What is Loss Portfolio Transfer
A loss portfolio transfer (LPT) is a reinsurance treaty in which an insurer cedes policies that have already incurred losses to a reinsurer. In a loss portfolio transfer, a reinsurer assumes and accepts an insurer’s existing open and future claim liabilities through the transfer of the insurer’s loss reserves. It is a type of alternative risk financing.
BREAKING DOWN Loss Portfolio Transfer
Insurers use loss portfolio transfers to remove liabilities from their balance sheets, with the most common reasons being to transfer risk from a parent to a captive or to exit a line of business. The liabilities may already exist (such as claims that have been processed but not yet paid) or may soon appear (such as incurred but not reported (IBNR) claims).
When an insurer uses a loss portfolio transfer, it is transferring timing risk and investment risk, which is the risk that the reinsurer will generate less investment income when losses from claims are paid faster than expected. If the reinsurer becomes insolvent or is unable to fulfill its obligations, the insurer will still be responsible for payments made to its policyholders.
For example, an insurance company has set aside reserves to cover liabilities from the workers’ compensation policies that it has underwritten. The present value of those reserves is $5 million. While the $5 million is likely to cover all of the losses it may experience, the insurer may ultimately have claims in excess of the reserve. It enters into a loss portfolio transfer with a reinsurer, who takes over the reserves. The reinsurer is now responsible for paying claims, but can use the reserves to generate a return greater than the claims it may have to pay.
LPT reinsurers will often take control of handing claims because the profit they can make will largely be dictated by their ability to run-off claims for less than book value.
If an LPT reinsurer is willing to assume loss reserve assets for less than book value, it enables the ceding entity to realize an immediate profit at inception of cover. This means that by entering into an LPT, the ceding company has some possibility of increasing its capital resources as well as reducing its regulatory capital requirement.
Why Insurers Use Loss Portfolio Standards
Insurers use loss portfolio transfers to immediately monetize any reserves that they have set aside to pay out claims. This can be a significant draw if the insurer has over-reserved, which can happen if its actuarial models have led it to establish premiums and reserves for future losses that wind up being greater than its loss experience. Reinsurers like loss portfolio transfers because they don't take on underwriting risk, and can use the reserves to generate an investment income greater than the losses they are obligated to pay.