Commutation Pricing in the Post Tax-Reform Era

This paper discusses how a reinsurer prices the commutation of a group of claims. A commutation is an agreement between an insurer and a reinsurer in which one payment by the reinsurer settles a group of claims that 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 determine the present value of 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/loss normally generated by a commutation. Also covered is a formula used to determine price and why the commutation price normally appears 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, IBNR development, payment profile(s), and interest rate selection. An additional example comments on the effects on commutation pricing when the payment patterns and interest rates used to determine the present value of the losses are not equal to those used to develop tax basis discounted reserves. 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 step-by-step approach with examples will make this subject more understandable.