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Concurrent Session: Risk Transfer (FAS 113)

Concurrent Session: Risk Transfer (FAS 113). Presentation by Michael G. Wacek Casualty Loss Reserve Seminar September 12, 2005. Risk Transfer Testing of Reinsurance Contracts: Analysis and Recommendations CAS Research Working Party on Risk Transfer Testing.

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Concurrent Session: Risk Transfer (FAS 113)

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  1. Concurrent Session:Risk Transfer (FAS 113) Presentation by Michael G. Wacek Casualty Loss Reserve Seminar September 12, 2005

  2. Risk Transfer Testing of Reinsurance Contracts:Analysis and RecommendationsCAS Research Working Party on Risk Transfer Testing Michael Wacek, Chairman (Odyssey Re) John Aquino (Benfield) Todd Bault (Sanford Bernstein) Paul Brehm (Guy Carpenter) Beth Hansen (Guy Carpenter) Pierre Laurin (Zurich) Mark Littmann (PricewaterhouseCoopers) Karen Pachyn (GE Insurance Solutions) Debbie Rosenberg (NY State Insurance Department) David Ruhm (Hartford) Mark van Zanden (Catlin)

  3. Context • CAS Leadership sought to ensure constructive input to AAA, which is engaged in dialogue with NAIC & others on risk transfer issue • Working party formed in June 2005 in anticipation of a call from AAA (COPLFR) for ideas on defining/testing risk transfer in reinsurance contracts • AAA issued call for ideas June 13 with July 15 deadline • Working party produced and submitted draft white paper to COPLFR on July 15, final paper on July 21 • Support from Reinsurance Committee and CAS Staff • White paper posted on CAS website on August 1 • Possibly a new speed record for a CAS working party!

  4. Disclaimer • Paper is intended as educational document • Not official position of the CAS • While read by subcommittee of Reinsurance Research Committee before release, not formally peer reviewed by CORP

  5. COPLFR Call for Ideas • What is an effective test for risk transfer?

  6. COPLFR Call for Ideas • What is an effective test for risk transfer? • What criteria should be used to determine whether a reinsurance contract transfers significant risk to the reinsurer?

  7. COPLFR Call for Ideas • What is an effective test for risk transfer? • What criteria should be used to determine whether a reinsurance contract transfers significant risk to the reinsurer? • What safe harbors, if any, should be established so that a full risk transfer analysis does not have to be completed for each and every reinsurance contract (i.e., in what instances is risk transfer “reasonably self-evident” and therefore cash flow testing is not necessary to demonstrate risk transfer)?

  8. COPLFR Call for Ideas • What is an effective test for risk transfer? • What criteria should be used to determine whether a reinsurance contract transfers significant risk to the reinsurer? • What safe harbors, if any, should be established so that a full risk transfer analysis does not have to be completed for each and every reinsurance contract (i.e., in what instances is risk transfer “reasonably self-evident” and therefore cash flow testing is not necessary to demonstrate risk transfer)? • What are the advantages and disadvantages of the suggested approach versus other approaches commonly used?

  9. Structure of Paper • Introduction • Determining Whether the Contract Transfers “Substantially All” Underlying Insurance Risk • “Significant Risk” and the “10-10” Test • Toward a Better Test • Illustration of the ERD Test • Identification of Contracts Subject to “Significant” Risk Requirement that do not Require Individual Testing • Possible Evolution of Risk Transfer Measurement • Summary • Suggested Priorities for Further Research

  10. Section 1: Introduction • Context • Disclaimers • Background on FAS 113 / SSAP 62

  11. Background on FAS 113 • Implemented 1993 • SSAP 62 risk transfer provisions largely same as FAS 113 • Effectively, SSAP 62 = FAS 113

  12. FAS 113 Risk Transfer Requirement One of 2 conditions must be met: • Reinsurer has assumed “substantially all” of the underlying reinsurance risk (Paragraph 11), or • Reinsurer has assumed “significant” insurance risk and it must be “reasonably possible” that the reinsurer may realize a “significant” loss from the transaction. (Paragraph 9)

  13. FAS 113 Risk Transfer Testing Flow Chart Measure Insurance Risk Transferred By Contract Substantially All? Yes No Significant? Yes No Book Contract as Reinsurance Book Contract as Deposit

  14. Not a Critique of FAS 113 • Working party agreed to treat FAS 113 as reasonable framework • Subject to fair interpretation of “substantially all”, “reasonably possible” and “significant” • Despite reservations about 1) focus only on reinsurer, and 2) definition of reinsurer loss

  15. Section 2: Determining Whether the Contract Transfers “Substantially All” Underlying Insurance Risk • Relevant risk is “downside risk” • If downside risk assumed by reinsurer is “same” as cedent’s downside risk on unreinsured portfolio, then contract transfers “substantially all” the insurance risk • Trivial case is prorata contract with flat ceding commission = cedent expense ratio and no cap, corridor, slides, PC

  16. Comparing Cedent and Reinsurer Downside Risk Two Methods Presented: • Compare cedent and reinsurer U/W margins in U/W loss scenarios • Compare cedent and reinsurer expected U/W deficits

  17. Comparing Cedent and Reinsurer Downside RiskExample 2.1 • First dollar non-standard auto quota share • Ceding Commission: Minimum – 19.5% @ 73% L/R 1 : 1 slide 30% @ 62.5% L/R .75 : 1 slide Maximum – 39% @ 50.5% L/R • Cedent expense ratio = 20% • Cedent U/W breakeven = 80% • Reinsurer FAS 113 breakeven = 80.5%

  18. Comparing Cedent and Reinsurer Downside Risk-Method 1

  19. Comparing Cedent and Reinsurer Downside Risk-Method 2

  20. Comparing Cedent and Reinsurer Downside RiskExample 2.1 • “Substantially All” < “All” • Reinsurer downside risk only slightly less than cedent’s • “Substantially All” condition met (both methods)

  21. Comparing Cedent and Reinsurer Downside Risk • Straightforward for prorata • Potentially applicable to excess, too • Other scenarios

  22. Section 3: “Significant” Risk Transfer and the “10-10” Test • “10% chance of 10% loss” (“10-10” test) common benchmark for significance testing • Present value U/W result at 90th percentile is a loss ≥ 10% of p.v. premiums • VaR90% ≥ 10%

  23. Problems with “10-10” • Not sufficiently discriminating • Some say “10-10” not stringent enough • Some traditional reinsurance contracts do not “pass”: • Low freq/high severity (typically XL) • High freq/low severity (typically QS) • Unintended consequences for reinsurance pricing

  24. “10-10” Cat Example 3.1 • U/W result at 90th percentile is 10% profit • Contract “fails” • In practice, since everyone sees cat xl as risky, test failure typically ignored • Ad hoc exception for “cat” problematical – how much “cat” is enough to qualify?

  25. “10-10” Quota Share Example 3.2

  26. “10-10” Quota Share Example 3.2 • Pitfalls of fitting a distribution to on-level loss ratios • Adjustments to historical loss ratios often have smoothing effect • Importance of parameter uncertainty

  27. “10-10” Quota Share Example 3.2Sources of Parameter Uncertainty in On-Level Loss Ratio Estimates • The ultimate loss estimates might be wrong; • The rate level history might be inaccurate; • The prospective rate changes assumptions might be wrong; • The historical claim trend estimates might be inaccurate; • The prospective claim trend assumptions might be wrong;

  28. “10-10” Quota Share Example 3.2More Sources of Parameter Uncertainty in On-Level Loss Ratio Estimates • The prospective loss ratios might not be distributed according to chosen model (e.g. lognormal) • The distribution assumption (e.g. lognormal) is right, but the “best fit” parameters might not be the true parameters • Cash flow timing assumptions, particularly regarding claims, might be wrong • The prospective exposure mix might be different from expected • For multi-year reinsurance contracts, the level of parameter uncertainty from all sources increases as the length of the coverage period increases • Other

  29. “10-10” Quota Share Example 3.2 • Fitted distribution (ignoring parameter uncertainty) yields VaR90% = 2% => contract “fails” • Adjusted distribution (for parameter uncertainty – judgmental) yields VaR90% = 6% => contract still “fails” • Does not seem like right result • Problem is with “10-10”

  30. “10-10” Quota Share Example 3.3 • A quota share of a portfolio with expected volatility of S&P 500 (given by σ = VIX) would frequently “fail” the “10-10” test • Quota share with expected L/R = 70%, commission = 25%, one year claim lag, requires σ ≥ 21% to yield VaR90 ≥ 10% • Chart of historical expected S&P 500 volatility (VIX)

  31. “10-10” Quota Share Example 3.3 • Unless intention is to set the bar for significant risk at a level higher than the typical volatility of the S&P 500, the “10-10” test defines too high a threshold

  32. “10-10” Unintended Consequences for Reinsurance Pricing • Implies unrealistic price controls on reinsurers, especially for low volatility business • Excerpt from Table 6 shows minimum permissible loss ratios for contracts without commissions, interest @ 5%

  33. “10-10” Unintended Consequence for Reinsurance Pricing

  34. Section 4: Toward a Better Test Two Major Shortcomings of “10-10” • Its focus on loss only at 90th percentile ignores information in the tail • It would be better to take account of loss potential in right tail, which can be extreme (e.g. cat XL) • Its requirement that both probability and loss exceed 10% is arbitrary • Why 10%? • Why not “5-20”, “20-5”, etc.?

  35. Toward a Better TestAddressing the First Shortcoming • Replace VaR90% with TVaR90% • TVaR90% = mean severity losses at and beyond 90th percentile • Idea suggested in VFIC’s 2000 paper

  36. Toward a Better TestAddressing the Second Shortcoming • Relax requirement that BOTH probability and severity of loss > 10% • Note that expected reinsurer deficit (ERD) = Freq(loss) x Sev(loss) • Freq(loss) = Prob (p.v. loss > 0) • Sev(loss) = E(p.v. loss | p.v. loss > 0) = TVaR at breakeven • ERD reflects frequency and severity in a single measure • Define “significant” risk as ERD = Freq(loss) x Sev(loss) > A • We illustrate A = 1%

  37. Toward a Better Test • ERD ≥ A is a variable TVaR standard: • Sev (loss) = TVaR1-Freq ≥ A Freq (loss) • ERD > A defines a “risk transfer frontier” that encompasses a wide variety of frequency – severity combinations

  38. Toward a Better Test

  39. Toward a Better Test To address the issue of contracts that have been engineered to remove most or all of the potential for loss in the right tail, the paper suggests consideration of a supplemental requirement that there be the potential for a reinsurer loss of some minimum threshold, say, 15% or 20% of premiums.

  40. FAS 113 Risk Transfer Testing Flow Chart (Expanded) Measure Insurance Risk Transferred By Contract Substantially All? Measure Significance Yes No ERD > 1%? Downside >x? Yes Yes No No Book Contract as Reinsurance Book Contract as Deposit

  41. Section 5: Illustration of the ERD Test(A = 1%) • Cat XL example 3.1 now passes • Any Cat XL with rate on line < 50% passes • Primary QS example 3.2 now passes • Primary QS example 3.3 (S&P 500 volatility) passes more often

  42. Illustration of the ERD Test > 1% TestExpected Loss Ratio = 70% (Lognormal) with Loss Corridor

  43. Illustration of the ERD Test > 1% TestExpected Loss Ratio = 70% (Lognormal) with Loss Cap

  44. Illustration of the ERD Test > 1% TestExcess Swing Plan Example

  45. Illustration of the ERD Test > 1% TestExcess Swing Plan Example

  46. Illustration of the ERD Test > 1% TestIndividual Risks (Total Loss Analysis)

  47. Section 6: Identification of Contracts Subject to Significant Risk Requirement that Do Not Require Individual Testing • Individual testing of every contract would be burdensome (and unnecessary) • Paper shows that several groups of contracts will pass ERD ≥ 1% under very general conditions • Individual risks • Most cat XL contracts • Most other XL contracts • Contracts with expected L/R > minimum permissible loss ratio • Contracts with immaterial premiums

  48. Section 7: Possible Evolution of Risk Transfer Measurement • Right Tail Deviation (RTD) framework (Wang) • Same framework for risk transfer testing and risk loading • Like ERD framework, Cat XL passes significance test • Method can address some highly structured contract scenarios • Most complex, less understandable to non-actuaries

  49. Section 8: SummaryResponse to COPLFR Question 1 • What is an effective test for risk transfer? • Transfer of “Substantially All” Risk • Comparison of cedent/reinsurer underwriting downside scenarios • Comparison of cedent/reinsurer EUDs • Transfer of “Significant” Risk • ERD Test • RTD Test

  50. Section 8: SummaryResponse to COPLFR Question 2 • What criteria should be used to determine whether a reinsurance contract transfers significant risk to the reinsurer? • ERD ≥ A (illustrated with A = 1%) • Possible supplemental requirement for minimum downside potential (perhaps 15% - 20%) • Alternatively, RTD framework Qualified Premium / Premium ≥ 100% • Other reasonable approaches

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