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The Actuary The magazine of the Institute & Faculty of Actuaries

Raiders of the loss portfolio

Scene 1 Vendors of the loss portfolio
Seller Hello, consulting actuary, thanks for coming in. The problem I have is that my company risks losing business because of a perceived lack of financial strength. My underwriters are already seeing less business coming their way, and there is a risk that our rating will drop. Given that rates are hardening, I need a quick and effective method of improving the company’s balance sheet. Do you have any suggestions?
Consultant I can see that this issue is critical to your business plan. From our recent review of your company’s reserves, I can identify the areas of the business causing most of your problems. You have a number of options, all revolving around transferring away the uncertainty of your liabilities. This could be to a reinsurer, to another insurer through a full legal transfer of liabilities, or back to your cedants through a commutation. You could use a combination of these, such as a transfer to a shell company within your group, and then reinsurance to protect the shell company.
Seller That’s very interesting. I particularly like the idea of using our shell company, as then I could really clean up the balance sheet of our underwriting company. Also, keeping the transfer within the group should reduce the number of legal and regulatory problems.
Consultant You may need reinsurance to protect the shell company against adverse development. This will limit its capital requirements, retaining more capital to support your underwriting company. Your next stage is to confirm the regulator is happy with your plans.

Scene 2 Crusaders of the loss portfolio
Seller Good morning, regulator. To improve my company’s image, I need to remove the liabilities for all past underwriting years completely from the balance sheet. My company will then have a clean balance sheet and will be able to write business competitively. We have a shell company in the group that has insurance authorisations, but no policyholders at present. I have the group’s agreement to transfer the claims liability and the supporting assets into the shell company.
Regulator My prime concern is that policyholders should be no worse off. At present they belong to a well capitalised company, but if you transfer policies to a shell company, your policyholders will lose this strength. What alternative protection do you propose?
Seller I have an actuarial report assessing the liabilities at £40m, and we will buy reinsurance to protect against possible deterioration of reserves up to £10m. This should be ample, and in the remote event it proves inadequate, the group will support the run-off.
Regulator I welcome this intent, but there have been instances of groups walking away from insurance subsidiaries whose liabilities have deteriorated. As a regulator it’s my job to be a professional pessimist. I need assurance that £10m cover will be adequate, even if claims suffer seriously adverse development. Therefore, if you are buying limited cover, you must commission an actuarial report indicating the amount of reinsurance sufficient to cover reserve deterioration with a high degree of certainty.

Scene 3 Graders of the loss portfolio
Seller Hello broker. I need to get cover for my company’s liabilities excess of current reserves of £40m. If you could get me unlimited cover we would save the cost of another actuarial report. After seeing the latest actuarial charge-out rates, I know where the ‘milli’ comes from in Milliman, the ‘till’ in Tillinghast, the ‘price’ in Pricewaterhouse
Narrator (hurriedly interrupting) That’s enough!
Broker Well, these guys have to bring home the bacon somehow, and you will find unlimited cover even more expensive, especially if you want a deductible as low as your current best estimate reserves. Our actuaries looked at the data you sent me, and their best estimate was £45m. True, this was based on consolidated triangles, but a reinsurer will start at the same point. You need to supply more data or explanations to persuade him the best estimate is closer to £40m. Also, I think you may be underestimating the reserve variability. I can illustrate these effects with a diagram [figure 1”. You can estimate the cost by counting the squares between the deductible you want (the green vertical line) and the relevant line each square will cost £1/2m (£5m¥10%).
Seller Hmm, so the cost according to my estimate must be the yellow area which contains (balances up fractions) about three squares. But the cost according to your actuaries’ estimate is the blue and yellow areas combined about ten squares. So you are telling me the cost should be £1.5m, but the reinsurer will charge £5m?! I’ll just have to convince him my company has written good business. I’ll get my underwriters to give him the same presentation they gave me, just before I gave them their bonuses.
Broker You had better stand him a good lunch first. If that doesn’t work, you could try accepting a higher deductible. The graph illustrates the effect of this as well. If you count squares between the £45m vertical and my ‘broker’ line, you will see that a £45m deductible will cost about £1.5m. Anyway, I’ll see what I can get for you in the market.

Scene 4 Traders of the loss portfolio
Reinsurer Good afternoon, broker. You said over the phone your client was looking for unlimited cover excess of £40m, but we are not quoting for unlimited covers at present. Also, my actuaries have analysed the data you sent me and their best estimate of the reserve is £47m. Of course, this is only on consolidated data and perhaps it would come down to £45m when they get more details and explanations, but cover from £40m would just be money-swapping and so would be expensive. You indicated your client had limited funds for this, so I am going to quote for a deductible of £45m and offer you cover of £15m excess of £45m, for a premium of £7m.
Broker £7m seems expensive, and my client has authorisation from her board to pay only £5m. I know that you will be able to earn a better investment yield than the seller, because you can invest more widely, and also that you get the diversification benefit of running a number of such portfolios. Surely these advantages mean you can offer a mutually beneficial deal?
Reinsurer The risks are greater than you realise. It’s not only that liabilities could be much greater than the best estimate; it’s also that they could materialise more quickly than expected, in which case we lose our investment yield advantage. Look at this table [table 1” which shows the net present value of our profit in £000s, on cover of £15m excess of £45m for a premium of £7m.
Loss amount scenarios run across the top of the table, with speed of payment scenarios down the side. Our profit drops rapidly as payments accelerate, and become losses if reserves deteriorate by more than 10% and payment speed increases by 25% or more. However, I have an alternative proposal. If your client doesn’t want to reduce the limit further, what about introducing a maximum payment schedule to bridge the gap to £5m? This limits the maximum payment recoveries we make in successive calendar periods and therefore protects us to some degree by reducing our loss making scenarios. As a result we can reduce the premium.
Broker That sounds promising, and I like the grid-style presentation showing the two effects together. I’ll discuss this with my client and ask her to supply more detailed data. Meanwhile, can you put together a payment schedule that will enable you to quote a £5m premium?

Epilogue Deciders of the loss portfolio
We finished with scenes of the broker taking the quotation back to the seller, and the seller discussing options with the consultant, which gave us the opportunity for a few more jokes. In practice there would have been other steps in the process, such as the seller seeing whether the maximum payment schedule was acceptable to the regulator and going through the formal transfer process.
We finished with four choices facing the seller:
– forget the transfer;
– buy £15m cover but with a maximum payment schedule;
– refuse a maximum payment schedule but buy only £10m cover; or
– go back to the board for more money.
What would you do?