When a ceding company and a reinsurer begin discussing the
prospects for commuting a treaty, it is likely that each of the parties has
already spent a considerable amount of time exploring the prospects and
desirability of commuting. Some or most of the members of the “commutation
team” have been assembled, the treaty has been thoroughly reviewed and at least
some of the participants have been engaged to apply their special talents.
These talents may relate to underwriting, actuarial, claims, legal, or accounting/auditing.
As activities move from the conceptual stage to the exploration and discussion
stage, greater emphasis will be placed upon the legal and actuarial aspects,
while maintaining active participation from claims personnel and, to a lesser extent,
underwriting. During the initial stages and as the commutation strategy
progresses, the auditor takes on an important support role by analyzing and, in
some instances, testing historic financial data. This vital data essentially becomes a
component of the foundation from which the claim managers, actuaries, and
attorneys formulate a commutation strategy.
This article will examine the role of the auditor before and
during the commutation process, from the reinsurer’s prospective.
Additionally, the article will explore the auditor’s role in situations which
may not ultimately culminate in commutation, and also situations where
commuting is either not considered or simply not a viable option. In these
later scenarios, although the functions performed by the auditor may be similar
to the procedures performed relating to the commutation process, the purpose
may be quite different. For example, the auditor’s focus may be to scrutinize
amounts included in “cash calls” and to verify compliance with the treaty or
certificate. The auditor’s focus could also be to verify erosion of underlying
coverage, and to test the adequacy of the ceding company’s reserves, which
would not necessarily be commutation related. Whatever the focus and scope of
the assignment, the auditor can prove to be an essential “tool” to obtain
critical data, in a timely manner, for management decision making.
Ideally, long before consideration is given to commutation,
the reinsurer would be closely monitoring claim development as reflected in
periodic statements from the ceding company. Assuming that an “Inspection of
Records Clause” is present in the reinsurance contract, reinsurer claim
representative(s) may have visited the cedant or third-party administrator and
inquired about any noticeable increase in claim submissions and/or settlement
severity. Even if the contract does not include an inspection of records
clause, there is an “implied right” to reasonable access to pertinent records.
Claim handling, use of outside counsel, reserving and related procedures and
philosophies would likely be topics discussed. A review of the content and
condition of “representative claim files” would also be desirable. These early
visits may have transpired before the reinsurance contract has attached.
Although
much of the data of interest to the reinsurer has likely been captured by the
cedant within periodic reports, when large dollar escalation is noticed, the
reinsurer may arrange for a preliminary review by a qualified auditing firm or
by the reinsurer's internal auditing staff. The focus of such a review should
be to verify that the ceding and allocation of claims is consistent with the
terms of the reinsurance contract through the following: Review and
verification of the line(s) of business being ceded; Careful attention as to
the categorizing of claim payments – i.e. have payments actually been made or
are there “settled-not-paid” amounts included with the paid claims listing?;
Identifying and testing the application of underlying, inuring
reinsurance; Also, scrutinizing
underlying policies to determine whether expenses are included or
in-addition-to limits; Tracing the transactions to confirm that these expenses
have not been incorrectly applied in order to erode the underlying coverage
prematurely, and questioning expenses that should not be allocated to the claim
file. In situations involving asbestos,
pollution and health hazard claims (APH), it is particularly important to have
an understanding of the data that has been collected by the ceding company, and
identifying pertinent data that has not been collected or made
available. This claim-specific detail will facilitate analysis and has
paramount significance in the development of trends. Identifying what trend, if
any, is reflected in the expense-to-indemnity ratio; Are the frequency and/or
value of new claims accelerating, static or declining? These are some of the
more important topics that should be answered within the scope of a preliminary
review and audit program. Combined, these inquiries aid in telling a “story” –
based on the reported historical claim experience.
Once the reinsurance treaty/certificate
attaches, and the reinsurer begins to receive periodic “cash calls”, it is
prudent to arrange for a visit to the ceding company or third-party
administrator to update the information obtained in the earlier visit(s) as
outlined above. The frequency and scope of such visits, of course, will be
dictated by the size of the request for payment. The auditors scope should be
expanded to include “transaction testing” sufficient for the auditor to express
a qualified (limited) opinion as to the reasonableness of the payment
request(s).
Prior
to visiting the cedant’s offices, the auditor would submit a document request which
would include a detailed claim listing for all items incorporated into
the “cash call(s)” under review. By submitting a document request several weeks
prior to the scheduled visit, the cedant should have sufficient time to
assemble a claim listing that would include vital claim-specific data. After review of the listing, the auditor
could make a “representative” claim file selection for closer inspection.
Ideally, although not always, the cedant will be able to provide certain data
files electronically, thereby facilitating and limiting the time required to
perform the “field audit”. Some ceding companies may not have the claim
files readily available. There may be files in off-site storage, at regional
claim offices or with local counsel. In the case of Lloyd’s, the claim files
may be at various Broker offices, usually with the Broker for the lead
underwriter. Obviously, the greater the difficulty in retrieving claim files
and source documents, the longer the lead-time will be before the audit can commence.
THE
FIELD AUDIT
At
the beginning of the field audit, the auditor should confer with the cedant’s
representative to discuss, in general terms, the purpose and scope of the
review. During this meeting the auditor should also inquire about any significant
personnel changes, changes in claim handling procedures and/or document
processing and reporting, which can later be explained within the audit report.
As the review proceeds, the audit program should have been structured so that
sufficient testing can be accomplished during the allotted time. It is
essential to test-vouch documentation and transactions in sufficient quantity
to prepare an informative report for the client.
In
most instances, at the completion of the fieldwork, the auditor should meet
with the cedant’s representatives for a “wrap-up”. This provides the auditor
and the cedant an opportunity to review deficiencies identified by the auditor.
This also provides a forum for a question-and-answer session. Any
misinterpretations can then be discussed and the potential for conflict
reduced. However, in contentious situations, for example if suit or arbitration
has been filed and the auditor is operating under the legal umbrella of
discovery, the auditor should consult with the client and the client’s attorney
before offering a “wrap-up” session.
THE AUDIT REPORT
Upon completion of the field audit, the
auditor drafts a report for submission to the reinsurer. The report should
express limited assurance that the “cash calls” appear either reasonable or
not, as the case may be. Any deficiencies in record management should be
outlined. If exceptions were found during the transaction-testing phase, the
report should contain specifics as to what the exceptions were, the specific
file(s) involved and, more importantly, a quantification of the value assigned
to the deficiencies. It is important that the auditor provide sufficient
details in the report to allow the client to make a decision to either pay the
cash call as submitted or deduct a “hold-back” from the requested amount until
the deficiencies are resolved.
A continuing benefit to the field audit is that the
reinsurer’s database can be updated to include the newly acquired data obtained
during the audit. Depending upon the amount of data and the length of time from
inception of claim history, the auditor can assist the reinsurer’s claim and
actuarial staff in projecting “burn rates” and policy erosion. This then may become the initial “early
warning sign” triggering a commutation.
A Commutation Agreement is “an agreement between the ceding
insurer and the reinsurer that provides for the valuation, payment and complete
discharge of all obligations between the parties under the particular
reinsurance contact(s)” (RAA 2003). Although several considerations may have
prompted commutation, uncertainty regarding future claims development and
financial ability to respond to these liabilities are usually two of the most
prominent reasons to follow “the path to commutation”.
After reviewing the reinsurance contract, the line(s) of
business reinsured, claim history and development, the social and political
environment, the financial strength or weakness of each the cedant and the
reinsurer, and the various reports issued by the claim department and the
auditors, management may decide to begin to assemble “the commutation team”.
Beginning internally, with the underwriting, claim and the legal departments,
the team will begin to compile the pertinent data for analysis. Actuarial and
accounting (auditing) skills will be added. After the preliminary review of the
input provided internally, management may decide to engage outside actuarial,
auditing, and legal services. “Feasibility/desirability” meetings and
discussions will be held and, if the decision to proceed is made, exploratory
queries could be “floated” to the ceding company.
One of the most important, yet difficult, evaluations to be
attempted relates not only to historical claim development, but also to
reserves; both case reserves and IBNR. The actuarial formulas vary widely, and
even if there is agreement upon which formulas to apply to the risks in
question, without accurate claim history, the foundation pins for the formulas
can cause distortion. Additionally, recent changes in the social and
economic climate could require adjustments to recorded case reserves,
especially for long-tail claims. For example, it appeared that asbestos-related
claims had stabilized and were trending downward as we entered the mid-to-late
1990’s. However, asbestos claims appear then to have taken a u-turn,
accelerating in the late 1990’s and continuing into the early 2000’s.
In “The Squeeze Continues” (Benfield 2003) the author
points out that in 2002. “….the massive reserve strengthening of prior years
loss reserves emerged as the big “catastrophe” loss of the year (2002)...
Fifteen companies increased reserves by more than $13 billion. Relatively
little of this was due to 11 September; much of it was caused by escalating
asbestos losses,…” Such large increases
point out the need to re-visit actuarial formulas applied in earlier periods.
Of equal importance, is the potential impact upon reinsurers, especially those
contemplating commutation with a ceding company that had invoked substantial
increases to reserves.
When the cedant notifies the reinsurers of sizable increases
to existing reserves like those described above, obviously the reinsurer will
want to collect all of the facts driving this decision. What change(s) took
place to warrant such an increase? What lines are affected? What
social/political changes have taken place? Is this the result of a single or
series of catastrophes? Have defense costs increased dramatically? What studies
have been done relative to claim and expense payment history for comparison to
existing reserves? These and other questions need to be answered so that the
reinsurers can adjust their time-line for attachment, erosion and projecting
“burn-rates”. The auditor can become a pivotal team member in collecting this
important data.
From the reinsurer’s prospective, any demonstrable reserve reduction
will reduce not only the aggregate case reserves, but also the IBNR estimate
tied to case reserves. This combination can provide support for reducing the
value of the commutation. Conversely of course, should the reserve testing
demonstrate the need to increase the reserves, the cost of commuting
will go up. In either situation, the reinsurer should be made aware of the best
estimate of case reserves and IBNR, to evaluate the possibility and desirability
of pursuing commutation as an option.
Consideration of commuting a reinsurance
contract requires the application of a team effort to reap the benefits of a
variety of skills. Experienced claim, underwriting, actuarial, legal and other
skills are essential ingredients for successful development and execution of
the plan. Auditor(s), specializing in reinsurance accounting/auditing, can and
should serve in essential supporting roles by providing tested results to team
members and management for decision making during the commutation process. The
role of the auditor (either internal or from external insurance/reinsurance
auditing firms) can be beneficial in providing current claim, expense and
reserve data for the commutation team and other ancillary purposes. These
include:
References:
1) RAA Reinsurance Association of America. 2003. Fundamentals of Property Casualty
Reinsurance with a Glossary of Reinsurance Terms. Pg. 23. www.reinsurance.org
2) Benfield Group PLC. March 2003. The Squeeze Continues.
Article published in Benfield Industry Analysis and Research, Vol. B4, 9-10.