Reinsurance Structures and On Level Loss Ratios Reinsurance Boot Camp July 2005

2 Agenda  Reinsurance Structures  Calculating an On Level Loss Ratio Adjustments to Premium Adjustments to Losses Adding in a Catastrophe/Shock load Dealing with a change in mix of business Filling in the gaps when data is unavailable

3 Reinsurance Structures  Standard Structures Pro Rata Excess of Loss  NonStandard Structures Stop Loss Loss Portfolio Transfer

4 What is a Pro Rata Treaty?  The cedant agrees to share x% of the premium and x% of the losses of a book of business.  The reinsurer returns some of the premium to the cedant in the form of a ceding commission.  One Pro Rata Structure, a Quota Share, cedes the same percentage on all risks.  A Variable Quota Share may cede different percentages for different limits.  A Surplus Share allows the cedant to retain a given amount, called a ‘line’, on any one risk and cede the remaining ‘lines’ to reinsurers.

5 Variable Quota Share

6 Surplus Share

7 Uses for Pro Rata Treaties  Surplus Relief Pro Rata Structures reduce net premium which improves (decreases) the cedant’s net-premium-to surplus ratio The ceding commission increases the cedant’s surplus, also improving (decreasing) the net-premium-to-surplus ratio.  Combined Ratio Improvement, in some cases Although straight Pro Rata Structures do not improve loss ratios, the cedant’s actual overall results can improve if the ceding commission received exceeds the cedant’s actual expenses (an “override”). Cedant’s overall portfolio results COULD be worse if they end up ceding out very profitable business instead of keeping it net.

8 What would I care about if I were pricing a Pro Rata Treaty?  Expected Loss Ratio for the covered business  Volatility of Loss Ratio/Loss Sensitive Features  Cedant’s actual expenses  Alignment of Interests

9 Other concerns -  Variable QS Do I have the appropriate data to estimate a loss ratio by limit?  Surplus Share Do I have surplus share data that represents the current line guide?

10 What is an Excess of Loss Treaty?  For any loss, the cedant retains the first x dollars and cedes out the next y dollars, in exchange for premium. Per Risk Per Occurrence  Example: 9M x 1M per occurrence For a loss sustained on any given occurrence, the cedant keeps the first 1M and the reinsurer picks up the next 9M.

11 Uses for Excess of Loss Treaties  Stabilize loss experience  Catastrophe Protection  Increased Risk Capacity

12 What would I care about if I were pricing an Excess of Loss Treaty?  Frequency of Layer Losses  Severity of Layer Losses  Volatility of Loss Ratio/Loss Sensitive Features  Alignment of Interests

13 What is a Stop Loss Treaty and what is it used for?  The cedant retains the first x of aggregate losses and cedes out the next y of aggregate losses to a reinsurer in exchange for premium.  X can either be a percentage or a fixed dollar amount  Stabilizes net results  Example: 10% excess of a 70% net loss ratio in exchange for 3% premium.

14 What would I care about if I were pricing a Stop Loss Treaty?  Expected Loss Ratio for the covered business  Volatility around the Loss Ratio  Special Funding features  Alignment of Interests  Accounting considerations

15 What is a Loss Portfolio Transfer and what is it used for?  The cedant gives a block of loss reserves to a reinsurer in exchange for premium.  Premium considers the discounted value of those reserves along with a risk charge.  Enables the cedant to cleanly exit a line of business and focus on their ‘going concern’ portfolio.

16 What would I care about if I were pricing a Loss Portfolio Transfer?  Loss Reserve Adequacy  Latent Liabilities  Interest Rate Assumptions  Alignment of Interests

17 Calculating an On Level Loss Ratio  Essential for pricing almost any prospective reinsurance structure.  Historical years of premium are adjusted to the prospective period’s rate and dollar levels.  Historical years of losses are adjusted to an ultimate settled basis and trended to the prospective period’s dollar levels.  Adjusted losses are ratio-ed to adjusted premium for an on level loss ratio.

18 Data Needs - Premium  Historical Premium Earned Premium if Losses Occurring treaty Written Premium if Risks Attaching treaty Historical Rate Changes Premium/Exposure Trend if Exposure Base is Inflation Sensitive

19 Data Needs - Losses  Historical Paid a/o Incurred Losses and ALAE Accident Year if Losses Occurring treaty Policy Year if Risks Attaching treaty Loss Development Triangle Loss Trend Catastrophe/Shock losses separately

20 Adjustments to Premium  Rate On Level Factors Parallelogram method Premium at Present Rates  Premium/Exposure Trend Yes if exposure base is insured value, sales, revenues, etc. No if exposure base is square feet, per vehicle, per employee, per doctor, etc.

21 Rate On Level Factors  Rate Changes should consider changes to base rates, schedule credits and debits, tier rating, LCMs. They should also be adjusted for changes in limits and attachment points on the underlying policies.  Parallelogram method uses geometry to calculate on level factors.  Premium at Present Rates re-rates all historical policies using prospective rates.

22 Rate On Level Factors

23 Premium/Exposure Trend  Trend from: Average Earned Date of experience period for Losses Occurring Average Written Date of experience period for Risks Attaching  Trend to: Average Earned Date of prospective period for Losses Occurring Average Written Date of prospective period for Risks Attaching

24 Adjustments to Losses  Catastrophe/Shock losses should be separated out.  “NonCat” Incurred Losses need to be adjusted to ultimate, settled basis. Use cedant’s own loss development triangle Supplement with industry/peer data if necessary  Ultimate, settled “noncat” losses need to be trended to prospective period. Trend from average date of loss of experience period Trend to average date of loss of prospective period

25 Incurred Loss Development Triangle (in thousands)

26 Loss Development (cont’d)

27 Developing Incurred Losses

28 Loss Trend

29 On Level Loss Ratios: Making a Selection  Select for Stability?  Select for Responsiveness?  Somewhere in the middle?

30 Stability versus Responsiveness

31 Adding a Catastrophe Load  Catastrophe Load By definition, catastrophes are low frequency, high severity. Your experience period may not even have had such a loss…yet… There are plenty of catastrophe exposure models available for property however. Catastrophe experience should be reviewed, but given little weight due to its inherently volatile nature.

32 Adding a Shock Load  Loss Experience versus Loss Exposure  Calculate a limited loss ratio at low stable level.  Add a load for larger losses that you are exposed to, but haven’t experienced yet. Use exposure curves to add an excess charge above that limited level Amortize in some large but possible loss

33 Dealing with a Shift in Business Mix  A loss ratio analysis done on an “all lines combined” basis will miss shifts in the business mix.  Should analyze each line of business separately and then weight results on prospective premium by line.

34 Dealing with Start-Ups and No Data  New line of business for a company  New company altogether

35 What to think about in “no data” situations  Competitor experience or rate comparisons, but consider: Growing pains/distractions in new line Competitive advantage? Position in the market cycle? “Burning your way in” Track record at prior carriers Rating of current carrier/current paper Company infrastructure established? Smaller but growing book and volatility