"substantially all" definition
I just wanted to clarify what "substantially all" really means. In #16aii of the Fall 2016 exam, the examiner's report says:
"It passes the “substantially all” rule. Risk transfer exists if the reinsurer assumes “substantially all” risks under the reinsurance portion, which is the case here with 50% QS."
Should we assume that 50%+ is enough for the substantially all rule and use this question as reference?
Comments
That's a very good question. This paper is also on Exam 6-US and there has been a lot of discussion there on that topic. It certainly doesn't seem that 50% should qualify as "substantially all".
But the text says "substantially all" means:
portions of the underlying insurance contracts.”
This would imply that any % quota-share agreement satisfies the substantially all exception (as long as there are no other risk-limiting features.) But that doesn't make sense. Any reinsurance contract would assume the risk relating to the reinsured portion of the contract!
The examiner's report for an old exam problem on this topic from the US exam talks about the proportion of the total loss distribution the reinsurer assumed. That seems to make more sense. Using that interpretation, you would need a high %, like maybe 90%, for "substantially all" to be satisfied.
For your exam, there's no way to know in advance how the examiners will interpret "substantially all". Your best bet is to reference the text as above, and the old examiner's report to justify your answer.
If you were given a quota-share problem with only 25% ceded, I'm not sure what a good answer would be. Maybe state that normally quota-share agreements satisfy "substantially all", even though 25% is a low %.
I don't understand why a 1% quota-share risk wouldn't qualify for reinsurance accounting. The share of premium (and claims) doesn't affect the overall agreement in anyway. You could ceded 1% of $100B of premium would still be risky to a smaller reinsurer.
A 50% quota share is just as risky as a 100% quota share (so long as total premiums/loss distributions are identical). All the examples may be high-ratio quotas (by accident or deliberately), but it doesn't really matter.
The text is pretty clear:
I read a bunch of 6US exams and they consistently state quota implies "substantially all". Questions often relate to "why a reinsurance contract that fails the reinsurance tests might still qualify for reinsurance accounting"
The "substantially all" clause appears to be meant for direct feed through reinsurance:
ABC Insurance writes Policy A and feeds exactly X% of premium to DEF reinsurance (whether on policy basis or book basis).
[Note: this knowledge is not part of the exam, but context helps me memorize things]
We are evaluating:
So if 90% of the risk of loss is retained then it meet the "substantially all" clause (In Canada). The way to get less risk than substantially all would be via a profit sharing, loss ratio caps, contingent commissions, etc.
In the USA (Rev. Proc. 77-37 3.01)
Both of these are generally in the context of "mergers & acquisitions", but the definitions could be easily transferable to insurance risk. If 90% of the fair market value of "insurance risk" net of re-insurance is transferred. This is why something with a HIGH loss-ratio cap (300%+) would still be considered "substantially all" (unless of course it was a low frequency - high severity risk where every loss would either be 0 or a very high loss ratio: 10000% - like earthquake).
- - Example - -
$1,000,000 Home
EQ = 1/500 ==> total loss
EQ Premium = 5 x 1/500 x $1,000,000 [total loss]
EQ Premium = $10,000
Option A: 300% LR Cap (but 100% premium transferred) - $10,000 / max loss = $30,000
Option B: Quota Share (EQUAL PREMIUM/EQUAL LOSS) @ 3%:
* $10,000 premium x 3% = $300
* Max loss = $30,000 (or 10,000%)
Option C: Higher underlying Direct Premiums [$333,333]
* With Quota Share (EQUAL PREMIUM/EQUAL LOSS) @ 3%
* With premiums similar to 300% LR after EQ loss: $333,333 for $1,000,000 coverage
* $333,333 premium x 3% = $10,000
* Max loss = $30,000 (or 300%)
Option A [does not qualify for re-insurance] due to CAP
Option B [qualifies for re-insurance] as quota share [would also qualify as per ERD=20%]
Option C [qualifies for re-insurance] as quota share [would NOT qualify as per ERD=0.6%]
The "substantially all" clause is designed for option C: over-priced premiums for direct writer with quota share agreements with re-insurer (or risk-based quota) where DIRECT Premiums AND DIRECT losses are ceded in the same proportions without caps (or commission adjustments). Adjustments to the PREMIUM or CLAIMS in relation to a re-isnurance contract would affect its ability to qualify for substantially all.
Purpose of "substantially all":
This clause is designed for predictable books that ARE PROFITABLE (unpredictable losses typically qualify for re-insurance accounting quite easily)