Definition: Process where the future value of an unpaid claim(s) and associated expenses is 'current valued, taking into account financial and non-financial aspects, to accelerate payment and close the case(s)
Buyer / Primary Ceding Company's Attraction To A Commutation
1. Accelerated settlement of the obligation
2. Improvement in current "wealth" using entity's perception of value of cash over non-cash assets
3. Cash flow for reinvestment or liquidity to deploy for other purposes
4. Certain immediate amount is substituted for an uncertain future amount
5. Possible admin cost saving associated with monitoring and collection efforts
6. Creating a marginal underwriting loss and federal income tax marginal adjustment
Seller / Reinsurer's Attraction To A Commutation
1. Accelerated settlement, often times ending relationship with buyer
2. Improvement in perceived "wealth" when considering financial and non-financial aspects
3. Limited attractive cash flow alternatives
4. A certain result, not subject to future events such as contract remediation or retroactive legislation or judicial results
5. LAE administrative expense savings
6. Creating a marginal underwriting gain with a probable adverse current tax consequence
Ambivalence Point
1. Definition: Point estimate monetary figure representing the highest value the seller is willing to pay the buyer
2. Formula: AP = (AP - Tax Basis Reserve) * Tax Rate + NPV Booked Reserve
Steps to Reach US Ambivalence Point
1. Calculate PV of loss
2. Calculate tax basis reserve as total loss * tax basis discounting factor
3. Calculate amount of unwind = Step 1 - Step 2
4. Calculate PV of Step 3
5. Calculate PV of the unwinding of the discount times the US tax rate
6. Calculate basis of seller's ambivalence point, i.e., cost not to commute = Step 1 - Step 5
7. US Ambivalence Point = (Step 6 - Step 2 * r) / (1 - r) where r = US Tax Rate