In their short paper, the authors describe an elegant decision rule for evaluating the attractiveness of potential reinsurance transactions. In effect, they propose comparing the premium quoted by reinsurers for a particular reinsurance structure to the portion of its premiums the ceding company would need to allocate, given its cost of capital, to retain the risk. If the reinsurance premium is lower than the cedent’s indicated capital cost premium, then the reinsurance is a buy. Otherwise, the risk should be retained.
Before introducing their approach they set up a straw man in the form of what they refer to as the current “industry standard approach” or ISA, which they quickly and rightly demolish. Whether the ISA they describe is, in fact, in widespread use is debatable, but its defects for reinsurance decision-making and capital planning are serious, and the authors make a convincing case that their approach is superior.
However, tantalizing as the authors’ approach may be, the brevity of the paper, its reliance on a single example, and the lack of distinction in that example between the reinsurer’s quoted premium and the ceding company capital cost premium make it difficult to see how a ceding company would apply it in practice. The aim of this discussion is to fill in key gaps in the paper in order to provide a clearer roadmap for the application of the proposed method.
