Retrospective reinsurance in portfolio transfers
Adverse loss development reinsurance, often referred to as Adverse Development Cover (ADC), is a specialized form of reinsurance designed to protect insurers against unexpected increases in their loss reserves.
This type of reinsurance is particularly valuable for managing the financial risks associated with historical claims, providing a safety net for insurers facing adverse reserve development.
Adverse loss development occurs when the actual losses from past underwriting years turn out to be higher than initially estimated. This can happen for various reasons – changes in the legal environment, unexpected inflation or new information about claims that were previously underestimated. When these losses exceed the reserves set aside by the insurer, it can lead to significant financial strain.
ADC transfers the risk of adverse loss development from the insurer to the reinsurer. This gives the insurer financial stability, allowing them to focus on core operations, without the looming uncertainty of past claims. It also allows the insurer to reallocate capital to more productive uses. And it can enhance an insurer's market value by reducing the uncertainty associated with historical claims.
ADC contracts can be structured in various ways, depending on the insurer’s needs. They may attach above, at, or below the booked reserves. And they have to exit above the booked reserves to ensure effective risk transfer.
The attachment point and limit of the ADC determine the extent of coverage provided.
While ADC provides significant benefits, it also comes with challenges.
The first one regards modelling uncertainty. Pricing and reserving ADC involves complex actuarial calculations to ensure the coverage is both adequate and cost-effective. This process requires a deep understanding of loss trends and the ability to model uncertainties accurately. Predicting future loss development is inherently uncertain. Actuaries have to account for various factors, such as changes in legal environments, economic conditions, and claim behaviours, which can affect the accuracy of their models.
Then there are regulatory considerations. ADC contracts must comply with regulatory requirements, which can vary by jurisdiction. Insurers and reinsurers need to navigate these regulations to ensure their ADC contracts are legally sound.
The cost of ADC can also be substantial, especially for insurers with a high risk of adverse loss development. Insurers have to weigh the benefits of ADC against its cost to determine if it’s a viable option for their risk management strategy.
One kind of ADC is Loss Portfolio Transfer (LPT). It is a first-euro ADC that transfers the entire portfolio of losses to the reinsurer, provides comprehensive coverage and is often used when an insurer wants to achieve economic finality on its back book.
It’s often used in portfolio transfer in combination with a business transfer agreement.
The portfolio transfer process can take time to complete. The LPT agreement provides economic finality as of the date of signing of the business transfer agreement, which provides legal finality only when certain conditions precedent occur, such as regulatory approvals.
To transfer the economic risk and benefits of the targeted portfolio as at the signing date, the transferor and the transferee will enter into a reinsurance agreement. Under this agreement the transferee will reinsure the transferor's liabilities in full under the portfolio. The transferor's direct liability to the policyholders won’t transfer to the transferee on signing. This liability will only transfer on completion of the regulatory transfer process or once legal finality is reached.
The LPT reinsurance agreement is a transitional arrangement pending approval of the transfer process and will terminate when the process is complete.
The premium can be a cash sum or possibly investment assets equal to the estimated liabilities as at the accounting reference date. The premium amount will be trued up post signing so that the actual assets transferred are equal to the actual liabilities transferred as at the date of signing. It can also be paid on a funds withheld basis.
Transaction legal documents will also usually include a transitional service agreement for managing claims. The transferor will outsource the administration of the targeted portfolio and claims handling to the transferee, again until legal finality is reached.
