Reinsurance Risk Transfer Testing Methods and Management of Process 2006 IASA - Farm Bureau Conference Reinsurance Risk Transfer Testing Methods and Management of Process Rob Downs, FCAS Actuary, Research and Development American Agricultural Insurance Company MAF Fall Meeting CUNA – Madison, WI September 29th, 2006 Risk Transfer Testing

“But how do you prove it is a duck?" Risk Transfer Testing "If it looks like duck, walks like duck, and quacks like a duck, .... it's probably a duck"... “But how do you prove it is a duck?"

Relevant Documents American Academy of Actuaries “Reinsurance Attestation Supplement 20-1: Risk Transfer Testing Practice Note” NAIC’s Statement of Statutory Accounting Principles; SSAP 62 Statement of Financial Accounting Standards, No. 113

Agenda Overview of Attestation Requirement Methods of Testing Reasonably Self Evident Scenario Testing Simulation Testing Example of Risk Transfer Analysis Risk Transfer Metrics & Criteria Responsibilities and Controls May 26, 2006 - FASB Bifurcation I.T.C.

Reinsurance Attestation CEO and CFO shall attest, under penalties of perjury, with respect to all reinsurance contracts for which the reporting entity is taking credit on its current financial statement, that to the best of their knowledge and belief after diligent inquiry: Consistent with SSAP 62, there are no separate written or oral agreements between the reporting entity and the assuming reinsurer that would, under any circumstances, reduce, limit, mitigate or otherwise effect any actual or potential loss to the parties under the reinsurance contract…; For each reinsurance contract entered into, …, for which risk transfer is not reasonably considered to be self-evident, documentation concerning the economic intent of the transaction and the risk transfer analysis evidencing the proper accounting treatment,…, is available for review; The reporting entity complies with all the requirements set forth in SSAP 62; The reporting entity has appropriate controls in place to monitor the use of reinsurance and adhere to the provisions of SSAP 62.

Summary of Attestation No separate arrangements Risk Transfer analysis is available Contracts meet SSAP 62 Appropriate controls in place

SSAP 62 - Paragraph 12 Indemnification of the ceding company against loss or liability relating to insurance risk in reinsurance requires both of the following: The reinsurer assumes significant insurance risk under the reinsured portions of the underlying insurance agreements; and It is reasonably possible that the reinsurer may realize a significant loss from the transaction.

Significant Loss Is Reasonably Possible Key SSAP 62 Concept Significant Loss Is Reasonably Possible

Risk Transfer Options Reasonably Self Evident? Document Contract File Yes No Document Contract File That it is “Self Evident” Risk Transfer Analysis Non-Stochastic Scenario Testing Stochastic Simulation Testing Or Analysis goes into U/W File Analysis goes into U/W File

Risk Transfer Analysis Complexity Reasonably Self Evident Scenario Testing Simulation Testing

AAA Practice Note: Reasonable Self Evident Straight Quota Share no risk-limiting features other than a loss ratio cap with negligible effect on the economics of the transaction. Single Year Property Catastrophe little or no risk limiting features apart from a reinstatement premium common to these types of contracts. Treaty Per Risk Excess of Loss arrangements with rates on line well below the present value of the limit of coverage, or without aggregate limits, sub-limits, or contingent features.

AAA Practice Note: NOT Reasonable Self Evident Aggregate excess of loss contracts most of these contracts either contain significant risk-limiting features, and/or attach in an expected layer of loss so that the premium approaches the present value of the coverage provided. Contracts with experience provisions experience accounts, experience rating refunds, or similar provisions if such provisions have a significant impact on the contract’s economics. Multiple year contracts many of these have provisions that protect the reinsurer from changes in exposure over the contract period and make the analysis complicated, and/or have features that adjust the terms of later years explicitly or implicitly based on results in earlier years; Quota share contracts with risk limiting features loss retention corridors, sliding scale commissions, loss ratio caps and/or sub-limits that significantly impact the amount of risk being transferred.

AAA Practice Note: Risk Transfer Cash Flow Testing Understand the Substance of the Agreement Develop Scenario Testing of Subject Losses Overlay the Contractual Terms Discount Rate Used Summary of Ceded Cash Flows Quantification of Cash Flows

Scenario Testing Reasonable Scenarios Requirements Common Sense “Reasonable Possible” Prior Results of Contracts Appropriate for contracts that risk transfer is obvious, but not “self-evident” Requirements Contract Provisions applied to scenario Investment Income needs to be considered Reasonable and Significant criteria. 10 / 10 “rule of thumb” implicitly met Document !

Scenario Testing Example: Surplus Share Contract Property Surplus Share Contract 1 Year Accident Year Contract 10 Million in Est. Subject Premium Provisional Commission of 25% Commission is Adjustable +/- 5% Occurrence Limit is 10 million Sliding Scale Commission Commission 25% at LR of 65% Commission 20% at LR of 75% or Greater Commission 30% at LR of 55% or Less Sliding Commission for LR between 55-75% (1 point for 2 points of LR)

Scenario Testing Historical As-If Results of Contract

Scenario Testing Example: Surplus Share Contract Memo to Contract File: “1994 Reinsurer result would be 95% LR plus 20% commission for an combined ratio of 115%. Investment income impact would be about 3%. Reinsurer Result of 12% loss to premium.” “2000 Reinsurer result would be 130% LR plus 20% commission for an combined ratio of 150%. Investment income impact would be about 3%. Reinsurer Result of 47% loss to premium.” “Based on this we believe reasonably possible that the reinsurer could have a significant loss and thus this contract satisfies risk transfer for SSAP 62.” Risk Transfer Analysis Completed !

Simulation Testing Stochastic / Simulation Modeling Contract Loss Model Generator Contract Terms Modeling Cash Flow Discounted Quarterly Distribution of Reinsurer Results are captured Risk Metrics are Summarized for 10,000+ simulations Actuarial Work Product Judgment in Loss Model Construction Two different actuaries could do the analysis and produce different distribution of results No single right way of modeling Documentation Standards of Assumptions

Loss Modeling Aggregate Losses Model Frequency-Severity Models Log-Normal Loss Ratio Model Reasonable for Quota Share and Aggregate Stop Loss Contracts. Frequency-Severity Models Simulate How Many Losses (if any) Simulate Size of Each Loss Used for Excess Contracts Combination Model Aggregate Model for “Normal Losses” Frequency-Severity Model for “Shock Losses” Used in Property Quota Share Contracts

Contract Modeling Need to be modeled: Not modeled: Contract Losses (from loss model) Upfront Premium Contingent Additional Premium Commissions (Flat or Variable) Contract features that mitigate risk transfer Loss Limitations (unless not significant) Not modeled: Reinsurance underwriting expenses Tax Impacts

Example: Surplus Share Loss Modeling Details

Example: Surplus Share Loss Modeling Details Two part Loss Model Simulation Normal Losses using a Log-Normal Cat Losses using Frequency/Severity Commission Provisional Paid Adjustment made at end of year. Occurrence Cap 10 million event limit Cap is applied to the Catastrophe Events Reinsurer Result Premium less Commission less Losses Dollars and as percent of Premium

Distribution of Reinsurance Results Graphical Display * See Back Exhibit for Complete Example

Risk Transfer Metrics & Criteria 10 / 10 Rule Tail Value at Risk (TVAR) Expected Reinsurer Deficit (ERD) None are “brightline” tests, only guides

Criteria: 10 / 10 10/10 Rule This was the initial rule of thumb used by auditors for risk transfer and has been highly criticized for being too simplistic, and not broad enough. 10 % probability of a loss to the reinsurer of at least 10% loss relative to premium. Inertia keeps this very relevant.

Percentile Ranking of Scenarios Ranked on Reinsurer’s Result “Nominal” – Real or Undiscounted Amount “NPV” - Net Present Value or Discounted Amount * See Back Exhibit for Complete Example

Criteria: TVAR Tail Value at Risk (TVAR) Tail Value at Risk is the average result above a certain threshold, not just the result at that percentile. Criteria comparable to the 10 / 10 Rule for TVAR would be TVAR value greater than 10% at the 10th percentile Better than 10 /10, but ERD is even better.

Tail Value at Risk (TVAR) Ranked on Reinsurer’s Result TVaR- Tail Value at Risk, is the average outcome above a certain probability threshold. Thus, the TVaR @ 10% = -59.4% which represents the average of the 10% worst scenarios * See Back Exhibit for Complete Example

Criteria: Expected Reinsurer Deficit (ERD) Better Duck-detector Proposed by the Casualty Actuarial Society working group. Better criteria to the 10/10 rule. Accounts for the probability and severity of a loss. The ERD is calculated by multiplying the probability of a reinsurer loss by the average reinsurer loss. Criteria of ERD of 1% would be close to 10/10 rule. (1% = 10% x 10%) A company might uses the criteria greater than 1% because it is more conservative on a more robust test. Accountants will be exposed to this more and more.

Expected Reinsurer Deficit (ERD) Calculation ERD = (Probability of a Reinsurer Deficit) X (Average Reinsurer Deficit) * See Back Exhibit for Complete Example

Significant Loss Is Reasonably Possible Ultimate Criteria Ultimately analysis and criteria’s are used to support the that the contract does or does not meet risk transfer criteria of : Significant Loss Is Reasonably Possible

Risk Transfer Ultimate Criteria Controls and Monitoring is a Attestation requirement. Risk transfer review should be done at contract negotiation / inception. Risk transfer review needs to be done every year. Maintain reinsurance contract file for each transaction that contains risk transfer documentation. Documentation of risk transfer controls and company guidelines is good idea. Document if ERD is a criteria that is used. Auditors will likely be looking if risk transfer analysis is available, documented, and monitored.

Risk Transfer Responsibilities Controls and Monitoring Controls and Monitoring is a Attestation requirement. Risk transfer review should be done at contract negotiation / inception. Risk transfer review needs to be done every year. Maintain reinsurance contract file for each transaction that contains risk transfer documentation. Documentation of risk transfer controls and company guidelines is good idea. Document if ERD is a criteria that is used. Auditors will likely be looking if risk transfer analysis is available, documented, and monitored.

FASB and Bifurcation “Bifurcation of Insurance and Reinsurance Contracts for Financial Reporting” Released: May 26, 2006 Interested Parties Commented by August 24, 2006 Generally not well received.

FASB ITC Proposal Risk Transfer and Bifurcation Passes Risk Transfer N Y Exempt from Bifurcation? Y N Bifurcation of Contract Based on Risk Insurance Component Deposit Component Reinsurance Accounting Deposit Accounting

Conclusions Responsible for Monitoring, Controls, and performance of Risk Transfer analysis and contract documentation. NAIC, FASB, & AAA will likely revise standards and guidelines. Need to meet your auditors requirements. Risk Transfer is an accounting requirement, and won’t make a company more profitable.