Commutations, Novations, and Other Alternative Loss Transfer Strategies Jason Palmer, CPA, Willis, Senior Vice President Tommy Tso, J.F. Shea Co. Inc., Risk Manager David Melick, AIG, Assistant Vice President Agenda • Background on Insurance Program Close‐Out Options • Captive Owner Perspective • Insurer Perspective • Accounting Perspective Background Commutation – Usually refers to the cancellation or dissolution of a reinsurance contract in which there are profits or losses to be allocated. Novation ‐ An agreement to replace one party to an insurance policy or reinsurance agreement with another company from inception of the coverage period. The novated contract replaces the original policy or agreement. Also known as cancel and rewrite. Background (Con’t) Loss Portfolio Transfer (LPT) ‐ A financial reinsurance transaction in which loss obligations that are already incurred and will ultimately be paid are ceded to a reinsurer. In determining the premium paid to the reinsurer, the time value of money is considered, and the premium is therefore less than the ultimate amount expected to be paid. The cedent's statutory surplus increases by the difference between the premium and the amount that had been reserved. Reinsurance Definitions Reinsurance – A transaction in which a reinsurer (assuming entity), for a consideration (premium), assumes all or part of a risk undertaken originally by another insurer (ceding entity). For indemnity reinsurance, the legal rights of the insured are not affected by the reinsurance transaction and the insurance entity issuing the insurance contract remains liable to the insured for payment of policy benefits. Assumption or novation reinsurance contracts that are legal replacements of one insurer by another extinguish the ceding entity’s liability to the policyholder. Reinsurance Definitions (Con’t) Retroactive Reinsurance – Reinsurance in which an assuming entity agrees to reimburse a ceding entity for liabilities incurred as a result of past insurable events covered under contracts subject to the reinsurance. A reinsurance contract may include both prospective and retroactive provisions. Captive Owner Perspective

• Why close‐out policies/programs? • Captive wind‐down/runoff • Lack of claims activity • Recover collateral • Underwriting profit • Take advantage of insurance market fluctuations Captive Owner Perspective (Con’t)

• When to close‐out programs? • Stabilization of claims • Insurance/Reinsurance market appetite • Need to free up collateral/surplus supporting existing programs Case Study 1 • Captive Owner with nine years of accumulated GL & WC exposure • Captive insured varying deductibles of $250K ‐ $1MM • Excess of $50MM in collateral held by insurer to support claims payments • Late‐2009, slowing insurance market allowed for discussion of program close‐out • Ultimately, seven policy years were commuted. Two most current years were evaluated as too green for commutation • Premium held by captive was then paid to insurer. Future claims became responsibility of insurer. Collateral was released back to insured. Case Study 2 • Captive Owner with nine years of accumulated Products/Completed Operations exposure • Captive insured varying SIRs of $2MM to $50MM • Long‐tail claims with minimal loss activity/development to date • Late‐2009, slowing insurance market allowed for discussion of program close‐out • Ultimately, eight policy years were closed‐out either through reinsurance or novation. • Premium held by captive was then paid to insurer. Future claims became responsibility of insurer. • Underwriting profit based on actuarial reserves vs. premium paid was deferred.

ASC 944‐605‐25‐22 Revenue Recognition of Retroactive Reinsurance – Amounts paid for retroactive reinsurance of short‐ duration contracts that meets the conditions for reinsurance accounting shall be reported as reinsurance receivables to the extent those amounts do not exceed the recorded liabilities relating to the underlying reinsurance contracts. If the recorded liabilities exceed the amounts paid, reinsurance receivables shall be increased to reflect the difference and the resulting gain deferred. Sample Transaction Assumptions • Premium Paid to Reinsurer (Assuming Entity) ‐ $9MM • Actuarial Outstanding Losses Reinsured ‐ $10MM • End of Year 1 –Paid Losses During the Year ‐ $1MM Actuarial Development ‐ $0MM

• End of Year 2 –Paid Losses During the Year ‐ $2MM Actuarial Development ‐ $4MM (Adverse) Results of Sample Transaction

Select Financial Statements Select Financial Statements Accounts Prior to Transaction Accounts After Transaction Balance Sheet Balance Sheet Cash $1MM Cash $1MM Investments $14MM Investments $5MM Reinsurance Recoverable $0MM Reinsurance Recoverable $10MM Deferred Gain ($0MM) Deferred Gain ($1MM) O/S Loss Reserves ($10MM) O/S Loss Reserves ($10MM) Capital & Surplus ($5MM) Capital & Surplus ($5MM)

P&L Statement P&L Statement Reinsurance Premium $0MM Reinsurance Premium $0MM Change in O/S Loss Reserves $0MM Change in O/S Loss Reserves $0MM Amortized Gain $0MM Amortized Gain $0MM Results of Sample Transaction (Con’t) Select Financial Statements Select Financial Statements Accounts 1st Year Accounts 2nd Year Balance Sheet Balance Sheet Cash $1MM Cash $1MM Investments $5MM Investments $5MM Reinsurance Recoverable $9MM Reinsurance Recoverable $11MM Deferred Gain ($0.9MM) Deferred Gain ($4MM) O/S Loss Reserves ($9MM) O/S Loss Reserves ($11MM) Capital & Surplus ($5.1MM) Capital & Surplus ($2MM)

P&L Statement P&L Statement Reinsurance Premium $0MM Reinsurance Premium $0MM Change in O/S Loss Reserves $0MM Change in O/S Loss Reserves $0MM Amortized Gain ($0.1MM) Amortized Gain $3.1MM Year 2 Sample Transaction Calculations End of Year 2 Revised O/S Losses at Date of Transfer ‐$14MM Less: Original Premium Paid to Reinsurer (Assuming Entity) ‐($9MM) Revised Deferred Gain on Retrospective Reinsurance ‐$5MM Year 1 and Year 2 Percentage of Losses Paid ($1MM + $2MM = $3MM/$14MM) ‐ ≈ 20% Amortized Deferred Gain on Retrospective Reinsurance at the end of Year 2 ‐ $1MM Questions?