Alternative Risk Transfer: Part II, BCAR Impact, Quota Share and Working Layer Excess of Loss Covers
Purchasing an aggregate stop loss provides a positive impact to the BCAR score by decreasing the capital charge. In year one, the benefit of the purchase is applied to the premium risk charge for the current accident year with benefit to the reserve risk charge in future years. In the first year, the accident year stop loss may reduce the premium risk charge significantly. The biggest reduction in the premium risk charge will occur when the stop loss provides protection between A.M. Best’s estimate of the expected loss ratio and 35 percent to 45 percent above that estimate. The decrease in the capital factor is equal to the limit purchased net of the AP that must be paid in the event of a loss. Surplus is reduced by the after-tax margin paid. For the second year, the reduction in capital charge is applied against the loss reserves. This reduces the benefit in the second year from that achieved in the first year, as the reserves are net of loss payments made in year one.
Two other structures that provide a positive impact to the BCAR score by decreasing the premium risk capital charge are structured quota shares and working layer excess of loss covers.
Quota Share and Working Layer Excess of Loss Covers
A quota share provides the largest benefit to reduce premium risk as it cedes the largest amount of premium dollars. In year one, the benefit of the purchase is applied to the premium risk charge for the current accident year with benefit to the reserve risk charge in future years. Offsetting this benefit somewhat is the increase in the credit charge for the reinsurance recoverable. However, the purchase of an unlimited quota share can be costly, as good results may be ceded away. An unlimited quota share may also be a difficult purchase in today’s market. The purchase of a structured quota share may help to provide a reduction to the capital charge as long as it is structured correctly. Potential structural features may include a cap and a sliding scale commission. In order to optimize the risk transfer as well as deliver the regulatory benefit, both of these features should be set at the appropriate level to maximize the capital relief. In the event that there are good results to the quota share, the cover can be commuted and the profits returned in the form of a profit commission after deducting a margin, which is the reinsurer’s cost for providing the cover.
A working layer excess of loss cover can provide similar benefits to that of a quota share from a capital management perspective. By choosing a layer with a significant amount of loss activity, a large amount of premium would be required to be ceded to transfer the expected loss component and the volatility above the expected loss component. In addition to leverage relief, other advantages of the excess of loss structure include providing significant frequency protection, inflation protection for long tail lines and protection against adverse judicial decisions. Similar to the quota share, these covers can be structured on a funds withheld basis with a significant profit share component upon commutation.