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13.10 SAP for reinsurance and business combinations
Publication date: 31 Jan 2021
us Insurance guide
Statutory accounting guidance for reinsurance is included in SSAP 61R for life, deposit-type, and accident and health contracts and SSAP 62R for property and casualty contracts. See IG 8 for SAP and GAAP differences related to risk transfer. Reinsurance accounting for property and casualty contracts under SAP is similar to US GAAP; therefore, the focus of this section will be on life reinsurance contacts. In order to recognize the benefit of a reinsurance contract, the agreement must not be entered into for the principal purpose of providing significant immediate surplus aid while not transferring all the significant risks of the business reinsured and leaving the expected potential liability of the ceding reinsurer unchanged. Appendix 791 of the NAIC’s Accounting Practice and Procedures Manual gives more prescriptive guidance on this objective for life and health insurers. SSAP 61R and Appendix 791 are rule-based guidance that is different from the more principle-based US GAAP requirements. As a result, there are a number of reinsurance contracts that are written with the intent of meeting the statutory risk transfer rules but are not considered to have transferred a significant risk of a significant loss to the reinsurer, as required under US GAAP. While there may be reinsurance contracts that achieve risk transfer for US GAAP and not SAP, this situation is less common. Reinsurance agreements must be evidenced by a written agreement or binding letter of intent no later than the “as of date” of the financial statement (December 31 for year-end financial statements). Binding letters of intent must be executed by a full written agreement within 90 days. See Figure IG 13-1 for a summary and observations related to Appendix A-791.
Figure IG 13-1
Summary of risk transfer requirements for life and health reinsurance in Appendix A-791
Summary of risk transfer requirements for life and health reinsurance in Appendix A-791
Accounting requirements
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Observations
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Paragraph 1 - Appendix does not apply to:
i. assumption reinsurance
ii. yearly renewable term
iii. certain non-proportional reinsurance such as stop loss and catastrophe reinsurance
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Exempted reinsurance types do not normally provide significant surplus relief at inception and are less of a regulatory concern.
Yearly renewable term (YRT) contracts exempted from Appendix A-791 are accounted for as reinsurance only when the treaty contains none of the conditions described in paragraphs 2.b., 2.c., 2.d., 2.h., 2.i., 2.j. or 2.k. of Appendix A-791. In addition, YRT with surplus relief in the first year greater than a treaty with zero premium and allowances is not exempt.
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Paragraph 2.a - Renewal expense allowances must be sufficient to cover anticipated allocable renewal expenses on the portion of business reinsured or a liability for the short fall accrued.
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Such expenses include commissions, premium taxes, billing, valuation, and maintenance, including salaries, computer usage, postage, etc.
The purpose is for the reinsurer to bear all of the risks of the business ceded, including allocable expenses.
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Paragraph 2.b - Reinsurer cannot have the right to additional surplus or assets either as an option or automatically at a future contingent or certain date.
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A provision that automatically converts a funds withheld or modified coinsurance treaty to coinsurance would normally fail unless certain restrictions are in place.
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Paragraph 2.c - Ceding company cannot be required to pay reinsurer for any negative experience unless the ceding company voluntarily terminates the contract.
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Payment of a loss carryforward in the event that the ceding company chose to voluntarily recapture the treaty when a loss carryforward existed would not preclude risk transfer.
Experience refund accounts that allow the cedant to retain profitability does not violate this provision.
Effective January 1, 2021, the NAIC added guidance to paragraph 2c related to YRT reinsurance of group term life. This new guidance is as follows:
Q – If group term life business is reinsured under a YRT reinsurance agreement (which includes risk-limiting features such as with an experience refund provision which offsets refunds against current and/or prior years’ losses (i.e., a “loss carry forward” provision), under what circumstances would any provisions of the reinsurance agreement be considered “unreasonable provisions which allow the reinsurer to reduce its risk under the agreement” thereby violating subsection 2.c.?
A – Unlike individual life insurance where reserves held by the ceding insurer reflect a statutorily prescribed valuation premium above which reinsurance premium rates would be considered unreasonable, group term life has no such guide. As long as the reinsurer cannot charge premiums in excess of the premium received by the ceding insurer under the provisions of the YRT reinsurance agreement, such provisions would not be considered unreasonable. Any provision in the YRT reinsurance agreement that allows the reinsurer to charge reinsurance premiums in excess of the proportionate premium received by the ceding insurer would be considered unreasonable. The revisions to this Q&A regarding group term life yearly renewable term agreements is effective for contracts in effect as of January 1, 2021.
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Paragraph 2.d - Reinsurance agreements cannot have a scheduled or automatic termination or recapture date.
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There can be no provisions in the agreement that would require the ceding company to terminate or recapture all or part of the treaty but there can be voluntary provisions.
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Paragraph 2.e - Payments to the reinsurer cannot exceed the income realized from the reinsured portion of the underlying policies.
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Reinsurance premiums cannot exceed the direct premiums the ceding company receives on the portion of policies reinsured. In circumstances when the ceding company is reinsuring a rider (such as a GLWB rider) and not the base policy, the ceding company sometimes asserts that the pricing of the rider is partially supported by spread margins or fees related to the base product, and as a result, in their analysis, adjust the explicit “premium charged to the policyholder” for purposes of the paragraph 2.e analysis to include fees or investment margin from the base contract. They may also state that the analysis should be done over the expected life of the contract and not look at individual settlement periods. Our view is that the ceding insurer should obtain confirmation from its domiciliary regulator that they do not object to the analysis being done in this way and do not object to the reinsurance credit taken by the ceding insurer.
Reinsurers cannot have the right to set direct policyholder rates. Reinsurers can increase the cost of insurance charges provided they do not exceed the rates the ceding company is receiving from policyholders.
Interest crediting is included in the calculation of income realized from direct policies.
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Paragraph 2.f - Treaty must transfer all of the following significant risks if the business is reinsured:
i. Morbidity
ii. Mortality
iii. Lapse
iv. Credit quality of invested assets
v. Reinvestment
vi. Disintermediation
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The word “significant” in this provision applies to the risk itself and not the amount of the risk transferred. The guidance defines which risks are deemed significant for most types of insurance.
Any limitations on coverage violate this provision unless the domiciliary regulator agrees that risks not transferred are immaterial and do not preclude reinsurance accounting. Clauses that would prevent passing the Appendix A-791 test include: caps and limits on coverage no matter how high or remotely possible (including exclusion for death or injury due to terrorist attacks, pandemics, or natural catastrophes), funds withheld or modified coinsurance for products when investment risk is significant for the product but do not pass all investment result to the assuming company (e.g., fixed interest rates or guaranteed minimum returns), ceding commissions or other experience adjustments that limit coverage or require more premium to be paid, and exclusion of lapse experience.
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Paragraph 2.g - If the investment risks (credit quality, reinvestment, and disintermediation) are significant, they must be transferred by transferring the underlying asset to the reinsurer or legally segregating the assets.
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Asset segmentation generally would not meet this requirement as it is not legally separating the payments on the assets for the benefit of the reinsurer. However, Appendix A-791 provides an exemption to legal segregation for lines of business that do not have significant credit quality, reinvestment, or disintermediation risk, which includes health insurance, traditional permanent (par and non-par), adjustable and indeterminate premium permanent, and universal life fixed premium. This guidance also requires a specific formula for determining the reserve interest rate adjustment.
If all rights of the reinsurer are a proportionate share, the assets underlying the entire block of policies can be segregated and not just the proportion reinsured.
Additionally, when ceding a portion of each policy in a block of policies to multiple reinsurers, it is not required to segregate assets separately for each reinsurer.
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Paragraph 2.h - Settlements must be made at least quarterly.
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This assures there is transfer of timing risk.
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Paragraph 2.i - The ceding insurer cannot be required to make representations or warranties about unrelated business or the future performance of the reinsured business.
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All representations need to be reasonable in relation to the business being reinsured.
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Question IG 13-1 provides an example of the SAP risk transfer requirements.
Question IG 13-1
When is it likely a life reinsurance contract would fail risk transfer under SAP?
When is it likely a life reinsurance contract would fail risk transfer under SAP?
PwC response
A life reinsurance contract would fail risk transfer under SAP when not all of the significant risks of the contract are transferred under the reinsurance contract. For example, a coinsurance agreement when there is an upper limit on losses in the event of pandemic (e.g., defined as amounts of deaths in a certain geographic area) would violate the requirement to transfer all of the mortality risk. Similarly, limitations on investment returns for a whole life policy when the return on the modified coinsurance receivable/payable is not based on the total return of the ceding company's general account investment portfolio or a specified portfolio of investments but is based on a fixed or variable interest rate return, would not transfer all of the investment risk.
13.10.1 SAP implications of retroactive versus prospective contracts
Under SAP, retroactive reinsurance does not require discounting of recoverables, so an immediate increase to surplus, akin to changing to discounted loss reserves, is achieved if risk transfer requirements are met on a retroactive reinsurance contract. As a result, insurance companies that purchase retroactive reinsurance coverage may obtain statutory accounting benefits, even though there is little or no benefit for GAAP purposes.
13.10.1.1 Exceptions to retroactive reinsurance accounting in SSAP 62R
SSAP 62R, paragraph 31, specifies five situations in which retroactive reinsurance is given prospective reinsurance accounting treatment. Those are:
- Structured settlement annuities for individuals purchased to settle policy obligations
- Novations
- The termination of, or reduction in participation in, reinsurance treaties entered into in the ordinary course of business
- Intercompany reinsurance agreements among companies 100% owned by a common parent or ultimate controlling person "provided there is no gain in surplus as a result of the transaction" (i.e., no net gain at inception, calculated as reinsurance premium paid less losses ceded less ceding commission received). If the intercompany reinsurance agreement results in a gain in surplus (e.g., reserves of $100 million are transferred for $90 million in cash and assets), the transaction is accounted for as retroactive reinsurance (i.e., no reduction in loss reserves) and the consideration paid by the ceding company is recorded as a deposit and non-admitted asset;
- Reinsurance/retrocession agreements that meet the criteria of property/casualty run-off agreements, which must be accounted for as described in paragraphs 81-84 of SSAP 62R. This exemption only applies to third-party agreements, not intercompany agreements subject to paragraph 31d of SSAP 62R.
13.10.2 SAP reinsurance accounting versus deposit accounting
For a summary of the prospective, retroactive, and deposit accounting models that would be applied by a ceding company under GAAP, refer to IG 8.
Figure IG 13-2 is a summary of the prospective, retroactive, and deposit accounting models that would be applied by a ceding company under statutory accounting.
Figure IG 13-2
Summary of the prospective, retroactive, and deposit accounting models
Summary of the prospective, retroactive, and deposit accounting models
Prospective reinsurance accounting |
Retroactive reinsurance accounting |
Deposit accounting (timing risk only, or no timing or underwriting risk) |
While GAAP requires a reinsurance recoverable asset to be reported separately from direct unpaid claim liabilities, statutory loss reserves on direct business are presented net of "ceded reserves" for unpaid claims. |
Statutory loss reserves on direct business are presented gross and the "ceded reserves" are reported separately as a retroactive reinsurance contra liability. |
Statutory deposit accounting is consistent with GAAP. |
Any gains or losses resulting from the retroactive reinsurance are recognized in the statement of income and are classified as "special surplus," and should not be reduced from "special surplus" until the actual retroactive reinsurance recovered exceeds the consideration paid. |
13.10.3 SAP for reinsurance of existing blocks of business
Statutory accounting for the reinsurance of life and health insurance blocks of business is governed by SSAP 61R. The ceding insurer must determine if the transaction is an assumption or an indemnity arrangement. In an assumption, the ceding insurer effects a novation in which it extinguishes its liability to the policyholder. An assumption typically results in a gain to the cedant because the liabilities (recorded at their ultimate value) are greater than the assets transferred in the transaction. The cedant should record a gain on the transaction once it has been relieved of its liability in the transaction (in some cases, this may not be immediate because the transfer of liability has to be approved by the policyholders in accordance with state insurance laws). The assuming company values the assets acquired at fair value and the liabilities in accordance with statutory guidelines. Any difference between the two is recorded as goodwill. More common than assumption reinsurance, indemnity arrangements are those in which the insurer has not been released from liability and are recorded consistent with other typical reinsurance arrangements. In addition, there are very specific and complex rules for the treatment of IMR when a large block of business is reinsured. In general, the ceding company releases the IMR associated with the block of business reinsured, and the assuming company records a liability for IMR in the amount of IMR released by the ceding company. See the life and health Annual Statement instructions for more detail.
Statutory accounting for retroactive property/casualty reinsurance, which are agreements to cover liabilities that occurred prior to the effective date of the reinsurance agreement, is governed by SSAP 62R. The ceding company receives immediate gain recognition for the difference between the reserves transferred to the reinsurer and the cash or assets paid, if any, but must maintain that gain in a special surplus account that is not transferred into unassigned surplus (and therefore generally not allowed to be dividended) until all losses are paid by the reinsurer. In addition, the ceding company does not reduce loss reserves for the reserves transferred, but instead records a contra liability called Retroactive Reinsurance Reserves Ceded. As a result, the ceding company receives no reduction in risk-based capital for the reinsurance because RBC is calculated using gross reserves (not net of Retroactive Reinsurance Reserves Ceded). As discussed in IG 13.10.1.1, there are five significant exceptions to the retroactive reinsurance accounting rules.
13.10.3.1 Ceding commissions in life and health reinsurance agreements
Under SSAP 61R, gains (net of income tax expense) on indemnity reinsurance transactions are recognized in surplus at inception, not net income, and are amortized into income "as earnings emerge from the business reinsured." An amount equal to the income tax effect of the gain is immediately recorded in “commissions and expense allowance on reinsurance ceded” as income. The Appendix A-791 guidance is not explicit on the use of either a statutory or effective rate to determine the income tax effect; therefore, we believe it is an accounting policy decision that that should be followed consistently. The ceding company can only amortize the surplus gain into income to the extent there are earnings on the business reinsured during that reporting period regardless of the expected future earnings, per Appendix A791, paragraph 3. As noted in that guidance, commissions received by the ceding company are included in the calculation of the gain that is recognized as a component of surplus.
In practice, we are aware that there are various ways to amortize the gain “as earnings emerge from the business reinsured.” Ceding companies should have established procedures to assess the emergence of profits of the business reinsured and should follow these procedures on a consistent basis. Amortization is not in constant relation to profit (like a GAAP DAC calculation); rather, it is as income emerges versus in relation to how income emerges.
Novations cause immediate gain recognition for the portion of the ceding business novated that was previously reinsured.
Question IG 13-2 addresses the amortization pattern of the gain.
Question IG 13-2
Can a ceding company amortize the gain on reinsurance into the income statement using a ratable pattern over the life of the reinsured block similar to amortizing DAC under GAAP?
Can a ceding company amortize the gain on reinsurance into the income statement using a ratable pattern over the life of the reinsured block similar to amortizing DAC under GAAP?
PwC response
No. The gain amortized in a reporting period cannot exceed the earnings in the period on the business reinsured. Therefore, unless the earnings on the underlying business are similarly ratable, a ratable amortization pattern will not be appropriate. If there are no earnings in a period on the underlying business then there cannot be any gain amortization. However, if there are sufficient earnings in early years of the reinsurance agreement then the gain could be amortized completely in the early years.
13.10.4 SAP assuming company reinsurance accounting
SAP accounting for the assuming reinsurer is governed by SSAP 61R and SSAP 62R. Ceding commissions paid by the assuming company are recorded as expense in the assuming company’s income statement, not as a direct adjustment to surplus as with the ceding company treatment. This treatment is akin to the direct insurer’s requirement to expense acquisition costs. In a large reinsurance contract, this ceding commission can be material to the income statement.
13.10.5 SAP for loss commutations
SSAP 62R, Property and Casualty Reinsurance, specifically addresses the accounting for a commutation; however, there appears to be a contradiction regarding the prescribed income statement presentation. Paragraph 74 states that the ceding company would eliminate the reinsurance recoverable against loss reserves and record the cash received as a negative paid loss. Paragraph 75 states that the ceding and assuming insurers should report any resulting net gain or loss in underwriting income. These paragraphs support net presentation.
Paragraph 76 states that the commuted balances should be written off through the accounts in which they were originally recorded, which suggests that gross underwriting accounting treatment (similar to a novation) is appropriate. Paragraph 88 supports this gross position by providing the requirement to disclose the effects of the commutation on premiums earned and losses and LAE incurred. The NAIC technical staff has confirmed this ambiguity in discussions but has not taken a position on which presentation is preferable, since that action would have to be taken by the regulators on the Statutory Accounting Principles Working Group.
SSAP 61R, Life, Deposit-Type and Accident and Health Reinsurance, paragraph 58, contains similar contradictory language.
We believe that net underwriting presentation is preferable for both SAP and GAAP (i.e., the loss should be recorded through loss expense or loss and LAE expenses). This view is applicable to both the ceding insurer (reassuming insurer) and the reinsurer. However, because there is (1) no clear guidance in GAAP, (2) ambiguous guidance in SAP, and (3) diverse presentation in practice, we would not object to gross underwriting presentation under SAP or GAAP. We believe that whichever method is selected by the company should be used consistently in both accounting models as well as consistently among reporting periods.
13.10.6 SAP accounting for seller's guarantee in a business combination
For statutory accounting purposes, the GAAP guidance on reinsurance in a purchase business combination has been rejected. As a result, reserve guarantees in a purchase business combination of an insurance company should generally be treated as retroactive insurance, in accordance with SSAP 62R. The result of this can be significant, since the RBC formula does not allow a credit for retroactive reinsurance. Therefore, property and casualty insurers must meet the same RBC requirements as if the reinsurance had not been obtained.
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