5E: REINSURANCE COMMUTATIONS. Moderator. Heidi E. Hutter Atrium Corporation. Panel. 3effrey H. Mayer Milliman & Robertson, Inc.

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1 1989 ENROLLED ACTUARIES MEETING 5E: REINSURANCE COMMUTATIONS Moderator Heidi E. Hutter Atrium Corporation Panel 3effrey H. Mayer Milliman & Robertson, Inc. Scott D. Moore Coopers & Lybrand Dale F. Ogden Dale F. Ogden & Associates 96'9

2 MS. HUTTER-" Welcome to Session No. SE on Reinsurance Commut~Ltions. There are plenty of seats here in the front of the room. l would like to ask ew:ryone else to just pick up the handouts at the back of the room and try and get seat.'d, so we can get started this morning. My name is Heidi Hutter, and I am the moderator for this panel. I'd li~e to first make a few announcements. Please be aware that this entire session will be E ecorded. We plan to allow time for questions and answers at the conclusion of this sessio, k. When we do get to the question and answer session, we would like ea :h person asking a question to step to the microphone located in the center of the room ind speak directly into the microphone when you are asking your questions so that everyor e can hear that. Also, at the conclusion of the session, we would ask that you comple e your evaluation forms for this session. The feedback from this year's sessions will certainly assist next year's planning committee. In defining a reinsurance commutation, the College of Insurance textb ~ok on reinsurance described it as "the estimation, payment and complete discharge ~f all obligations, including the future obligations between the parties for reinsurance Ic sses incurred." In other words, it is a buy out of a reinsurance contract that had already ~ een in place. Much of the reinsurance commutation activity in the marketplace in~ olves an insolvent company, an insolvent reinsurer or both insolvent parties. Comr lutations are not restricted to insolvencies. In fact, in my experience in the last few ye its, I have seen an increasing number of situations where commutations are used to wir d up an insurance relationship where, in fact, both parties are still solvent. This morning, our first speaker is Dale Ogden. He will survey the type.' of situations that give rise to a commutation. Dale is president of Dale F. Ogden and A.' sociates. Prior to forming his own firm, Dale was executive vice president and chief o Ferating officer of Kramer Capital Consultants and a manager at Peak, Marwick and Mitcl=ell. Dale? 970

3 Solvency Considerations in Negotiating Reinsurance Commutations An important part of the insurance business is to help bring financial stability to its customers by mitigating certain types of risk. This has always been difficult; but in constantly changing legal, social, economic, and political climates, it becomes virtually impossible. Liberalization of the tort system, judicial fiat, and changes in federal and state regulation have created an unstable environment in which to conduct the business of insurance. This is obvious not only because of the number of recognized insolvent companies, but also the unprecedented size of the insolvencies and the number of officially unrecognized insolvencies. In this author's opinion, for example, there is at least one multi-billion dollar, publicly-traded international insurer, the darling of Wall Street, that is marginally solvent at best, yet continues to operate with a favorable rating. Much of its asset for ceded reinsurance recoverable (an amount that exceeds its stated surplus) is questionable. That insurer has been actively trying to commute its questionable reinsurance treaties for years. There is a price to pay for underwriting virtually anything and then "burning the reinsurer!" PURPOSE OF REINSURANCE The purpose of reinsurance is much like the purpose of insurance. Reinsurance should help bring financial stability to its customers (ceding insurers) by mitigating certain types of risk. Unfortunately, much reinsurance has caused the opposite effect. Insolvencies, uncertainties about collection, contract disputes, and abusive contract terms have, for many insurers, magnified their financial problems, not solved them. Many insurers and reinsurers gambled with their surplus; many failed. This situation has resulted in many more companies wishing to commute reinsurance treaties to resolve disputes and eliminate the uncertainty of collection. A ~reinsurance commutation" is a contract or an amendment to an existing contract in which a reinsurer buys out of its liabilities to a ceding insurer (the "cedant"). In exchange for an agreed payment or series of payments, the cedant absolves the reinsurer of all obligations that were created by the original reinsurance contract. A reinsurance commutation is much like a loss portfolio transfer. The reinsurer transfers its liabilities back to the original insurer. However, the insolvency of one or both of the parties materially affects the parties' motivations and bargaining power. It creates a situation in which it likely will be necessary to obtain both regulatory and court approvals in order to avoid a "voidable preference" under insurance company liquidation law. 971

4 INSOLVENCIES AND LIQUIDATIONS As with any corporation, once an insurance company is recognized as being insolvent, it becomes necessary either to recapitalize it or to Ik uidate it. In the seventies, recapitalization worked. Most insolvencies were sm~ll personal lines carriers with inadequate rates. However, despite efforts by many insurance departments to rescue insolvent insurers, liquidation seems to be the only prudent course of action for most impaired and insolvent insurers. The liquidation of a property-casualty insurer involves the unravel ing of complicated contractual relationships, often built up over decades. Assets must be converted into cash and distributed to creditors (e.g., claimants, policyholders, an~[ guaranty funds). All creditors of equal priorities must be treated equally. Thl~ liquidator must determine the total assets and liabilities and then pay each creditor the same proportion of its claim against the company's estate. Unfortum Ltely, most of the principal assets and liabilities of an insurer, solvent or othemrise, can only be estimated. One of the principal assets of most insurers is ceded reinsurance r,,coverable on paid and unpaid losses. Companies often don't even know the magnil ude of their reinsurance recoverable on unpaid losses (including IBNR). This inj ormation has not historically been shown on the statutory balance sheet of insurm s. Schedule P of the 1989 statutory annual statement will provide a partial remedy. The new schedules will contain information on both gross and net (of rein~ ~urance) incurred, paid, and reserved losses. Insolvent Cedants For many insurers, particularly insolvent insurers, ceded reinsural ce recoverable on unpaid losses is their single largest asset. It often is larger than the total of cash and invested assets. To liquidate the insurer, it may be necessary to convert reinsurance recoverable into cash to pay claims, particularly v'hen there is no guaranty fund involvement. To accomplish that conversion, the liq lidator commutes the reinsurance contract, absolving the reinsurer of any further lj ability. Insolvent Reinsurers For an impaired or insolvent reinsurer, assumed reinsurance pay~lble usually is its largest liability. By commuting its liabilities, the assets of the reinsurer can be equitably distributed to its creditors. Thus, a program to commt te all or a major portion of a reinsurer's assumed reinsurance liabilities is equivaler t, respectively, to a total or partial liquidation. Here are several examples. 972

5 Several syndicates on the New York Insurance Exchange, who wrote mostly assumed reinsurance, have successfully eliminated their insolvencies through voluntary commutation programs. Universal Reinsurance Corporation, in 1985, began to liquidate through commutations. This program has also been successful. Mentor Insurance Company, Ltd., Bermuda, according to the trade press, is attempting to liquidate through mass commutations. Unfortunately, the liabilities exceed the assets by such a multiple (perhaps five or six times) that agreement among the creditors may not be feasible. Each of these programs has as its goal the fair and timely distribution of the reinsurer's assets to its creditors. If successful, the commutation programs are quicker and less costly. They also produce less disruption in the marketplace and in the cedants' operations. To respond to this situation, the New York Superintendent of Insurance has proposed legislation that would permit impaired or insolvent reinsurers to enter into commutation agreements. Commutations by impaired or insolvent reinsurers would be subject to regulations promulgated by the Department and to final approval by the Superintendent. The New York Insurance Laws currently provide that any transfer of or lien created upon the property of an insurer within four months of an order to show cause why the company should not be liquidated constitutes a preference and is voidable. Under the proposed legislation, commutations approved by the Superintendent could not be challenged later. REASONS FOR COMMUTATION One of the principal reasons for reinsurance commutations is to assist with the liquidation process of an insurer or a reinsurer. The liquidation process often is further complicated because the company is both insurer and reinsurer. Some other reasons for commuting reinsurance contracts follow. The reasons for which a company purchased reinsurance (surplus enhancement, underwriting capacity, income stabilization, etc.) may no longer be valid. Older reinsurance contracts often involve amounts that are no longer material to either party. Commuting the contract may save significant administration costs (both time and expense) to both parties. 973

6 The original contract may have been retrospectively r ~ted so that every claim the cedant makes to the reinsurer is m~ gnified and reimbursed by the cedant in the form of additional pl emium. By commuting the treaty the ceding company saves m,,re in additional premiums than it would collect After several years, most of the remaining liabiities under workers' compensation treaties are lifetime or ~nnuity-type claims. To save the cost of making periodic payment~ for several decades, the parties may commute the entire contract or perhaps, only individual claims. The cedant then either establishes an annuity reserve or purchases an annuity from a lit ~ insurance company. Disputes over coverage and the meanings of contract terms may be compromised and settled through a negotiated ccmmutation, rather than through expensive and time-consuming clz im-by-claim litigation. These and other reasons also apply in the case of insolvencies. My discussion of reinsurance commutations will focus mainly on situations where,~ither the primary insurance company (the "cedant"), the reinsurer, or both, are imt aired or insolvent and in the process of liquidation. Many of the same concepts will apply to solvent, ongoing insurers and reinsurers. INSOLVENT CEDANT SOLVENT REINSURER Our first situation involves an insolvent cedant and a solvel.t, credit worthy, reinsurer. The first question that should be asked is, "Why shouh either the cedant or the reinsurer commute?" If the cedant doesn't benefit from the commutation, the liquidator (court-supervised or otherwise) would be irrespon,,ible to accept a commutation. Conversely, the reinsurer wouldn't want to relinq ~ish its cash flow and settle the contract early unless it could also benefit in so: ne way. A little background is necessary before we answer this question. Most re insurance treaties contain an insolvency clause similar to the following: Notwithstanding any other provisions to the contrary, in the event of lhe insolvency of the Company, the reinsurance provided hereunder shall be payable by the reinsurer directly to the Company or its liquidator, receiver or statutory successo], on the basis of the liability for the business reinsured hereunder, without diminution dther because (x) of such insolvency or (y) the liquidator, receiver or statutory su~ eessor of the Company has failed to pay all or a portion of any of a claim, except e 3 provided by Section 315 of the New York Insurance Law or except (i) where ~ m agreement specifically provides for another payee of such reinsurance in the event of insolvency 97~

7 of the Company, and (ii) where the reinsurer with the consent of the direct insureds has assumed such policy obligations of the Company as direct obligations of the reinsurer to the payees under such policies. This means that the reinsurer cannot avoid liability merely because the cedant is insolvent. The reinsurer still pays. The question now is, "What does the reinsurer still pay?" The language sounds as though the reinsurer pays the same amount as if the cedant were still in business. While I am certain that is the intent, it probably is not the outcome. Why the Reinsurer Commutes In an ongoing solvent insurer, there is presumably a diligent, trained claims staff handling each claim. There is motivation to protect the company's surplus and maintain the relationship with the reinsurer by not "burning the treaty!" Claims are investigated, negotiated, compromised and settled, where possible. Some claims go to trial when deemed prudent by the claims staff. Defense counsel are managed and controlled, to whatever extent possible, to maximize the benefit and minimize the cost. In addition, the reinsurer has the potential for recovery of losses on future contracts with the cedant. Once the primary company is recognized as being insolvent, many of the incentives to protect the reinsurer disappear. Although most receivers and liquidators try valiantly to hold the organization together (some with more success than others), many problems still occur. Claims are often handled by many different guaranty funds, each with its own priorities (and politics). Where guaranty funds are not involved, many individual insureds will be handling their own claims. Some of those insureds are judgement-solvent; others are incapable of paying even small judgments. Priorities and incentives now change dramatically. Under guaranty funds, there likely is a per claim limit that varies from state to state and, in many cases, is less than the policy limit. In my experience, guaranty funds often are not concerned with amounts in excess of their per claim limit. Defense costs may escalate as the responsibility for claims handling is abdicated to defense counsel. There no longer are any business incentives to protect the reinsurer. If the claims are handled by the individual insureds, then the situation may be worse. The insureds likely are ignorant of the law and inexperienced in handling claims. Therefore, they rely more heavily on defense counsel, driving up the cost of the claim and the size of legal fees. 975

8 To avoid personal liability, the insured may assigl its rights under the policy to the plaintiff in exchange for a re] ease. Since the plaintiff now expects to receive only a portion of any settlement amount, the plaintiff may demand and Lhe insured may agree to a larger settlement than might olherwise be warranted. Review procedures by the liquidator try ~) minimize this, but it still happens. Larger than normal sett]ements will affect the reinsurer's liabilities more than the insurer s liabilities. There always will be the risk that reinsurance liabilities increase., dgnificantly under a liquidation. While a responsible liquidator will use every means to minimize these effects, there are no guarantees that it will not happen. ThereJ Ore, the reinsurer might be willing to pay extra to avoid this risk. Since the reinsur ~r's liability under the contract is more uncertain than usual, the reinsurer may wit h to commute the contract to: eliminate qualified audit opinions and adverse foot lotes to its financial statements; further other business plans, such as a corporate reo rganization, stock offering, merger or acquisition; or mitigate the administrative cost of managing a "run-off" treaty, conducting audits, investigating every claim, an~[ disputing questionable claims. A commutation payment equal to the present value of a somewhat inflated loss amount probably will still be less than the ultimate losses ordinaz ily incurred under the contract. By commuting, the reinsurer actually enhances its ~urplus, but at the loss of future investment earnings. This is another way th~.t a commutation resembles a loss portfolio transfer. Why the Cedant Commutes Given the protection of the insolvency clause and the inherent risk of increased liabilities, why then would the cedant commute? There are seve "al reasons. Most insolvencies are caused by poor management; poor management usually manifests itself in virtually every operation of the company. Failure to follo v the terms of the treaty is common. Examples are: O delegating underwriting authority to managing gener il agents in violation of contract terms; 976

9 failing to report losses to the reinsurer when they exceed a threshold amount or when injuries fall within certain prescribed categories; and ceding classes of business that are specifically excluded from the contract. There usually are valid arguments that the reinsurer should provide coverage of all claims, but those arguments are not all foolproof. Furthermore, the cost of claimby-claim arbitrations would waste the assets of the company's estate. A commutation can settle all disputes in one negotiation, without expensive litigation, and may allow the cedant to recover at least some of the claims that otherwise might not have been covered under the contract. The cedant may also need to convert its asset for reinsurance recoverable into cash so that it can pay as much as possible as soon as possible to its creditors. It can thus avoid a prolonged and expensive liquidation. It may also give the company the funds it needs to pursue other uncertain assets (such as agents' balances, subrogation recoveries, and legal claims against management, auditors, agents and brokers, owners and others who have negligently contributed to the insolvency). SOLVENT CEDANT INSOLVENT REINSURER This situation is my personal favorite. It has been the practice of many companies to purchase reinsurance from the "cheapest guy in town!" The results of this practice were exactly what one should have expected m "You get exactly what you pay for!" I know of several situations where primary companies, caught up in irresponsible price competition, purchased a lot of reinsurance for a small fraction of the expected claims. They later found out that they have to pay for their own irresponsible (or total lack of) underwriting. Consider this (far from complete) list of liquidating reinsurers: American Centennial Insurance Company, American Independent Reinsurance Company, Constellation Reinsurance Company, Dominion Insurance Company, Fremont Reinsurance Corporation, Mead Reinsurance Corporation, Mentor Insurance Company, Limited, Mission Insurance Company, Northeastern Insurance Company of Hartford, Omaha Indemnity Company, 977

10 Resolute Reinsurance Company, Transit Casualty Company, Union Indemnity Insurance Company, Universal Reinsurance Corporation, and various syndicates of the New York Insurance Exchange and the Insurance Exchange of the Americas. Some of these companies are not insolvent, or at least they ha',en't yet admitted their insolvency. Those that allegedly are not insolvent have c, ;ased writing new business and continue "to fulfill their responsibilities to their exis,ing clients." This does not necessarily mean they are paying claims; rather, it usual: y means that they are actively pursuing commutations to avoid recognizing and ;o eliminate their insolvencies. Commutations are a rational reaction to an irratio lal market. How many companies were not affected at all by the impairment )r insolvency of at least one of those reinsurers, or perhaps one I have omitted In the case of companies like Transit and Mission, who wrote both direct busine~ s and reinsurance, their ceding companies are out in the cold, reduced to the status )f a lower priority creditor. There are no bargains when buying reinsurance. As an aside, in September, 1985, I spoke in Kansas City at the Casualt? Loss Reserve Seminar about Reinsurance Security. I made the comment that as a c ~nsequence of the economics of the reinsurance business, small reinsurers have nc place in the market. A senior officer of one of the smaller companies listed a hove strongly disagreed with my position, citing the success of his own company to refute my comment. They stopped writing business in My comment stan is. Why the Reinsurer Commutes The motivations of both parties are much clearer in this instan,'e. The insolvent reinsurer must commute on favorable terms, below the true eco: 1omic value of its liabilities in order to survive or at least come to a "soft landing.' In addition, the reinsurer saves the cost of administering its business. If it comn tutes, it no longer needs to audit cedants or verify claims. It settles all its liabiliti.~s with one check instead of perhaps thousands of checks. The cedants all benefil because they get more money sooner and the assets of the estate are not wasted on administration costs and lawyers' fees. Why the Cedant Commutes On the other hand, the cedant who refuses to commute faces al] kinds of horrible consequences. If everyone else commutes first, there may be no assets left for the cedant. Conversely, there are those who hope that everyone else c )mmutes, that the 978

11 reinsurer regains solvency, and their claims are paid in full. them into this mess; why change now? Furthermore: Naive optimism got The financial statements of the cedant (and perhaps its noninsurance parent) may be qualified (or at least footnoted) by its independent auditors. This may interfere with many corporate activities, cause a significant drop in stock price, and possibly lead to adverse takeover activities. All amounts due from the reinsurer are non-admitted assets; therefore, the cedant experiences loss, perhaps material loss, of statutory surplus. This often causes a reduction in or loss of its rating; its capacity to write business is reduced; and it often results in adverse selection. Finally, if the amounts are significant, failure to commute may result in the impairment or insolvency of the cedant, and ultimately, its liquidation. In some cases, it doesn't matter. Either way, the cedant is destroyed. In my experience, some ceding companies, particularly those with large recoverables, take a while to realize that they must commute, but eventually they do. Individual versus Group Commutations In the above discussion, I have assumed that the liquidation of the reinsurer is negotiated with individual cedants. This need not always be the case. It is possible with regulatory support and court approval to: estimate the amounts due each cedant, compare the total of these amounts with the known assets of the reinsurer, and distribute to each cedant an equal proportion of its estimated recoverable amount. Such an approach is being tried in at least one situation. The only result I see thus far is a competition for the highest fees between the court-appointed liquidators, the actuaries, and the lawyers. In the commutation legislation being proposed in New York, this issue remains open and presumably will be addressed either by regulations or on a case by case basis. Will the commutation formula have to be the same for all cedants or will the Superintendent approve separately negotiated arms-length commutations with each 979

12 commuting party? My experience seems to indicate that indi~ idually negotiated commutations are more likely to succeed. There should, however, be a target discount (percentage of ultimate losses, case reserves, etc.) for inch commutation that allows the reinsurer to reach a "soft landing." If the com:nutation does not reduce the insolvency of the reinsurer at least proportionately, the n it should not be approved. Capital infusion plans by parent companies or potei tial investors can change this requirement. INSOLVENT CEDANT INSOLVENT REINSURER My first comment is, "Good Luck!" Hopefully, this scenario will r ~main rare. A big difference in the two situations described above is in who has an advantage in negotiating a commutation. If one party is solvent and the other is insolvent, then the insolvent party usually has an advantage. Furthermore, as a wise old lawyer once told me, "If you have the money, they have the problem!" T lerefore, since the reinsurer has the money, the reinsurer has an advantage. Whe~ l both parties are insolvent, the reinsurer has a clear advantage. The double insolvency case therefore resembles the case with an i.~solvent reinsurer and a solvent cedant. There is, however, at least one difference. ~ince both parties are insolvent, it likely will be necessary to obtain the approv tls of courts and regulators in two jurisdictions. The commutation should not fi vor the insolvent cedant more than any other cedant of the insolvent reinsurer; ot~ erwise, a voidable preference may exist. A possible solution is for both parties to letain an independent actuary or reinsurance expert jointly to calculate the comml ~tation value. Alternatively, both parties could retain their own actuaries. Let the actuaries calculate commutation values independently. Ground rules, based on the size of the reinsurer's insolvency and any disputed coverage items, should be established. The actuaries compare assumptions and results and resolve as many differences as possible. Finally, they agree about the remaining areas where tl mir results differ. Others then negotiate the commutation and resolve those remaining differences, subject to the final approval by the liquidators, the regulators, al Ld the courts. If the actuaries cannot agree, then a third actuary, chosen by the ~wo actuaries, can be retained as an umpire, similar to an arbitration procedu~'e, but with less formality. Rather than allowing the umpire to compromise th ~ two results (by picking a number in between the two results), the umpire must Iick the commutation value as calculated by one or the other. This keeps the actus ties more realistic in their calculations. The size of the difference between the two results usually is smaller under this system. 980

13 SOLVENT CEDANT SOLVENT REINSURER When both parties are solvent, neither has an unfair advantage. There needs to be a commonality of interest to save administration costs on a run-off treaty or to resolve disputes. When a valid business purpose exists, a mutually acceptable commutation usually can be negotiated. Some contracts even contain special commutation clauses. Commutation procedures could be added as an addition to the arbitration clauses of many reinsurance treaties. It always is easier to agree on an approach before a dispute exists. SUMMARY OF NEGOTIATIONS Most of you probably are in the position of the solvent party, a position of disadvantage. However, you never know when you might be on the other side of the table. When faced with negotiating a commutation of any reinsurance contract, you should know where you stand. One should follow these rules: Understand the contracts thoroughly, not just the written words, but also the way the contract has been handled by both parties. Understand the situations and motivations of all parties, including the liquidators, the regulators, and the courts. If possible, resolve underwriting and coverage disputes before calculating ultimate losses or commutation values. Calculate ultimate losses, the present value of ultimate losses, and commutation values based on the agreed coverages. Also calculate the magnitude of any remaining disputed items. Be realistic (and be sure your actuaries are realistic) about quantifying liabilities and the potential for recovery, recognizing the solvency of the parties. If necessary, use a modified arbitration procedure to resolve any remaining differences. Avoid reinsurance security problems. Buy only the reinsurance you need. Do not be lured by cheap reinsurance. Buy reinsurance only from "top quality" reinsurers. Use smaller reinsurers only with extreme caution. Ratings mean virtually nothing. You should evaluate reinsurers for yourself or hire someone competent to do so. As we learned in Economics 101, "There is no such thing as a free lunch!" 951

14 MS. HUTTER" Thank you, Dale. Our next speaker this morning s Jeffrey Mayer. 3effrey is a consulting actuary with the New York office of Milliman 6 Robertson. Prior to joining M&R, 3effrey was a vice president with Kramer Capital ~ nd, prior to that, spent five years with Peat Marwick. 3effrey is a Fellow of the Casualty Actuarial Society and a member of the American Academy of Actuaries. He is a frequent speaker at the CAS ard other actuarial forums. 3effrey has authored a paper for the CAS 1988 Call Paper Pr ngram, has served on the CAS Examination Committee and currently serves on the Anerican Academy Committee on Property and Liability Issues. Jeffrey will now discuss the considerations in establishing a commutati, m price. MR. MAYER. Good morning. Thanks, Heidi. Firstly, Dale, you ~ere not nearly as controversial as we thought you would be over dinner last night. The following is the situation that I will discuss" A company, comm~,nly referred to in these situations as the ceding company, has decided that it is in the r best interest to cancel their contract with their troubled reinsurer. Dale told them th~ t it made sense to do that. The ceding company now must calculate, with accuracy, its excess 1~ sses, a portion of the distribution that in the past it may not have paid significant attent on to. I say "with accuracy", because they are going to get only one shot to do this calc Jlation. Once the losses are transferred and consideration is paid, for the most part, busir ess is done. This is the scenario we will use in going through the exhibits. The :ive major pricing issues that we consider are: The amount of the future payments, what we refer to as the reserves, the population of losses being commuted. That includes case reserves, the case development, reserves that have been reported but have not been repcrted in the excess layer and reserves that have not been reported altogether -- total population of losses. Number two is the timing of payments. For the most part, when loss reserving is done, consideration to the timing of payments is not a top priority. We ar_~ more concerned with the ultimate lossesl when the payments are made is not quite as mportant. In this case, timing of payments is at least as important as what the ultimate,,alue will be. Thirdly, the interest rate. Once we have determined the ultimate po)ulation of losses, the reserves, once we have determined the timing of payments, we nee ~ to take the time value of money into account using a particular rate of interest. Is ei ~ht percent right? Is 35 percent right, as Dale suggested might be the case? Fourth, the economic value of risk. Once we've done the calculations, have put pencil to paper, we have a number. Depending on whether I'm the primary com ~any or the ceding company, I must determine the amount of risk I can tolerate. Do I v ant to assume an excess layer, a layer that I've never in the past had to really consider, or would I rather take the risk of waiting to see whether my troubled reinsurer can m Lke it. One's risk aversion, or lack thereof, will certainly influence the price. Finally, the financial implications of how these numbers get bookec on the financial statements must be considered. I'm going to probably spend no more thm five seconds on that at the end, enabling Scott Moore to do justice to this issue. 982

15 Let's talk about the IBNR valuation. As I started to say, the sources of IBNR are as follows: case development, normal case reserve developing up or down. Primary companies have that; reinsurers have that; it needs to be taken into account. Number two are the truly unreported claims -- those claims that are external to the company; they have not been sent to the mailroom; they are not on the computer yet; they truly are external to the process, one, two, three, five, fifteen, twenty years away from being reported. Third, those claims which have been reported to the primary company. They are below their retention, say, in an excess situation; they just have not gotten up to the excess layer. So, they are IBNR to the reinsurance layer but certainly need to be taken into account. In effect, that could be considered a subset of case development on the smaller claims actually developing up to the excess layer. From the individual ceding company's perspective, the excess layer data presents a whole host of problems, some of which they didn't have to deal with when they were working with the net layer. One is the aberration of data. In all likelihood, the excess layer will be more erratic and more difficult to predict than losses limited to $50,000 or $I00,000 or $200,000 or whatever the layer may be. Instability -- possibly, the number one reason why you bought the reinsurance in the first place, in order to avoid that instability, and that is something that the ceding company needs to deal with. Do we perform a treaty by treaty analysis? Is that valid? It may or may not be. From the industry perspective, we won't talk about the proverbial RAA studies and making use of the information in those studies. That's not altogether wrong and there is a lot of logic to that, but there are a couple of caveats that need to be made. One is that the ceding company, in doing the evaluation, needs to be -- what's the right term? -- intellectually honest with themselves in recognizing that their business -- because, after all, it is their underlying business that's being ceded or now reassumed -- may very well be worse than the average RAA. Stated another way, not everybody can be better than the RAA. 3ust a couple of observations. The RAA, over the last couple of years, seems to have been developing trends higher than might have been the case in years past, and that certainly should be reflected. (Slide) I will discuss a couple of techniques and some methodology and thoughts that one should have when evaluating the excess layer for purposes of the commutation and the reassumption of those excess losses. Firstly, data that one wants to look at is the typical data that one would have in a reserve study. At this point, what we are doing is really no different than a very rigorous loss reserve study; one which has not only paper consequences in terms of does it go up on the balance sheet on line one or is it below the line in the surplus account but actually translates into economics in real dollars, 983

16 Some of the information that you want to have is the paid losses, out~ tanding losses, the paid allocated expenses, the claim counts, gross, net, ceded, policy limit profiles, exposures, and basic qualitative knowledge of the business. This is not necessarily exhaustive. Whatever one might think they'd like to have in a loss ~eserve study, they should try to get as part of the commutation analysis. The advantages that the ceding company has over, say, somebody.,lse who might be trying to assume these excess losses would be supposedly a better knowledge of the underlying book of business. After all, they wrote the underlying po icy. The pitfall is that the data may be too unstable to project with any sort of confident e. The ceding company, again, is doing this type of analysis possibly for he first time. The data history may be too short to measure the tail. Again, projecting tl ke tail is a problem that comes up in all reserve studies. The ceding company probably h~ s their way around that when doing a net analysis, with the ceding layer and the excess I lyer. Probably the leveraged part of the excess layer is more significant than it is on the net data. The company may very well not have a proper appreciation for hob large that tail is, what the relationship of IBNR to case reserves is and might be. Tl~e ceding company must be very careful to not allow its intuition, which in all likelihooj may be woefully too short, get in the way of doing a proper analysis. Some possible approaches, one of which we will discuss with a parti :ular example in a few minutes, is doing a net development and a gross development, st btracting the two, producing an estimate of the ceded losses; doing an actual ceded de~ elopment analysis, the type which we'll get to in a little while, just taking a look at incur red losses and paid losses for the excess portion only. We are looking at ceded losses and using industry development faclors if we feel the internal factors to this particular contract are too unstable. Another way of doing a net loss projection and one which has probably been done many times ~y the company is applying industry increased limited factors in order to gross it up and hen the difference becomes the ceded excess losses under the contract. I'm sure there are other approaches. probably would be most common. These were the three to for r approaches that The advantages for the assuming company, who is now transferring tllese losses back to the ceding company is that, in theory, they should have a greater fi~miliarity with the excess business, with excess development, what the pitfalls and problel ns are and so on. In all likelihood, they have a larger data base with this type of infor nation. It is their bread and butter, and they probably have factors external to the corr pany for that type of analysis. A longer data history may be available; better appreciat on for the tail, as we discussed a minute ago, about how the ceding company may nct have the proper appreciation. In fact, the assuming company or the reinsurer nay have a better appreciation for that tail. The pitfalls are that if a reinsurance company had a proper appreciation, they wouldn't be in the mess that they're in right now. The payment pattern -- a dollar paid today costs a heck of a lot more than a dollar paid five years from now, and that needs to be properly taken into account. 984

17 The RAA does not publish the payment data as they have for the incurred losses. There is some school of thought that says that, for the excess layer, the payment pattern is not that much longer than the reporting pattern at the excess layer. Once that excess layer is reported to the company, payment is not too far behind. Conservatism probably has a place for the ceding company who is now reassuming. The interest rate. I'm not in any better position to discuss what interest rate is proper. I think all of you would have a good feel for what that would be. Probably using a no risk rate makes sense. The length of the security of the vehicle used to finance the commutation should be compared to the pay-out pattern, probably conservative, on the short side. A lower rate would make sense for negotiating purposes. If eight percent is the right Treasury note risk rate or eight and a quarter or whatever the number might be right now, and if the investment department of the company feels they can get nine or ten percent, that's something they can consider for themselves. But, for starters, probably a no risk rate makes the most sense. The economic value of risk. We do the analysis, we put pencil to paper, we come up with a nice, "expected type" number, an actuarial number, a certifiable number, one that makes a whole lot of sense, but now the question is" How much risk do we want to assume? Does the ceding company feel comfortable assuming these estimated, ultimate losses? If not -- but if they feel they really have to because the reinsurer is not likely to pay them a hundred cents on the dollar, that needs to be factored in. On the other hand, do they want to possibly wait and see whether they'll get a hundred cents on the dollar, or is the likelihood of getting eighty cents on the dollar better than assuming the risk of taking this excess layer, one that they don't feel particularly comfortable with? I'm going to skip over the financial effects for a minute and get back to that at the end. We'll go right into the example now. 3ust the typical triangle of incurred ceded losses. There is nothing particularly fancy, nothing erratic about this example. I'm just trying to demonstrate how one might project the ultimate losses. I will assume a familiarity with the triangle and development factors. Using this analysis, the data goes out 72 months. A judgment needs to be made about the tail factor. In this case, we selected four percent. That may or may not be right, but certainly -- again, as I mentioned earlier -- one must be sensitive to how long that tail on the excess business might be. Certainly significantly higher than the net tail factor, and higher than the gross factor; the excess tail should be the highest if you were trying to rank those three. Making use of these factors, we project the ultimate ceded losses on the far right corner. We can do this using incurred losses or, as the next exhibit shows, we can do that using paid losses. Obviously, we can use a whole host of other methods, but now [ am only using incurred and paid. The importance of the paid development is not only in the fact that it can lead to an independent estimate of the ultimate ceded reserves but that, in fact, it is the paid development which will determine the payout pattern. 985

18 As you can see on the bottom line, what is implied by our paid select ons are that these excess ceded losses, will pay out approximately 18 percent in the first 12 months from the beginning of the year. By the end of 24 months, we've paid out roughly 45 percent; that grows to 69 percent and so on. It is that pay-out pattern that can independently be used to project he ultimate ceded losses but, at least as importantly, it is what is used to project the pa iment pattern, the timing of the payments, that we discussed just a minute ago. Once that is done, and we now have our ultimate losses, our ultimat,~ reserves, and our pay-out pattern, we spread these by future calendar year. We start with our ultimate losses. We subtract the paid losses through 12/88, if that's the evalu~ltion date, and the difference gives us the reserve, the population of losses that are now l.eing reassumed by the ceding company. Using the payment pattern on the bottom line of the pattern exhibit in distributing over the years, produces payments in calendar year '89, calendar year ' and so on. The $8.4 million of reserves of December '88 pay out, in this particultr example, fairly quickly, approximately $3.2 million in the first calendar year subseqlent to the reserve analysis, another 2.2 million in the second year and so on. For this example I've used a discount rate of seven percent; that may or may not be the right thing to do if we were doing an analysis at this point. We p'esent value back, taking into account the time value of money of these losses, assumin~ that all losses are paid midway through the year. The 1989 losses of $3.2 million will earn seven percent for approximat..,ly half a year; the $2.2 million for about a year and a half and so on. The discounted value of the $g.4 million is approximately $7.4 million. Forgetting expenses for a minute, we're done. We stop right now if lo negotiating was taking place, no concern of risk aversion and so on. We would say tllat for purposes of reassuming the $8.4 million, the ceding company needs to rec.~ive a check for $7,418,000. That $7,418,000 would be the proper number to fully pay c [f the liabilities of $8.4 million over the appropriate eight or ten years. For the purposes of conservatism, what I call massaging the pay-out ~attern might be a reasonable way to temper some of the risk. If the 17.8 percent, 44.6 percent and so on; the pay-out pattern that we consider to be the best, the expected, proper pay-out pattern, in effect, the ceding company who is now reassuming these le ~ses may very well want to calculate the present value using a skewed, shorter pay-out pattern, one that would be more conservative. An alternative pay-out pattern was picked, in no particular scientific way; this pay-out pattern is faster than the one previously used. That alternate pay-ol t pattern used and applied the same way as the original pay-out pattern, produces a present value of $7.6 million. The example is not that sensitive to the differences; instead of getti ig the $7.4 million as with the prior pay-out value, we now get $7.6 million. Again, we are done, if there were no other expenses to be considered, no other risk factors, no other negotiating factors; consideration of $ would be transferred from th~ reinsurer to the ceding company for purposes of commuting the $8.4 million of liabiliti~ s. 986

19 This is the examplel that's the process. Obviously, there are other issues. Firstly, there would be accounting issues which I will touch upon in just one second and then turn it over to Scott. There are negotiating issues. Is $7.6 million the number that the reinsurer had in mind? In all likelihood, he probably believes that the undiscounted reserve number is less than $8.4 million. He probably has lower reserves on his books than the $8,447,000. What ultimately gets settled for is not going to be solely a function of what the actuaries calculated by putting pencil to paperl that's the starting point. The final number will be the result of a whole host of factors, including, again, the risk aversion of the ceding company to either taking on this business versus waiting for a potentially insolvent reinsurer. I will just go back to the fourth exhibit in the narrative and talk about the financial effects. (Exhibit) The actual long-term effect -- by long term, I mean the actual economic value effect, forgetting statutory accounting. The actual long-term economic businessman's effect is the difference between the settlement and the ultimate discounted value of the losses. If we have done it correctly and, in fact, they received $7,418,000 and we were correct that's what the ultimate loss on a discounted basis settled out for, then, in fact, the economic effect is zero~ it was a wash. The short-term effect, which might be referred to as the reporting effect, the statutory accounting effect, is the difference between settlement, which is discounted losses and the corresponding carried reserves that the ceding company now needs to put up. They may have received discounted consideration for the losses, but they are responsible and required to put up undiscounted losses. The short-term effect in our example would have been the difference between the $8,447,000 of undiscounted reserves and the roughly $7.4 million of premium or the effect of $I million hitting the surplus. Hopefully, on an economic basis, at worst, it's a wash and if they are lucky, maybe they've broken enough conservatism to carry it. I'm going to turn it over to Scott. (Applause) MS. HUTTER: Thank you, 3effrey. Our last speaker this morning is Scott Moore, who will discuss the accounting treatment of commutations. Although Scott is speaking last in the lineup this morning, the financial impact of a commutation usually is an integral part of the negotiation process for each party. Scott is a partner in the firm of Coopers & Lybrand in New York. He has been with Coopers & Lybrand for eleven years, where he specializes in the insurance and reinsurance industry. Scott? 987

20 PRICING AND COST CONSIDERATIONS OF LOSS COMMUTATIONS Jeffrey H. Mayer, FCAS, MAAA Consulting Actuary I. Major Pricing Issues Ao B. C. D. E. The Amount of Future Payments (IBNR Evaluation) The Timing of Payments The Interest Rate The Economic Value of Risk The Financial Effects II. IBNR Evaluation for Casualty Excess of L~ss A. Sources of IBNR 1. Case development 2. Unreported claims 3. Reported claims which are unrel)orted to the excess layer. B. Individual Ceding Company Perspectile i. "Aberrations" in the data. 2. Instability - or - that's why {ou bought reinsurance in the first place. 3. Is "Treaty by Treaty" analysis helpful? C. Industry Perspective - The R.A.A. Dita i. Everyone is not better than average. 2. It is not necessarily dominate~ by hazardous risks and high layers; it really can be representative. 3. There is a great deal of variation between companies in the data base. 4. The development pattern has be~n worsening over time. 988

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