I understand that initially the primary company takes a charge for the
contract. However, I don't understand why there would ever be a net gain
on the contract (that would then have to be deferred). Isn't the purpose
of the contract that the primary company pays the reinsurance premium and
then if adverse development occurs there is no net balance sheet nor net
income statement effect? If gross incurred losses increase such that the
reinsurance coverage is triggered, wouldn't the reinsurance recoverable
increase to offset the incurred loss increase?
Also, I don't understand Miccolis' section on cost of capital. Does
anybody know how Miccolis comes up with the following statements/why they
are true/what they mean?
1. Since a p/c insurer can freely invest in risk-free securities, such as
U.S. Treasury securities, an investor should not expect a yield
differential solely from the capital & surplus funds.
2. There is a zero cost of capital if the risk associated with the
investment income on capital & surplus is directly reflected in the
valuation.
3. It appears that the cost of capital is ill-defined for valuation
purposes.
4. Thus, while the investment of capital & surplus funds in themselves
might be risk-free, the other income (or loss) is not. The cost of capital
is an essential element to the income valuation model that produces the
desired total average rate of return.
5. If one considers the valuation of a particular company for a particular
buyer without the cost of capital, it would include adjusted surplus plus
the discounted value of projected future earnings where the discount rate
reflects the buyer's assessment of risk and the corresponding risk/return
requirements. However, the discount rate selected for this value
computation should be higher than the total IRR required by the buyer.
Thanks for your help.
Georgia