An Introduction to Reserving and Financial Reporting Issues for Non- Traditional Reinsurance DerekA. Jones, ACAS, MAAA 73 AN INTRODUCTION TO RESERVING AND FINANCIAL REPORTING ISSUES FOR NoN-TRADITIONAL REINSURANCE ABSTRACT Non-traditional reinsurance contracts, and finite risk reinsurance contracts in particular , are structured differently from traditional reinsurance. The incorporation of special features that make each contract unique tends to preclude standard portfolio loss reserving. This paper introduces the basic features related to common types of finite risk reinsurance contracts that provide prospective (e.g., aggregate stop-loss) or retroactive (e.g., adverse development cover) coverage. This paper will also discuss some of the considerations related to financial reporting issues for non-traditional reinsurance. The appendix will provide basic examples of prospective and retroactive deals to illustrate the balance sheet and income statement impacts for both the buyer and seller of finite risk reinsurance. 74 I. INTRODUCTION Non-traditional reinsurance is characterized by the transfer of risk through customized arrangements that are produced for the specific needs of a cedant. For finite risk arrangements, the risk transferred from the ceding entity will be limited and correspond to a limited upside for the reinsurer. Though finite risk reinsurance is a subset of non- traditional reinsurance, the terms "non-traditional" and "finite" are used interchangeably throughout this paper. When finite risk reinsurance first emerged, it provided an alternative to traditional reinsurance for both reinsurers and cedants. Ceding companies found a less expensive mechanism to smooth earnings and to address other issues such as adverse loss development and diminished underwriting capacity. Reinsurers, on the other hand, began to incorporate overall aggregate limits of liability and were better able to protect themselves against adverse selection and catastrophic losses. As cedants participated to a greater degree in their own ultimate loss exposure, finite reinsurance began to align the interests of the ceding company with the reinsurer. This, in turn, led to increased flexibility in the structure of reinsurance arrangements and enabled cedants to address needs that were not satisfactorily met by traditional reinsurance. Common uses of finite risk reinsurance were: • Deferral of taxes • Discounting of loss reserves • Earnings stabilization • Risk management related to mergers and acquisitions 75 • Surplus protection via all of the above These uses continue to drive the demand for finite risk reinsurance (although the current interest rate environment has reduced the impact of the time value of money). In recent years, however, the significant increases in the cost of traditional reinsurance have contributed to the demand for finite risk arrangements. Additionally, for emerging issues like terrorism or mass torts such as asbestos and toxic mold, finite risk reinsurance may be the most appropriate approach, from both the cedant and reinsurer perspective, to provide adequate protection. II. TYPES OF CONTRACTS AND COMMON STRUCTURAL FEATURES A. Types of Non-Traditional Reinsurance Arrangements - Retroactive The most common retroactive arrangements are loss portfolio transfers (LPT's) and adverse development covers (ADC's). For both types of deals, the reinsurer provides protection from the loss reserve deterioration for claims that have already been incurred. The reinsurer assumes a portion of the ceding entity's reserve uncertainty in return for a fixed premium. Loss portfolio transfers. With respect to LPT deals, the ceding entity is able to reduce future loss payment uncertainty by transferring a "portfolio" of reserves off of its balance sheet to the reinsurer. The premium paid to transfer the reserve uncertainty is based on the present value of the liabilities, plus an additional amount to reflect the risk to the reinsurer of further development of the transferred liabilities. LPT's protect the ceding 76 entity from the deterioration of past written business and are often used in mergers or acquisitions in order to wall off future exposure to loss from discontinued operations. A..dverse development covers. ADC deals are also intended to protect the ceding entity against unexpected development of past liabilities. In these cases, however, the ceding entity retains the underlying portfolio of loss reserves. As a result, ADC deals do not reduce reserve leverage to the same extent as with LPT's. For these deals, the premium is based on the reinsurer's evaluation of both the potential for adverse development and the expected timing of additional loss payments. ADC deals typically provide a specific dollar amount of coverage for potential development in excess of the ceding entity's carried reserves at the selected accounting date. In general, LPT deals tend to apply to smaller segments of business (e.g., a single line of business that the cedant has exited) than ADC deals, which commonly address larger groupings (e.g., all casualty lines of business combined). .B Types of lanoitidarT-noN ecnarusnieR Arrangements- evitcepsorP The most common prospective finite reinsurance arrangements are aggregate stop-loss covers, finite quota share treaties, and spread loss covers. Aeere~ate stoD-Ioss covers. The typical use of aggregate stop-loss covers is to stabilize earnings of the ceding entity. For this type of deal, the reinsurer typically provides a loss ratio corridor of protection above the ceding entity's planned future loss ratio in return for a fixed premium. Aggregate stop-loss reinsurance contracts often cover multiple 77 (typically three to five) years together; this further reduces the volatility of the ceding entity's earnings. (See Illustration 1 in the Appendix for a sample of this type of deal.) Finite quota share treaties. In a traditional quota share agreement, the reinsurer assumes a fixed percentage of the ceding entity's premium and corresponding losses and returns a ceding commission to the cedant. Finite quota share agreements are generally similar to and provide the same benefits as traditional quota share reinsurance. Like traditional quota share agreements, the primary benefit of finite quota share protection to the cedant is surplus relief, which in turn provides an increase in underwriting capacity. The main difference between finite quota share and traditional quota share is the aggregate limit of liability. For a finite quota share agreement, this is typically reflected via features such as a loss ratio cap for the reinsurer or a loss corridor, which defines a layer of loss for which the reinsurer does not pay the cedant. Also, the net cost of finite quota share reinsurance is typically less than traditional quota share because profits tend to be returned to the cedant. (See Illustration 2 in the Appendix for a sample of this type of deal.) Spread loss covers. Spread loss covers are similar to multi-year aggregate stop-loss deals; their focus is also to stabilize future years' earnings. With spread loss covers, the reinsurer commits to pay a defined level of loss across a number of future years. Like aggregate stop-loss covers, spread loss coverage can reduce the impact on earnings of specific covered events (e.g., catastrophes) or claim experience that is worse than expected. 78 .C Common Features of Finite Risk Reinsurance Deals Although each finite risk reinsurance deal is tailored to the ceding entity's specific needs, finite risk contracts tend to have a number of common structural features. The most significant feature is the contractual limitation on the ultimate amount of losses to be paid under the arrangement. By definition, this is found in all finite reinsurance deals, but aggregate limits are increasingly common in traditional reinsurance arrangements as well. Other features that are frequently incorporated into finite risk reinsurance deals include the following: • Recognition of the time value of money • Cedant participation in upside (profit sharing) and downside (additional premiums) Sub-limits of liability • • Multiple years • Cancellation and commutation provisions Time value of money. The time value of money is most commonly recognized in finite reinsurance by the use of an "experience account" that is initially funded by the premium paid by the ceding entity. For both retroactive and prospective deals, the experience account is typically established as the initial premium paid by the ceding entity, less the reinsurer's explicit provision for profit (the "margin") and brokerage fees. Loss payments under the contract are paid from the experience account and, while the 79 experience account balance (EAB) is positive, it accrues interest at a negotiated interest rate. When the experience account is held by the ceding entity ("funds withheld" basis), the interest credit tends to be higher than when the experience account is held by the reinsurer ("funds held/transferred"). In a funds transferred scenario, the credit is usually based on the risk-free interest rate. In a funds withheld scenario, the credit is higher because the reinsurance premium is essentially loaned back to the ceding entity. The higher interest rate for funds withheld scenarios also accounts for the credit risk to which the reinsurer is exposed; the reinsurer is still obligated to the cedant if the experience account is inadequate. Cedant participation. In finite risk reinsurance, it is common for the ceding entity to share both the potential upside and downside of the contract. When experience is favorable, most contracts allow for any positive experience account balance to be refunded to the ceding entity. The reinsurer, in fact, typically has a limited and small upside that is contractually defined as its margin. Due to the limited upside to the reinsurer, finite reinsurance contracts may be "overfunded" in order to minimize the downside to the reinsurer. This tends to be acceptable to cedants because of the profit sharing arrangement, which makes it likely that the reinsurer will return any initial overfunding to the cedant. Most prospective reinsurance arrangements also have provisions that ensure the ceding entity participates in the downside. For stop-loss and spread loss covers, this is commonly reflected in additional premiums to be paid depending on the cedant's loss 80 experience. When these additional premiums (AP's) are contractually defined, they may be referred to as "hard AP's." On the other hand, "relationship" agreements by which a ceding entity promises to renew or extend a current contract in order to make a reinsurer whole for adverse experience represent "soft AP" arrangements. Soft AP arrangements continue to exist, but they are increasingly rare in the current reinsurance environment. For finite quota share contracts, the ceding entity typically participates in the upside and downside by way of a sliding scale ceding commission, which is increased for favorable experience and decreased for poor experience. Sub-limits of liability. Another means for reinsurers to reduce its downside is to incorporate sub-limits of liability. For retroactive deals, sub-limits are typically used to reduce the reinsurer's exposure to losses that are unusually difficult to estimate. For prospective deals, sub-limits are used to limit the exposure to shock losses. Reduced life span of contracts. In most cases, profit sharing occurs at commutation of the reinsurance contract. This is typically initiated by the ceding entity although when the commutation may occur is contractually defined. Unlike most traditional reinsurance agreements, finite risk reinsurance is expected to commute soon after the cedant has achieved the intended benefit. From the reinsurer's perspective, early commutation can be appealing because it accelerates the recognition of the margin. Assuming any related experience account balance is projected to be positive, finite risk deals tend to commute shortly after the contractual window opens. Although the life span tends to be longer when interest rates are lower (and thus the experience account grows more slowly), the 81 average life span of finite risk deals is shorter than that of traditional reinsurance arrangements. III. RESERVING ISSUES The basic characteristics of finite risk reinsurance (limited risk transfer, investment income credit, profit sharing between cedant and reinsurer, commutation clauses) are unique for each contract. In addition to the non-homogeneous nature of finite risk reinsurance contracts, the underlying exposure typically varies for each contract. As each finite risk reinsurance arrangement is tailored to meet the specific needs of the cedant, it is practically impossible to apply standard actuarial loss reserving methods to a group of finite contracts. As a result, ultimate loss estimation by the reinsurer is done on a deal- by-deal basis. Included below is a list of basic issues to consider when estimating the reinsurer's liabilities for a particular finite risk deal. A. Understanding the Structure - Start with the Pricing Analysis A key initial step to projecting the reinsurer's ultimate liabilities associated with a particular finite risk deal is to understand its structural features. Following is a list of some preliminary questions to address for this step: • What is the purpose of the deal? Does the cedant have surplus constraints, rating agency concerns, etc? 82