Commutations

Study guides: Exam 6C, Exam 6U

A Commutation is the termination of an existing reinsurance contract by agreement, in which the reinsurer pays the cedant a lump sum and is thereby released from all future obligations under the contract. The recoverable asset disappears from the cedant's balance sheet and the underlying liability returns to it in full.

\text{Commutation price} \approx \text{PV(expected future recoveries)} \pm \text{negotiation}

• Why a cedant commutes: to eliminate credit exposure to a deteriorating reinsurer; to obtain cash now rather than recoveries over decades; to end a dispute; to simplify a run-off; or because the reinsurer offers a price above the cedant's own valuation.
• Why a reinsurer commutes: to close a book and release the capital supporting it; to cap exposure to adverse development; to exit a line or a jurisdiction; and to convert an uncertain long-tail obligation into a known payment.
• The pricing is a present-value negotiation between two parties with different views of ultimate losses, different discount rates and different risk appetites. A commutation happens precisely where those views differ enough to create a zone of agreement — the cedant's minimum acceptable price being below the reinsurer's maximum.
• Accounting and capital effects are immediate. The reinsurance asset is derecognised, cash is received, and the difference goes through profit or loss. The gross liability is unchanged, so Capital Required rises — commutation reverses the capital credit the reinsurance was providing.
• The risk transferred back is real. After commutation the cedant carries the full tail, including the possibility of adverse development it had previously ceded. A commutation that looks favourable on the expected value can be badly unfavourable in the tail.
• Risk Transfer considerations attach. A commutation negotiated on terms that effectively unwind a contract retroactively, or one accompanied by a replacement arrangement that returns the risk, invites scrutiny about whether risk was ever genuinely transferred.

Should the Cedant Commute? A cedant holds a \$60 million recoverable from a reinsurer, expected to be paid over 12 years. The cedant's discount rate is 4\%, giving a present value of \$41 million. The reinsurer offers \$36 million in cash now. The reinsurer's financial strength rating has been downgraded twice in two years, and the cedant assesses a 15\% probability of the reinsurer failing before the recoveries are paid, with an expected recovery of 50\% in that event.

Evaluate.

Answer Expected present value allowing for default:

\begin{align*}
\text{EPV} &= 0.85(\$41\text{M}) + 0.15(0.50 \times \$41\text{M}) \\
&= \$34.85\text{M} + \$3.08\text{M} \\
&= \$37.9\text{M}
\end{align*}

The offer of \$36 million is \$1.9 million below the credit-adjusted expected value — so on expectation alone, decline.

But the expected value is not the whole decision:

• Variance. The alternative to \$36 million certain is a distribution with a 15\% chance of recovering roughly \$20 million. A cedant unable to absorb that outcome should pay for the certainty.
• The default probability is an estimate. Two downgrades in two years suggests deterioration, and the 15\% could easily be 25\% — at which point the EPV falls to \$35.9 million and the offer is fair.
• Capital. Commuting removes the recoverable, so Capital Required rises and the MCT ratio falls. Against that, an uncollateralised recoverable from a deteriorating reinsurer already attracts an unfavourable credit risk charge, so the capital swing is smaller than it first appears.
• Adverse development. After commuting, all future deterioration on the underlying claims is the cedant's. If the book is long-tail liability with genuine tail uncertainty, that transfer back is worth more than \$1.9 million.

A defensible conclusion: negotiate toward \$38–\$40 million; commute if the credit assessment is deteriorating or the cedant cannot bear the default scenario; decline if the reinsurer stabilises and the tail risk is what the cedant most wants to keep ceded.