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9.5 Evaluating risk transfer for long-duration reinsurance contracts
Publication date: 31 May 2022
us Insurance guide
ASC 944-20-15-59 indicates that the reinsurance contract must indemnify the ceding entity against loss or liability relating to insurance risk, and there must be a reasonable possibility that the reinsurer may realize a significant loss from assuming insurance risk (e.g., mortality and morbidity risk). Contracts that fail either of these criteria are accounted for as deposits. This assessment should be performed at contract inception, and a reassessment is required upon any change or adjustment to the contractual terms as outlined in ASC 944-20-15-62 through ASC 944-20-15-65.
9.5.1 Defining the contract – long-duration reinsurance
ASC 944-20-15-37 stresses substance over form in defining “the contract” that is subject to risk transfer analysis and accounting. All contracts, including contracts that may not be structured or described as reinsurance, must be assessed for potential reinsurance accounting. Although the legal form and substance of a reinsurance contract generally will be the same, this may not always be the case. Analysis and judgment is required to determine the contract for accounting purposes. In some instances, features of other related contracts may need to be considered part of the accounting contract. It is therefore important to determine whether the ceding entity and the reinsurer have made any other legally binding agreements (e.g., collateral/funding agreement, separate reinsurance agreement passing the risk back to the insurer or insurer affiliate, servicing agreement, separate profit-sharing contracts), whether oral or written, in conjunction with the reinsurance contract being assessed. If so, they should be considered part of the accounting contract, particularly if they were negotiated at the same time or in contemplation of entering into the reinsurance contract. Such agreements are often referred to as “side agreements.” In some instances, the side agreements serve to negate some or all of the risk transfer in the reinsurance contract.
Different kinds of exposures combined in a program of reinsurance should not be evaluated for risk transfer together, even if in the same contract. Doing so may allow a component of a contract that does not meet the conditions for reinsurance accounting to be accounted for as reinsurance by being designated as part of a larger reinsurance program. For example, for a multi-coverage program combining several distinct lines of business, each line should be evaluated separately as part of the risk transfer test.
9.5.2 Insurance risk – long-duration reinsurance
The requirement that the ceding entity must be indemnified from insurance risk precludes reinsurance accounting for reinsurance of investment contracts. ASC 944-20-20 defines investment contracts as "long-duration contracts that do not subject the insurance entity to risks arising from policyholder mortality or morbidity." Common examples of investment contracts are guaranteed investment contracts (GICs) and annuities payable not based on life contingencies (e.g., single-premium deferred annuity contracts, fixed period payout annuities). Additionally, certain annuity contracts where no insurance risk remains after separating market risk benefits and embedded derivatives would be considered an investment contract.
9.5.3 Reasonable possibility of significant loss – long-duration reinsurance
ASC 944-20-15-59 requires that indemnification of the ceding entity against loss or liability relating to insurance risk in reinsurance of long-duration contracts have the “reasonable possibility” that the reinsurer may realize “significant loss.” However, the guidance does not define "reasonable possibility" or "significant loss" for purposes of the risk transfer criteria. Determining the amount of risk transfer of long-duration contracts is a matter of judgment after evaluating all facts, both qualitative and quantitative.
ASC 944 does not specify an explicit quantitative test to determine the reinsurer’s exposure to significant loss for long-duration contracts. In practice, various types of quantitative tests with entity-specific thresholds (of reasonable possibility and significance) are used to evaluate whether insurance risk transferred under long-duration contracts meet this “reasonable possibility of significant loss” requirement. In practice, entities also use qualitative judgments about whether the range of assumptions used in preparing loss scenarios is reasonably possible.
ASC 944-20-15-61 notes that the evaluation of mortality risk or morbidity risk in contracts that reinsure universal life-type policies and other long-duration contracts must be consistent with the criteria for distinguishing investment contracts from universal life-type contracts in ASC 944-20-15-16 through ASC 944-20-15-19 used for direct contracts. ASC 944-20-15-19 requires a test of mortality risk be a present value calculation. ASC 944-20-15-19 is silent as to which discount rate (expected earned rate or GAAP discount rate used for liability for future policy benefits or otherwise) should be used.
The "stepping in the shoes" exception afforded to short-duration contracts (when 100% of the risk is transferred even if there is not a significant risk of loss to the reinsurer under the reinsurance contract) is not afforded to long-duration contracts. However, there are some circumstances when entities may analogize to the "stepping in the shoes" exception rather than perform a quantitative assessment to demonstrate that risk has been transferred for a long-duration contract. For example, some entities have qualitatively concluded that they should account for life reinsurance contracts as reinsurance as long as they transfer all risks of the underlying contracts (e.g., 100% coinsurance). However, the presence of an experience rating feature, “forced” recapture terms, or other provisions that vary from the direct insurance contract would generally indicate further risk transfer analysis is required.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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