2015 Fall 26a: Gross-Net vs. Gross-Ceded
if big change in program
REINSURANCE PROGRAM: use B (if big change in program) [NOTE: answer is wrong in examiner's report]
Consideration would be given to the type and consistency of a company’s reinsurance programs
Isn't A: Gross - Net still correct as the ceded results would not necessarily be consistent - due to changes in program: Ceded results could be significantly different if big change to program. The NET may not change as substantially as ceded. A lot of unexpected results could occur due to this "big change".
net retention change is a specific example regarding coverage percentages of each company. Here the program terms and conditions are stable, but the limits/coverages are not. It should be "easy" to correct the historical ceded data to estimate liabilities.
Comments
In the real world, this question likely wouldn't have the same answer for all situations. One approach would be to do the analysis both ways:
You would then also have net and ceded directly so you could calculate gross as net + ceded as a 3rd option to see what you get. Having done the analysis in these different combinations, we'd be in a better position to make the final estimate than if we'd made the decision on method at the outset based only on theoretical considerations.
The reason I said the answer is wrong in the examiner's report is that in the source paper, under "Reinsurance Program", their example was that if the net retention had changed significantly, then it may not be appropriate to use "net" as a starting point. In other words, start with gross & ceded instead, which is Option B. But the examiner's report said to use Option A in that circumstance, which seemed to be the opposite of what was alluded to in the paper.
It's interesting that the examiner's report said few candidates received full marks. I'm guessing that's because many interpretations are possible. In fact, for each of the 4 conditions, you could probably find a situation that could justify option A and another different situation that could justify option B.
I feel that the key question to which two to choose as a starting point is whether we want to reflect the difference/change in question in the calculation.
Based on learning battleacts and question 2015 Fall 26a. My conclusion is that in general we should avoid reflecting the difference/change in the calculation. This is why in the cases like different payment pattern in ceded business (affecting ceded), and big change in the reinsurance program (affecting ceded), the answer says Option A (using gross and net) is more appropriate. This aligns with the example in the source paper that if there is a significant change in the net retention (affecting net), net is not used as a starting point.
One exception though, is that for discount rate, we need to reflect the difference. this is why if NPV & CPV use different discount rate, we may want to calculate GPV using the two, and if the discount rate for ceded is different, we may want to choose Option B.
My conclusion is totally based on the reading and answer in the examiner's report for question 2015 Fall 26a. Not sure if it makes sense.
still confused about why option B is chosen for the discount rate section. In the source text it says if net and ceded discount rates are different, we should calculate net and ceded, not "gross and net" or "gross and ceded". So is there a reason why "gross and ceded" is selected if net and ceded discount rates are different?
As for the original question here, I'm assuming if I explain in the answer "assuming that the change in the reinsurance program here is a significant change of net retention level, option B should be selected since using net as a starting point would not be appropriate" and still get the marks for it.
I think both PsEm6C and jc2018 make valid points and that there is no single correct answer to this problem.
A point I would make in response to PsEm6C is that your reasoning is very plausible. But if there were a significant change to the reinsurance program both ceded and net may change significantly. So calculating gross and net would still mean you're reflecting the change in the calculation. You would need more details of the change in reinsurance to decide which option is better. Even so, I think you explained your reasoning well enough for full credit (if I were the grader.)
To jc2018, it sounds like you are proposing a third option, Option C, where you calculate net and ceded. I don't know why they didn't provide this option as it clearly is a valid way of proceeding. Your answer is well reasoned and I think that it also deserves full credit.
My overall judgment is that this exam question was not a good question. I would not expect it to reappear. If they want to test this material again they will have to create a better question. If it were me, I would create a numerical example that would make it absolutely clear that one or the other option was the better one.