Reinsurance Commutation

By Jim Klann · Casualty Actuarial Society · 2013

Study guide: Exam 6U

A study note by Jim Klann on reinsurance commutation, the agreement between a ceding insurer and a reinsurer that provides for the valuation, payment and complete discharge of all obligations under a reinsurance contract. It focuses on the accounting for, and taxation of, commutations, and looks briefly at the parties' motivations, at pricing and at reserving in order to explain the accounting.

On the syllabus

Exam 6U — objective D3; the whole study note (2013); candidates should refer to Edition 5 of the Odomirok et al. paper, Financial Reporting Through the Lens of a Property/Casualty Actuary, when reviewing it.

Introduction

When an insurer and a reinsurer enter into a contract they expect a lengthy relationship, but one party may later want to end it early by executing a commutation agreement; the reinsurer typically makes an immediate payment to the primary insurer and is absolved from all future involvement with the claims or policies covered.
Commutations present challenges to the actuary in the areas of pricing, reserving and accounting.

Motivations of the Parties

Either party may wish to exit a particular line of business; for the primary insurer, commuting may be a first step before a loss portfolio transfer to a third party.
Either party may have concerns about the other's solvency: commutation eliminates credit risk to the primary insurer, or provides an immediate cash infusion and spares the reinsurer a future liquidator.
The relationship may have frayed over disputes about claim resolution or contract provisions.
The parties may hold different views of loss development, so that a commutation at an intermediate price leaves each side convinced it is getting a good deal.
The original contract may provide for commutation under given terms after a given period, typically in reinsurance for long-tailed lines such as accident and health and workers compensation.

Pricing

Each side estimates the claim payments that would occur without commutation (the reinsurer's loss reserves, the primary insurer's reinsurance recoverables), estimates when they would occur, and applies a discount factor for risk and the time value of money; the two parties' estimates are unlikely to be identical.
Each party must consider the effect of taxation, and factors unique to its motives, such as the possible distribution of future claims where solvency is an issue.
The parties must agree on a price within the range of overlap of their acceptable prices, or the commutation will not take place.

Accounting and Reserving

A worked example of two insurance companies, Primary and Re, shows paid losses, reserves and ultimate losses, gross, ceded and net, before and after a commutation.
Commutations distort the loss triangles in Schedule P, Parts 2 and 3, and the claim closure rates in Part 5 of the reinsurer's Schedule P, which actuaries must take into account when calculating loss development factors or assessing reserve adequacy.
The ceding company must disclose commutations in Section E of the reinsurance note to the financial statements, but the disclosure does not break amounts down by accident year or line of business, and there is no disclosure requirement for the reinsuring company.
In the example, the commutation reduces the primary insurer's pretax income and statutory surplus by 100 and increases the reinsurer's by 150.

Accounting and Taxation

For tax purposes unpaid losses are valued on a discounted basis, using a company's own or IRS payment patterns and IRS published discount rates, so the buying and selling companies will probably have applied different discount factors.
In the example, Primary applies a discount factor of 0.875 and Re 0.85, and the commutation produces a tax decrease of 13.13 for Primary and a tax increase of 23.63 for Re, an asymmetry caused by the differing reserve amounts and discounting.

Sources

Reinsurance Commutation (Jim Klann) — the document: title, author, the headings and the text of all eight pages (sha256 241b38316fff3c86…); the PDF prints no date or publisher, so the year (2013) and the CAS as issuing body are taken from the content outline, and the document itself calls the paper a study note
CAS Exam 6U Content Outline, Fall 2026 — the citation ("2013") and the instruction to refer to Edition 5 of the Odomirok et al. paper