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9.6 Accounting for ceded long-duration reinsurance contracts
Publication date: 31 May 2022
us Insurance guide
A ceded reinsurance contract must first be evaluated for risk transfer to determine whether the arrangement should be accounted for as reinsurance or under a deposit accounting model, as described in IG 9.5.
When a long-duration reinsurance contract passes risk transfer, the reinsurance recoverable arising from benefits of the contract is measured using methods and assumptions consistent with those used to measure the covered direct insurance benefit liability. Additionally, in accordance with ASC 944-30-35-64, proceeds from reinsurance transactions that represent recovery of acquisition costs reduce the applicable unamortized acquisition costs in such a manner so that net acquisition costs are capitalized. In some instances, this amount will be represented by the amount characterized as the "ceding commission" in the contract. However, in other instances, the ceding commission specified in the agreement may be more or less than the amount representing recovery of acquisition costs, requiring an understanding of the substance of the transaction in order to determine the amount by which capitalized acquisition costs should be reduced. Any remainder would be part of the "cost of reinsurance," as described in IG 9.6.2.
9.6.1 Reinsurance recoverable for ceded long-duration reinsurance contracts
There is no specific guidance on how to determine the reinsurance recoverable asset for ceded contracts. ASC 944-40-25-34 provides only general guidance.
Reinsurance recoverables shall be recognized in a manner consistent with the liabilities (including estimated amounts for claims incurred but not reported and future policy benefits) relating to the underlying reinsured contracts. Assumptions used in estimating reinsurance recoverables shall be consistent with those used in estimating the related liabilities.
Various approaches to calculating the reinsurance recoverable are used in practice that attempt to mirror the measurement of the underlying covered direct contracts. Generally, the common goal of such approaches is to present the net income statement effect of the direct policies on an after ceded basis by using cash flow assumptions and methodology for calculating the reinsurance recoverable consistent with those used for the direct policies (akin to an accounting hedge), combined with a cost of reinsurance that must be amortized. These approaches become more complex when the reinsurance contracts are not on a proportional basis (e.g., excess of loss). Additionally, the determination of reinsurance recoverables for ceded reinsurance contracts subject to ASU 2018-12 is impacted by the new requirement to review (and update as necessary) all insurance assumptions on at least an annual basis (see IG 5.2.4) and to remeasure the liability for future policy benefits using the current upper-medium grade rates (see IG 5.2.3 for further guidance).
9.6.1.1 Application to traditional and limited payment long-duration contracts
Reinsurance recoverables relating to reinsurance of traditional and limited payment contracts are required to be recognized and measured in a manner consistent with the liabilities relating to the underlying reinsured contracts, including using consistent cash flow assumptions. As a result, a net premium ratio and retrospective updating of cash flows should be used in the recognition and measurement of reinsurance recoverables for traditional and limited-payment long duration contracts, consistent with the direct liabilities. On direct contracts, a net premium ratio is used to derive a constant profit margin over the entire life of a group of contracts (i.e., the cohort). Employing this constant margin concept to the reinsurance recoverable results in accounting that is consistent with the purpose of the transaction - to act as an economic hedge of the reinsured business.
Two acceptable methods for determining the reinsurance recoverable are the “net cost” method, which is calculated in relation to the entire direct cohort’s gross premiums, and the “standalone” method which is calculated only in relation to the contracts within the cohort that are subject to the reinsurance treaty (using either direct premiums on reinsured contracts or ceded premiums as the accrual basis). In proportional reinsurance of a contemporaneous reinsurance treaty, both methods will yield the same result; however, in certain circumstances (e.g., if the timing/amount of ceded premium is not consistent with the direct premium), the standalone method will not achieve a constant margin.
The cash flow assumptions for the reinsurance, such as estimates of mortality, morbidity, terminations, and expenses, need to be consistent with those for the direct policies, in accordance with ASC 944-40-25-34 and ASC 944-605-35-15. In addition, entities are required to use a locked-in contract issue date upper-medium grade yield in calculating the net premium ratio, ceded benefit expense and interest accretion for income statement purposes, as well as a current upper-medium grade yield for balance sheet remeasurement of the reinsurance recoverable, consistent with the principles applicable to direct insurance contracts.
In many instances, an insurer may enter into a ceded reinsurance contract on a prospective basis, meaning that the reinsurance contract covers direct insurance contracts issued contemporaneously with and/or for some period subsequent to the inception date of the reinsurance contract. The locked-in contract issue date yield curve used to measure each new portion of the reinsurance contract recognized and for subsequent income statement measurement should be consistent with the locked-in issue date yield curve used to measure each of the direct reinsured contracts. In subsequent periods, the current yield curve (i.e., current upper-medium grade curve) is used for balance sheet remeasurement purposes for both the direct liability for future policy benefits and the reinsurance recoverable.
Reinsurance contracts may also be executed subsequent to the direct contract issue dates, and market interest rates may have changed between the date that the underlying insurance contracts were issued and the date the reinsurance contract is recognized in the financial statements. The yield curve at the date the reinsurance contract is recognized should be used as the locked-in issue date yield curve for initial measurement of the reinsurance recoverable and any cost of reinsurance and for subsequent income statement measurement purposes. This is required to comply with the principle in ASC 944-40-35-6A(b)2 that the discount rate for income statement purposes is the discount rate at the contract issue date; in this case, that is the reinsurance contract issue date. Using the current yield curve also satisfies the ASC 944-40-25-34 requirement that the reinsurance recoverable be recognized in a manner consistent with the liabilities relating to the underlying reinsured contracts, and using consistent assumptions. That is, the direct liabilities that are being referenced in ASC 944-40-25-34 are the direct liabilities as remeasured using the current yield curve at the date the reinsurance contract is recognized in the financial statements. There is no immediate comprehensive income or loss relating to the initial recognition of the reinsurance recoverable.
Example IG 9-1 illustrates the accounting for 100% coinsurance of a block of traditional inforce insurance contracts.
EXAMPLE IG 9-1
Reinsurance of inforce contracts
Reinsurance of inforce contracts
For simplicity, this example ignores acquisition costs and reinsurer credit risk, assumes use of an equivalent level discount rate and assumes that the reinsurance transaction is executed for initial consideration equal to the GAAP liability for future policy benefits.
A group of direct life insurance contracts was written on 1/1/X1 when the upper-medium grade fixed income discount rate was 5%. Three years later, on 12/31/X3, the direct writer remeasures the liability for future policy benefits using a 3% rate, which represents the current upper-medium grade fixed income discount rate.
On 12/31/X3, the liability for future policy benefits measured using the locked in rate of 5% used to calculate benefit expense and accrete interest expense is $100 million, while the remeasured liability using the current 3% rate is $110 million. A debit balance (unrealized loss) of $10 million exists in accumulated other comprehensive income (AOCI) relating to the direct liability remeasurement.
On the same day, 12/31/X3, the direct writer cedes 100% of the contracts in the group through a coinsurance contract for initial consideration of $110 million, for which the locked-in rate for the reinsurance policy would be 3%, the rate at the recognition date of the reinsurance contract.
What amounts should the direct writer recognize for the reinsurance recoverable and cost of reinsurance in connection with ceding the group of contracts?
Analysis
The direct writer would recognize a ceded reinsurance recoverable of $110 million for the consideration paid of $110 million. The reinsurance recoverable and any cost of reinsurance (in this case $0) would be measured using the discount rate at the date the reinsurance contract is recognized; there is no “day one” accumulated other comprehensive income associated with the reinsurance contract because the 5% locked-in discount rate used to measure benefit expense and interest accretion on the direct liability is not relevant to the reinsurance contract entered into three years later.
In subsequent periods, the direct policies will continue to use 5% while the reinsurance recoverable will use 3% for future income statement interest accretion and benefit expense/ceded benefit expense recognition, resulting in a 2% negative spread differential recognized in income. The direct insurance liability and reinsurance recoverable will be remeasured each period end using the current period-end discount rate, with the difference between the locked-in issue date discount rates (5% for the direct contracts and 3% for the reinsurance contract) and current discount rate measurement of the balances recognized in AOCI. Over time, the starting difference in AOCI between the direct policies and the reinsurance contract of $10 will unwind through OCI as the group of direct contracts approaches maturity in a pattern consistent with the spread differential in the income statement such that on a total comprehensive income basis, the net of the direct and reinsurance transactions will be zero.
Calculating the ceded net premium ratio under the “net cost” method
The numerator in the ceded net premium ratio (cNPR) calculation would be the present value of expected ceded premiums minus ceded benefits (“net cost”), and the denominator would be the present value of expected gross direct premiums of the entire direct cohort.
Additionally, a ceding entity should calculate the ceded net premium ratio and reinsurance recoverable by utilizing the cohorts of the reinsured direct policies when calculating the net premium ratio and related reinsurance recoverable. For example, if the direct writer cedes two cohorts within one reinsurance contract, each of the two cohorts would require a separate calculation to determine their respective ceded net premium ratios. Alternatively, if one direct cohort is subject to multiple reinsurance contracts, the ceding company will calculate one ceded net premium ratio that considers all reinsurance contracts associated with the cohort.
Example IG 9-2 illustrates how a ceding entity can establish the ceded net premium ratio and calculate the reinsurance recoverable under the “net cost” method when a direct cohort is subject to multiple reinsurance contracts.
EXAMPLE IG 9-2
Calculation of initial ceded net premium ratio and reinsurance recoverable under the “net cost” method
Calculation of initial ceded net premium ratio and reinsurance recoverable under the “net cost” method
Insurance Company A has a cohort of traditional life insurance contracts with estimated total cash flows summarized below. (Note that the cash flows used in this example are based on the direct cohort net premium ratio calculation in Example IG 5-1).
Direct activity |
Benefits |
Gross premiums |
Net premiums |
Net premium ratio |
Total - Cohort 1 |
$4,504 |
$6,338 |
$4,504 |
71.07% |
The cohort is subject to two reinsurance treaties which were entered into at inception of the direct cohort (note that discounting of cash flows to derive the ceded net premium ratio uses the initial reinsurance contract issuance discount rate, which for simplicity of illustration is assumed to be 0%). One treaty is a 50% coinsurance agreement and the other reinsures any benefits in excess of $220 per year (before application of the 50% coinsurance), for an annual premium of $10. Using the direct cash flows in Example IG 5-1, the total benefits in excess of $220 are $154. The total cash flows for both reinsurance treaties are below.
Reinsurance - Cohort 1 |
Benefits (A) |
Premiums (B) |
Net cost (B-A) |
Treaty 1: 50% coinsurance |
$2,252 |
$3,169 |
$917 |
Treaty 2: Excess of $220 claims |
$154 |
$200 |
$46 |
Total reinsurance - Cohort 1 |
$2,406 |
$3,369 |
$963 |
How is the initial ceded net premium ratio calculated, and how is the reinsurance recoverable calculated under the “net cost” method?
Analysis
Under the net cost approach, the total pre-tax income statement impact of the reinsurance in each period is equal to the gross premiums for that period multiplied by the ceded net premium ratio (with any cumulative catch up, as necessary). The change in the reinsurance recoverable is therefore the difference between (1) actual ceded premiums less benefits for each period and (2) the actual gross premium of the total cohort multiplied by the ceded NPR. This results in a constant profit margin over the life of the cohort on a net of reinsurance basis.
The ceded net premium ratio is calculated by first determining the projected net cost of reinsurance over the life of the cohort by taking the difference between projected total ceded premiums and benefits ($3,369 - $2,406 = $963), and then dividing the net cost by expected gross premiums of the cohort ($963 / $6,338 = 15.2%).
In this example, profits before reinsurance from the direct cohort are expected to be 28.9% of gross premiums (1 – the NPR of 71.1%). The 15.2% represents the portion of the total profit of the direct cohort ceded to the assuming company.
The table below illustrates the calculation of the reinsurance recoverable over the life of the cohort. (Note amounts are rounded to the nearest dollar.)
Year
|
Net Cost (A)
|
Gross premium x cNPR (15.2%)
(B) |
Change in recoverable
(A-B) |
Recoverable balance
|
1 |
160 |
76 |
84 |
84 |
2 |
143 |
72 |
71 |
155 |
3 |
127 |
68 |
59 |
213 |
4 |
110 |
65 |
45 |
259 |
5 |
92 |
62 |
31 |
290 |
6 |
76 |
58 |
18 |
307 |
7 |
62 |
55 |
7 |
314 |
8 |
50 |
53 |
-3 |
312 |
9 |
40 |
50 |
-10 |
301 |
10 |
31 |
47 |
-16 |
285 |
11 |
24 |
45 |
-21 |
264 |
12 |
17 |
42 |
-25 |
238 |
13 |
13 |
40 |
-28 |
211 |
14 |
9 |
38 |
-29 |
181 |
15 |
6 |
36 |
-30 |
151 |
16 |
4 |
34 |
-30 |
121 |
17 |
3 |
33 |
-29 |
92 |
18 |
2 |
31 |
-29 |
63 |
19 |
-2 |
29 |
-31 |
32 |
20 |
-5 |
28 |
-32 |
0 |
Total |
963 |
963 |
0 |
As discussed in more detail in IG 9.7.1.1, there may be differences in the cohorts used by the ceding entity and those used by the assuming entity in a reinsurance arrangement. The entity that is not the administrator of the business should ensure that the data the administrator provides is in enough detail to allow for the required disclosures and cohort level for measurement. Refer to IG 10.3 for further information.
Additionally, when the reinsurance contract is a short-duration contract covering long-duration direct policies, such as certain stop-loss reinsurance, the reinsurance benefit will be recognized over the life of the short-duration reinsurance contract, but the direct claim experience will be recognized over the longer term of the direct contracts, resulting in a mismatch in revenue and expense recognition.
Reinsurance NPR cap
For direct traditional and limited payment long-duration insurance contracts (see IG 5.2.5), an immediate charge is recognized in income for the amount by which the present value of future benefits and expenses exceeds the present value of future gross premiums (i.e., if the NPR exceeds 100%). No specific guidance addresses how this principle relating to direct contract liabilities should be applied to reinsurance recoverables. Following the guidance in ASC 944-40-25-34 that reinsurance recoverables should be recognized in a manner consistent with the direct liabilities being reinsured, to the extent that the insurer has recognized an immediate loss on the reinsured portion of the direct contracts in the current period, the insurer should recognize an immediate gain on the reinsurance ceded contract. However, in accordance with the reinsurance guidance in ASC 944-40-25-33 that prohibits gain recognition upon entering into a reinsurance contract, an insurer should not recognize a gain at inception of a reinsurance transaction to offset a previously recognized loss on direct business.
Judgment will be required in applying this guidance to situations when the insurer has purchased reinsurance on only a portion of a cohort and the cohort is generating a loss, or in situations when the insurer has purchased reinsurance on multiple cohorts, some of which have reached the 100% cap and others have not.
Reinsurance recoverable “floor”
The liability for future benefits on directly written contracts cannot be less than zero (i.e., an asset) at the cohort level. The net premium calculation can result in a liability balance of less than zero that must be floored at zero for products when the rate of premium increase exceeds the rate of increase in the assumed mortality rate over the term of the contract, such as yearly renewable term insurance. In these situations, an entity would recognize a charge to income to prevent the recognition of an asset.
There is no specific guidance as to how the” liability floor” guidance for direct contracts impacts the measurement of the reinsurance recoverable. We believe an acceptable interpretation is that in situations when the ceding entity is prohibited from recognizing an asset on the direct contracts in accordance with the liability floor provisions, it may also not recognize a liability relating to the purchased reinsurance contract.
However, there may be certain circumstances when the recognition of a reinsurance liability may be appropriate. For example, a noncancellable yearly renewable increasing premium term or excess of loss reinsurance contract may be purchased to reinsure level premium direct insurance contracts. In that circumstance, following the net premium approach and constant margin principle discussed for the ceded reinsurance transaction, a ceded reinsurance liability may result. Conceptually, a net liability can result in various situations in which cash flows relating to ceded premium are lower (or benefits are higher) in earlier periods but the impact of reinsurance is recognized for accounting purposes on a constant margin basis.
9.6.1.2 Application to non-traditional contracts
In some cases, a cedant may reinsure death or other insurance benefits (such as no lapse guarantee benefits) that require an additional direct liability in accordance with ASC 944-40-25-27A. In such instances, as required by ASC 944-40-30-20, a ceded benefit ratio using the same assumptions and scenarios used to establish the direct contract liability should be used to establish a reinsurance recoverable. The reinsurance recoverable is calculated using premiums ceded under the terms of the contract multiplied by the ceded benefit ratio (excess benefit payments ceded under the terms of the reinsurance contract as the numerator and direct contracts’ assessments as the denominator) less ceded excess benefits paid to date under the contract, which is similar to the reinsurance recoverable described for traditional contracts in IG 9.6.1.1.
9.6.2 Initial measurement - cost of reinsurance
ASC 944-605-30-4 states that "the difference, if any, between amounts paid for a reinsurance contract and the amount of the liabilities for policy benefits relating to the underlying reinsured contracts is part of the estimated cost to be amortized." A common interpretation of this requirement is that all amounts paid to the reinsurer, less the expected recoveries and reimbursements to be paid to the ceding entity, plus or minus any "ceding commission" not representing recovery of acquisition costs, comprise the "net cost" to be amortized.
The consideration paid may be in the form of investments. The transfer of the investments must meet the conditions to be treated as a sale under ASC 860 to be derecognized (and for any gain or loss on the sale of those assets to be recognized immediately in income). If so, the fair value of those assets, along with any other consideration received or paid, including any ceding commission received from the reinsurer that does not represent recovery of acquisition costs, would be components of the net consideration paid to the reinsurer. Typically, funds withheld and modco treaties do not meet the ASC 860 sale criteria.
The cost of reinsurance to be amortized arises primarily due to differences between the cash flow and discount rate assumptions used by the ceding enterprise in its liability for future benefits and those negotiated in pricing the risk transferred, as well any risk premium and profit margin. One area of difference that is likely for all products is the discount rate, because the reinsurer’s return on investment used in pricing the assumed business will be different from the discount rate used in measuring the liability for future policyholder benefits under GAAP.
Due to the differences between the "book value" liabilities and the fair value consideration exchanged, the cost of reinsurance may in some cases result in a net debit, and in other cases a net credit. Reinsurance contracts do not result in immediate gain recognition unless the reinsurance contract is a legal replacement of one insurer by another and the cedant’s liability to the policyholder is extinguished, as noted in ASC 944-40-25-33. Therefore, to the extent that the "net cost" is a credit, that amount is recorded as a deferred gain and amortized as described in IG 9.6.3.
In a "net debit" situation, ASC 944 requires amortization of the net cost of reinsurance rather than the immediate recognition of a loss. In most situations, this would be appropriate, with the rationale being that the cedant has paid the reinsurer to take on the uncertainty inherent in the direct insurance liabilities (i.e., the risk that the liabilities may develop adversely in the future). As a result, the "net cost" can be viewed as a prepaid asset providing future benefit to the cedant in the event of adverse development. However, when a premium deficiency test is required (e.g., for universal life-type contracts), and when an entity’s accounting policy is to include reinsurance-related balances and cash flows in that analysis, the inclusion may result in a write-off of any net debit. See Question IG 7-2 in IG 7.3.3.
With the elimination of the impairment test for DAC and changes to premium deficiency guidance for traditional and limited pay contracts under ASU 2018-12, entities will no longer be able to write off any net debit resulting from a reinsurance transaction or impair DAC for those contracts. The amortization expense related to any remaining DAC (after reduction for consideration received from the reinsurer representing recovery of DAC) and cost of reinsurance for traditional and limited pay contracts will continue throughout the remaining life of the direct contracts, even if those contracts are 100% ceded.
For limited payment contracts, a cost of reinsurance can be established which represents the portion of the consideration relating to the deferred profit liability.
Question IG 9-1
Should an insurance entity establish a cost of ceded reinsurance on reinsurance treaties that reinsure limited payment contracts?
Should an insurance entity establish a cost of ceded reinsurance on reinsurance treaties that reinsure limited payment contracts?
PwC response
Reinsurance of limited payment contracts introduces additional complexity due to the nature of the contracts. The objective of using a net premium approach, which is also required for reinsurance accounting, is to reflect a constant margin over the life of the contracts. On limited payment contracts, as profit is earned over time through DPL amortization on the direct contracts, from a reinsurance perspective, this profit emergence should be similarly captured.
There is no explicit guidance for recognizing a ceded DPL, however, upon initial recognition of a reinsurance contract ceding limited payment contracts, insurance entities should determine if a cost of reinsurance exists that relates to the direct DPL. By establishing a cost of reinsurance to represent the deferred profit to be recognized over time, and amortizing this balance using the same driver as the direct DPL, a ceding entity can appropriately reflect the impact of the reinsurance.
9.6.3 Amortization of the cost of reinsurance
ASC 944-605-35-14 notes that the period of amortization of the cost of reinsurance (which, as noted in IG 9.6.2, may be a net debit or a net credit) depends on whether the reinsurance contract is long-duration or short-duration. If the reinsurance contract is short-duration, the cost is amortized over the reinsurance contract period. If the reinsurance is long-duration, the cost is amortized over the life of the underlying reinsured contracts.
ASC 944 is silent as to the pattern of amortization. In practice, some view the amortization as similar in concept to the amortization of DAC and, accordingly, amortize the cost of reinsurance using a straight-line pattern consistent with DAC amortization under ASU 2018-12. Alternatively, a pattern of recognition based on premiums, gross profits, gross margins, or some other method that reflects the economics of the transaction and the principles of ceded reinsurance accounting may also be appropriate. It would also be consistent with the requirement that assumptions used in accounting for reinsurance costs be consistent with those used for the direct contracts.
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