CAS Exam 7 Spring 2018, Question 22
Study guide: Exam 9
An insurance company needs to strengthen its capital position in order to maintain its financial strength rating. The company currently has no reinsurance and is considering the following two strategies:
Strategy 1: Issue an $80 million surplus note
- Coupon rate on surplus note = 8%.
- Bond yield = 5%.
- Coupons are paid out annually.
- The surplus note cannot be repaid for a minimum of 5 years.
Strategy 2: Purchase quota-share reinsurance
- Gross earned premium = $200 million.
- Economic margin on contract = 15% of ceded premium.
- The insurance company will cede 10% of its earned premium in the first year.
- It is projected that the company's profits will strengthen its surplus over time and the cession will be reduced to 8% in the second year, 3% in the third year, and eliminated in the fourth year.
- The projected annual gross earned premium is stable over the next five years.
Part a (0.75 points)
Calculate the cost of each strategy in the first year and determine which strategy is preferred on a one-year basis.
Part b (1.25 points)
Calculate the cost of each strategy over five years, using the bond yield as a discount rate, and determine which strategy is preferred on a five-year basis.
Part c (1 point)
Identify the three paradigms for measuring the value in a reinsurance structure and identify which of the paradigms was used to evaluate the quota share reinsurance structure in Strategy 2 above.
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