March 11-12, 2004 Finite Reinsurance - Where’s the Risk? David Molyneux, FCAS, MAAA PartnerRe New Solutions Inc.

2 Topics  Finite Reinsurance Basics  Risk Transfer & Accounting Treatment  Trends

3 Finite Basics – Buyer’s Perspective  Smooth Earnings & Reduce Volatility  Capital/Surplus Management  M&A  Tax Management  Balance Sheet Optimization  BCAR  Cost Efficiency

4 Finite Basics - Seller’s Perspective  Motivation behind transaction is not primarily Risk Transfer  Defined maximum limit  Good balance between upside and downside

5 Finite Structures  LPT/Adverse Development Covers  Aggregate Stop Loss  Finite Quota Share  Multi-Year Funding

6 Finite Reinsurance - Deal Features  Highly Structured  Defined Limit  Additional premiums to offset adverse experience  Funds Withheld or Funds Transferred  Profit Sharing  Multi-Year  Optionality  Explicit recognition of Investment Income

7 Concern Over Finite Post Enron – more concern over Balance Sheet Integrity Finite  Explicit Recognition of Invest Income – in line with the true underlying economics of insurance  Reducing Volatility - same goal as traditional reinsurance  De-leveraging Capital – can be more cost effective than CM

8 Accounting Treatment & Measuring Risk FASB 113 Qualifying for Reinsurance Accounting Treatment: “It is reasonably possible that the reinsurer may realize a significant loss from the transaction.” Significant Loss “… based on present value of all cash flows between the ceding and assuming enterprises….”, “… same interest rate shall be used to determine present value of cash flows…” Reasonably Possible No explicit guidance given for determining what is “reasonably possible”

9 Accounting Treatment & Measuring Risk In Practice  Scenario Approach  Rules of Thumb - “10/10 Rule” Loss Measurement  Cash flows excluding brokerage, expenses, taxes  Single discount rate versus yield curve Probability Measurement  Variety of approaches

10 “10/10 Rule” Defining a 10% Loss Loss at 90th Percentile Average Loss between th Percentile

11 “10/10 Rule” Defining a 10% Probability Past Practice Subjective Measurement/Scenario Approach Current Practice More Technical Modeling On-level Loss Distributions Payout Patterns/Variability

12 Issues – Finite Quota Share FASB nd Test – reinsurer must assume “significant insurance risk under the reinsured portions of underlying contracts….” ; there must be “variation in amount or timing of payments…”; no delay in timely reimbursement Substantially all the risk exception  Caps  Loss Corridors  Slides  Materiality

13 Issues - Aggregate Stop Loss  “In the Money” Covers  Multi-Year  Appropriate Interest Crediting Rate for FW

14 Issues - LPT/ADC  Rating Agency Scrutiny AM Best gives credit for XS of Discounted Carried  Appropriate Interest Crediting Rate for FW

15 Current Environment  More Scrutiny from Regulators, Auditors & Rating Agencies  Lack of Uniformity in Measuring Risk  “Changing Face of Finite”  More Risk built into Structures  Higher Cost  Development of New Products