A commutations overview: Effectively managing reinsurance programs

Overview
A reinsurance commutation is, in essence, an early termination of a contract of reinsurance in return for a mutually agreed upon consideration.  The parties to the commutation intend to terminate the reinsurance contract and to, thus, “unwind” the entire reinsurance transaction to a mutually agreed “as of” effective date.  After the commutation is complete, there is no ongoing reinsurance cover in place and future risks are borne on a net basis to the cedant.  It is possible that a new reinsurer may be brought in to handle the prospective risks through a new reinsurance arrangement; however, this can be problematic based on market conditions and other factors.  For example, if the underlying business is performing poorly, any available replacement terms might be onerous and/or restrictive.
The reasons for a commutation vary; however, the key categories include:

• The cedant has strategic reasons to exit a particular line of reinsured business;

• There are credit concerns regarding a particular assuming reinsurer, probably due to the perception of an above average insolvency risk;

• The commutation improves a reinsurer’s underwriting results, since the price of the commutation is often less than the carried reserves;

• There could be favorable tax advantages as a result of the commutation for either or both parties;

• There is a disagreement over the appropriate reserves to be carried, or in general, over the reinsurance contract’s terms.

Whatever the motivation, one fundamental fact should be emphasized—a commutation is a risky undertaking given the inherent variability of loss reserve development and the pattern of reported claims over time.  For example, commutations negotiated during the early 1990’s may have been seemingly, at the time, “good” deals.  However, the continuing pattern of adverse casualty and environmental development has recast many of these transactions in disastrous terms.  Therefore, a fundamental assumption regarding commutations should be that they be entered into with considerable caution and a fair degree of general skepticism.  Any actuarial assumptions regarding the development of reserves over time should include a reasonable range of possible outcomes in order for all parties to fully understand the potential risks.
Additionally, counterparty credit risk is implicit in every reinsurance transaction; a cedant pays premiums to a reinsurer immediately with the expectation of receiving indemnification for losses over time.  For decades, that business expectation was taken for granted; however, the environmental debacle of the late 1980’s has changed that belief permanently.  During the 1990’s alone, more than 20 companies exited the London and International market due to insolvencies.  The domestic markets have also been affected by catastrophic and latent losses that have yielded several insolvencies.  Burdened by this pattern of increasing insolvencies, the concept of reinsurance “security” has grown in prominence and caused a “flight to quality” that favors the larger, better capitalized reinsurers.  Clearly, the best means of mitigating this inherent credit risk is in adhering to proactive monitoring and controls to ensure that the most financially viable panel of reinsurers possible is utilized.
The insolvency of a US, UK, Bermuda or other alien reinsurer brings with it a patchwork of varying regulatory proceedings.  These include Rehabilitations, Liquidations, Involuntary Schemes of Arrangement (similar to rehabilitations), Cut-off Schemes (similar to liquidations) and many other forms.  Despite the venue or form of the regulatory proceeding, one key fact bears careful consideration.  That is, the ultimate financial failure of a reinsurer will create a de minimus financial distribution, over time, to the cedant/creditor.
As a general matter, the insolvency proceedings over the past decade have produced ultimate recoveries to cedants of less than 40 cents on the dollar, with many yielding nil to this class of creditor.  Clearly, a primary company is in a much better position to trade a commutation today for the inherent uncertainty of a protracted insolvency administration.  Therefore, in this context, a recovery of 70 to 80 cents on the dollar today is a far better alternative than waiting for the result of an insolvency proceeding.
The most well managed primary companies understand this fundamental issue and are proactive in identifying these risks and establishing internal protocols to manage an active commutation program.  Those who hesitate are disadvantaged relative to their more proactive competitors.  In this context, he who hesitates is lost.
In the current market environment, there are a number of solvent reinsurers seeking to commute business with cedants and are actively offering a variety of solicitations.  These are often solvent companies that have entered into a voluntary run-off and are using commutations in conjunction with their business model to reduce assumed liabilities quickly and efficiently.  Thus, a never-ending cascade of such solicitations is received by primary carriers from such (solvent) run-off entities on an ongoing basis.  Our advice to the reader is to view these offerings critically and focus your commutation efforts exclusively on the financially impaired universe of reinsurers.
In addition, there are several other factors that should be considered when determining what and when to commute. For example:

• The reinsurance terms of a commutation should provide enough of an economic outcome to warrant their assumptions, on a net basis, of the entire book of underlying business.  The proffered terms must provide for a significant degree of IBNR recoverable with a discount factor present for the time value of money.  Often, the cedant is unwilling to entertain a discount, or may even seek a premium (say, 150% or more) for those “commercial” commutation deals involving solvent reinsurers.  Clearly, however, assuming reinsurers will rarely commute a cover without some degree of discount present.  Thus, there are conflicting demands at work in this dichotomy.

• The surplus impact to the cedant of unwinding the transaction must not be overly onerous—despite the potentially favorable economics of the situation.  In the ultimate “triumph of accounting over economics”, many primary carriers are holding recoverables from reinsurers that are clearly on the path to failure as they are unwilling to take a financial “haircut” today for a commutation due to the immediate financial statement and surplus implications.

• Quota share reinsurance is often purchased to provide surplus relief to a cedant.  Thus, an “unwinding” of this type of reinsurance transaction through a commutation could cause some undesirable financial statement presentation issues to the cedant and adversely impact their appetite to commute.

• Each side to the transaction should consider obtaining the financial statements of the respective parties involved (if available) and do some high level modeling of what the impact of the transaction could be to their balance sheet.  It will also allow for some measure of the appetite of the respective parties for a commutation.  For example, if they appear to be cash flow constraints or possess borderline IRIS ratio issues.  This could also bring to light potential rating agency impacts or DOI implications that could affect their desire to transact.

Pricing of the Commutation
In terms of pricing the commutation, there are a number of factors that must be considered.  Usually, calculations begin with a determination of the cost to the reinsurer of not commuting.  This cost is the difference between the following two quantities:

• The present value of expected future paid losses (using an after-tax discount rate appropriate to the company and line of business)

• The present value of the tax benefit related to the unwinding of the federal tax discounted reserves (using the IRS prescribed discounting procedure)

Next, the cost of commutation is calculated by subtracting from the cost of not commuting the value of the tax on the underwriting gain or loss generated by the commutation.  This is the result of the takedown in reserves and payout of the final cost of commutation.  This final cost of commutation represents the break-even price and reflects no loading for risk or profit.
It is this calculation where significant scrutiny should be given to the assumptions used for determining IBNR reserves, discounting losses and determining taxes.  A thorough commutation analysis should include a range of outcomes, as mentioned earlier with respect to reserve development estimates, as well as a thorough examination of possible tax scenarios including the realization of carry-forwards and the potential impact of the alternative minimum tax.
These calculations obviously require significant expertise and judgment.  As a general matter, the most difficult commutation negotiations involve either a purely unseasoned book of underlying business or, conversely, one that has substantial ceded losses.  This difficulty is largely due to the impact either of these situations have on the process described above.
General Considerations
Although it seems obvious, it is imperative that all parties mutually agree to an effective date for the commutation that will serve as the basis for any valuation procedures including, for instance, the present value of the ceded loss reserves.  The date should coincide with the natural flow of the underlying business.  For instance, it should not be materially impacted by premium booking and renewal activity.  The date can coincide with the Treaty Year Anniversary, but it can also differ.  For 12/31 anniversary treaties, experience has shown that a 3/31 commutation date often works well, whereas, a 6/30 or 9/30 date is often problematic given the high degree of general premium bookings around those dates.
While the general inclination in a commutation is to commute all effective years of assumption between the two parties, it is possible to commute only one or two years through a so-called “lasering” transaction.  This is almost always the norm in a long-term relationship between two financially solvent parties; situations in which the inducement to commute is based purely on business considerations.  For example, a large public carrier may want to commute only a few years of a long-term treaty program with a large reinsurer due to a strategic exit from a certain line of business.
In terms of negotiating strategy, there is a tendency in the Property & Casualty industry to “abandon” the commutation process to various parties within an organization (i.e. Legal, Actuarial, Finance, Claims, etc.).  Although each of these parties is required in the overall process, it is a critical error not to have the direct negotiating done by key “business people”.  The best commutations are achieved by having a key businessperson—with the authority to make a deal—work with their business counterpart in the other organization.  The workout team (or consultants) would do the detail “file” work on the account and have the more working level discussions with the other party.  Clearly, however, a senior business leader must communicate the initial and final offers.  Reinsurers (and Rehabilitators) want to transact business with decision makers within an organization.
An additional, and potentially substantial, “wrinkle” to any commutation agreement is the presence of contentious claims (or even those that might be subject to an Arbitration proceeding).  It is possible to craft a commutation agreement that “carves out” a certain ceded account to allow the dispute/resolution process to move forward unimpeded.  It is more desirable, however, to attempt to resolve these matters within the context of an overall “global” commutation, if at all possible.  The key caveat is that overall economic goals of the transaction should not be sacrificed to achieve a resolution of any one claim.
Resource Requirements and Strategy
As a practical reality, there is an ideal time “window” in which cedants and reinsurers tend to focus on reinsurance commutations the most—that being during the latter half of the year and particularly during the fourth quarter.  Year-end allows the reinsurer to reduce its liabilities and allows the cedant to clean-up legacy recoverable issues.  (There is bonus potential in getting deals done!)
A commutation can be a very laborious process, with several from recent experience taking upwards of six months from inception to ultimate resolution.  It can be a business annoyance as resources necessary to support the timeline of a commutation effort are often conflicted by various other duties and time requirements.
As a general matter, commutation and “work-out” activities require a very different approach and mind-set than do ongoing business activities.  The latter are based on long-term relationships and the opportunity for both parties to enjoy a mutually advantageous and profitable relationship over time.  A commutation, on the other hand, is a contentious matter, which will (often) lead to the collapse of any long-term relationships.
This is an important point that bears emphasis; the degree to which internal management resources are used in a commutation effort could impact longer-term goal realization.  For this reason, companies often tend to utilize a workout unit, or utilize outsourced resources and advisors, to do the key day-to-day activities related to the commutation.
Other Aspects of the Commutation Process
One of the most important steps in the entire process is that paid loss recoverable balances be fully reconciled with the cedant (and broker) to the effective “as of” date.  As a practical matter, accounts often experience delays in reporting between the cedant and reinsurer, and these delays can have a profound impact on actuarial estimates of ultimate reserves.  Further, since a commutation represents a full and final release between both parties, any “surprise” transactions that are discovered after the agreement (those not properly reported or reconciled) could have a tremendous impact on the perceived economics of the transaction.  This risk is more prevalent in the context of excess of loss rather than quota share reinsurance.
In the same vein, assuming reinsurers should perform a thorough audit over both the premium and loss processes as soon as practicable.  This detail work is critically important at the outset of the commutation cycle as it will profoundly impact the IBNR reserve estimation process and could help discern trends and adverse developments essential to properly valuing the transaction.  It is an opportunity for the commutation team to review some of the underlying account files in detail to better gauge the cedant’s due diligence and claims handling procedures.  Some of the questions that should be asked are:

• How timely and thorough are the bordereaux reports from the cedant?

• How effective are the system controls in place?

• What reconciliation efforts from prior reviews are present?

• How effective are the controls for capturing and ceding all premium related transactions?  Has a full universe of transactions been reported?  Is any non-subject business to this agreement being ceded to the reinsurer?

• Have all endorsements been reported?

To the extent the business in question was sourced by an intermediary, it is efficacious to utilize the placement broker to assist in the commutation effort.  Despite the representations by placement brokers that they are “unbiased” in such matters, there is a strong tendency to work most diligently on behalf of whichever party (cedant or assuming reinsurer) that is likely to produce future business on their behalf.  (There is, however, an ongoing economic cost to the broker from having to administer the claims throughout the period of a run-off.)  To the extent the book represents a “one-off” transaction; their efforts will be minimal at best.  The broker partner is critical in assisting in the accounting and claims reconciliation process that underlies this effort and should be actively utilized to assist in the reconciliation between ceded loss bordereaux reports and what the reinsurer records.  Delays are often caused by the intermediary themselves; thus, it is imperative that reconciled and timely data be used at the outset of these negotiations.
Broker developed IBNR estimations are not recommended.  Their use will rarely be viewed as objective and often, because of reasons discussed above, their quality is often lacking.  Likewise, the cedant should utilize their own draft Commutation Agreement rather than one developed by the placement broker (or the counterparty).
As mentioned, the estimate of IBNR will have a significant impact on the cost of commutation.  The settlement patterns of the line of business and its age at commutation most directly affect the amount of IBNR that will be estimated.  Clearly, less mature and/or longer-tailed lines of business will likely have more IBNR (as a percentage of total incurred loss) and will often rely more heavily upon the Bornheutter-Ferguson methodology of loss reserve estimation.  This methodology utilizes an expected loss ratio, along with historical development patterns (either based upon the actual underlying experience or from some similar industry benchmark data), to estimate expected IBNR.  More mature and/or shorter-tailed lines will likely have less IBNR (as a percentage of total incurred loss) and will be more susceptible to methods like the standard Chain Ladder development method based upon either actual experienced loss development or on industry benchmarks.
Either method, if used appropriately, should produce reasonable estimates of IBNR.  In most cases, it is recommended that at least four different estimates be made of the IBNR reserve.  Two Bornheutter-Ferguson estimates based on paid and incurred losses and two Chain Ladder estimates based on the same data.  The results from all of these estimates should be examined together and any differences reconciled before a final estimate of IBNR is made.
If a dispute arises regarding the IBNR estimate, the most likely candidates for further analysis would be the applicability of the expected loss ratio from the Bornheutter-Ferguson technique and/or the applicability of the selected loss development pattern from either technique.  These assumptions should be as reflective of the actual underlying business as possible and the use of industry data in their place is often a distortion for books with special underwriting guidelines, markedly different pricing philosophies or atypical case reserving/claims handling practices.
The choice of discount factor should be relatively objective and based upon objective external data points as much as possible.  It should reflect current yields; however, it should also be an after-tax yield specific to the company’s tax situation.  It should also take into account any change in the tax situation that may be caused by the commutation itself.
As a general caveat, the party initiating a commutation should draft the first version of the operative Commutation Agreement to be provided in the deal.  Always work off of an agreement that is advantageous to your position.  It is always a better negotiating ploy to make modifications away from your standard agreement than to attempt to modify an opponent’s agreement to include your required verbiage.  The following contractual features need to be addressed in any agreement:

• Offset. Do not allow for any offset with any other reinsurance agreements (ceded or assumed) that may exist with the other party, or their affiliates.  This agreement must stand solely on its own and have no impact to other contractual relationships or entities.

• Governing Law. To be determined by a variety of factors

• Funding Clause. Insist on including contractual verbiage that is quite specific as to the mechanics of funding the consideration of the Agreement.  Words to the effect of:  “Within 48 hours of the mutual execution of this Agreement, Reinsurer will wire transfer $XX to the Reinsured’s account ABCXXX in full settlement of the Commutation Agreement (as per the Consideration Clause) representing a full and final release of the Subject Business of this Commutation Agreement.”  Time and again, the agreement should be specific as to the business commuted and that it is a full and final release.

• Specificity. The Agreement should clearly specify which contracts are being commuted and for what terms.  You want to preclude the other party from attempting to later reinstate some features for a recovery (i.e. alleged accounts that were somehow “not included”, etc.).

• DOI Approval. It is possible, given the potential financial materiality of the agreement, that regulatory approval may be required.  Keep this contingency in mind during the negotiation timeline.

Finally, to the extent that there are any Letters of Credit present, there are two options:

• If unused to date, simply cancel them with the reinsured and the bank;

• If partially or fully used to date, the Letter of Credit draw downs can be used as a partial method of funding the overall Commutation proceeds.

In the context of a reinsurer that undergoes regulatory intervention and insolvency, it is possible that a “preference” transaction may be deemed (an assertion that a transaction such as a commutation done between 90 and 180 days of the insolvency filing date is adverse to creditors generally).  The impact could be to unwind the deal.  While this is a very uncommon risk, it does bear close scrutiny in the context of a teetering reinsurer.  Again, time is of the essence.  When everyone knows there is a problem, it is too late to act.

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Steve McElhiney is the President of EWI Risk Services, Inc., a reinsurance intermediary based in Dallas, and a subsidiary of NL Industries a diversified industrial company.  He also serves as President of Tall Pines Insurance Company of Vermont, an affiliated captive insurance company.  His insurance industry experience has spanned over two decades with groups including Fireman’s Fund, TIG, and Overseas Partners US Reinsurance Company. 
Mark Jones is the Director of Research & Development and a Consulting Actuary with Perr&Knight. His primary responsibility is the development of new products and services for all areas of the firm. Mark has a broad background including experience with ratemaking, regulatory compliance, competitive analysis, catastrophe modeling and reserving for most personal and commercial lines of business. He also has experience in the development and implementation of predictive models, dynamic financial analysis tools for reinsurance applications, financial forecasting applications for budgeting and retention analysis, rate monitoring tools for most lines of business and ad hoc statistical studies for claims investigation, premium audit and loss control. Mark’s skill set includes an extensive knowledge of insurance data systems and company operations, as well as Visual Basic, SQL, R and other software.