Swing Rated Premium Example

Swing Rating Terms:

Ceded premium is
adjusted to equal to a 3%
minimum rate + ceded
loss times 1.1 loading
factor, subject to a
maximum rate of 15%
Use the aggregate
distribution to your right
to calculate the ceded loss
ratio under the treaty

Band of Burns
Low
High
Average Probability
0.0%
0.0%
0.0%
9.0%
0.0%
2.5%
1.3%
6.0%
2.5%
5.0%
3.8%
9.0%
5.0%
7.5%
6.3%
10.2%
7.5% 10.0%
8.8%
11.4%
10.0% 12.5% 11.3%
15.0%
12.5% 15.0% 13.8%
12.0%
15.0% 17.5% 16.3%
9.0%
17.5% 20.0% 18.8%
7.8%
20.0% 25.0% 21.9%
6.0%
25.0% 50.0% 30.3%
4.8%

Swing Rated Premium Example

- Solution

Annual Aggregate Deductible

The annual aggregate deductible (AAD) refers to a

retention by the cedant of losses that would be

otherwise ceded to the treaty
Example: Reinsurer provides a $500,000 xs $500,000
excess of loss contract. Cedant retains an AAD of
$750,000
Total Loss to Layer = $500,000. Cedant retains all
$500,000. No loss ceded to reinsurers
Total Loss to Layer = $1 mil. Cedant retains
$750,000. Reinsurer pays $250,000.
Total Loss to Layer =$1.5 mil. Cedant retains?
Reinsurer pays?

Annual Aggregate Deductible

Discussion Question: Reinsurer writes a $500,000
xs $500,000 excess of loss treaty.
Expected Loss to the Layer is $1 million (before
AAD)
Cedant retains a $500,000 annual aggregate
deductible.
Cedant says, I assume that you will decrease
your expected loss by $500,000.
How do you respond?

Annual Aggregate Deductible

Example
Your expected burn to a

Band of Burns
Low
High
Average Probability
0.0%
0.0%
0.0%
9.0%
0.0%
2.5%
1.3%
6.0%
2.5%
5.0%
3.8%
9.0%
5.0%
7.5%
6.3%
10.2%
7.5%
10.0%
8.8%
11.4%
10.0%
12.5% 11.3%
15.0%
12.5%
15.0% 13.8%
12.0%
15.0%
17.5% 16.3%
9.0%
17.5%
20.0% 18.8%
7.8%
20.0%
25.0% 21.9%
6.0%
25.0%
50.0% 30.3%
4.8%
Prob Wtd Avg:
11.1%

$500K xs $500K
reinsurance layer is
11.1%. Cedant adds an
AAD of 5% of subject
premium
Using the aggregate
distribution of burns to
your right, calculate the
burn net of the AAD.

Annual Aggregate Deductible

Example - Solution
Annual Aggregate Deductible as % of SPI:

5.0%

Band of Burns

Low
High Average Probability
0.0% 0.0%
0.0%
9.0%
0.0% 2.5%
1.3%
6.0%
2.5% 5.0%
3.8%
9.0%
5.0% 7.5%
6.3%
10.2%
7.5% 10.0%
8.8%
11.4%
10.0% 12.5% 11.3%
15.0%
12.5% 15.0% 13.8%
12.0%
15.0% 17.5% 16.3%
9.0%
17.5% 20.0% 18.8%
7.8%
20.0% 25.0% 21.9%
6.0%
25.0% 50.0% 30.3%
4.8%
Prob Wtd Avg:
11.1%

Savings
from
AAD
0.0%
1.3%
3.8%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
5.0%
4.2%

Burn
Net of
AAD
0.0%
0.0%
0.0%
1.3%
3.8%
6.3%
8.8%
11.3%
13.8%
16.9%
25.3%
6.8%

Limited Reinstatements
Limited reinstatements refers to the number of times

that the risk limit of an excess can be reused.

Example: $1 million xs $1 million layer
1 reinstatement: It means that after the cedant uses
up the first limit, they also get a second limit
Treaty Aggregate Limit =
= Risk Limit x (1 + number of Reinstatements)

Limited Reinstatements
Example
$1 million xs $1 million layer
1 reinstatement
Simulated Year 1
Individual Ceded
Losses Loss
$000's $000's
2,000
1000
2,000
1000
2,000
0

Simulated Year 2 Simulated Year 3

Individual Ceded Individual Ceded
Losses Loss Losses Loss
$000's
$000's $000's
$000's
3,000 1000
3,000
?
1,500
500
1,500
?
1,500
500
1,500
?
2,000
?

Reinstatement Premium
In many cases to reinstate the limit, the cedant

is required to pay an additional premium

Choosing to reinstate the limit is almost always
mandatory

Reinstatement premium should simply be

viewed as additional premium that reinsurers
receive depending on loss experience

Reinstatement Premium
Example 1

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Reinstatement Premium
Example 2
$1 million xs $1 million layer
2 reinstatements: 1st at 50%, 2nd at 100%.
Upfront Ceded Premium = $250,000
Simulated Year 1
Simulated Year 2
Simulated Year 3
Individual Ceded Reinst Individual Ceded Reinst Individual Ceded Reinst
Losses Loss
Prem Losses Loss Prem Losses Loss Prem
$000's
$000's $000's $000's $000's $000's $000's $000's $000's
3,000
1,000
125
1,500
500 62.5
1,250
?
?
2,000
1,000
250
1,500
500 62.5
2,000
?
?
2,000
1,000
1,500
500 125.0
2,000
?
?
2,000
-

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Reinstatement Example 3

Reinsurance Treaty:
$1 mil xs $1 mil
Upfront Premium = 400K
2 Reinstatements: 1st at 50%,
2nd at 100%
Using the aggregate
distribution to the right,
calculate our expected
ultimate loss, premium, and
loss ratio

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Reinstatement Example 3
Solution

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Reinstatement Example 4

Note: Reinstatement provisions are typically found on high

excess layers, where loss tends to be either 0 or a full limit
loss.
Assume: Layer = 10M xs 10M, Expected Loss = 1M, Poisson
Frequency with mean = .1

Upfront Premium = 1.2M

1 Reinstatement at 50%
# of
Expected
Loss Net of
Reinst
Total
Clms
Prob
Loss (000's) Reinst Limit Premium Premium
0 90.48%
0
0
0
1,200
1
9.05%
10,000
10,000
600
1,800
2
0.45%
20,000
20,000
600
1,800
3
0.02%
30,000
20,000
600
1,800
4
0.00%
40,000
20,000
600
1,800
5
0.00%
50,000
20,000
600
1,800
Prob Wtd Avg
100.0%
1,000
998
57
1,257
Projected Loss Ratio:
79.5%
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Deficit Carry forward

Treaty terms may include Deficit Carry forward Provisions,

in which some losses are carried forward to next years

contract in determining the commission paid.
Example:

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Deficit Carry forward Example

Solution - Shift Sliding Scale Commission
terms.

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DCF/Multi-Year Block

Question: How much credit do you give an account for

Deficit Carry forwards, other than using the CF from the
previous year (e.g. unlimited CFs)?

Can estimate using an average of simulated

years, but this method should be used with caution:
Assumes independence (probably unrealistic)

Accounts for both Deficit and Credit carry forwards

Deficits are often forgiven, treaty terms may change, or
treaty may be terminated before the benefit of the deficit
carry forward is felt by the reinsurer.
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DCF/Multi-Year Block - Example

Average LR
Std Dev
Avg Comm

Year 1
71.52%
9.98%

Year 2
71.39%
9.95%

Year 3
71.69%
10.08%

3-Year
Block
71.54%
5.84%

28.25%

28.28%

28.20%

27.39%

69.62%
67.96%
77.54%
73.85%
88.54%
55.43%
67.49%
71.83%
63.93%
75.92%

69.42%
63.91%
71.13%
58.66%
91.61%
79.21%
78.55%
78.42%
59.58%
70.11%

52.09%
68.91%
74.77%
46.96%
72.24%
65.86%
80.54%
73.05%
47.51%
72.82%

63.71%
66.93%
74.48%
59.82%
84.13%
66.83%
75.53%
74.43%
57.01%
72.95%

Simulation
1
2
3
4
5
6
7
8
9
10

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Technical Summary
Modeling loss sensitive provisions is easy.
Selecting your expected loss and aggregate
distribution is hard
Steps to analyzing loss sensitive provisions
Build aggregate loss distribution
Apply loss sensitive terms to each point on
the loss distribution or to each simulated year
Calculate probability weighted average of
treaty results

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Additional Issues & Uses of

Aggregate Distributions
Correlation between lines of business
Reserving for loss sensitive treaty terms
Some companies Use aggregate distributions to measure

risk & allocate capital. One hypothetical example:

Capital = 99th percentile Discounted Loss x Correlation
Factor
Fitting Severity Curves: Dont Ignore Loss Development
Increases average severity
Increases variance claims spread as they settle.
See Survey of Methods Used to Reflect Development in
Excess Ratemaking by Stephen Philbrick, CAS 1996
Winter Forum

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Risk transfer

FASB 113: A reinsurance contract should be booked using

deposit accounting unless:
The reinsurer assumes significant insurance risk
Insurance risk not significant if the probability of a
significant variation in either the amount or timing of
payments by the reinsurer is remote
It is reasonably possible that the reinsurer may realize a
significant loss from the transaction.
10/10 Rule of Thumb: Is there a 10% chance that the
reinsurer will have a loss of at least 10% of premium on
a discounted basis
Calculation excludes brokerage and reinsurer
internal expense.
SFAS 62 governs statutory accounting. Requirements are
similar to FASB 113.
Recent regulator concerns have centered on pro-rata
reinsurance.

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Risk Transfer Recent

Developments

New York State Draft Bifurcation Proposal:

Bifurcation applies to any pro-rata treaty that contains one
of the following features: profit commissions, sliding scale
commissions, loss ratio corridors or caps, occurrence limits
below an unspecificed % of premium, etc.
Excess of loss and facultative contracts are excluded
If above conditions are met, premium must be split as
follows:
Premium covering exposure in excess of the 90 th
percentile of the loss distribution counts as reinsurance.
The remaining premium should be booked as a deposit.
Rule would be applied retroactively to business written
1/1/94 and later.
Appears unlikely that NAIC will approve this proposal, but
proposal emphasizes regulators concerns.

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Concluding Comment
Aggregate distributions are a critical element in

evaluating the profitability of business.

They are frequently produced by (re)insurers as a
risk management tool.
They are being used on a broader spectrum of
contracts to review risk transfer.
Some accountants and regulators seem to treat
these aggregate distributions as if they were gospel.
Critical to effectively communicate the difficulties in
projecting aggregate distributions of future results.
Need to make regulators and accountants
understand the degree of parameter uncertainty.

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