GERLING GLOBAL FINANCIAL PRODUCTS Loss Reserve Reinsurance Casualty Actuaries in Reinsurance June 16, 2000

GERLING GLOBAL FINANCIAL PRODUCTS Loss Reserve Reinsurance - Current Accounting Treatment GAAP - SFAS 113: –Reinsurance consideration is not considered “premium” –Gain or loss from retroactive reinsurance must be amortized Statutory Accounting - Chapter 22 of NAIC Manual: –Reinsurance consideration is not considered “premium” –Gain or loss from transaction flows through “other income” –No reduction in net loss reserves –Surplus gain is considered “Segregated Surplus” –Other special rules for retroactive reinsurance coverage Outside the U.S.: –Rules vary, but most domiciles allow some immediate recognition of gain or loss from the transaction

GERLING GLOBAL FINANCIAL PRODUCTS Loss Reserve Reinsurance - Current State of the Market Since 1996, the market for Loss Reserve Reinsurance has been very active. –Significant portion of traditional reinsurance market –Majority of finite reinsurance market –Gerling Global Financial Products: since 1997, 45% of bound transactions and 65% of revenue Motivation for transactions has changed –Prior to SFAS 113, primary motivation was surplus relief –Since SFAS 113: °Statutory surplus relief still a motivation °Many other reasons for these deals

GERLING GLOBAL FINANCIAL PRODUCTS Loss Reserve Reinsurance - Deals that still work: “Economic” reinsurance protection - pure risk deals Reinsurance of a non-U.S. ceding company U.S. cedants not subject to GAAP or SAP - public entities U.S. insurance companies looking for statutory surplus protection Mergers and acquisitions - “Purchase Accounting” exception Loss reserve insurance deals - usually tax-motivated “No accounting impact” as the primary benefit

GERLING GLOBAL FINANCIAL PRODUCTS Public/Government Entities Includes State Funds as well as municipalities These entities rarely use SAP or GAAP Reasons for the increase in activity: –More Liabilities –More Assets –General trend toward privatization

GERLING GLOBAL FINANCIAL PRODUCTS The Situation: Insurance Company A has $500 million of loss reserves on its balance sheet, including $50 million for Asbestos and Environmental claims (A&E). The Concern: The company wants to: –1. Unlock some of the “discount” in the loss reserves, and –2. Protect Statutory Surplus against further reserve increases Example - Statutory Surplus Protection

GERLING GLOBAL FINANCIAL PRODUCTS Example - Statutory Surplus Protection Second Layer $20 million Retention $450 million First Layer Coverage $50 million Second layer 90% of $50 million Carried Reserves Premium: $45 million

GERLING GLOBAL FINANCIAL PRODUCTS Mergers and Acquisitions “Purchase Accounting Exception” Under GAAP, Loss Reserve reinsurance can be accounted for as a guarantee from the seller if done in conjunction with an acquisition Under SAP, “Segregated Surplus” can be turned into “Earned Surplus” after an acquisition These deals are often structured like the Surplus Relief deals

GERLING GLOBAL FINANCIAL PRODUCTS Example - Environmental Remediation Insurance The Situation: Company A, a gas utility, has $100 million of liabilities arising from pollution of old MGP sites. They have negotiated a claim settlement of $50 million with their casualty insurers, and payment is imminent. The Concern: Company A wants the claims settlement excluded from taxable income, and wants to avoid including the claims settlement in the calculation of a rate reduction for its customers.

GERLING GLOBAL FINANCIAL PRODUCTS Second Layer $20 million Retention $50 million Coparticipation aligns interest of Company and Insurer First Layer Coverage $50 million 80% of $25 million Risk Layer Company Retention Benefits: –At inception, no net impact on the balance sheet or “true” income –Taxable income is matched with “true” income Current Estimate Example - Environmental Remediation Insurance Premium: $50 million

GERLING GLOBAL FINANCIAL PRODUCTS Example: “No accounting benefit” is a benefit TREATY 1 Client Company Client Company TREATY 2 Safer Loss Reserve Reinsurance Risky CAT/Stop Loss Reinsurance Treaty #1 is aggressively priced and highly risky Loss Reserve Reinsurance provides income and stability for the Reinsurer and has minimal impact on current net premium and income Transactions are unlinked and each passes the risk transfer test on a stand-alone basis

GERLING GLOBAL FINANCIAL PRODUCTS Theme of Presentation: Accounting considerations drive much of the reinsurance business