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8.11 Loss commutations – short-duration reinsurance
Publication date: 30 Sep 2020
us Insurance guide
Loss commutations are agreements to terminate all or part of a reinsurance agreement in return for cash (or other form of payment), generally at a discounted amount. Loss commutations result in the insurer reassuming the risk of liabilities for losses previously ceded to the reinsurer. Under a loss commutation, the reinsurer is generally released of the obligation for payment of known and unknown losses and uncertainties associated with severity of the losses. The insurance entity is no longer covered for (1) investment risk, and (2) loss (reserve) risk. The primary business reasons insurers initiate loss commutations are:
- The reinsurer is having or has previously had trouble performing under the contract
- The reinsurer is known to be in serious financial difficulty
- It is suspected that the reinsurer may not be able to perform in the future
- The assuming entity believes it was misled
- The parties believe it is more efficient to end the relationship, as much of the variability in frequency, severity of the coverage period has passed, and therefore statutory surplus strain has passed
- Features in the reinsurance agreement encourage termination when the policies are profitable with the elimination of profit sharing after a period of time
The accounting treatment for the insurance entity originally ceding the business is to eliminate the existing reinsurance recoverable and recognize a gain or loss immediately for the difference between the cash (or other consideration) received and the reinsurance recoverable. Gain or loss recognition is immediate because a commutation is a legal extinguishment of all rights and obligations under a reinsurance contract. While there is no definitive guidance as to the income statement presentation of the gain or loss, we believe that presentation as a single amount in loss expense is appropriate. Alternatively, presenting cash received from the commutation as a reduction in ceded premium and the elimination of the reinsurance recoverable as additional loss expense effectively reverses all activity previously recorded from the financial line items effected by the contract in past periods. Whichever method is selected should be consistently applied.
The cash received represents the fair value of the future claims payments. As claim liabilities typically are not discounted, there will be a loss on commutation. In situations when the entity recognizes a gain, the entity should determine why such a gain occurred and its impact on the underlying direct contract estimates and assumptions (including premium deficiency considerations).
The accounting by the reinsurer “mirrors” that of the ceding insurer, except that the reinsurer may have a different accounting policy as to gross versus net income statement presentation.Occasionally, a ceding entity will substitute one reinsurer for another, releasing the original reinsurer. As the primary obligor to a contract is a key provision, such substitution constitutes a commutation of the original contract and creation of a new contract. There will be a gain or loss on the terminated contract and a new risk transfer evaluation on the new retroactive reinsurance agreement.
Frequent commutations between a ceding and assuming insurer may bring into question whether there was ever an intent to transfer risk, especially for aggregate excess of loss contracts that are commuted as incurred losses approach the attachment point.
Question IG 8-10 addresses the accounting impact of a reporting entity reassuming its own risk from a third-party reinsurer.
Question IG 8-10
Alpha Insurance Company cedes financial guarantee business with an approximate 15-year life on a quota share basis to Beta Reinsurance Company. Beta subsequently retrocedes 100% of the risk assumed from Alpha to Omega Reinsurance Company. Premiums under both contracts are paid at inception. The retrocession to Omega was not a condition of the original reinsurance agreement between Alpha and Beta and Alpha was not involved in arranging the retrocession.
Seven years later, Omega wants to exit the financial guarantee business and Alpha is willing to reacquire the risk it originally ceded. To accomplish this, Omega could negotiate a commutation of the retrocession contract with Beta and Beta could simultaneously negotiate a commutation of its reinsurance agreement with Alpha. Alternatively, Omega could negotiate a new retrocession agreement directly with Alpha. Assume there are no existing claim liabilities relating to the reinsured business.
What is the accounting impact of Alpha reassuming its own risk, albeit from a different third party reinsurer rather than from a commutation of its original contract with Beta?
Alpha Insurance Company cedes financial guarantee business with an approximate 15-year life on a quota share basis to Beta Reinsurance Company. Beta subsequently retrocedes 100% of the risk assumed from Alpha to Omega Reinsurance Company. Premiums under both contracts are paid at inception. The retrocession to Omega was not a condition of the original reinsurance agreement between Alpha and Beta and Alpha was not involved in arranging the retrocession.
Seven years later, Omega wants to exit the financial guarantee business and Alpha is willing to reacquire the risk it originally ceded. To accomplish this, Omega could negotiate a commutation of the retrocession contract with Beta and Beta could simultaneously negotiate a commutation of its reinsurance agreement with Alpha. Alternatively, Omega could negotiate a new retrocession agreement directly with Alpha. Assume there are no existing claim liabilities relating to the reinsured business.
What is the accounting impact of Alpha reassuming its own risk, albeit from a different third party reinsurer rather than from a commutation of its original contract with Beta?
PwC response
Whether Alpha reassumes its own risk by commuting its contract with Beta or by entering into a retrocession contract with Omega, the economic substance of the two approaches is the same and therefore the accounting result is similar. Even though the contract with Beta has not legally been modified, in substance, it has been commuted. That is, through the two agreements, Alpha has reassumed its own risk. ASC 944-20-15-40 states that the determination as to what constitutes a contract “...involves a complete understanding of that contract and other contracts or agreements between the ceding enterprise and related reinsurers.” The accounting should follow the substance of the combined contracts.
Therefore, the transaction should be accounted for similar to a commutation. Any excess of the remaining prepaid ceded premium asset with Beta over the premium received from Omega represents a loss that should be recognized immediately. This elimination of the prepaid ceded premium asset reflects that any remaining prepaid asset in excess of the unearned assumed premium is not recoverable, as there is no net benefit (i.e., reduction in risk) from these two transactions. If there were any existing claim liability relating to the reinsured business that Alpha legally assumed from Omega, such amount represents a deposit obligation and would be a component of the net loss calculation as well. Alternatively, if there is an excess of premium received from Beta over any remaining prepaid ceded premium asset with Omega, such amount would result in a potential gain. Such gain would be recognizable when no obligations or contingencies remain under the contracts with both Beta and Omega, consistent with the accounting for a commutation between two parties.
The legal contracts between Alpha and Beta and between Beta and Omega still exist; consequently, any amounts payable to Omega and receivable from Beta would be presented separately on Alpha’s balance sheet as they are with any separate counterparties.
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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