What it means
An insurer that has written policies in the past may still owe claim payments that will take years to settle, such as liability or injury claims. These unpaid amounts sit on the balance sheet as loss reserves, and the insurer carries the risk that they turn out higher than estimated.
A loss portfolio transfer (LPT) moves that risk to a reinsurer. The insurer pays a premium to the reinsurer, and the reinsurer agrees to pay the covered claims, either in full or up to an agreed limit.
The premium is usually lower than the face amount of the reserves because the reinsurer can invest the money until claims fall due, which is called discounting. The reinsurer also charges for taking the risk and for its expenses.
Insurers use LPTs for several reasons. They may want to shed old business after exiting a line, clean up a balance sheet before a sale, release trapped capital, or stabilise results against reserve surprises.
They are particularly attractive when the old reserves are uncertain, as the deal fixes the cost. The accounting effect depends on the type of contract.
If it transfers sufficient risk, it is treated as reinsurance, and the gain or loss is recognised according to the accounting rules in the relevant market. If it does not transfer enough risk, it may be treated as a deposit.
An LPT does not remove the insurer's legal duty to policyholders. If the reinsurer fails to pay, the original insurer is still responsible, so the quality of the reinsurer is a key consideration.
Pricing depends on the reserving estimate, the expected payment pattern and the interest rate the reinsurer can earn. A longer, more uncertain payment pattern generally means a bigger discount to face value but also a bigger risk margin.
Both parties normally commission an independent actuarial review of the claims before the price is agreed.
In practice
Real-world examples.
Example
A property and casualty insurer decides to stop writing employers' liability cover. It transfers its old reserves to a reinsurer so management can concentrate on its remaining business. The claims team is also reduced, because the reinsurer takes over day-to-day handling of the covered claims under a service agreement.
Example
A company preparing to sell an insurance subsidiary arranges an LPT on the subsidiary's old claims, giving the buyer certainty about the price and the likely outcome. The seller prefers a clean exit without lingering exposure to old claims, and the deal can close faster as a result.
Example
A mid-sized insurer is under pressure from a rating agency over weak reserves. It buys an LPT with an aggregate limit, which reduces volatility and improves its capital ratios. Management explains to the rating agency that the aggregate limit caps the reinsurer's exposure, so the price is lower than for unlimited cover.
Formula
Calculation
Immediate effect on the insurer = Reserves transferred - Premium paid to the reinsurer
Suppose an insurer holds $50,000,000 of reserves for old liability claims and agrees an LPT with a reinsurer for a premium of $46,000,000.
Reserves removed from the balance sheet = $50,000,000.
Cash paid = $46,000,000.
Immediate effect = $50,000,000 - $46,000,000 = $4,000,000 favourable, before deducting any costs and ignoring accounting subtleties.
If the claims later cost $55,000,000 instead, the reinsurer absorbs the extra $5,000,000 (subject to any limit), while the insurer's cost stays fixed at $46,000,000.Case study
Seen in the real world.
Brightwater Mutual is an illustrative, fictional insurer that stopped writing commercial transport liability five years ago. Claims continued to arrive, and the actuaries estimated the remaining liabilities at $80,000,000 with a wide range of possible outcomes.
The board arranged a loss portfolio transfer with a specialist reinsurer, paying $72,000,000 for cover up to $95,000,000 of claims. This released $8,000,000 of reserve margin and, more importantly, fixed the cost of an uncertain run-off.
Two years later, the claims turned out higher than the central estimate, around $88,000,000. In this fictional example the reinsurer bore the extra cost, and Brightwater's board concluded that certainty had been worth the discount it gave up.
Watch out
Common mistakes.
- Treating an LPT as cover for new claims, when it only deals with claims from policies already written and past events.
- Assuming the insurer is free of all responsibility, when a reinsurer's failure could leave the original insurer liable to policyholders.
- Ignoring the cost, which includes the reinsurer's margin for taking uncertain claims as well as expenses.
Questions
People also ask.
Why would a reinsurer accept an LPT?
Because it can invest the premium until claims are paid and expects to earn a margin if its estimates of the claims are accurate.
What is the difference between an LPT and a retroactive reinsurance contract?
They are closely related: an LPT is a common form of retroactive cover that transfers losses that have already occurred.
Can an LPT be reversed?
Not easily, as the contract is typically final and the price reflects that finality.
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