Placement StructuresAdvanced

Run-off & Commutation

Closing a treaty out for good

Ending a reinsurer's obligations early, for a single agreed cash payment, instead of waiting years for claims to fully develop.

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Definition

A treaty in run-off has stopped accepting new business but its existing obligations continue exactly as written — claims are paid as they emerge, for as long as they take, which on long-tail casualty business can be decades. A commutation ends that tail early: cedent and reinsurer agree a single lump-sum payment, calculated to represent the present value of all future claims, and the reinsurer is fully and finally released from the contract.

Commutation is a negotiation over an unknowable number: the true cost of claims that have not yet fully developed, so both sides bring their own actuarial estimate and settle somewhere between them.
The cedent trades certainty and immediate cash now for the possibility that the reserve proves conservative and the reinsurer would have paid more later; the reinsurer trades cash today for closing its books and freeing the capital held against the reserve.
Once commuted, the reinsurer owes nothing further whatever claims actually emerge later — the cedent has effectively re-assumed the tail risk in exchange for the commutation payment.

Commutation payment ≈ Discounted present value of expected future claims

Both sides discount the same undiscounted reserve at their own assumed rate and loss-development pattern, which is exactly where the negotiation happens.

Worked example

A casualty treaty closed to new business ten years ago still carries a $40M undiscounted reserve for claims expected to keep emerging for another fifteen years. Cedent and reinsurer agree to commute for $27M today, reflecting the time value of money and each side's view of how the reserve will actually develop.

Scenario · figures in USD

Two actuarial views meet in the middle

A long-tail liability treaty in run-off carries a $50M undiscounted reserve for claims still expected to emerge over the next twenty years. The cedent's actuaries discount it at 4% and expect the reserve to run off faster than plan; the reinsurer's actuaries use a more conservative 3% discount rate and a slower development pattern.

Undiscounted reserve	$50M
Cedent's discounted estimate	$29M
Reinsurer's discounted estimate	$35M
Gap between the two views	$6M
Commutation agreed at the midpoint	$32M
Reinsurer's obligations after payment	Nil — fully and finally released

So whatNeither $29M nor $35M is "correct" — both are estimates of claims that have not happened yet. The $32M is simply the price both sides accepted to stop guessing and close the file.

Check your understanding

After a treaty is commuted, what happens if the actual claims later turn out to cost far more than the commutation payment assumed?

The cedent bears the full difference — the reinsurer has been finally released. Commutation is a final release. Whatever claims actually cost afterwards is the cedent's risk, because that is precisely what it agreed to re-assume for the payment received.

Why would a reinsurer ever agree to pay a lump sum now instead of simply paying claims as they emerge over the run-off period?

It frees the capital held against the reserve and closes its books with certainty. Capital held against a long-tail reserve is capital that cannot be deployed elsewhere. Commutation frees it in exchange for a known, final cost.

Word problem

A property treaty in run-off carries an $18M undiscounted reserve expected to pay out evenly over the next six years, as six payments of $3M received at the end of each year. Using a 5% annual discount rate, calculate the present value the cedent would accept as a fair commutation, to the nearest $100,000, and compare it with the $18M undiscounted figure.

Show a hint

Discount each of the six $3M payments back to today at 5%, one year further out each time, then add them up.

Reveal the worked answer

PV factors at 5%: year 1 = 0.9524, year 2 = 0.9070, year 3 = 0.8638, year 4 = 0.8227, year 5 = 0.7835, year 6 = 0.7462
PV of each $3M payment: $2.857M, $2.721M, $2.591M, $2.468M, $2.351M, $2.239M
Sum of the six present values = $15.2M (to the nearest $100,000)
Undiscounted reserve was $18M; the fair commutation is roughly $2.8M lower once discounted

A fair commutation is about $15.2M against an $18M undiscounted reserve — the difference is purely the time value of six years of deferred cash flows at 5%. Every year a payment is pushed further into the future, the gap between the undiscounted and discounted figure widens, which is exactly why commutation negotiations are fought over the discount rate almost as hard as the reserve itself.