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An Introduction to Reserving and FinancialReporting Issues for Non- Traditional

Reinsurance

DerekA. Jones, ACAS, M A A A

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A N I N T R O D U C T I O N T O R E S E RV I N G A N D F I N A N C I A L R E P O RT I N G I SS U E S F O R

N o N - T R A D I T I O N A L R E I N S U R A N C E

A B S T R A C T

Non-t radi t ional re insurance contracts , and f in i te r i sk re insurance contracts in par t icular

a re st ruc tu red d i ffe ren tly f rom t rad i t iona l r e insurance . The incorpora t ion o f spec ia l

fea tu res tha t make each con t rac t un ique t ends to p rec lude s t andard por t fo l io loss

rese rv ing . Th i s paper in t roduces the bas ic f ea tu res re l a t ed to com m on types o f f in i t e r i sk

re insurance contracts that provide prospect ive (e .g . , aggregate s top- loss) or re t roact ive

(e .g . , adverse deve lopm ent cover) coverage . Th i s paper wi l l a lso d i scuss some o f the

considera t ions re la ted to f inancia l repor t ing issues for non- t ra di t ional re insurance. Th e

append ix wi l l p rov ide bas ic exam ples o f p rospec t ive and re t roac tive dea l s to i l lus t r a te the

ba lance shee t and income s t a t ement impac t s fo r bo th the buyer and se l l e r o f f in i t e r i sk

re insurance.

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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 o f finite

risk reinsurance were:

Deferral of taxes

Discounting of loss reserves

Earnings stabilization

Risk management related to mergers and acquisitions

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Surp lus p ro tec t ion v ia a l l o f the abov e

These u ses con t inue to d r ive the dem and fo r f in i te ri sk r e insurance (a l though the cu r ren t

in teres t r a t e env i ronm ent has r educed the impac t o f the t ime va lue o f money) . In recen t

yea r s , however, the s ign i f i can t inc reases in the cos t o f t r ad i t iona l r e insurance have

con t r ibu ted to the dem and fo r f in i te r i sk a r rangem ents . Add i t iona l ly, fo r emerg ing i s sues

l ike t e rro r i sm or m ass to r t s such as a sbes tos and tox ic mold , f in it e r i sk r e insurance m ay

be the mos t appropr ia t e approach , f rom bo th the cedan t and re insure r pe r spec t ive , to

prov ide adequa te p ro tec tion .

I I . T Y P E S O F C O N T R A C T S A N D C O M M O N S T R U CT U R A L F E AT U R E S

A. Types of Non-Tradi tional Reinsurance Arrangements - Retroactive

The mos t common re t roac t ive a r rangements a re loss por t fo l io t r ans fe r s (LPT ' s ) and

adverse deve lo pm ent covers (AD C's ) . For bo th types o f dea l s, the r e insure r p rov ides

pro tec t ion f rom the loss r e se rve de ter io ra t ion fo r c l a im s tha t have a l r eady bee n incurred .

The re insure r a s sumes a por t ion o f the ced ing en t i ty ' s r e se rve uncer t a in ty in r e tu rn fo r a

f ixed p remium .

L o s s p o r t f o l i o t r a n s f e r s . W ith respec t to LP T dea l s , the ced ing en t i ty i s ab le to r educe

fu tu re loss paym ent uncer t a in ty by t r ans fe r ring a "por t fo l io" o f r e se rves o ff o f i t s ba lance

shee t to the r e insure r. The p rem ium pa id to t r ans fe r the r e se rve uncer t a in ty is based on

the p resen t va lue o f the l i ab i l it i es , p lus a n a dd i t iona l am ount to r e f l ec t the r i sk to the

re insure r o f fu r the r deve lopm ent o f the t r ans fe r red l i ab i l it ie s . LP T ' s p ro tec t the ced ing

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ent i ty f rom the deter iora t ion of pas t wri t ten business and are of ten used in mergers or

acqu is i t ions in order to w al l off fu ture exposu re to loss f rom discont inued operat ions .

A..dverse d e v e l o p m e n t c o v e r s .ADC deals are a lso in tended to protect the ceding ent i ty

aga ins t unexpec ted deve lopm ent o f pas t l i ab i l it ie s . In these cases, however, the ced ing

ent i ty re ta ins the under ly ing por t fol io of loss reserves . As a result , ADC deals do not

reduce rese rve l eve rage to the same ex ten t a s wi th LP T ' s . For these dea ls , the p rem ium

is based on the re insure r ' s eva lua t ion o f bo th the po ten t i a l for adverse deve lopm ent and

the expec ted t iming o f add i t iona l loss payments . AD C dea l s typ ica lly p rov ide a spec i f ic

do l l a r amount o f coverage fo r po ten t i a l deve lopment in excess o f the ced ing en t i ty ' s

carr ied reserves a t the se lected accou nt ing date .

In general , LPT deals tend to apply to sm al ler segm ents of business (e.g ., a s ingle line of

bus iness tha t the cedan t has ex i t ed ) than ADC dea l s , wh ich commonly address l a rge r

group ings (e .g ., a l l casual ty l ines of busine ss comb ined) .

B. Types of Non-Traditional Reinsurance Arrangements- Prospective

The mos t common prospec t ive f in i t e r e insurance a r rangements a re aggrega te s top- loss

covers , f in i te quota sha re t rea ties , and spre ad loss covers .

A e e r e ~ a t e s t o D - I os s c o v e r s .The typical use of aggregate s top- loss covers i s to s tabi l ize

ea rn ings o f the ced ing en t i ty. For th i s type o f dea l , t he r e insure r typ ica l ly p rov ides a loss

ra t io co r r idor o f p ro tec t ion above the ced ing en t i ty ' s p lanned fu tu re loss r a tio in r e tu rn fo r

a f ixed p remium. Aggrega te s top- loss r e insurance con t rac t s o f t en cover mul t ip le

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(typically three to five) years together; this further reduces the volatility of the ceding

enti ty's earnings. (See Illustration 1 in the Appendix for a sample of this type of deal.)

F i n i te q u o t a s h a r e t r e a t i e s . 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 commiss ion 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 di fference 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.)

S p r e a d l o s s c o v e r s . 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.

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C. Common Features o f Finite Risk Reinsurance Deals

Alth oug h each f in i te ri sk re insurance deal i s ta i lored to the ceding ent i t y ' s speci f ic needs ,

f in it e ri sk con t rac ts t end to have a numb er o f com m on s t ruc tu ra l fea tu res . The mos t

s ignif icant fea ture is the contractual l im i ta t ion on the u l t imate am ount o f losses to be paid

unde r the arrangem ent . By def ini t ion, th is i s found in a ll f in ite re insuranc e deals , but

aggrega te l imi t s a re inc reas ing ly com m on in t r ad i tiona l r e insurance a r rangem ents a s we l l .

Other fea tures that are f requent ly incorporated in to f in i te r i sk re insurance deals include

the fol lowing:

Recogn i t ion o f the t ime va lue o f m oney

Ced ant par t ic ipat ion in upside (prof it shar ing) and down side (addi t ional

p r e m i u m s )

Sub-l imi ts of l iabi l i ty

Mu l t ip le years

Cance l l a t ion and com mu ta t ion p rov i s ions

Ti m e v a l u e o f m o n e y. T h e t i m e v a l u e o f m o n e y i s m o s t c o m m o n l y re c o g n iz e d i n f i ni te

re insurance by the use o f an "exper ience acc oun t" tha t i s in i t i a lly funded by the p rem ium

paid by the ceding enti ty. For both re t roact ive and prospect ive deals , the exper ience

accoun t i s typ ica l ly e s t ab l ished as the in it i a l p rem ium pa id by the ced ing en ti ty, l e s s the

re insure r ' s exp l i c it p rov i s ion fo r p ro f i t ( the "m arg in" ) and b rokerage fees . Loss

payments under the con t rac t a re pa id f rom the exper ience accoun t and , whi l e the

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exper ience account balance (EAB) is posi t ive , i t accrues in teres t a t a negot ia ted in teres t

r a te . W hen the exper ience accoun t i s he ld by the ced ing en t i ty ( " funds wi thh e ld" bas i s) ,

the in te res t c red i t t ends to be h igher than when the exper ience accoun t i s he ld by the

re insurer ("fund s held/ t ransfe rred") . In a funds transferred scenar io , the credi t is usual ly

based on the r isk-f ree in teres t ra te . In a funds wi t hhe ld scenar io , the credi t i s h igh er

becau se the r e insurance p remium i s e s sen t ia l ly loaned back to the ced ing en t ity. The

h igher in te rest r a te fo r funds w i thhe ld scenar ios a l so accoun t s fo r the c red i t r isk to w hich

the re insurer i s exposed; the re insurer i s s t i l l obl igated to the cedant i f the exper ience

account i s inadequate .

Ce da nt par t ic ipation. In f in i te r i sk re insurance, i t i s common for the ceding ent i ty to

sha re bo th the po ten t i a l ups ide and downs ide o f the con t rac t . W hen exper ience is

favorab le , mos t con t rac t s a l low fo r any pos i t ive exper ience accoun t ba lance to be

refunde d to the ced ing enti ty. Th e re insurer, in fac t, typic al ly has a l imi ted and sma l l

upside that i s contrac tual ly def ined as i ts ma rgin . Due to the limi ted upside to the

re insure r, f in i t e r e insurance con t rac t s may be "over funded" in o rde r to min imize the

dow ns ide to the r e insure r. Th i s t ends to be accep tab le to cedan t s because o f the p ro f i t

sha r ing a r rangement , which makes i t l i ke ly tha t the r e insure r wi l l r e tu rn any in i t i a l

over fund ing to the cedan t .

Mos t p rospec t ive re insurance a r rangements a l so have p rov i s ions tha t ensure the ced ing

ent i ty par t ic ipates in the dow nside . For s top- loss and spread loss covers , th is i s

com m only re f lec ted in add i tiona l p rem ium s to be pa id dep end ing on the cedan t ' s loss

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exper ience . W hen these add it iona l p rem ium s (AP ' s ) a re con t rac tua l ly de f ined , they may

be re fe rred to a s "ha rd AP ' s . " On the o the r hand , " re la t ionsh ip" ag reem ents by w hich a

ced ing en t i ty p romises to r enew or ex tend a cu r ren t con t rac t in o rde r to make a r e insure r

wh ole fo r adverse exper ience rep resen t " so f t AP " a r rangements . Sof t AP a r rangem ents

con t inue to ex i s t , bu t they a re inc reas ing ly ra re in the cu r ren t r e insurance env i ronm ent .

For f in it e quo ta sha re con t rac t s, t he ced ing en t i ty typ ica l ly pa r ti c ipa tes in the ups ide and

dow ns ide by w ay o f a s l id ing sca le ced ing comm iss ion , which i s inc reased fo r f avorab le

exper ience and d ec reased fo r poor exper ience .

S u b - l i m i t s of l i ab i l i ty. Ano the r mean s fo r r e insure rs to r educe i ts downs ide i s to

incorporate sub- l im i ts of l iabi li ty. For re t roact ive deals , sub- l imi ts are typical ly used to

reduc e the re insu rer ' s exposure to losses that are unu sual ly di ff icul t to es timate . For

prospec t ive deals , sub- l im i ts are used to l im i t the exposu re to shock losses .

R e d u c e d l if e s p a n o f c o n t r a c t s .In mos t cases , p ro f it sha r ing occurs a t comm uta t ion o f

the re insurance con t rac t . Th i s i s typ ica l ly in i ti a t ed by the ced ing en t i ty a l though w hen

the com m uta t ion m ay occur i s con trac tua l ly de f ined . Un l ike mos t t r ad it iona l r e insurance

agreements , f in i t e r i sk r e insurance i s expec ted to commute soon a f t e r the cedan t has

ach ieved the in tended benef i t. F rom the re insure r ' s pe rspec t ive , ea r ly com m uta t ion can

be appea l ing because i t acce le ra tes the r ecogn i t ion o f the marg in . Assu m ing any re la t ed

exper ience accoun t ba la nce i s p ro jec ted to be pos i t ive , f in i te r isk dea l s t end to com m ute

shor t ly a f t er the con t rac tua l w indow opens . Al thou gh the l i fe span tends to be longer

when in te res t r a t e s a re lower ( and thus the exper ience accoun t g rows more s lowly) , the

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ave rage l i f e span o f f in i t e ri sk dea l s i s sho r t e r t han tha t o f t r ad i t i ona l r e insu rance

a r rangemen t s .

I I I . R E S E RV I NG I S S U E S

The bas i c cha rac t e r i s t i c s o f f i n i t e r i sk r e insu rance ( l imi t ed r i sk t r ans fe r, i nves tmen t

i n c o m e c r e d i t , p r o f i t s h a r i n g b e t w e e n c e d a n t a n d r e i n s u r e r, c o m m u t a t i o n c l a u s e s ) a r e

un ique fo r each con t r ac t . In add i t ion to the non- hom oge neou s na tu re o f f in i t e r i sk

re insu rance con t r ac t s , t he unde r ly ing expos ure typ ica l ly va r i e s fo r each con t r ac t . As each

f in i te r isk r e insu rance a r r angem en t i s t a i l o red to mee t t he spec i f i c need s o f t he cedan t , i t

i s p rac t i ca l ly imposs ib l e to app ly s t anda rd ac tua r i a l l o s s r e se rv ing me thods to a g roup o f

f in i t e con t r ac t s . As a r e su l t , u l tima te lo s s e s t ima t ion by the r e insu re r i s done on a dea l -

by -dea l bas i s .

I n c l u d e d b e l o w i s a l i st o f b a si c i s s u e s t o c o n s i d e r w h e n e s t i m a t i n g t h e r e i n s u r e r ' s

l iabi l i t ies for a par t icu lar f in i te r i sk deal .

A . U n d e r s t a n d i n g t h e S t r u c t u r e - S t a r t w i t h t h e P r i c i n g A n a l y s i s

A key in i t i a l s t ep to p ro jec t ing the r e insu re r ' s u l t ima te l i ab i l i t i e s a s soc ia t ed wi th a

pa r t i cu la r f i n i t e r i sk dea l i s t o unde r s t and i t s s t ruc tu ra l f ea tu re s . Fo l low ing i s a l i st o f

som e p re l im ina ry ques t ions to addres s fo r t h i s st ep :

W h a t i s t h e p u r p o s e o f t h e d e a l ? D o e s t h e c e d a n t h a v e s u r p l us c o n st r a i n t s, r a t in g

a g e n c y c o n c e r n s , e t c?

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I s t h e c o n t r a c t r e t ro a c t i v e o r p r o s p e c t i v e ?

W h a t li n es o f b u s i n e s s a r e c o v e r e d ?

W h a t t y p e o f c o v e r a g e is p r o v i d e d ? F o r o t h e r t h a n q u o t a s h a r e a r r a n g e m e n t s , w h a t

l a y e rs o f c o v e r a g e d o e s t h e r e i n s u re r p ro v i d e ? F o r q u o t a s h a r e a r r a n g e m e n t s , w h a t

i s t h e a s s u m e d p e r c e n t a g e a n d a r e t h e r e a n y l o s s c o r r i d o r s f o r t h e c e d a n t ?

W h a t a n n u a l l im i t s , s u b - l i m i t s a n d a g g r e g a t e l i m i t s o f t h e r e i n s u r e r ' s l i a b il i ty e x i s t ?

D o e s t h e c o n t r a c t q u a l i f y fo r r e i n s u r a n c e t r e a t m e n t o r i s d e p o s i t a c c o u n t i n g

r e q u i r e d ?

I s l o s s r e s e r v e d i s c o u n t i n g u s e d ?

I s t h e r e a n e x p e r i e n c e a c c o u n t ? I f s o , w h a t i s t h e i n it i al f u n d i n g a n d h o w i s t h e

i n t e r es t c re d i t d e t e r m i n e d ?

I s t h e r e a p r o v i s i o n f o r a d d i t i o n a l p r e m i u m s f r o m t h e c e d a n t ?

W h a t i s t h e r e i n s u r e r ' s m a r g i n ?

I s t h e r e a c o m m u t a t i o n p r o v i s i o n ? I f s o , w h i c h p a r t y (r e i n s u r e r o r c e d a n t ) c a n

c o m m u t e a nd u n d e r w h a t c i r c u m s t a n c e s ?

T h i s i s n o t i n t e n d e d t o b e a n e x h a u s t i v e l i s t a n d t h e s e a r e g e n e r a l l y n o t u n i q u e t o f i n i t e

r i s k d e a l s . I t i s, h o w e v e r , p a r t i c u l a r l y i m p o r t a n t t o a d d r e s s s o m e o f t h e s e i t e m s i n o rd e r

t o a p p r o p r i a t e l y re f l e ct t h e i s s u e s s p e c i fi c to e a c h i n d i v i d u a l d ea l . W h e n e s t i m a t i n g

l o s s e s a t t h e i n d i v i d u a l d e a l l e v e l , t h e r el a t i v e i m p o r t a n c e o f t h e s e i s s u e s is m a g n i f i e d .

F r o m t h i s l i st , it is c le a r th a t m a n y o f th e k e y i s s u e s s h o u l d b e a d d r e s s e d i n t h e p r i c i n g

a n a l y s i s f r o m t h e i n it i a l u n d e r w r i t i n g p r o c e s s .

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B. Considering the Experience Accou nt

In m any cases, f ir ii te r i sk dea l s tha t fund con t rac tua l loss paym ents v ia an exper ience

accoun t w i l l i nc lude a p rov i s ion tha t a l lows the cedan t, and som et imes a l so the re insure r,

to com m ute the con t rac t . A t the com m uta t ion da te , a s ign i f i can t por t ion o f the

exper ience accoun t b a lance i s typ ica l ly r e tu rned to the ced ing en t i ty and the re insure r i s

re l eased f rom fu tu re ob l iga t ions to the cedan t . The ex per ience accoun t r e fund is

s o m e t i m e s k n o w n a s t h e " p r o f i t c o m m i s s i o n " a n d i s f r e q u e n t l y e q u a l t o 1 0 0 % o f t h e

exper ience accoun t ba lance . As a r e su l t , man y re insurer s tend to ho ld rese rves ( inc lud ing

unearned p rem ium ) based on a 100% com bined ra t io , l e ss i ts b rokerage cos t s and marg in .

Th i s approach makes sense when the exper ience accoun t ba lance i s p ro jec ted to be

pos i tive . A ques t ion a ri ses , however, o f how to address s i tua t ions in wh ich the

exper ience accoun t i s p ro jec ted to be nega t ive .

As d i scussed ea r l i e r, an exper ience accoun t i s typ ica l ly equa l to p remium payments by

the cedan t , l e s s the r e insure r ' s marg in and con t rac tua l loss payments , p lus inves tment

income acc rued v ia an in te res t c red i t on the ba lance . I f, however, the loss payments fo r

the deal are requested ear l ier than expected o r the in teres t ra te envir onm ent deter iora tes

and the in teres t credi t i s lower than expected, i t i s poss ible that the exper ience account

m ay be exhaus ted . I f add i t iona l p rem ium s a re no t ava i l ab le to r ep len ish the exper ience

accoun t in these cases, the r e insure r may no t r ea l i ze i t s fu ll marg in and cou ld be exposed

to an econom ic loss fo r the con t rac t .

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C. Monitoring Actual and Expected Loss Emergence

One o f t he cen t ra l i s sues r e l a ted to r e se rve e s t im a t ion i s how the ac tua l l o s s em erge nce

c o m p a r e s t o t h e e x p e c t e d e m e rg e n c e . T h i s i s a c o m m o n i s s u e fo r r e s er v i n g , b u t i t h a s

ex t r a s ign i f i cance fo r non- t r ad i t i ona l r e insu rance due to the im pac t o f t he t ime va lue o f

m o n e y.

F o r t h e r e in s u re r, p r o b l e m s c a n e m e rg e w i t h c h a n g e s i n e i t h e r t h e t i m i n g o r m a g n i t u d e o f

r epor t ed lo s ses from the ced in g en t i ty. Gene ra l ly, a s low dow n o r dec rease in lo s s

repor t ing i s favorab le to the r e insu re r. I f , how ever, ac tua l l o s ses exceed the expec ta t ions ,

the re a re d i f f e ren t i s sues to cons ide r.

F i r s t , a t empora ry speed-up in lo s s r epor t ing by the ced ing en t i t y wi l l r educe the

r e i n s u r e r ' s b e n e fi t s f r o m t h e t i m e v a l u e o f m o n e y. A s t h e e x p e r i e n c e a c c o u n t is u ti l iz e d

to pay lo s ses to the cedan t ea r l i e r t han an t i c ipa t ed , t he in t e re s t c r ed i t w i l l no t g row as

e x p e c t e d . A s a r es u l t, t h e e x p e r i e n c e a c c o u n t c o u l d b e e x h a u s t e d b e f o r e t h e r e in s u r e r ' s

ob l iga t ions have been se t t l ed . Thus , even i f t he in it i a l u l t ima te lo s s es t ima te were

accura t e on an und i scoun ted bas i s , acce l e ra t ion in c l a im paymen t s cou ld l ead to an

econ om ic lo s s fo r t he r e insu re r.

I f ac tua l l o s ses du r ing a r epor t ing pe r iod a re cons i s t en t ly g rea t e r t han expec ted , a s econd

prob lem m ay em erge : t he in i t ia l l o ss p ro jec t ion cou ld be unde r s t a t ed . C lea r ly, t h i s can

a l so exhau s t t he expe r i e nce accoun t ea r l ie r t han an t i c ipa t ed . A re l a t ed and m ore sub t l e

i s sue is wh e the r t he cedan t beg ins to unde r- r epor t l o s ses to the r e insu re r. As m os t f i n i t e

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d e a l s i n c l u d e p r o v i s i o n s f o r a d d i t i o n a l p r e m i u m s f r o m t h e c e d a n t , t h e c e d a n t w i l l h a v e

incen t ive to de l ay the t r i gge r ing o f any AP pa ym en t to the r e insu re r. A de lay in the

t r a n sf e r o f A P ' s f o r m t h e c e d a n t w i l l i nc r e a s e t h e l i k e li h o o d o f a n e c o n o m i c l o s s t o t h e

re insurer.

( S e e I l l us t ra t i on s 3 A a n d 3 B f o r e x a m p l e s o f t h e p o t e n t ia l i m p a c t o f a r e p o r t i n g s p e e d - u p

a n d s l o w d o w n . )

U n l i k e d e a l s w i t h f a v o r a b l e c l a i m e x p e r i e n c e , w h i c h t h e c e d a n t i s e x p e c t e d t o c o m m u t e ,

dea l s t ha t gene ra t e ne t l o s ses to the r e insu re r w i l l r equ i r e a m ore r igo rous a na lys i s fo r t he

purp ose o f e s t ima t ing the r e insu re r ' s u l t ima te l i ab i li t i es .

D. Projecting the lnterest Credit

The t im e va lue o f mo ney i s mo s t f r equen t ly r e f l ec t ed in f in i te ri sk r e insu rance v i a an

expe r i e nce accoun t , w h ic h accum ula t e s i n t e re s t un t il l o s ses a re pa id f rom the accoun t . In

mos t ca ses , t he in t e re s t c r ed i t fo r t he expe r i ence accoun t i s based on a r i sk - f r ee in t e re s t

r a t e. The c red i t t yp ica l ly r e fl ec t s a mod es t sp read a bove the r i sk - f r ee r a t e - t he ced ing

e n t i ty a n d r e i n s u r e r w i l l n e g o t i a t e th e s p r e a d , w h i c h t e n d s t o v a r y d e p e n d i n g o n w h e t h e r

t h e e x p e r i e n c e a c c o u n t i s a f u n d s w i t h h e l d o r f u n d s t r a n s f e r re d a r r a ng e m e n t . F o r t h e

p u r p o s e o f p r o j ec t i n g t h e f u t u re e x p e r i e n c e a c c o u n t b a l a n c e , i t i s n e c e s s a r y t o e s t i m a t e

the fu tu re va lues o f t he r isk - f r ee in t e re s t r a te . A co m m on and s im ple approach i s to

u t i l i ze the t e rm s t ruc tu re o f i n t e res t ra t e s based on the sp o t ra t e s o f U .S . Tre asu ry

secur i t ies .

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E. Testing the Sensitivity o f Los s Projections

For a ny re insura nce deal , i t i s impo rtant to tes t the sensi t iv i ty of the subject losses to

var i a t ions in the as sumpt ions tha t under l ie the r e insure r 's loss p ro jec tions . The key

concerns to the r e insure r a re the l eve l o f sub jec t losses and the co r respon d ing t iming o f

the payou t o f those losses . U nders tand ing the po ten t i a l va r i ab i li ty o f the losses i s c r it i cal

in order for the re insurer to determine a range of reasonable loss es t imates as wel l as the

bes t e s t ima te w i th in tha t r ange .

For re t roact ive re insurance, sensi t iv i ty tes t ing is of ten more s im pl is t ic , thou gh no less

impor tan t , t han fo r p rospec t ive reinsurance. For L PT and AD C dea l s , the sub jec t losses

have a l ready been incur red so po ten ti a l adverse (o r f avorab le ) deve lopme nt o f the sub jec t

losses i s the in i t ia l focus . V arying the ta i l of the loss dev elop m ent pat terns that under l ie

the in i ti a l loss p ro jec t ions i s a s imp le and reasona b le approach to t e s t ing the sens i t iv ity o f

the nomina l loss am ounts .

For p rospec t ive re insurance , a com m on approach to sens i t iv i ty t e s t ing i s s tochas t i c

s imula t ion o f fu tu re loss l evel s . G iven tha t the sub jec t losses have no t been incur red fo r

p rospec t ive re insurance , th i s usua l ly invo lves mod e l ing the c l a im f requency and sever i ty

com ponen t s o f loss. A no tab le benef i t o f s imula t ions i s tha t the use r can iden ti fy

conf idence level percent i les for the expected re insured losses .

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From the re insure r ' s pe r spec tive , the t iming o f the loss payou t can b e as im por tan t a s the

ac tua l amou nt to be pa id . Thus , fo r bo th p rospec t ive and re t roac t ive re insurance deal s , it

i s a l so impor tan t to r ev iew a l t e rna t ive payou t pa t t e rns toge the r wi th the va r ious loss

pro jec tions . By com bin ing a l t e rna t ive payou t p a t t e rns wi th va r ious expec ta t ions o f the

nomina l loss amounts , the r e insure r can p roduce a r ange o f e s t ima tes o f the economic

va lue o f the cov erage p rov ided .

F. C o n s i d e r i n g B u l k R e s e r v e s

Due to the l a rge s i ze o f mos t ind iv idua l f in i t e r e insurance dea l s and the in tens ive

underw r i t ing p rocess invo lved , these books o f bus iness t end to be com pr i sed o f a smal l

num ber o f con trac t s . As each dea l has un iqu e fea tu res and i s r e se rved ind iv idua l ly, the

law of l a rge numbers wi th r e spec t to loss r e se rv ing does no t typ ica l ly app ly to f in i t e

re insurance . Thus , i t is wor thw hi le to cons ide r the appropr ia t eness o f bu lk o r "non-

spec i f i c" r e se rves fo r the overa l l book o f f in i te r e insurance .

At i ssue is whether the to ta l carr ied reserve for a l l contracts ref lec ts an adequate

prov i s ion fo r the po ten t i a l o f adverse scenar ios . A key cons ide ra t ion in deba t ing th i s

top ic i s how the re insure r de f ines i t s "bes t e s t ima te" o f loss fo r ind iv idua l con t rac t s .

W hi le ma ny approaches a re poss ib le , th ree approaches a re r ead i ly ava i l ab le based on the

re insure r ' s s im ula t ion o f fu tu re loss ou tcomes .

F i r st , the re i s the m os t l ike ly ou tcome ( i .e ., t he mod e) o f the loss d i s tr ibu t ion . Th e mo de

m igh t be ap pea l ing because i t i s the s ing le ou tcome wi th the g rea tes t p robab i l i ty o f

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o c c u r r in g . T h e p r o b l e m w i t h t h is , h o w e v e r, i s th a t u s i n g t h e m o d e c o m p l e t e l y i g n o re s a ll

o t h e r p o s s i b l e o u t c o m e s . C o n s i d e r a n e x a m p l e i n w h i c h 9 0 % o f th e p o s si b l e o u t c o m e s

fo r a con t r ac t p roduce lo s s e s t ima tes o f $0 and 10% produc e $1 ,000 ,000 - i s i t r ea sonab le

to ca r ry $0 fo r t h i s con t r ac t ? Suppose each con t r ac t i n the book has a s imi l a r l o s s

d i s t r ibu t ion - wo u ld $0 be an appropr i a t e r e se rve to ca r ry fo r t he en t ir e book? The

p o s i t i v e l y s k e w e d n a t u r e o f m o s t a g g r e g a t e l o s s d i s tr i b u t io n s i m p l i e s t h a t t h e m o d e c o u l d

be g ross ly inadequa te in som e cases . As the con t r ac t s ' l o s s d i s t r ibu t ions a re inc reas ing ly

skew ed to the r igh t , the re i s a g rea t e r need fo r a bu lk r e se rve w hen th e mo de und e r l i e s t he

los s r e se rve bes t e s t ima te .

To a d d r e s s t h e b a s ic p r o b l e m w i t h t h e m o d e , a n a l t e rn a t iv e i s t h e e x p e c t e d v a l u e o f t h e

los s d i s t r ibu t ion (i .e ., t he mea n) . Th e me an i s a we igh te d ave rage o f a l l p ro j ec t ed

o u t c o m e s a n d r e f l ec t s t h e e x p e c t e d p r o b a b i li t y th a t e a c h c o u l d o cc u r. T h e m e a n v a l u e f o r

each con t r ac t , t he re fo re , exp l i c i t l y r e f l ec t s a p rov i s io n fo r a ll exp ec ted scena r ios .

A d i ff e ren t approach wou ld be to book los s e s t ima tes tha t co r re spond to a spec i f i c

conf idenc e l eve l fo r each con t r ac t . Th e l i ke ly expec ta t ion unde r ly ing th i s approac h i s

t h a t t h e s e l e c t e d p e r c e n t i le p r o d u c e s a c o n s e r v a t i v e e s t i m a t e ( o t h e r w i s e th e m e a n o r m o d e

w ould l i ke ly be se l ec t ed ) .

In p rac t i ce , bu lk r e se rves fo r f in i t e r e insu rance a re no t o f t en used . As no ted ea r li e r, m any

f in i t e r i sk r e insu rance con t r ac t s a r e booked to 100% combined r a t io s , wh ich wi l l t end to

p r o d u c e c o n s e r v a t i v e e s t i m a t e s i n a g g r e g a te . A s e c o n d a r y a rg u m e n t a g a i n st b u l k

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r e se rves i s tha t booked rese rves a re genera l ly und i scoun ted , so the amount o f po ten t i a l

disco unt i s an im pl ic i t buffer.

G. Establishing Claim Liabilities When Deposit Accounting is Required

As disc usse d in Sect ion IV - FINANCIAL STATEMENT REPORTING ISSUES, one of the key

issues re la ted to f in i te r i sk re insurance is whether a contract qual i f ies for re insurance

accoun t ing o r depos i t accoun t ing . Th i s i s s t r ic t ly a f inanc ia l r epor t ing i s sue , however,

and does no t a ffec t the loss e s tima t ion p rocess . Th e p reced ing d i scuss ion app l i e s equa l ly

regard less o f wh e the r r e insurance o r depos i t accoun t ing i s used . One d i ffe rence to no te i s

tha t , un l ike under r e insurance accoun t ing , the depos i ts and l i ab il i ti e s r ecorded by the

ced ing and assu ming en t i t i e s a re typ ica l ly based on the d i scou n ted va lues o f the expec ted

subject losses .

I V . F I N A N C IA L S TAT E M E N T R E P O R T I N G I SS U E S

A. Reinsurance versus Deposit Accounting

Regard less o f the r epor t ing purpose ( i . e . , GAAP versus s t a tu to ry ) , the key i s sue to

address when accoun t ing fo r f in i t e r i sk r e insurance con t rac t s i s whe the r r e insurance

accoun t ing is pe rmi t t ed o r depos i t accoun t ing i s r equ i red . U .S . GA AP f inanc ia l

s t a t ements re ly on S ta tement o f F inanc ia l Accoun t ing S tand ards (SFA S) No . 113 w hi le

s t a tu to ry accoun t ing depends on S ta tement o f S ta tu to ry Accoun t ing Pr inc ip les (SSAP)

No. 62 fo r gu idance in de te rmin in g w hen re insurance t r ea tment i s pe rmiss ib le .

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With both forms of accounting, reinsurance treatment requires that both underwriting and

timing risk be transferred to the reinsurer. The language used to define the conditions of

insurance risk transfer is essentially identical; in fact, the U.S. statutory guidance is

copied almost verbatim from SFAS 113 . Following are the conditions as defined by

SFAS 113:

a. The reinsurer assumes significant risk under the reinsured portions of the

underlying insurance contracts.

b. It is reasonably possiblethat the reinsurer may realize a significant lossfrom

the transaction. (Emphasis added.)

If either of these conditions is not met, deposit accounting is required. For the purpose of

evaluating insurance risk transfer, SFAS 113 and SSAP 62 state an outcome is

reasonably possible if its probability is more than remote. In reviewing the potential

significance of loss, the accounting statements establish that it is necessary to evaluate the

net present value of the cash flows (premiums, commissions , losses, and loss adjustment

expenses) from reasonably possible outcomes of the transaction.

It has been frequently observed that the language in SFAS 113 does not specify how to

quantify the amount of risk transfer. While some rules of thumb exist, there is a great

deal of uncertainty related to the terms reasonably possible and s ignif icant loss .The

most commonly cited target is the 10/10 rule, which implies sufficient risk is

transferred if the reinsurer has a 10% probability of sustaining a 10% loss. This

discussion, however, is not intended to address how to determine whether sufficient risk

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is transferred. The interested reader is referred to guidance from the CAS Committee on

Valuations, Finance, and Investments ( Considerations in Risk Transfer Testing ). Note,

however, that the accounting statements are clear about contractual features that delay the

timing of payments from the reinsurer to the cedant. As SSAP 62 states, any feature that

can delay timely reimbursement violates the conditions for reinsurance account ing and

thus requires deposit accounting.

B . R e i n s u r a n c e A c c o u n t i n g - P r o s p e c t i v e v e rs u s R e t r o a c t i v e

Contracts that qualify for reinsurance accounting are treated differently depending on

whether a contract provides prospective or retroactive coverage. Generally, prospective

reinsurance covers incurred losses assumed from future events while retroactive

reinsurance covers liabilities from past insurable events. It is possible that some contracts

contain both prospective and retroactive provisions. When this occurs, the provisions

should be accounted for separately unless this is not feasible, in which case the full

contract should be treated as retroactive reinsurance.

Under U.S. statutory accounting, there are some exceptions to the rule for retroactive

reinsurance. The following should instead receive prospective reinsurance treatment:

* Structured settlement annuities for individual claims;

Novations - these are primarily agreements by which the liabilities of the cedant

are completely extinguished;

Termination of or reduced participation in reinsurance treaties; and

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Intercompany agreements that do not produce a gain in surplus as a direct result

of the arrangement.

From the ceding entity's perspective, retroactive reinsurance is most commonly used to

increase policyholder surplus. This occurs via implicit loss reserve discounting that

underlies the pricing of retroactive reinsurance. For example, the ceding entity may be

required to book an undiscounted reserve of $100 million related to claims for past events

it covered. If the discounted value of these liabilities at the reinsurance contract effective

date were $80 mill ion, the reinsurer and cedant might agree to a premium o f $88 million.

The intent of this deal would be to create an additional $12 million of surplus for the

ceding entity as it pays $88 million up front to the reinsurer to assume the future payment

obligations with an estimated nominal value o f $100 million. For the reinsurer, the $8

million difference between the reinsurance premium and the discounted reserve estimate

reflects a provision for both profit and the risk of adverse development of the assumed

book of business.

As explicit loss reserve discounting is allowed only in very limited circumstances,

accounting treatment of retroactive reinsurance is somewhat different from prospective

reinsurance. As the accounting guidance states, this is due to potential abuses related to

surplus creation by cedants and the corresponding distortion of underwriting results.

For the ceding entity, it must reflect loss and loss adjustment expense reserves gross of

retroactive reinsurance on the balance sheet and all other schedules and exhibits of the

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f i na n c ia l s t a t e m e n t s. T h e a m o u n t o f r et r o a c t iv e r e i n su r a n c e m u s t b e s h o w n a s a c o n t ra -

l i ab i l i t y on the ba l ance shee t and be r epor t ed a s a wr i t e - in i t em spec i f i ca l ly iden t i f i ed a s

Re t roac t ive Re insu rance Ceded . In add i t ion , any su rp lus c rea t ed by the r e t roac t ive

re insu rance t r ansac t ion mu s t be r e s t r i c t ed a s a spec ia l su rp lus fund . Th i s fund i s no t

r e l eased in to unass igned su rp lus un t i l t he r e insu rance r ecove r i e s exceed the cons ide ra t ion

pa id fo r t he r e t roac t ive r e insu rance ag reem en t . (See I l l u s tr a t ion 4 fo r an exa m ple o f t he

t r e a t m e n t f r o m t h e c e d i n g e n t i t y ' s p e r s p e c t i v e .)

For the r e insu re r, i t mus t exc lude the a s sumed re t roac t ive r e insu rance f rom los s and lo s s

a d j u s t m e n t e x p e n s e r e s e r v e s o n t h e b a l a n c e s h e e t a n d a ll o t h e r s c h e d u l e s a n d e x h i b i t s o f

t h e f in a n c i al s t a te m e n t s . T h e a m o u n t o f r e tr o a c t i v e r e i n s u ra n c e m u s t b e s h o w n a s a

con t r a - l i ab i l i t y on the ba l ance sh ee t and be r epor t ed a s a wr i t e - in i t em spec i f i ca l ly

i d e n ti f i ed a s R e t r o a c t i v e R e i n s u r a n c e A s s u m e d .

W h i l e t h e b a l a n c e s h e e t e f fe c t s o f r e t r oa c t i v e r e in s u r a n c e a r e s i m i l a r b e t w e e n G A A P a n d

s t a tu t o r y a c c o u n t i ng , o n e n o t a b l e d i f f e r e n c e b e t w e e n t h e t w o i s r e f l e c te d o n t h e i n c o m e

s t a te m e n t . U n l i k e G A A P , s t a t u to r y a c c o u n t i n g a l l o w s t h e i m m e d i a t e r e c o g n i t io n o f t h e

re t roac t ive r e insu rance ga in ( fo r the ced i ng en t i t y ) o r l o s s ( fo r t he a s sum ing en t i t y ) on the

i n c o m e s t a t e m e n t . T h i s m u s t b e r e c o r d e d a s a w r i t e - i n it e m , re f l e c t e d i n O t h e r I n c o m e ,

a n d s p e c i fi c a l l y i d e n t if i e d a s R e t r o a c t i v e R e i n s u r a n c e G a i n o r L o ss . U n d e r G A A P, t h e

i m m e d i a t e r e c o g n i t i o n o f g a i ns o r l o s s es f r o m r e t ro a c t i v e r e in s u r a n c e i s p e r m i s s i b l e o n l y

i f t he ced ing en t i t y no long e r has any ob l ig a t ion to i t s po l i cyho lde r.

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C. Deposit Accounting

When a f in i t e r i sk a r r angemen t r equ i r e s depos i t accoun t ing , t he re i s no in i t i a l impac t on

the lo s s and lo s s ad jus tm en t ex pens e r e se rve en t r i e s on the ba l ance shee t o f e i the r pa r ty.

The re i s a l so no in it i a l imp ac t on the i r i ncom e s t a t emen t s .

A t the onse t , t he ced ing en t i t y r eco rds a depo s i t ( i .e . , a s se t ) equa l t o the ne t con s ide ra t ion

pa id to the a s sum ing en t it y. The a s su min g en t i t y r eco rds a co r re sp ond ing l i ab i l i t y on i t s

ba l ance shee t . No te tha t t h i s l i ab i li t y is no t pa r t o f t he lo s s r e se rve ; i n s tead , i t is a

sepa ra t e i t em on the ba l ance shee t and can be v i ew ed a s a " ' l o s s -equ iva len t " r e se rve . As

noted in Section III - RESERVINGISSUES,he am oun t o f t he depos i t o r l i ab i l i ty i s based

o n t h e d i s c o u n t e d v a l u e o f t h e c e d e d o b l i g a t i o n .

Af te r t he in i t i a l f i nanc ia l r epor t ing da te , t he ba l ance shee t and income s t a t emen t r e f l ec t

ad jus tmen t s t ha t addres s : ( a ) ac tua l paymen t s be tween ced ing and a s suming en t i t y ; (b )

u n w i n d i n g o f t h e u n d e r l y i n g d i s c o u n t ; a n d ( c ) r e v i s io n s to t h e e x p e c t e d a m o u n t a n d

t iming o f fu tu re " los s" paym en t s . I t em (a ) is r e f l ec t ed a s a d i rec t ad jus tmen t to the

depos i t o r li ab i l i ty he ld . I t ems (b ) and ( c ) , how ever, a ff ec t bo th the inc om e s t a t emen t and

the ba l ance shee t .

As long a s the t iming and am oun t o f t he ac tua l ca sh f lows a re a s expec ted , i t em (b ) i s t he

o n l y a d j u s t m e n t t o t h e i n c o m e s t a t e m e n t . T h i s i s c a l c u la t e d a s th e p r o d u c t o f t h e

e ffec t ive y i e ld and the r ema in ing depos i t . Fo r the ced ing en t i t y, i t em (b ) i s a c r ed it to

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expected or if interest rates are lower than projected, the cedant's experience account

balance might not be sufficient to cover the reinsure r's liabilities. As a result, the

reinsurer could suffer a net loss, so it is very important to monitor both loss emergence

and the projected interest credit. This will enable the reinsurer to assess the adequacy of

the experience account, to determine whether reserves in excess of the experience

account balance are necessary, and to determine whether additional premiums will be

required. Clearly, these considerations combined, together with the accounting issues

that apply to all reinsurance contracts, present some different challenges from traditional

reinsurance. Hopefully, this paper will provide the reader with a foundation from which

to address the main reserving and financial reporting issues related to this family of

insurance products, which continue to emerge.

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V I . B I B L I O G R A P H Y

1 . CAS Com m i t t ee on Va lua t ions , F inance , and Inves tment s , "Ac coun t ing Rule

Guidanc e S ta tement o f F inanc ia l Accou n t ing S tandards No . 113 - Cons ide ra t ions in

Risk Trans fe r Tes t ing , " C asua l ty Ac tua r i a l Soc ie tyForum Fa l l 2002 , pp . 30 5-338 .

2 . Lane, Morto n,Alternative Risk Strategies Risk Books, 2002.

3 . Fe ldb lum, Sho lom, "Se lec ted Notes to the F ire and Casua l ty Annua l S ta tement" ,

Four th Ed i t ion, Cas ual ty Actuar ia l Socie ty Stud y Note , 1999.

4 . Fe ll , Bruce , "F in i t e Re insurance , " Casua l ty Loss Rese rve Seminar, Sep tem ber 2003 .

5 . F inanc ia l Acco un t ing S tandards Board , "S ta tem ent o f F inanc ia l Acc oun t ing

Standards No . 113 , Accoun t ing and Repor t ing fo r Re insurance o f Shor t -Dura t ion andLong-D ura t ion Cont rac t s , " F inanc ia l Accoun t ing S tandards B oard , Decem ber 1992.

6 . In te rna tiona l R i sk Man agem ent Inst i tu te , "Th e Risk Repor t ," January 1998 .

7 . Na t iona l Assoc ia t ion o f Insurance Com miss ioners ,Accounting Practices and

Procedures Manual 2003 Edi t ion.

V I I . A P P E N D I X

I l lus tr a t ion 1 - Sam ple Aggrega te S top-Loss Dea l

I l lus tr a t ion 2 - Sam ple F in i t e Quota Share Dea l

I l lus tr a t ion 3 - Mo ni to r ing Loss Emerg ence

I l lus t ra t ion 4 - Retro act ive Reinsura nce

I l lus t ra t ion 5 - Dep osi t Ac cou nt ing

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A g g r e g a t e S t o p - L o s s Illustration 1

B a c k g r o u n d :

C o v e r a g e P e r i o d : 1/1/03-12/31/05Subjec t prem ium : $50,000,000S t op - lo s sattac hme nt point: 75%Limit: 10%C o v e r a g e : 10% XS 75%

or $5M X S $37.5MIntere st credit: 4.25%Com m utat ion provision: cedant will receive 100% of experience accountbalance if comm utation occurs after the end of the exposure period (i.e.,1/1/06or later).

l l 0

1008 0 9 0 i i ii ilii iliiii:i ilil il il iiiil, i ii ii i

70 - -

60 - -

50 - -

A40 -

30 - -

20 - -

10 - -

0

A = retained by AB C below th e stop-loss attachment p oint loss ratio o f 75%B = assumed by XY Z; loss ratio layer from 75% to 85%C = retained by ABC a bove the stop-loss ratio limit of 85%

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Finit e Quota Share Illustration 2

Background: ABC would like to reduce its premium lever age in order to expand its volume. ABC

enters into a quota share with XYZ in the fol lowing scenario:

Quota share percentage: 50%Expected loss ratio: 65%Aggregate limit loss ratio: 110%Expected expense ratio: 30%Cedingcommission:

minim um at 60% loss ratio 39%minim um at 80% loss ratio 19%

110

100

90

80

70

60

50

40

30

20 -

10

0

A

'lllll,li A = 50% share retain ed by ABCB = 50% assumed by XYZ for loss ratio < 60%, ceding commi ssion = 39%C = 50% share assumed by XYZ wi th sliding scale ceding commissio nD = loss ratio corridor from 80% to 90%, retained by ABCE = 50% share assumed by XYZ for loss ratio from 90% to 110% (aggregate limit)

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M o n i t o r i n g L o ss E m e r g e n c e - R e p o r t i n g S p e e d - U p I l lus t ra t ion 3 A

N om in a l U l t . 100 ,000 ,000

CalendarYear

E x p e c te d L o s s P a y o u t a n d E x p e r i e n c e A c c o u n t B a l a n c e

Payou t Pa t te rn In te res t Losses% $ Credi t a t 5% Paid

Exp. Acct .Balance

01 15.0%2 2 5 .0%3 2 5 .0%4 10.0%5 1o . o%6 10 .0%7 5 .0%

Tota l 100 .0%

Presen t Va lu e o f Exp ec t ed Lo s s

85 ,635 ,23815,000 ,000 4 ,281 ,762 (15 ,000 ,000) 74 ,917 ,00025,000 ,00 0 3 ,745 ,850 (25 ,000 ,000) 53 ,662 ,85025,000 ,00 0 2 ,683 ,143 (25 ,000 ,000) 31 ,345 ,99310,000 ,000 1 ,567 ,300 (10 ,000 ,000) 22 ,913 ,29210,000 ,000 1 ,145 ,665 (10 ,000 ,000) 14 ,058 ,95710,000 ,000 702 ,948 (10 ,000 ,000) 4 ,761 ,905

5,000 ,000 238 ,095 (5 ,000 ,000) 0100 ,000 ,000

85,635 ,238

CalendarYear

A c t u a l L o s s P a y o u t a n d E x p e r i e n c e A c c o u n t B a l a n c e

Payou t Pa t te rn In te res t Losses% $ Credi t a t 5% Paid

Exp. Acc t .Balance

01 25 .0% 25 ,000 ,00 0 4 ,281 ,762 (25 ,000 ,000)2 30 .0% 30 ,000 ,000 3 ,245 ,850 (30 ,000 ,000)3 30 .0% 30 ,000 ,000 1 ,908 ,143 (30 ,000 ,000)4 10 .0% 10 ,000 ,000 503 ,550 (10 ,000 ,000)5 5 .0% 5 ,000 ,000 28 ,727 (5 ,000 ,000)6 0 .0% 0 NA 07 0 .0% 0 NA 0

Tota l 100 .0% 100,000 ,000

85,635 ,23864,917 ,00038,162 ,85010,070,993

574,542(4,396,731)

N AN A

C o m m e n t s : W hen the pay out pa t te rn i s accele ra ted , the exper ience acc ount i s exhau s ted before a l lc la ims a re se tt l ed . Th e re insurer i s st i ll ob l iga ted to pay the rema in ing $4 .4 mi l l ion and thus incu rsa net loss for this deal .

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M o n i t o r i n g L o ss E m e r g e n c e - R e p o r t in g S l o w d o w n I l lustrat ion 3B

No mina l Ul t . 100 ,000 ,000

CalendarYear

E x p e c te d L o s s P a y o u t a n d E x p e r i e n c e A c c o u n t B a l a n c e

Payou t Pa t te rn In te res t Losses% $ Credi t a t 5% Paid

Exp. Acct .Balance

01 15.0%2 25 .0%3 25 .0 %4 10 .0%

5 10 .0%6 l 0 .0%7 5 .0%

Tota l 100 .0%

Presen t Va lue o f Expec t ed L os s

85 ,635 ,23815,000 ,000 4 ,281 ,762 (15 ,000 ,000) 74 ,917 ,00025,000 ,00 0 3 ,745 ,850 (25 ,000 ,000) 53 ,662 ,85025,000 ,00 0 2 ,683 ,143 (25 ,000 ,000) 31 ,345 ,99310,000 ,000 1 ,567 ,300 (10 ,000 ,000) 22 ,913 ,292

10,000 ,000 1 ,145 ,665 (10 ,000 ,000) 14 ,058 ,95710,000 ,000 702 ,948 (10 ,000 ,000) 4 ,761 ,9055,000 ,000 238 ,095 (5 ,000 ,000) 0

100 ,000 ,000

85 ,635 ,238

CalendarYear

A c t u a l L o s s P a y o n t a n d E x p e r i e n c e A c c o u n t B a la n c e

Payou t Pa t te rn In te res t Losses% $ Credi t a t 5% Paid

Exp. Acc t .Balance

01234567

Tota l

85 ,635 ,23815.0% 15 ,000 ,000 4 ,281 ,762 (15 ,000 ,000) 74 ,917 ,00020 .0% 20 ,000 ,000 3 ,745 ,850 (20 ,000 ,000 ) 58 ,662 ,85020.0% 20 ,000 ,00 0 2 ,933 ,143 (20 ,000 ,000) 41 ,595 ,99315.0% 15 ,000 ,000 2 ,079 ,800 (15 ,000 ,000) 28 ,675 ,79210.0% 10 ,000 ,000 1 ,433 ,790 (10 ,000 ,000) 20 ,109 ,58210.0% 10,000 ,000 1,005,479 (10,00 0,000 ) 11,115,06110.0% 10 ,000 ,000 555 ,753 (10 ,000 ,000) 1 ,670 ,814

100.0% 100,000 ,000

C o m m e n t s : W hen th e p ayou t pa t t e r n i s s l owe r t han expec t ed , t he re i s a pos i t i ve expe r i ence accoun tba lanc e wh en a l l c la im s a re se t tl ed . Th is i s p rof i t tha t wi l l typ ica l ly be re turned to the cedant . Inm any cases , the cedant wi l l com m ute the cont rac t in order to recognize th i s ga in pr ior to thef ina l c la im se t t l ement .

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Retroact ive Reinsuran ce I l lus t ra t ion4

Background: AB C Insurance Com pany (A BC) w ould l ike to ge t surplus re l ie f v ia a loss por t fo l iot ransfer to X YZ R einsurance Com pan y (X YZ ) effec t ive 12/31/03. AB C chose to t ransferthe reserves for it s book of accountants profess ional l iab i l ity, whic h i t has been running of fs ince exi t ing tha t market . At 12/31/03, the undiscounted unpaid losses for th is book w ere$100.0 m i l l ion .

Prior to effectin g the LPT , total assets are $1.25 bil l ion, total loss reserv es are $1.0 bil l ion.Ass um e no balance sheet ac t iv i ty o ther than the LP T and i t s runoff .

Expected payout pat tern:

Calend ar Yea r 2004 2005 2006 2007 2008 2009 2010% Paid 15% 25% 25% 10% 10% 10% 5%

PV a t 5% (mi l l i ons ) $85.6

Reinsurance p remium: $90.0

Ceding Ent i ty Account ing:

12/30/03 Pr ior to LPT)

Asse t s Liabi l i ties , Surplus , and Oth er Fu nds

Cash $1,250.0 Unp aid lossPol icyholdersurplus

1,000.0250.0

12/31/03 Subse quent to LPT)

Assets Liabi l i ties , Surplus , and Oth er Fund s

Cash $1,160.0 Unp aid loss $1 ,000.0

Retro re insurance cede d (100.0)Totall iabil i t ies $900.0

Specia l surplus f rom re t ro re $10.0Una ss igned surplus 250.0

Pol icyholdersurplus $260.0

C o m m e n t s :1 )

(2)

Cash d ec reases by the amoun t o f t he LPT p remium ($90.0 m i l l ion ) wh i l e l i ab il i ti e s dec reaseby the a mou nt o f the t ransfer red reserve ($100.0 m i l l ion) .Th e ceda nt cannot ga in f rom the surplus re l ie f unt il the losses pa id / re im bursed ex ceed theconsidera t ion paid to the re insurer. As a resul t , the surplus ga in ($10.0 m i l l ion) i s res t r ic ted andrecorded as "specia l surplus f rom re t roac t ive re insurance ."

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R e t r o a c t i v e R e i n s u r a n c e I l lus t ra t ion4(Continued)

. . . 12 /31 /08

Assets Liabil i t ies, Surplus, and O ther Fund s

Cash $1,160.0 Unpaid loss $915.0Retro reinsuranc e ceded (15.0)Totall iabil i t ies $900.0

Special surplus from retro re $10.0Unass igned surplus 250.0Pol icyholdersurplus $260.0

1 2 / 3 1 / 0 9

Assets Liabil i t ies, Surplus, and O ther Funds

Cash $1,160.0 Unpa id loss $905.0Retro reinsuranc e ceded (5.0)Totall iabil i t ies $900.0

Special surplus from retro re $5.0Unass igned surplus 255.0Pol icyholdersurplus $260.0

12 /31 /10

Assets Liabil i t ies, Surplus, and O ther Fund s

Cash $1,160.0 Unpaid loss $900.0Retro re insurance ceded 0 .0Totall iabil i t ies $900.0

Special surplus from retro re $0.0Unass igned surplus 260.0Pol icyholdersurplus $260.0

C o m m e n t s :

(1)

(2)

(3)

As o f 12/31/08, $85.0 m il l ion of the $100.0 mil l ion t ransferred has been paid . This does notexceed the LP T premium , so the $10.0 m il l ion of surplus re l ief is s t i ll rest r ic ted .As of 12/31/09, $95.0 m il l ion of the $100.0 mil l ion t ransferred has been paid . The$5.0 m ill ion of transferred loss st il l to be paid is restricted surplus; the rem ainin g $5.0 mill ionof the $10.0 mil l ion of surplus re l ief i s earned as unass igned surplus.

As of 12/31 / 10, a ll t ransferred l iabi li t ies have been paid a nd the ful l $10.0 m il l ion of re l ief hasbeen earned.

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Depos i t Acco un t i ng Illustration 5

Background: XYZ Re provides excess-of-loss coverage to ABC Primary Insurance Company. XYZ will

not begin to reimburse ABC until 2 years from the effective date o f the contract.

Expected Loss : 50,000,000 (initial)51,000,000 (revised at end of year 1)

Expected Payout : Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 70% 0% 25% 30% 30% 10% 5%

Premium:

XY Z A cc oun t ing :

Comments:

40,399,180 (present value at 5% of initial expected loss)

Interest Cash DepositExpense Payment LiabilityInitial liability 40,399,180Y1 interest at 5% 2,019,959 42,419,139EOYI 0 42,419,139Upward Revaluation 1,000,000 43,419,139Y2 interest at 3.81% 1,614,448 45,033,587EOY2 0 45,033,587Y3 interest at 3.81% 1,713,952 46,747,539EOY3 (12,750,000) 33,997,539Y4 interest at 3.81% 1,779,184 35,776,723EOY4 (15,300,000) 20,476,723Y5 interest at 3.81% 1,361,641 21,838,364EOY5 (15,300,000) 6,538,364Y6 interest at 3.81% 831,155 7,369,520EOY6 (5,100,000) 2,269,520Y7 interest at 3.81% 280,480 2,550,000EOY7 (2,550,000) 0

(1) Due to the 2-year delay before payments by XYZ, this deal does not transfer timingrisk and therefore requires deposit accounting.

(2) XYZ initially records a liability equal to the consideration paid by ABC.(3) Each year, unwinding o f discount is reflected as interest expense on the income statement

and as an increase to the deposit liability on the balance sheet.(4) At the end of Year 1, the estimated subject losses are revised upward by $1,000,000.

This is reflected as interest expense to XYZ and also as an increase to the deposit liability.In addition, the effective yield is revised from 5% to 3.81% to reflect the expect timingand amount of future payments. The effective yield is calculated so that the liability declilto $0 at the same time as the final loss payment is made.

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