CAS Exam 7 Spring 2012, Question 19
Study guide: Exam 9
ABC Company is a small personal lines insurance company. ABC is lightly capitalized relative to its written premium. The company's CFO worries that the rating agencies might downgrade the company if it experiences extremely adverse underwriting results in the upcoming accident year. ABC Company has received quotes for stop-loss reinsurance programs from two reinsurance companies. The CFO is considering the following options.
| Option | Reinsurer's rating | ABC's expected return on GAAP equity |
|---|---|---|
| Reinsurer X | AAA | 10% |
| Reinsurer Y | A– with negative outlook | 15% |
| No reinsurance | 25% |
Part a (1.5 points)
Discuss the CFO's reinsurance options with regard to the costs of financial distress and taxation.
Part b (1 point)
Discuss, in terms of agency theory, a CFO bonus structure for ABC Company in which the CFO's bonus is maximized by achieving a 30% return on GAAP equity and minimized by achieving less than a 15% return on GAAP equity.
Answer this question and see the worked solution