Commuted Value of Claims - Fall 2013 Q18

danielle4nan

Hello,
Within this example, a reinsurer is entering into a commutation agreement with a primary insurer. Some of the advantages of this transaction for the primary insurer are admin cost savings (no longer have to monitor claims), removes concern of creditworthiness of reinsurer, while the disadvantages are risk of future adverse loss experience and increased capital requirements to support the liabilities.

I am confused as to whether in this case the reinsurer is assuming the liabilities of the primary insurer? Or this transaction at the point where the claims that were previously assumed by the reinsurer being transferred back to the primary insurer?

I find if confusing that the primary insurer has less admin expenses, but higher capital requirements to support the liabilities, for example.

Thanks in advance!

chrisboersma

The primary motivation for a reinsurer to commute is to bring certainty to its results; however, there are other benefits to the reinsurer associated with commutation, including capital relief and savings in claims adjusting and administrative costs. From an insurer’s point of view, there can be a benefit from [this] commutation if there is a concern in respect of the creditworthiness of the reinsurer — the receipt of cash extinguishes this risk. Insurers also will save administrative costs. Insurers, however, once they receive the cash payment will be subject to the risk of any future adverse loss experience in respect of the commuted liability and will have to hold capital for this risk.

There are two ways to commute claims:
1. reinsurere commutes BACK to insurer (bringing uncertainty back)
2. insurer commutes (NEW contract) to a reinsurer (bringing certainty).

The entire paragraph above refer to #1. Claims are being commuted back to insurer. This is typically how commutations work. Otherwise it would just be called a new reinsurance contract.

Savings in admin are due to no longer requiring additional reports / financial transactions with reinsurer:

To Commute or Not To Commute, that Is the Question

The reinsurer's obligation to cede and pay claims continues many years after the termination of the contract, unless it is commuted. A commutation allows the reinsured to receive cash now to invest for the payment of future claims, and the reinsurer's commitment ends. Regardless the reason for the commutation, and there are many, care must be taken in drafting the agreement to avoid future disputes.

https://www.irmi.com/articles/expert-commentary/to-commute-or-not-to-commute

graham

Thx chrisboersma. Good answer.

To danielle4nan: I see your confusion. When I first did this problem (a long time ago) I wasn't sure what was happening either. But yes, the reinsurer is giving the claims back to the insurer. The reinsurer also has to pay the primary insurer an agreed upon price to take the claims back, but the mechanics of that are beyond the scope of the syllabus.

danielle4nan

Thanks everyone! I appreciate it, I understand now.

jptardif2

Hi Graham, when you talk about "The reinsurer also has to pay the primary insurer an agreed upon price to take the claims back", is that what the margin is?

Thanks!

graham

Not quite. The margin is different from the commutation price. In this problem, the margin is just a cushion when calculating the present value of the claims that are being transferred from the reinsurer back to the primary insurer. The commutation price is the amount the reinsurer pays the primary insurer to be relieved of the liability.

The calculation of the commutation price isn't on the syllabus but just to give a really simplified example:

• suppose the primary insurer calculates PV = $1,000 for the claims to be transferred
• suppose the reinsurer calculates PV = $1200 for the claims to be transferred (the reinsurer's actuary doesn't always value the claims the same way as the primary insurer's actuary because they might use a different margin and/or discount rate or other parameters in the PV calculation)

The primary insurer and the reinsurer would likely agree on a price between $1,000 and $1,200, let's say $1,100.

• the reinsurer would then pay the primary insurer this amount ($1,100) and would be relieved of what they believe is a liability of $1,200.
• the primary insurer would receive $1,100 from the reinsurer and assume liability for what they believe is a liability of $1,000

So they both think they got a good deal monetarily. (Only 1 of them did but we won't know which until the claims are settled.) But there are other benefits to a commutation so in overall terms they probably both got what they wanted.

suomi

How can we tell from the question whether the reinsurer is giving claims back to the insurer or vise versa? In the question, the table says "Estimated Payment to Reinsurer", I assumed this meant the the insurer is paying the reinsurer to take the rest of their claims?

I am confused, isn't the commuted value of the claims the commutation price? (The price the insurer thinks the reinsurer should pay to commute their claims back to the insurer)

Thanks
@Staff-T1 @Staff_T2 or @graham

Staff-T1

Hi,

I wasn't in the original discussion but here's my 2 cents on this.
There is an error in the question according to the Examiner's report -> so for this specific question, assuming either is fine.

Generally for commutation, assets (cash payment) and liability (future claims) move in the same direction. This means that when you send cash over to someone, you also send over your liabilities and release it to the person receiving the cash. So when you receive a cash payment from a reinsurer, you are also receiving the obligation to handle future claims and vice versa for sending cash over.

You are right for your second point. It's just confusing because the actual wording should be payment from reinsurer

suomi

thank you, understood!!

AndrewL

Hello,

@chrisboersma mentioned above that Primary Insurer can commute NEW Claim to reinsurer. Could you please explain further what this mean?

Also, graham mentioned that reinsurer pays commutation price to insurer, which makes sense

In the Freihault text example below, the contract commutes automatically. To prevent that, the insurer can pays a fee of $50,000. Is that what @chrisboersma meant above?

Thanks,
Andrew

graham

@AndrewL - I sent you a message.