Commutation Pricing in the Post Tax Reform Era

This paper discusses how to reinsurer prices the commutation of a group of claims. A commutation is when an insurer and a reinsurer agree to settle a group of claims with one payment by the reinsurer when they have not been settled by (or perhaps reported to) the insurer. After discussing the reasons for commutations, an example is used to discuss the after tax interest rate that is used to present value the claims. Also discussed is how to determine the value of the unwinding of the discount, as well as the tax on the underwriting gain normally generated by a commutation. Also covered is a formula used to determine price and why the commutation price normally looks low to insurance companies. the second more complicated example develops a commutation price for a typical property/casualty line. The overall discussion in this example touches upon a number of different points to keep in mind when pricing commutations. Some of these points include contract analysis, handling of adjustable features, IBNR development, and payment profile selection. The last part of the paper deals with sensitivity analysis where interest rates, tax rates, and payment profiles are varied to see their effect on the indicated price. While initially appearing complex, it is hoped that this step by step approach with examples will make this subject more understandable.