Sunday 18 August 2013

#31 Light technical session

A commutation is a deal where the holder of one or more insurance policies agrees to sell those policies to another company. The price is, or should be, broadly speaking, based on the value of all actual and potential losses that have been and might be claimed against those policies, multiplied by the chance of such claims being made.

When you take out an insurance policy to protect yourself from a risk, the insurance company often insures itself against the risk of you making a claim by taking out a reinsurance policy with a reinsurer, who may in turn insure itself through retrocession, which is essentially a further level of reinsurance.

There are three parts to a commutation of reinsurance. Imagine two insurance managers having lunch and discussing the value of each one of these parts during each of the three courses and you've caught a reasonable glimpse of one of the few parts of the financial sector that still occasionally gets business done in that way. Why haven't those claims been paid? Because they haven't been notified to the reinsurer. Who's job is that? The broker's. Why haven't they done it yet? It's not at the top of their priority list. What's the next step? We're taking the broker out for a massive curry.

The first part consists of "unpaid paids" i.e. claims paid by the insurer but not yet paid in turn by the associated reinsurer. The second part consists of "outstandings", i.e. claims notified to the insurer but not yet paid by anyone and the third part consists of "IBNR" i.e. claims that have been incurred (I use this word loosely, in an indirect sense and in association with the philosophical concept of causality) but not yet reported to either the insurer or the reinsurer, let alone paid by either one of them. Valuing this third part of the deal inevitably involves some guesswork.

No comments