net Cash Flows

    $

    1,700,000

    $

    (240,000)

    $

    (480,000)

    $

    (720,000)

    $

    (480,000)

    $

    (240,000)

    $

    (140,000)

    $

    -

    $

    (600,000)

    * 2,000,000 x (1.20 +.15 -1.30)

    Present Value of Cash Flows:

    US Treasury Yield

    0%

    3.525%

    4.374%

    4.872%

    5.383%

    5.893%

    6.140%

    6.386%

    Present Value

    $

    1,700,000

    ($231,828)

    ($440,612)

    ($624,243)

    ($389,188)

    ($180,250)

    ($97,916)

    $0

    ($264,037)

    PV of Paids

    $

    2,000,000

    -

    -

    -

    -

    -

    $2,798

    $62,241

    $

    2,065,039

    Test:

    Total Present Value of Cash Flows

    ($264,037)

    =

    -12.8%

    Loss to Reinsurer

    Present Value of Amounts to be Paid to Reinsurer

    $

    2,065,039

    Gain (Loss) to Reinsurer for ALL Assumptions

    Loss Ratio

    Greater than 10% chance that reinsurer will suffer a 10% loss

    Payout

    75%

    90%

    120%

    Fast

    11.4%

    6.1%

    -16.3%

    Medium

    15.1%

    8.9%

    -12.8%

    Slow

    16.0%

    12.2%

    -8.6%


    Slide84 l.jpg

    Risk Transfer Test – Contract 3

    • CONTRACT 3:

    • Base assumptions same as CONTRACT 1

    • Retrospective rated premium (RPP) based on combined ratio of contract

      • Mo minimum combined ratio and capped at 110%

      • RPP is payable as of the end of Year 5

    • STEP 1 – Does contract pass underwriting risk?

    • YES ~ Reasonable potential variability in loss payments (75% to 120%)

    • RPP somewhat mitigates but significant amount of variability still present

    • STEP 2 – Does contract pass timing risk?

    • YES ~ Reasonable variability in timing of loss payments (“slow to “fast” payout patterns over 7 years)

    • STEP 3 – Does reinsurer have reasonable possibility of significant loss?

    • NO ~ See quantitative analysis on next slide

    • CONCLUSION

    • Contract fails – Account for contract as DEPOSIT


    Slide85 l.jpg

    Risk Transfer Test – Contract3

    Assumptions:

    Estimated ultimate loss ratio:

    120%

    Estimated payout pattern (medium):

    Year

    1

    2

    3

    4

    5

    6

    7

    Total

    End of Year

    10%

    20%

    30%

    20%

    10%

    6%

    4%

    100%

    Cash Flows:

    Year

    1/1/X1

    12/31/X1

    12/31/X2

    12/31/X3

    12/31/X4

    12/31/X5

    12/31/X6

    12/31/X7

    Total

    Premium

    $

    2,000,000

    $

    2,000,000

    Commission

    (300,000)

    (300,000)

    Loss Payments

    (240,000)

    (480,000)

    (720,000)

    (480,000)

    (240,000)

    (144,000)

    (96,000)

    (2,400,000)

    RPP

    260,000

    144,000

    96,000

    500,000

    *

    Net Cash Flows

    $

    1,700,000

    $

    (240,000)

    $

    (480,000)

    $

    (720,000)

    $

    (480,000)

    $

    20,000

    $

    -

    $

    -

    $

    (200,000)

    * 2,000,000 x (1.20 +.15 -1.10)

    Present Value of Cash Flows:

    US Treasury Yield

    0%

    3.525%

    4.374%

    4.872%

    5.383%

    5.893%

    6.140%

    6.386%

    Present Value

    $

    1,700,000

    ($231,828)

    ($440,612)

    ($624,243)

    ($389,188)

    $15,021

    $0

    $0

    $29,150

    PV of Paids

    $

    2,000,000

    -

    -

    -

    -

    $195,271

    $100,714

    $62,241

    $

    2,358,226

    Test:

    Total Present Value of Cash Flows

    $29,150

    =

    1.2%

    Loss to Reinsurer

    Present Value of Amounts to be Paid to Reinsurer

    $

    2,358,226

    Gain (Loss) to Reinsurer for ALL Assumptions

    Loss Ratio

    NOT greater than 10% chance that reinsurer will suffer a 10% loss

    Payout

    75%

    90%

    120%

    Fast

    19.3%

    1.7%

    -2.0%

    Medium

    21.6%

    4.7%

    1.2%

    Slow

    24.3%

    8.1%

    5.4%


    Finite example sample cash flows l.jpg

    Finite example – sample cash flows


    Slide87 l.jpg

    Red Flags

    Risk Transfer

    Provisions that require careful analysis:

    • Retrospective Premiums - Premium rate is adjusted based on loss experience.

    • Sliding Scale Commissions - Commission rate is adjusted based on loss experience.

    • Contingent Commissions - Additional commission based on profit

    • Floating Retentions - Ceding company’s retention is adjusted based on the experience of the contract, last dollar paid contracts.

    • Accumulating Retentions - Aggregate covers

    • Loss Ratio Corridors / Loss Ratio Caps - Additional retention by the ceding company for a lower cost of reinsurance.


    Catf considerations l.jpg

    CATF Considerations

    • A principles-based standard should be maintained, yet additional interpretation and guidance should be provided. 

    • The proper standard should not be whether the reinsurer accepted risk, which focuses more on reinsurance pricing as opposed to risk transfer, but whether the cedant ceded sufficient risk.


    Catf considerations89 l.jpg

    CATF Considerations

    • The accounting should follow the economics and intent of the contract from the ceding company’s view rather than the reinsurer’s view.

    • Safe harbors should be established whereby only those contracts where loss transfer is not reasonably self-evident would require further evaluation of risk transfer.

    • The 10/10 benchmark is not appropriate for all types of reinsurance contracts, nor is there likely to be any type of bright-line indicator that would work across all types of reinsurance contracts.


    Catf considerations90 l.jpg

    CATF Considerations

    • Different methods for risk transfer testing should be allowed, similar to how there are many acceptable methods for loss reserving. 

    • In the past, documentation has not always been adequate to clearly demonstrate risk transfer. 

    • As the complexity of a reinsurance contract increases, the necessity of having actuarial involvement in analyzing risk transfer increases.


    Catf recommendations l.jpg

    CATF Recommendations

    Consideration should be given to requiring actuarial involvement in some areas of risk transfer analysis. Guidance should be provided as to which contracts would most likely require actuarial evaluation.  

    • Data issues should be identified that may occur as more sophisticated risk transfer testing methods are used.

    • Due to the short timeline of the project, additional testing and analysis still need to be performed on the proposals of methods of risk transfer evaluation included in the AAA report.  


    Aaa risk transfer working group l.jpg

    AAA Risk Transfer Working Group

    • Technical Issues In Risk Transfer Testing, Cont’d

      • What to do if interest rate on funds held or experience account is very different from interest rate used for discounting?

      • Does “cash flows” mean cash that has changed hands or does it also include implied cash flows?

      • Consideration of brokerage fees?

      • Consideration of commutation clauses, sunset clauses or special termination provisions.

      • Consideration of ceding commissions paid in the future or at contract expiration.

      • Consideration of maintenance fees.


    Aaa risk transfer working group93 l.jpg

    AAA Risk Transfer Working Group

    • Technical Issues In Risk Transfer Testing, Cont’d

      • Consideration of special cancellation rights

      • Consideration of multi-year contracts

      • What are the components of the numerator and the denominator in a test for significance of loss to the reinsurer?

      • In a probabilistic analysis, should the numerator for each scenario, or to the weighted average of the denominator values for all scenarios?


    Aaa risk transfer working group94 l.jpg

    AAA Risk Transfer Working Group

    • Risk Transfer Testing Issues Regarding Data, Methods and Interpreting Results

      • Data considerations for modeling the subjet business – e.g. sources, limitations, adjustments

      • How should process risk, parameter risk and model risk be considered in risk transfer testing?

        • Constantly moving target? Granularity of Data?

        • Assumptions in Models?

      • What type of analysis (e.g. point estimate vs. range vs. probabilistic scenario testing) is indicated by specific types of contracts/features?


    Aaa risk transfer working group95 l.jpg

    AAA Risk Transfer Working Group

    • Risk Transfer Testing Issues Regarding Data, Methods and Interpreting Results, Cont’d.

      • What kinds of methods (e.g., Value at Risk, Tail Value at Risk, Expected Reinsurer Deficit, Relative Risk testing) work with specific types of contracts/features?

      • Provide comprehensive examples of risk transfer analysis, interpretation of results and accounting for various real-life contracts.

      • Monitor FASB’s project on bifurcation and decide whether to give input


    Aaa practice note l.jpg

    AAA Practice Note

     We believe that contracts in which risk and reward are effectively transferred away from the cedant regardless of the probability of loss, should not be subject to cashflow testing using a standard of “reasonable possibility of significant loss” as prescribed in SSAP 62.

    We believe that the Expected Reinsurer Deficit test described in the CAS Working Party report may be a useful testing method that follows the precepts for cashflow testing outlined in SSAP 62. However, we do not believe it is appropriate to apply it as a bright-line standard test, and we believe that further analysis is required to determine what threshold may be reasonable under various circumstances.


    Aaa risk transfer working group97 l.jpg

    AAA Risk Transfer Working Group

    • Safe Harbors and definition of “reasonably self-evident”

      • Review current comment papers on this topic and make recommendations if appropriate

      • Add examples to illustrate concepts

    • Technical Issues In Risk Transfer Testing

      • How to determine the appropriate interest rate to be used for discounting.

      • How to treat a guaranteed interest rate on funds held or experience account (e.g. should this be additional premium?)


    Evaluating risk transfer process l.jpg

    Evaluating Risk Transfer – Process

    • The Substance of Arrangement

      • Identify the Contract or Contracts being evaluated

        • Obtain and Read Entire Contract and Related Contracts, if any

        • Substance does not Always Follow Form

      • Obtain from the Audited Company an Understanding of the Business Purpose and Substance of the Transaction.

      • Obtain and Review as much Background to the Transaction as Possible

      • Obtain and Review Underwriting Memo, Accounting Memo Risk and/or Risk Transfer Memo

        • In unavailable, there might be control implications and an inability for auditor to conclude on risk transfer


    Alternatives to var tests l.jpg

    Alternatives to VaR Tests


    Alternative measures of risk l.jpg

    Alternative Measures of Risk

    • Expected Deficit

    • Tail Value at Risk

    • Other Coherent Measures

    • Exponential Transforms

    • Transforming the 10-10 Rule


    Weaknesses of methods l.jpg

    Weaknesses of Methods

    • Value-at-Risk (VaR) method at 90%

      • Only reflects severity of losses at one point on probability distribution and ignores all other information in the tail

      • Fails low frequency/high severity contracts (e.g., catastrophe covers)

      • Fails some high frequency/low severity contracts (e.g. non-standard automobile)

      • Deems acceptable those contracts engineered to “pass the test”

    • What Method Should be used?


    Better methods l.jpg

    Better Methods

    • Tail VaR (TVaR) = mean severity of PV (underwriting loss) at and beyond 90th percentile

      • Suggested by 2002 CAS Paper

    • Expected Reinsurer Deficit =probability of PV (underwriting loss) X average severity (ERD = Frequency x Severity > A)

      • Average severity = TVaR @ economic breakeven point

        • Suggested by CAS Risk Transfer Working Party 2005 with A = 1%? (Consistent with 10% - 10% Rule)

    • Why is ERD preferred?

      • Reflects full right tail risk in severity definition

      • Replaces separate Frequency and Severity requirements into single integrated measure


    Expected deficit l.jpg

    Expected Deficit

    • Loss x Probability

    • Single loss: 10-10 ~ 5-20 ~ 2-50 etc.

    • Or average deficit: expected value over all scenarios of the reinsurers loss in the losing scenarios = E(P – L)+

    • From examples:

      • Property Catastrophe = -40%

      • Quota Share = -3%

      • Finite = -3%


    Accounting developments l.jpg

    Accounting Developments


    Supervisory approach l.jpg

    Supervisory Approach

    • Attestation of Chief Executive Officer and Chief Financial Officer

      • No separate written or oral agreements between the reporting entity (or its affiliates or companies it controls) and the assuming reinsurer that would under any circumstances, reduce, limit, mitigate or otherwise affect any actual or potential loss to the parties under the reinsurance contract other than inuring contracts that are explicitly defined in the reinsurance contract except as disclosed herein;

      • For each such reinsurance contract, the reporting entity has an underwriting file documenting the economic purpose of the transaction and the risk transfer analysis evidencing the proper accounting treatment, which is available for review; and

      • The entity has appropriate internal controls in place to monitor the use of reinsurance


    Finite interrogatories l.jpg

    Finite Interrogatories

    • 298 reporting entities out of 2,765 total Property and Casualty Insurers (10.8%).

    • 278 Insurers and 20 Risk Retention Groups

    • 184 Nationally Significant and 114 Not Nationally Significant


    Naic approach l.jpg

    NAIC Approach

    Therefore, the overall industry impact of these transactions is approximately 7% of industry surplus but equals 31% of surplus for those entities that reported. There were thirty companies that didn’t give a response on which criteria caused them to qualify. The NAIC is currently contacting those companies for more information.

    Note: The balances will not always foot due to rounding and incomplete reporting data.


    Fbi naic state regulatory role l.jpg

    FBI – NAIC – State Regulatory Role

    • E-mail from FBI Supervisory Special Agent:

      • “The meeting time has changed again.  Could everyone please meet at 12:30 PM between Duane and Broadway, in front of the daycare playground.  It is supposed to be across from the FBI office at 26 Federal Plaza.  From there we will walk over to the office…” 


    Fbi naic state regulatory role109 l.jpg

    FBI – NAIC – State Regulatory Role

    • The FBI appears to be looking for potential violations of Title 18 of the U.S. Code, sections 1033/1034. These provisions of Federal law basically state it is a crime for those in the insurance industry who “knowingly, with the intent to deceive, make any false material statement or report or willfully and materially overvalue any land, property or security

      • (A) in connection with any financial reports or documents presented to any insurance regulatory official or agency or an agent or examiner appointed by such official or agency to examine the affairs of such person, and

      • (B) for the purpose of influencing the actions of such official or agency or such an appointed agent or examiner…”


    Summary l.jpg

    Summary

    • The primary issues in finite reinsurance revolve around whether there is adequate risk transfer, the accounting and disclosure and the credit allowed in the solvency regime for reinsurance. Misuse of financial reinsurance has resulted in misrepresentation of the financial position to supervisors, policyholders, investors, creditors and other stakeholders requiring enhanced corporate governance and management accountability.

    • The main concern with these arrangements is when they are deliberately constructed as a deception or where there is intentional fraud by the company management (e.g., links between related parities or “off contract” arrangements are concealed from the insurer’s stakeholders, regulators, and creditors). In this respect, they are no different from any other type of deception, which regulators cannot necessarily prevent.


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