1. 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

2. “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?"

4. 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

5. 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, FASB Bifurcation I.T.C.

6. 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.

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

8. SSAP 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.

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

10. 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

11. Risk Transfer Analysis Complexity
Reasonably
Self Evident
Scenario
Testing
Simulation
Testing

12. 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.

13. 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.

14. 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

15. 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 !

16. 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)

17. Scenario Testing Historical As-If Results of Contract

18. 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 !

19. 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

20. 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

21. 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

22. Example: Surplus Share Loss Modeling Details

23. 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

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

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

26. 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.

27. 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

28. 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.

29. 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 10% = -59.4% which represents the average of the 10% worst scenarios
* See Back Exhibit for Complete Example

30. 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.

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

32. 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

33. 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.

34. 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.

35. 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.

36. 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

37. 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.