Tax and Accounting Issues

Futures or options held directly as a hedge are accounted as a realized capital gain or loss

• In "good years' these capital losses can be used to offset ordinary taxable income to the extent that a bona fide hedging strategy is documented and accepted by the IRS (Sounds like a fun discussion, doesn't it?)


• In "bad" years, using NOL against realized gains may not be tax-efficient


• No protection of underwriting income or reported ratios

Model Investment Law may limit or proscribe index options

To Hold as a Hedge, or Pay to Use a "Transformer" and Account as Reinsurance?

"Transformers" are corporate vehicles (generally off-shore) that sell reinsurance contracts that are exactly backed by an offsetting capital market transaction.

"Transformers" can:

• Protect some accounting results for the company, such as loss ratio, combined ratio, and net income;


• Prevent mismatch of capital gains and ordinary taxable income;


• Avoid model investment law issues and specific state requirements for insurer portfolios subject to them.

Loss Warranty Reinsurance

A reinsurance contract that must satisfy two requirements for recovery.

1. The ceding company must have losses in excess of the treaty's retention, and


2. The entire industry's direct loss must exceed a separate, higher warranty amount.


• PCS estimated industry occurrence or aggregate loss.


• Physical characteristics of event: earthquake magnitude or storm force.

Many sellers of loss warranty covers are essentially "transformers' backed by catastrophe index products.

Summary

Buyers considering insurance derivatives must address three questions:

1. What kind of risk do they want to transfer?


• Insurance risk, or


• Index risk


2. Do they want to transfer it as reinsurance or as a balance-sheet transaction?


3. Whom should they buy it from?

Although there are half-way alternatives, buyers will choose insurance derivatives, on the CBOT or elsewhere, when they decide that:

1. They are willing to transfer index risk, not insurance risk;


2. They want direct balance-sheet treatment without protection of income statement, underwriting results, or reported ratios;


3. They can get better terms or more capacity dealing directly with investors instead reinsurers.

Are these sensible decisions today?

Conclusions

Current prices on the CBOT and for loss warranty products do not offer a clear advantage over traditional reinsurance.

There is more capacity for off-exchange oprions, but it's not very attractive for other reasons.

Don't ignore basis risk, It matters.

Most buyers would find a significant advantage in using a Transformer and taking protection as reinsurance.

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