Reinsurance agreements must contain the element of risk transfer where the reinsurer assumes significant insurance risk and may realize a significant loss from the transaction.
Situation and Facts: Dolby Insurance Company (“Dolby”) sells nonstandard auto policies. Dolby and Freedom Reinsurer (“Freedom”) executed a quota share reinsurance treaty. Under the treaty, Dolby cedes 50% of its losses and premiums, excluding policy fees, to Freedom. The provisional ceding commission is 30% at a 65% loss ratio. Sliding scale commission based on loss experience is as follows:
Dolby’s policy fees are approximately 6% of the written premium. As prescribed in the treaty, Dolby reports to Freedom ceded activity information within 30 days after the end of each month. Any balances due to Dolby, are paid by Freedom within 10 days of receiving the information. For every successful policy acquisition, Dolby pays 19% in commission expense, 2.35% in premium taxes, and 6% in policy fees. Defense and cost containment (“DCC”) is about 4% according to Dolby’s actuarial analysis. DCC ceded to Freedom is capped at 2% in accordance with the treaty.
Question: Does Dolby’s reinsurance contract with Freedom transfer risk in accordance with SSAP No. 62R, Property and Casualty Reinsurance?
Guidance: SSAP No. 62R, Property and Casualty Reinsurance
The essential element of a reinsurance agreement is the transfer of risk where the reinsurer indemnifies the ceding entity, not only in form but in fact, against loss or liability relating to insurance risk, which requires both of the following (SSAP 62R, paragraph 13):
- The reinsurer assumes significant insurance risk under the reinsurance agreement if both the amount and timing of the reinsurer’s payments depend on and directly vary with the amount and timing of claims settled by the ceding entity; and
- It is reasonably possible the reinsurer may realize a significant loss from the transaction.
Application: In order for there to be transfer of risk, Dolby must be indemnified by Freedom against loss or liability related to insurance risk. Let’s apply point 1 and 2 to the facts presented.
Point 1: The treaty meets point 1 of the guidance as policies covered are short tail and reimbursements from Freedom to Dolby are submitted within 10 days of reporting to Freedom. The facts presented do not indicate a delay in the timing of payments and amounts may vary depending on the turnout of the month.
Point 2: There must be a reasonable possibility of significant loss for Freedom for risk transfer to exist. Neither “reasonable possibility” nor “significant” loss is defined in the standard. Common industry practice is the “10/10 Rule” which indicates that a 10% chance for the reinsurer to sustain a 10% loss (relative to premium) then risk transfer exists. However, this rule has been criticized by the industry to be narrow with focus on losses only at the 90th percentile.
Expected Reinsurer Deficit
The Expected Reinsurer Deficit (ERD) method was developed to consider all loss outcomes. ERD measures the frequency of a reinsurer’s loss over a range of loss outcomes, including those beyond the 90th percentile. The formula for ERD is pT/P, where p is probability of net income loss; T is average severity of net economic loss, when it occurs; and P is expected premium.
To better illustrate the ERD method of calculating risk transfer, let’s incorporate the facts presented above. In accordance with the treaty, Freedom’s minimum required loss ratio is 75%. But how frequently does Freedom experience a 75% loss ratio and how severe is it?
By applying the average loss ratio and standard deviation to 500,000 loss scenarios using the NORMINV function in Excel, Freedom will experience a loss ratio of at least 75% at a rate of 6% (required loss ratio occurred 30,000 times, divided by 500,000 scenarios).
Average severity of the required loss ratio is computed by summing loss ratios equal to or greater than 75% divided by its frequency (30,000). In this example using the 500,000 scenarios, average severity of the required loss is at a rate of 80%, providing for an average loss severity of to Freedom of 60% (severity 80% x required loss ratio 75%).
Expected Reinsurer Deficit
ERD to Freedom is 3.6% (frequency 6% x average severity of loss 60%). ERD is greater than 1%, an indication of risk transfer.
Conclusion: In order for the reinsurance agreement to contain the element of risk transfer, both components of insurance risk must exist. The agreement between Dolby and Freedom passed both components of insurance risk. The amount and timing of payments depend on, and directly vary with, the amount and timing of claims settled and, based on the ERD analysis, it is reasonably possible that Freedom may realize a significant loss from the transaction. Absent the element or risk transfer, Dolby would need to account for the transaction under the deposit method.
This article follows the sequential order of SSAP 62R. However, in practice, the substantially all exception (paragraph 16) would be applied prior to evaluating the possibility of a significant loss (paragraph 13). Click here to learn more on the substantially all exception and its application.