Risk assumption vehicles: To take or to transfer

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By Jessica Lasher, Christine K. Kogut | 12 February 2014

This article was originally published in the Spring 2014 issue of The Examiner by the Society of Financial Examiners (SOFE).

Risk assumption vehicles include loss portfolio transfers (LPTs), novations, and commutations, which enable property and casualty insurance companies to cede or assume obligations that have already been incurred on an insurance policy or reinsurance agreement. On the ceding side, the insurer can eliminate the volatility associated with open claims and claims incurred but not yet reported for long tail lines of coverage, remove undesirable exposures, improve solvency, reduce collateral requirements, and lower administrative costs. On the assuming side, an insurer can expand into new or specialized lines of business, or diversify underwriting exposure.

Each vehicle has distinct advantages depending on the circumstances, but, in general, the type of assumption agreement used in a transfer typically depends on a company’s business needs and future goals, the parties involved in the agreement, and the nature of the exposure being transferred.

Characteristics of risk assumption vehicles

Risk assumption transactions typically involve three parties:

  • The policyholder or insured risk (Company A)
  • Company A’s current insurer and the party that is considering ceding the risk (Company B)
  • The (re)insurer that is considering assuming Company A’s risks from Company B (Company C)

Loss portfolio transfers

A LPT is a reinsurance transaction in which loss obligations that have already been incurred and will ultimately be paid are ceded to a (re)insurer. It is a two party agreement that does not require policyholder/insured consent. Under a LPT, Company C assumes the risk from Company B without Company A being notified. Similar to most reinsurance transactions, the original policy issuer transferring the exposure remains liable for the incurred losses in the event that the assuming entity fails to honor its contractual obligations. The absence of policyholder/insured consent can often make a LPT easier to execute and more attractive to assuming entities. As such, pricing of LPTs is often more advantageous than a comparable novation agreement. LPTs can be a great option for insurance entities that want to exit a particular line of business or geographic area, improve underwriting results, or increase surplus.

Novation

A novation agreement cancels and rewrites a contract by replacing one party to an insurance policy or reinsurance agreement with another party. In a novation, Company C assumes the risk from Company B but must also obtain the consent of Company A. Unlike a LPT, a novation agreement extinguishes all future liabilities associated with the novated contracts. Therefore, the company transferring the risk is not liable for future losses in the event that the assuming company is unable to fulfill its obligation. Company C steps into the shoes of Company B. The full and complete transfer of liabilities can be an important benefit for companies that intend to wind up operations in an efficient and cost effective manner. Managing the conflicting interests of the multiple unaffiliated parties, regulatory concerns, and licensing requirements for the assuming entity can make novation agreements costly and difficult to execute.

Commutation

Commutation agreements discharge future liability associated with an insurance policy or reinsurance agreement, thus eliminating the (re)insurer’s future exposure. In a commutation, there are two possible situations. Company A assumes the risk “back” from Company B, and there is no Company C. This may be the case where an insured has a policy with their captive, and decides to dissolve the captive and self-insure the coverage. Alternatively, Company C could be a reinsurer on the risk, and Company B commutes, or assumes back, the risk ceded to Company C.

Commutations are often utilized to remove a financially troubled reinsurer from a program or terminate pooling arrangements to reduce administrative costs when pooling years have become mature and more predictable. Commuting commercially insured liabilities to place into a captive program can be advantageous in certain markets.

In general, LPTs and novations move risk down a “new path,” whereas commutations send the risk “back to where it came from.” The appropriateness of a specific vehicle may overlap in several circumstances, and the best option may come down to the inclination of the market.

Pricing

While the mechanics used to evaluate the loss liability within a risk assumption transaction are the same regardless of the vehicle type, the uncertainty that surrounds any insurance transaction and the price assigned to that unknown element are unique to each agreement. The motivation surrounding the deal and the parties involved will determine the nature of the terms and the process.

The scope of liabilities such as lines of business, policy years, and limits of coverage included within the transaction needs to be narrowly defined. Essentially, the assuming entity will be responsible for paying the remaining unpaid liabilities transferred by the ceding entity. The cash paid at some point in the future to a claimant, and timing of those payments, are two significant unknowns in the valuation of risk assumption pricing.

An actuarial analysis provides estimates of these future payments by gathering and applying actuarial assumptions and loss development patterns to the loss data. These development patterns provide insight into the amount and timing of estimated future loss payments. Actuaries use historical loss payments and case reserves established by adjustors as the foundation for these estimates. The claims adjustor evaluates facts about the claim that are available today and the actuary considers the facts that the adjustor will learn tomorrow.

Future liability depends heavily on the underlying characteristics of the risk. For instance, property losses tend to be settled relatively quickly, and do not have much development, whereas workers compensation claims can stay open and have development and payments over 20 years. Long tail business is more typically the target of risk assumption agreements than short tail lines. Future liability as represented by claim behavior is very specific to claimant, industry, and injury/disease, and future claim costs can be influenced by medical costs, legal representation, inflation, and claim handling. Often, the actuary relies on specific company historical loss experience, general insurance industry assumptions, or some combination thereof to quantify the future loss dollars.

The liabilities subject to risk assumption vehicles typically tend to involve more “mature” claims in policy years that have expired many years in the past. Less uncertainty surrounds the risk, and claim development is relatively minor because the claim adjustor has years of data on the claim, which provide more insight into the potential settlement value. Albeit, the settlement amount is not fully known until the claim is closed—and does not reopen.

In some mature policies, the number of open claims is minimal, allowing individual claims to be evaluated separately. This process includes a review of each claim to quantify the uncertainty on individual claim aspects, and more generally involves an analysis that focuses on the group of open claims. This detailed analysis of the potential outcome of each open claim is much different than the traditional reserve analysis performed at least annually by the actuary.

If less mature policy years or in-force policies are part of risk assumption agreements, the uncertainty of the actuarial estimates is significantly increased. Further, an individual claim review would prove impractical with a vast number of open claims. In all situations, regardless of the age of the claim, the risk assumption transaction is implicitly trading uncertainty for certainty.

The cost of a risk assumption transaction—or premium—is the amount exchanged for the risk. While it can include many components, it is, at its core, the estimated amount of money that will be paid out after the transaction date to claimants. This amount is subject to certain, and sometimes vastly different, assumptions on the part of the ceding and assuming companies that are negotiating to find common ground regarding the pricing of that risk. The negotiations include sharing assumptions for future claim activity and often involve scenario testing, which allows the parties to isolate a range of estimates that are further refined through negotiation.

Under certain circumstances, it may be prudent to not only consider a range of reasonable results, but also the range or probability of all possible results. This additional consideration can give an indication of the maximum amount of future payments reasonably expected under the agreement. One approach is to isolate each open claim, and consider the amount of the claim limit that has not been exhausted by past payments. This analysis results in the true maximum amount of future payout and eliminates nearly all uncertainty, assuming no additional future reopened claims or late reported claims develop. Having this number in hand may help in not only deciding whether or not to enter into the agreement, but also in considering the appropriateness of transaction premium that nears or exceeds this amount.

The premium in a risk assumption agreement is typically paid or received in a lump sum on the transaction date, but the liabilities are paid at various points in the future. This situation raises the question of the time value of money or discounting. Premium dollars collected can be invested and earn interest before that money has to be released in the form of claim payments. The premium has an opportunity cost. The transaction should consider the time value of money by allowing the discounting of future payments. Therefore, the timing of future payments will be estimated and a discount rate will be applied. Discounting will be another negotiating factor to the agreement.

Discount rates can be based on the current interest rate environment, hurdle rates, cost of capital, or even a duration matching approach. One approach that may help focus the discussion is scenario testing, which similar to the technique used to develop future payment amounts, can provide a range of payout patterns and demonstrate the sensitivity of various interest rates on the results.

A methodical evaluation can provide an essential framework for discussion, but at the end of the day, what will be paid, when it will be paid, and how much of a discount is applied is a negotiation that can be contentious or fairly amiable, as in the case of affiliated parties.

Sealing the deal

Drawing up a contract that has clear and concise language on the release of future liabilities is an essential first step. The appropriate due diligence on the legal aspects of the transaction is nearly as important as the negotiations.

Sealing the deal also has a regulatory component. The degree of oversight will vary depending on each state’s requirements. In general, disclosure can be made by notifying the state (if required) and including financial details of the transaction in financial statements by some or all parties.

Often, the nature of regulatory approvals depend on the type of entity. Reinsurers typically are not subject to any approvals; traditional insurance companies are only required to disclose financial information; and captive insurance companies generally need to notify the state of the transaction and receive approval before it is executed. Before even considering a risk assumption option, the initiating party must understand the statutory implications.

Avoiding the pitfalls

Any limitation in obtaining accurate current data on historical claims will hamper the determination of future risks and greatly constrain the usefulness of the company specific assumptions in determining claim development.

The need to time stamp data also poses a challenge. Time stamping is needed because claim information flows into the claims handling process on a continuous basis, but an actuarial analysis for assessing unpaid claim liabilities is performed using financial and claims detail at a specific date (i.e., the evaluation date). Often, this work takes time to complete, and negotiations may rely on numbers that are a few months “stale.” For example, a transaction may be based on data as of September 30th for negotiations that take place in November. It is therefore important to consider the subsequent movement of claims experience as part of the negotiations by either unwinding payments after the evaluation date as an additional part of the financial agreement, by making the transaction contingent on a follow-up review of the claims data, or incorporating some other method to recognize subsequent changes in risk.

Some groups have an additional hurdle to overcome: obtaining agreement from their members. And while members are not specifically engaged in the transaction, some may have input into the outcome. Reaching an agreement with one party is typically hard enough, but seeking consensus with perhaps dozens of members greatly compounds the difficulty of the transaction. In general, the more seats at the table, the harder it is to reach an agreement.

Special considerations may also need to be given to certain lines of business (such as workers compensation) that have specific statutory requirements. For these lines, there may be limitations to the extent that a company can completely extinguish its liabilities. Specifically, the transaction may be less straightforward when an injured worker does not receive entitled benefits. Statutory and legal review at the onset is prudent for agreements involving statutorily protected lines of business.

While the articulation of clear and concise objectives and open communication between all parties can help circumvent these pitfalls, there is no better safeguard than advance planning. Such planning should ideally take place before the transaction is a twinkle in one’s eye. In practice, this would take the form of an exit strategy that was put in place at inception when the terms of the underlying contract were determined. This is most notable for group or pooling situations, where parties may recognize that their initial risk arrangement may not last indefinitely. Under this circumstance, having an exit plan is prudent and can be anticipated by tailoring the treaty participation agreement to acknowledge the “potentially temporal juncture.” Some agreements may specify the number of years at which point the commutation would be allowed or even required. Some of the awkwardness of negotiating the commutation can be reduced by including a price based on an independent third party’s actuarial analysis in the initial contract’s language with pre-agreed terms.

Accounting

Generally accepted accounting principles (GAAP) in the United States provide limited guidance for the accounting treatment of risk assumption agreements. As such, some divergence in practice has developed in the recognition of these transactions in the financial statements.

Assuming entities generally identify proceeds received from LPTs and novations as premium, and the losses assumed are recognized as loss reserves on the balance sheet with an offsetting losses incurred amount recorded on the income statement. Typically, gains resulting from the transaction are deferred and amortized over the underlying expected claim settlement period, and any loss would be recognized immediately.

Entities ceding an LPT generally maintain the original liability on their balance sheet and establish an offsetting reinsurance receivable. If recorded liabilities exceed the amounts paid, reinsurance receivables need to be increased to reflect the difference. Any resulting gain is deferred and amortized over the expected remaining settlement period of the underlying claims. However, if the amount paid exceeds the recorded liability, the ceding company should increase the related liabilities or reduce the reinsurance receivable or both at the time the reinsurance contract is entered into, so that the loss is immediately reflected in a company’s earnings. Due to the ceding company’s continued obligation to the policyholder (Company A), the ceding (transferring) company (Company B) needs to continue to track and report the claims activity and associated receivable until all claims are settled. Depending on the size of the LPT and types of exposures, this tracking could require ongoing actuarial analyses and continued testing of the LPT liabilities and associated claims activity as part of the company’s financial statement audit for many years.

Under a novation agreement, however, the transferring company (Company B) completely removes the total amount of novated liabilities from its balance sheet, because these obligations are fully extinguished. As such, any premium paid to novate liabilities is effectively treated as claims payments, and fully settles the associated liabilities. Any resulting gain or loss is recorded as a component of incurred losses or as a separate line item on the income statement in the period the novation takes place. Gains are not amortized over the payment pattern of the novated liabilities due to the transferring company’s full extinguishment of debt associated with the novation.

Proceeds paid by a ceding (transferring) company as part of a commutation agreement are netted against incurred losses transferred, and the net gain or loss is recognized on the income statement or as a component of incurred losses. The proceeds paid are not typically reflected as a component of premium. Similar to novation agreements, gains are not amortized over the life of the commuted liabilities by the transferring entity due to the fact that the transferring entity has fully extinguished its obligation associated with the commuted claims.

Conclusion

There are indeed a myriad of accounting, actuarial, and regulatory details that go into making a risk assumption agreement a successful venture for a company. Careful consideration and analysis needs to play an essential part of a company’s due diligence. Understanding the nuances of the different risk assumption vehicles can smooth the road for a company but the direction—whether it’s a LPT, novation, or commution—must be driven by a company’s risk tolerances and strategic objectives. Only then can the unique benefits of a risk assumption agreement truly flow to a company.