What Is Commutation Agreement in Reinsurance

While the general trend in a switch is to commute all the actual years of acceptance between the two parties, it is possible to commute for only one or two years through a so-called “lasering” transaction. This is almost always the norm in a long-term relationship between two financially solvent parties; Situations where the incentive to move is purely based on commercial considerations. For example, due to a strategic exit from a particular industry, a large public airline may only want to shut down for a few years of a long-term contract program with a major reinsurer. How do you explain a switch? PASS No 62R, Property and Casualty Reinsurance, paragraphs 73 to 76, provides for the accounting treatment of conversions. As a general rule, the party initiating a conversion should draft the first version of the operational conversion agreement to be provided in the agreement. Always work on an agreement that is beneficial for your position. It`s always a better negotiation trick to make changes outside of your standard agreement than trying to change an opponent`s agreement to fit your required choice of words. The following contractual characteristics must be taken into account in any agreement: General considerations Although it seems obvious, it is essential that all parties mutually agree on a date of entry into force of the conversion that serves as the basis for all valuation procedures, including, for example, the present value of reserves for attributed losses. The date must coincide with the natural course of the underlying activity.

For example, it should not be significantly affected by booking and reward renewal activities. The date may coincide with the anniversary of the contract year, but it may also vary. For 12/31 anniversary contracts, experience has shown that a 3/31 conversion date often works well, while a 6/30 or 9/30 date is often problematic given the high proportion of general premium bookings around this data. In this calculation, the assumptions used to determine IBNR reserves, discount losses and tax determination must be examined in detail. An in-depth analysis of switching should include a number of outcomes, as already mentioned with regard to estimates of the evolution of reserves, as well as a thorough examination of possible tax scenarios, including the holding of conferences and the potential impact of alternative minimum tax. Overview A reinsurance conversion is essentially a premature termination of a reinsurance contract in exchange for a mutually agreed consideration. The parties to the conversion intend to terminate the reinsurance contract and thus “reimburse” all reinsurance activities by a mutually agreed “expiry date”. After the completion of the conversion, there is no reinsurance coverage in progress and future risks are paid net to the transferor.

A new reinsurer may be called upon to manage the potential risks posed by a new reinsurance contract; However, this can be problematic due to market conditions and other factors. For example, if the underlying business is malfunctioning, the available replacement conditions may be onerous and/or restrictive. Sometimes an insurer – also known as a transferring company – decides that they no longer want to take a certain type of risk and no longer need to resort to a reinsurer. To withdraw from the reinsurance contract, the reinsurer must negotiate with the reinsurer, with negotiations leading to a conversion agreement. In the context of a reinsurer subject to regulatory intervention and insolvency, it is possible that a “preferential” transaction may be considered (a claim that a transaction such as a conversion between 90 and 180 days before the date of filing of insolvency is generally detrimental to creditors). The impact could be to reverse the agreement. While this is a very unusual risk, it needs to be looked at closely in the context of a fluctuating reinsurer. Here, too, time is of the essence. When everyone knows there is a problem, it is too late to act. Each of the two methods, if used appropriately, should lead to adequate estimates by the IBNR.

In most cases, it is recommended to make at least four different estimates of the IBNR reserve. Two Bornheutter-Ferguson estimates based on losses paid and received, and two Chain Ladder estimates based on the same data. The results of all these estimates should be considered together and any differences should be reconciled before a final estimate of the IBNR is made. If the IBNR estimate is challenged, the most likely candidates for further analysis would be the applicability of the expected loss ratio of the Bornheutter-Ferguson technique and/or the applicability of the loss development model selected from both techniques. These assumptions should reflect as much as possible the actual underlying activity, and using industry data in its place is often a bias for books with specific underwriting policies, significantly different pricing philosophies, or atypical case booking/claims handling practices. The choice of the discount factor should be relatively objective and based as far as possible on objective external data points. It should reflect current performance; However, it should also be an after-tax return specific to the company`s tax situation. It should also take into account any change in the tax situation that may be caused by the conversion itself.

Similarly, reinsurers should conduct a thorough review of the premium and claims processes as soon as possible. This detailed work is crucial at the beginning of the transformation cycle as it will profoundly affect the IBNR reserve estimation process and could help identify unfavorable trends and developments that are critical to the proper valuation of the transaction. This is an opportunity for the switching team to review in detail some of the underlying account files to better assess the assignor`s due diligence and claims handling procedures. Some of the questions to ask yourself are: In addition, the risk of counterparty default is implicit in any reinsurance transaction; A transferor immediately pays premiums to a reinsurer in the hope of receiving compensation for losses over time. For decades, this commercial expectation has been taken for granted; However, the environmental debacle of the late 1980s definitely changed that belief. In the 1990s alone, more than 20 companies left the London and international markets due to insolvencies. Domestic markets are also affected by catastrophic and latent losses, which have led to several insolvencies. Burdened by this trend of increasing insolvencies, the concept of reinsurance “security” has gained prominence, causing a “quality leak” that favors larger, better-capitalized reinsurers. Clearly, the best way to mitigate this inherent credit risk is to maintain proactive monitoring and controls to ensure that the most financially viable panel is used by reinsurers. For example, suppose Fred Insurance Company (“Fred”) has been in business for three years. Fred and Sally Reinsurer (“Sally”) have entered into a co-ownership agreement for 2014 and Fred is selling 50% of his business to Sally.

In the third year, Fred and Sally decide to separate. They agree on a conversion value of $900, which takes into account both the time value of the money and the expected future loss payments. Prior to the conversion, Fred gave Sally $1,000 in reserves. Sally`s reserve methods are 10% higher than Fred`s; As a result, Sally assumed reserves for losses of $1,100…

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