Risk assumption vehicles offer insurance companies two options: transferring risk to a reinsurer or reacquiring risk from a separate entity. The processes used to evaluate the loss liability within a risk assumption transaction are the same regardless of the vehicle type. However, uncertainty that surrounds any insurance transaction and the price assigned to that unknown element are unique to each agreement.
In the article “Risk assumption vehicles: To take or to transfer” Milliman’s Chris Kogut provides perspective on how an actuarial analysis can assist in pricing a risk assumption transaction. Here is an excerpt:
… 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.