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8.5 Evaluating risk transfer for short-duration contracts
Publication date: 30 Sep 2020
us Insurance guide
To qualify for reinsurance accounting, ASC 944-20-15-59 indicates that a reinsurance contract must indemnify the ceding entity against loss or liability relating to insurance risk. In order to determine if a contract qualifies for reinsurance, reporting entities must obtain a complete understanding of the contract, and evaluate all of the features in the agreement, as well as how those features interrelate. All contract features should be evaluated to determine if they limit the amount of insurance risk the reinsurer assumes (e.g., through experience refunds, cancellation features, adjustable features), or delay the timely reimbursement of claims by the reinsurer. To the extent the risk-limiting features cause the contracts to not meet the significant risk transfer criteria, the entire reinsurance contract should be accounted for as a financing transaction (i.e., deposit accounting). Refer to IG 8.5.5 for further discussion of risk-limiting features.
Many reinsurance contracts contain terms that are intended to limit to some degree the variability in underwriting results to the reinsurer. In its broadest usage, the term “finite reinsurance” refers to contracts that are designed to transfer just enough risk to achieve a business objective for the ceding entity and no more. This will keep the cost of the reinsurance to an amount that relates solely to the business objective.
The premium-to-surplus ratio is a key statistic used by regulators and analysts to measure the financial leverage of an insurer. It is a convenient surrogate for estimating the amount of loss that an insurer's capital can support. This measure uses premiums before (gross) and after (net) considering ceded premiums. The cost of a traditional reinsurance product may be more than the ceding entity is willing to pay. This may result in revisions to the traditional reinsurance contract to reflect the cost objective of the buyer or the risk appetite of the seller. A finite reinsurance transaction may also be purchased when the ceding entity needs to reduce its net premiums but believes the underlying business is profitable and does not wish to forego the profit. A reinsurer is willing to forego this profit potential in return for a limit on its loss potential -- a finite risk transaction. If actual losses turn out to be higher than the limit accepted by the reinsurer, however, the total loss to the insurer (i.e., the combination of premiums paid to the reinsurer and the excess loss) could be more than it would have been under the "traditional product." Certain contract designs maximize the amount of premium ceded to the point of not representing the true risk ceded. This artificially improves the ceding entity’s leverage ratio and makes it appear that the insurer does not have as much risk as it actually does. Such contracts may be structured as quota share contracts with caps, loss corridors, or sliding scale commissions.
In a free market environment, product development and innovation is expected. Such innovation may, however, lead to complex terms and conditions. The greater the number and/or degree of risk-limiting features that exist in a contract, the more difficult it is to assess whether the insurance risk transferred is significant enough for the contract to be accounted for as reinsurance rather than as a deposit.
8.5.1 Defining the contract – short-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. Careful analysis and judgment is required to determine the boundaries of a contract for accounting purposes. In some instances, features of other related contracts may need to be considered part of the subject 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 subject 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.
Similarly, 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.
8.5.2 Risk transfer criteria for short-duration reinsurance contracts
For short-duration contracts, ASC 944-20-15-41 identifies two criteria that must be met in order for a contract to be accounted for as reinsurance.
Excerpt from ASC 944-20-15-41
- Significant insurance risk. The reinsurer assumes significant insurance risk under the reinsured portions of the underlying insurance contracts. Implicit in this condition is the requirement that both the amount and timing of the reinsurer’s payments depend on and directly vary with the amount and timing of claims settled under the reinsured contracts.
- Significant loss. It is reasonably possible that the reinsurer may realize a significant loss from the transaction.
Each contract needs to be analyzed based on the facts and circumstances of each transaction, the operating environment, and the contract’s potential impact on the reporting entity’s financial reporting. The assessment of significant insurance risk and significant loss is discussed further below.
8.5.3 Significant insurance risk – short-duration reinsurance
To determine whether the contract passes significant risk, both the qualitative and quantitative features of a contract should be considered, as well as the business purpose of the contract and the cash flows and associated probabilities and outcomes. The assessment should be performed at contract inception, and only reassessed upon modification of the contract. Reassessment of significant insurance risk transfer is required for all but the most trivial changes in financial and non-financial terms.
Significant insurance risk requires both the amount and timing of the reinsurer’s payments to depend on and vary directly with the amount and timing of claims settled under the reinsured direct insurance contracts. The insurance risk born by the reinsurer need not be proportionate. A reinsurer may provide coverage on an excess of loss basis and still have significant underwriting risk. The evaluation is performed in relation to the insured portions of the underlying insurance contracts rather than all aspects for the contracts.
Significant insurance risk would not be transferred if the probability of a significant variation in either the amount or timing of payments by the reinsurer is remote. In assessing whether there would be a significant variation in the amount of losses, reporting entities would need to consider risk-limiting features. For instance, a loss cap or a corridor may reduce or eliminate variability in the amount of losses ceded under a contract.
Contractual provisions that delay timely reimbursement to the ceding entity may also result in significant insurance risk not being transferred. Examples include payment schedules or accumulating and floating retentions from multiple years. ASC 944-20-15-48 states that “timely” should “be evaluated based solely on the length of time between payment of the underlying reinsured claims and reimbursement by the reinsurer.” It does not matter if a contract provision stipulates that interest will be assessed on the amount owed to the cedant as a result of a contract provision that delays timing of reimbursement to the cedant by the reinsurer.
Timing delays may be built into features that may not appear on initial review to impact cash flow at all, such as coverage changes and other techniques. Careful evaluation of the business purpose of each contract provision and a review of cash flow scenarios are necessary to determine whether a contract meets the timely reimbursement criteria. Risk-limiting features are discussed in IG 8.5.5.
8.5.4 Reasonable possibility of a significant loss – short-duration reinsurance
ASC 944-20-15-41 does not define “significant loss” for purposes of the risk transfer criteria. It also does not define “reasonable possibility.” Determining the reasonable possibility of a significant loss will require an assessment of the qualitative and quantitative facts and the use of judgment.
To determine the amount of loss for a given reasonably possible scenario, ASC 944-20-15-51 requires the comparison of (1) the present value of all cash flows between the ceding and assuming entities to (2) the present value of amounts to be paid to the reinsurer, before commissions. Insurers must consider all cash flows (included within the reinsurance contract or potentially by combining side agreements) between the ceding entity and assuming entity in the present value calculation, as there may be payments that effectively represent premiums or refunds of premiums that are not characterized as such in the contract or side agreements. Additionally, ASC 944-20-15-49 indicates that the same interest rate should be used to compute the present value of the cash flows for each reasonably possible outcome tested. The rate should reflect both (1) the expected timing of payments to the reinsurer and (2) the duration over which those cash flows are expected to be invested by the reinsurer. In performing this quantitative assessment, insurers must consider reasonably possible outcomes. Typically, reporting entities would consider their historical premium and loss experience in developing reasonably possible outcomes. If an insurer does not have enough of its own historical data, then industry experience may be used.
Question IG 8-1 addresses which cash flows should be included in the significant loss calculation.
Question IG 8-1
Are cash flows associated with the reinsurer’s administration of the agreement included in the significant loss calculation?
Are cash flows associated with the reinsurer’s administration of the agreement included in the significant loss calculation?
PwC response
No. Cash flows related to expenses of the reinsurer, such as taxes or operating expenses, are excluded from the calculation. Only the cash flows between the two parties to the contract are included.
In practice, informal quantitative guidelines have been used to define the reasonable possibility of significant loss criterion. While more than a 10% probability of at least a 10% loss is widely used, there is no “bright line” in the accounting literature. For a plain vanilla reinsurance contract without complex provisions and risk-limiting features, there may be numerous reasonably possible scenarios that could result in a 10% loss while remote scenarios could cause an even greater loss. If the assumptions supporting the estimate are reasonable, a 10% chance of a 10% loss may be sufficient to conclude that a significant loss is reasonably possible.
The further away from a plain vanilla contract (and the more loss limiting features included in the contract), the greater the percentage of loss needs to be in order to qualify for reinsurance accounting. In more complex contracts, a loss that is capped at 10% may not be considered significant.
In addition, qualitative factors need to be considered in evaluating whether a loss is significant, including:
- The relationship between the possibility of loss and the potential magnitude of the loss
- Maximum possible loss
- Rate used to discount the cash flows in the quantitative assessment
- Range of assumptions used
- Possibility that the assumptions could all be realized at the same time
- Other indirect factors, such as the impact of reinsurance versus deposit accounting on the entity’s risk-based capital and other key ratios (e.g., premiums/surplus ratio, debt covenants)
Question IG 8-2 discusses the impact of contract limits on the quantitative significant loss test. Question IG 8-3 addresses accounting practice for contracts with a low probability of loss but a high level of loss severity.
Question IG 8-2
Would a contract that has a 15% probability of a 10% loss, but no probability of a loss above 15% due to contract limits meet the quantitative significant loss test?
Would a contract that has a 15% probability of a 10% loss, but no probability of a loss above 15% due to contract limits meet the quantitative significant loss test?
PwC response
Most likely not. Although the assessments are facts and circumstances dependent, there would be limited circumstances in which this would be considered a reasonable possibility of a significant loss. In this scenario, the business purpose is more likely financial, such as a loan.
Question IG 8-3
How should contracts with a low probability of loss and a high level of severity, such as a catastrophe cover, be evaluated?
How should contracts with a low probability of loss and a high level of severity, such as a catastrophe cover, be evaluated?
PwC response
The informal quantitative guideline for the probability of loss criterion can be problematic for certain types of reinsurance that have a low frequency of occurrence but potentially high severity of loss, such as catastrophe covers. Accounting practice has evolved such that catastrophe covers are deemed by most practitioners to be reinsurance, even if the probability of loss is very low but the potential magnitude of the loss in comparison to the amounts to be paid to the reinsurer is significant. This also assumes that the potential inclusion of risk-limiting features does not significantly limit the loss exposure. Typically, the premium for such coverage is very small, with little to no financing economics. As a result, reinsurance accounting has little impact on the financial statements unless the event occurs.
8.5.5 Risk-limiting contract features – short-duration reinsurance
As the structures of risk-limiting reinsurance transactions become more complex, and their terms become more indefinite, the economics become increasingly difficult to quantify. Terms that make it difficult or impossible to evaluate the economics of a transaction suggest that reinsurance accounting may not be appropriate.
Figure IG 8-5 summarizes common risk-limiting features that may be present in reinsurance contracts, and their respective features. The existence of one or more of these features does not immediately cause the contract to fail risk transfer; however, the effect of each feature should be evaluated in the risk transfer analysis.
Figure IG 8-5
Common risk-limiting features
Common risk-limiting features
Risk-limiting feature
|
Attributes
|
Sliding scale, profit or contingent commissions
|
|
Adjustments to coverage
|
|
Experience accounts
|
|
Retrospective premium adjustments
|
|
Reinstatement clauses
|
|
Loss caps
|
|
Loss corridors
|
|
Dual triggers
|
|
Side letters
|
|
Use of captives or affiliates
|
|
Funds withheld
|
|
Indefinite terms / auto-renewals
|
|
Commutation clause
|
|
In addition to the common risk-limiting features listed in Figure IG 8-5, unique risk transfer considerations may need to be considered based on the structure of the reinsurer. If the structure includes special purpose vehicles with limited activities and ability to finance losses, then the ability to pay potential losses should be considered.
Evaluating whether insurance risk is transferred is complex, and the effect of any risk-limiting features on this evaluation will likely require the collaboration of actuaries with the accountants performing the assessment.
To the extent the contract passes the risk transfer assessment, the terms of the contract and timing of entering into the agreement should then be analyzed to determine if the contract should be accounted for under prospective or retroactive reinsurance accounting. Refer to IG 8.6 for a description of this accounting assessment. If the contract fails the risk transfer assessment, the contract should be reported using deposit accounting. Refer to IG 8.7 for a discussion of the accounting implications.
Question IG 8-4 addresses the application of the “timely reimbursement” criteria.
Question IG 8-4
A reinsurance contract contains a loss corridor, whereby aggregate losses within the range of 50% to 70% can be ceded to the reinsurer, only if the losses are at or in excess of a 70% loss ratio (i.e., a cumulative catch up of cessions will occur when a 70% loss ratio exists, and all losses within the corridor will be ceded, but if the losses fall below 70%, no losses can be ceded).
If the trigger point is expected to be met, the reinsurer reimburses the ceding entity as the underlying losses are paid. However, if the initial loss estimate is below the trigger point, the reinsurer has no obligation, and therefore no losses are paid or accrued by the reinsurer (regardless of when the underlying losses are paid) until such time as that estimate changes to trigger coverage under the reinsurance contract. If payments are made by the reinsurer based on an initial loss estimate that exceeds the trigger point, and the claim subsequently settles for less than the limit, all amounts previously paid will be returned to the reinsurer.
Would this reinsurance contract provision meet the “timely reimbursement” criteria in evaluating risk transfer?
A reinsurance contract contains a loss corridor, whereby aggregate losses within the range of 50% to 70% can be ceded to the reinsurer, only if the losses are at or in excess of a 70% loss ratio (i.e., a cumulative catch up of cessions will occur when a 70% loss ratio exists, and all losses within the corridor will be ceded, but if the losses fall below 70%, no losses can be ceded).
If the trigger point is expected to be met, the reinsurer reimburses the ceding entity as the underlying losses are paid. However, if the initial loss estimate is below the trigger point, the reinsurer has no obligation, and therefore no losses are paid or accrued by the reinsurer (regardless of when the underlying losses are paid) until such time as that estimate changes to trigger coverage under the reinsurance contract. If payments are made by the reinsurer based on an initial loss estimate that exceeds the trigger point, and the claim subsequently settles for less than the limit, all amounts previously paid will be returned to the reinsurer.
Would this reinsurance contract provision meet the “timely reimbursement” criteria in evaluating risk transfer?
PwC response
It depends on the expectation of the loss ratio and the tail associated with the underlying coverage.
To the extent the reinsurance agreement reinsures auto coverage and the expected loss ratio under the agreement is 85%, the timely reimbursement criteria would likely be met. This is due to the fact that the business has a relatively short tail (i.e., claims are expected to be reported within a year), and there is an expectation that the cumulative catch up provision will occur based on the expected loss ratio exceeding the 70% cap. Therefore, when paid losses begin to emerge within the corridor, the time between when those losses would have been reimbursed from the reinsurer, and when they actually will be reimbursed, based on the 70% cap being met, will likely be within a year. As such, any potential timing delay would likely be considered insignificant.
In contrast, if the coverage related to a longer tail line, such as general liability, and the loss experience by underwriting year is erratic (i.e., losses have not emerged consistently based on the experience of the insurer), then the contract would not meet the “timely reimbursement” criteria. The inclusion of this clause with a longer tail line would causes the contract to fail significant risk transfer if all calculations are done on a paid basis.
Example IG 8-1 illustrates a risk transfer analysis for an excess of loss reinsurance contract. Example IG 8-2 and Example IG 8-3 show the analysis for an excess of loss reinsurance contract with a retrospectively-rated premium adjustment.
EXAMPLE IG 8-1
Risk transfer analysis of an excess of loss reinsurance contract
Risk transfer analysis of an excess of loss reinsurance contract
P&C Insurance Company enters into an excess of loss reinsurance contract that covers its general liability book of business and is expected to pay claims over the next seven years for losses occurring in the current year.
Cover: $1,000,000 of loss per occurrence in excess of $1,000,000
Annual Premium: $2,000,000
Commission: 15% of the premiums ceded
Loss Ratio: It is reasonably possible that the ultimate ratio on the contract could range from 75% of premiums ceded to 120% of premiums ceded.
Payment Pattern: The payment pattern is expected to vary; the majority of claims are expected to be paid at least 2 years from the occurrence date. The entity has estimated three payment patterns under each reasonably possible loss ratio: fast, medium, and slow.
Assumptions in loss scenario used to demonstrate risk transfer:
Estimated ultimate loss ratio: 120%
Estimated payment pattern (“medium” speed of payment):
Year 1
|
10%
|
Year 2
|
20%
|
Year 3
|
30%
|
Year 4
|
20%
|
Year 5
|
10%
|
Year 6
|
6%
|
Year 7
|
4%
|
100%
|
Loss payments are made at the end of the year.
Premiums are received on the first day of the contract period.
Interest rate used: US Treasury yield curve
Cash flows:
Year
|
1/1/X1
|
12/31/X1
|
12/31/X2
|
12/31/X3
|
12/31/X4
|
12/31/X5
|
12/31/X6
|
12/31/X7
|
Total
|
Premium
|
$2,000,000
|
$2,000,000
|
|||||||
Commission
|
(300,000)
|
(300,000)
|
|||||||
Loss payments
|
(240,000)
|
(480,000)
|
(720,000)
|
(480,000)
|
(240,000)
|
(144,000)
|
(96,000)
|
(2,400,000)
|
|
Cash flows
|
$1,700,000
|
(240,000)
|
(480,000)
|
(720,000)
|
(480,000)
|
(240,000)
|
(144,000)
|
(96,000)
|
($700,000)
|
Present value of cash flows:
Year
|
1/1/X1
|
12/31/X1
|
12/31/X2
|
12/31/X3
|
12/31/X4
|
12/31/X5
|
12/31/X6
|
12/31/X7
|
Total
|
US Treasury yield curve
|
0
|
3.525%
|
4.374%
|
4.872%
|
5.383%
|
5.893%
|
6.140%
|
6.386%
|
|
Present value
|
$1,700,000
|
(231,828)
|
(440,612)
|
(624,243)
|
(389,188)
|
(180,250)
|
(100,714)
|
(62,241)
|
($329.076)
|
Does this contract transfer significant risk?
Analysis
Assuming the contract has a valid business purpose, the evaluation of underwriting risk, timing risk, and reasonable possibility of a significant loss is as follows:
Does the contract have uncertainty in the ultimate amount of cash flows paid to P&C (has underwriting risk been transferred)? Yes. The contract has reasonable potential variability in loss payments. As discussed above, losses and adjustable premiums could vary from a best case of $1,500,000 (annual premium multiplied by the 75% loss ratio) to a worst case of $2,400,000 (annual premium multiplied by the 120% loss ratio). There are no other features that would serve to reduce variability.
Does the contract have uncertainty in the timing of cash flows paid and received by P&C (has timing risk been transferred)? Yes. The contract has an expected payout pattern of seven years with other reasonably possible scenarios. No provisions in the contract limit the timely reimbursement of losses.
Does the reinsurer have a reasonable possibility of a significant loss on the contract? Yes. An analysis of the expected cash flows reveals that a significant loss to the reinsurer would occur under a reasonably possible scenario.
Test:
Total present value of cash flows
|
($329,076)
|
= (16.5%) potential loss to reinsurer
|
Total present value of amounts to be paid to reinsurer (gross)
|
$2,000,000
|
An analysis of the expected cash flows of the contract is required to determine their expected present values under a number of different loss and payout assumptions. The loss scenario used in the test uses a loss ratio of 120%, which is at the high end of the range of reasonably possible loss ratios.
Since the entity has demonstrated that the reinsurer is exposed to the possibility of a significant loss under a reasonably possible scenario, no further tests are required. For illustrative purposes, however, the table below summarizes the results of other reasonably possible outcomes using other loss ratios in the range of loss ratios and faster and slower payment patterns.
Loss ratio
|
|||
Payout
|
75%
|
90%
|
120%
|
Fast
|
19.3%
|
6.1%
|
(20.2%)
|
Medium
|
21.6%
|
8.9%
|
(15.5%)
|
Slow
|
24.3%
|
12.2%
|
(12.1%)
|
Since the contract transfers underwriting and timing risks and the reinsurer has a reasonable possibility of incurring a significant loss, the contract would be accounted for as reinsurance.
EXAMPLE IG 8-2
Risk transfer analysis of an excess of loss reinsurance contract with a retrospectively rated premium adjustment
Risk transfer analysis of an excess of loss reinsurance contract with a retrospectively rated premium adjustment
P&C Insurance Company enters into an excess of loss reinsurance contract that covers its general liability book of business and is expected to pay claims over the next seven years for losses occurring in the current year.
Cover: $1,000,000 of loss per occurrence in excess of $1,000,000
Annual Premium: $2,000,000, subject to a retrospectively rated premium adjustment. The retrospectively rated premium is based on the combined ratio of the contract (losses plus commissions as compared to premiums). The adjustable feature has a minimum combined ratio of 100% and a maximum combined ratio of 130%. The RRP is payable beginning as of the end of year 5.
Commission: 15% of the premiums ceded
Loss Ratio: It is reasonably possible that the ultimate ratio on the contract could range from 75% of premiums ceded to 120% of premiums ceded.
Payment Pattern: The payment pattern is expected to vary; the majority of claims are expected to be paid at least 2 years from the occurrence date. The entity has estimated three payment patterns under each reasonably possible loss ratio: fast, medium, and slow.
Assumptions in loss scenario used to demonstrate risk transfer:
Estimated ultimate loss ratio 120%
Estimated payment pattern (“medium” speed of payment):
Year 1
|
10%
|
Year 2
|
20%
|
Year 3
|
30%
|
Year 4
|
20%
|
Year 5
|
10%
|
Year 6
|
6%
|
Year 7
|
4%
|
100%
|
Loss payments are made at the end of the year.
Premiums are received on the first day of the contract period.
Interest rate used: US Treasury yield curve
Cash flows:
Year
|
1/1/X1
|
12/31/X1
|
12/31/X2
|
12/31/X3
|
12/31/X4
|
12/31/X5
|
12/31/X6
|
12/31/X7
|
Total
|
Premium
|
$2,000,000
|
$2,000,000
|
|||||||
Commission
|
(300,000)
|
(300,000)
|
|||||||
Loss payments
|
(240,000)
|
(480,000)
|
(720,000)
|
(480,000)
|
(240,000)
|
(144,000)
|
(96,000)
|
(2,400,000)
|
|
ADJ. Prem.:
|
Min
|
0
|
0
|
0
|
0
|
||||
Max
|
0
|
4,000
|
96,000
|
100,000
|
|||||
Cash flows
|
$1,700,000
|
(240,000)
|
(480,000)
|
(720,000)
|
(480,000)
|
(240,000)
|
(140,000)
|
0
|
($600,000)
|
Present value of cash flows:
Year
|
1/1/X1
|
12/31/X1
|
12/31/X2
|
12/31/X3
|
12/31/X4
|
12/31/X5
|
12/31/X6
|
12/31/X7
|
Total
|
US Treasury yield curve
|
0
|
3.525%
|
4.374%
|
4.872%
|
5.383%
|
5.893%
|
6.140%
|
6.386%
|
|
Present value
|
$1,700,000
|
(231,828)
|
(440,612)
|
(624,243)
|
(389,188)
|
(180,250)
|
(97,916)
|
0
|
($264,037)
|
Does this contract transfer significant risk?
Analysis
Assuming the contract has a valid business purpose, the evaluation of underwriting risk, timing risk and reasonable possibility of a significant loss is as follows:
Does the contract have uncertainty in the ultimate amount of cash flows paid to P&C (has underwriting risk been transferred)? Yes. The contract has reasonable potential variability in loss payments. Losses and adjustable premiums could vary from a best case of $1,700,000 (annual premium multiplied by the 75% loss ratio plus retrospectively rated premium) to a worst case of $2,300,000 (annual premium multiplied by the 120% loss ratio less a retrospectively rated premium adjustment). While the adjustable feature somewhat mitigates the amount of underwriting loss, a significant amount of variability is still present.
Does the contract have uncertainty in the timing of cash flows paid and received by P&C (has timing risk been transferred)? Yes. The contract has an expected payout pattern of seven years. No provisions in the contract limit the timely reimbursement of losses.
Does the reinsurer have a reasonable possibility of a significant loss on the contract? Yes. An analysis of the expected cash flows reveals that a significant loss to the reinsurer would occur under a reasonably possible scenario. Using the same loss and payout assumptions as Example IG 8-1 and adding the cash flows from the RRP. Since the combined ratio of the contract is greater than 130%, the maximum under the adjustable feature term, an additional premium of $4,000 will be due the reinsurer at 12/31/X6 and an additional $96,000 at 12/31/X7.
Test:
Total present value of cash flows
|
($264,037)
|
= (12.8%) potential loss to reinsurer
|
Total present value of amounts to be paid to reinsurer (gross)
|
$2,065,039
|
Since the entity has demonstrated that the reinsurer is exposed to the possibility of a significant loss under a reasonably possible scenario, no further tests are required. For illustrative purposes, however, the table below summarizes the results of other reasonably possible outcomes using other loss ratios in the range of expected loss ratios and faster and slower payment patterns.
Loss ratio
|
|||
Payout
|
75%
|
90%
|
120%
|
Fast
|
11.4%
|
6.1%
|
(16.3%)
|
Medium
|
15.1%
|
8.9%
|
(12.8%)
|
Slow
|
16.0%
|
12.2%
|
(8.6%)
|
Although the variability of loss is somewhat reduced by the retrospectively rated premium, the reinsurer still has the potential for a significant loss under reasonably possible outcomes.
Since the contract transfers underwriting and timing risks and the reinsurer has a reasonable possibility of incurring a significant loss, the contract should be accounted for as reinsurance.
EXAMPLE IG 8-3
Risk transfer analysis of an excess of loss reinsurance contract with a retrospectively rated premium adjustment
Risk transfer analysis of an excess of loss reinsurance contract with a retrospectively rated premium adjustment
P&C Insurance Company enters into an excess of loss reinsurance contract that covers its general liability book of business and is expected to pay claims over the next seven years for losses occurring in the current year.
Cover: $1,000,000 of loss per occurrence in excess of $1,000,000
Annual Premium: $2,000,000, subject to a retrospectively rated premium adjustment. The contract has a retrospectively rated premium adjustment based on the combined ratio of the contract (losses plus commissions as compared to premiums). The adjustable feature has no minimum combined ratio and a maximum combined ratio of 110%. The RRP is payable beginning as of the end of year 5.
Commission: 15% of the premiums ceded
Loss Ratio: It is reasonably possible that the ultimate ratio on the contract could range from 75% of premiums ceded to 120% of premiums ceded.
Payment Pattern: The payment pattern is expected to vary; the majority of claims are expected to be paid at least 2 years from the occurrence date. The entity has estimated three payment patterns under each reasonably possible loss ratio: fast, medium, and slow.
Assumptions in loss scenario used to demonstrate risk transfer:
Estimated ultimate loss ratio 120%
Estimated payment pattern (“medium” speed of payment):
Year 1
|
10%
|
Year 2
|
20%
|
Year 3
|
30%
|
Year 4
|
20%
|
Year 5
|
10%
|
Year 6
|
6%
|
Year 7
|
4%
|
100%
|
Loss payments are made at the end of the year.
Premiums are received on the first day of the contract period.
Interest rate used: US Treasury yield curve
Cash flows:
Year
|
1/1/X1
|
12/31/X1
|
12/31/X2
|
12/31/X3
|
12/31/X4
|
12/31/X5
|
12/31/X6
|
12/31/X7
|
Total
|
Premium
|
$2,000,000
|
$2,000,000
|
|||||||
Commission
|
(300,000)
|
(300,000)
|
|||||||
Loss payments
|
(240,000)
|
(480,000)
|
(720,000)
|
(480,000)
|
(240,000)
|
(144,000)
|
(96,000)
|
(2,400,000)
|
|
ADJ. Prem.:
|
Min
|
0
|
0
|
0
|
0
|
||||
Max
|
260,000
|
144,000
|
96,000
|
500,000
|
|||||
Cash flows
|
$1,700,000
|
(240,000)
|
(480,000)
|
(720,000)
|
(480,000)
|
20,000
|
0
|
0
|
($200,000)
|
Present value of cash flows:
Year
|
1/1/X1
|
12/31/X1
|
12/31/X2
|
12/31/X3
|
12/31/X4
|
12/31/X5
|
12/31/X6
|
12/31/X7
|
Total
|
US Treasury yield curve
|
0
|
3.525%
|
4.374%
|
4.872%
|
5.383%
|
5.893%
|
6.140%
|
6.386%
|
|
Present value
|
$1,700,000
|
(231,828)
|
(440,612)
|
(624,243)
|
(389,188)
|
15,021
|
0
|
0
|
$29,150
|
Does this contract transfer significant risk?
Analysis
Assuming the contract has a valid business purpose, the evaluation of underwriting risk, timing risk and reasonable possibility of a significant loss is as follows:
Does the contract have uncertainty in the ultimate amount of cash flows paid to P&C (has underwriting risk been transferred)? Yes. The contract has reasonable potential variability in loss payments. As discussed above, losses and adjustable premiums could vary from a best case of $1,500,000 (annual premium multiplied by the 75% loss ratio) to a worst case of $1,900,000 (annual premium multiplied by the 120% loss ratio less a retrospectively rated premium adjustment). While the adjustable feature mitigates the amount of underwriting loss, a significant amount of variability is still present.
Does the contract have uncertainty in the timing of cash flows paid and received by P&C (has timing risk been transferred)? Yes. The contract has an expected payout pattern of seven years. No provisions in the contract limit the timely reimbursement of losses.
Does the reinsurer have a reasonable possibility of a significant loss on the contract? No. An analysis of the expected cash flows reveals there are no reasonably possible scenarios under which the reinsurer would incur a significant loss.
Test:
Total present value of cash flows
|
$29,150
|
= 1.2% potential gain to reinsurer
|
Total present value of amounts to be paid to reinsurer (gross)
|
$2,358,226
|
The sum of the present value of all the expected cash flows using all of the assumptions presented above is a gain to the reinsurer of $29,150.
Since the chosen loss scenario produced a gain, the entity would rerun the test using the other reasonably possible scenarios. The table below summarizes the results of other reasonably possible outcomes using other loss ratios in the range of loss ratios and faster and slower payment patterns.
Loss ratio
|
|||
Payout
|
75%
|
95%
|
120%
|
Fast
|
19.3%
|
1.7%
|
(2.0%)
|
Medium
|
21.6%
|
4.7%
|
1.2%
|
Slow
|
24.3%
|
8.1%
|
5.4%
|
The reinsurer has only insignificant exposure to loss under reasonably possible outcomes.
Since all of the risk-transfer tests have not been passed, the contract is accounted for as a deposit.
8.5.6 “Stepping in the shoes” exception – short-duration reinsurance
ASC 944-20-15-53 allows a limited exception to the requirement that a reinsurer have a reasonably possible chance of incurring a significant loss. Essentially, it permits a reinsurer to account for the assumed business under reinsurance accounting, without further quantitative risk transfer analysis, based on the premise that the economic nature of the reinsurance contract virtually matches the economic position of the insurer’s risk on the reinsured portions of the underlying insurance policies.
Excerpt from ASC 944-20-15-53
…the ceding entity shall be considered indemnified against loss or liability relating to insurance risk only if substantially all of the insurance risk relating to the reinsured portions of the underlying insurance contracts has been assumed by the reinsurer. That condition is met only if insignificant insurance risk is retained by the ceding entity on the reinsured portions of the underlying insurance contracts. The assessment of that condition shall be made by comparing both of the following:
- the net cash flows of the reinsurer under the reinsurance contract
- the net cash flows of the ceding entity on the reinsured portions of the underlying insurance contracts.
No more than trivial insurance risk on the reinsured portions of the underlying insurance contracts may be retained by the cedant, and the reinsurer’s economic position must be virtually equivalent to having written the relevant portions of the reinsured contracts directly. If the economic position of the reinsurer relative to the insurer cannot be determined, the contract would not qualify for the scope exception.
Examples of contracts that may meet the “stepping in the shoes” exception include straightforward quota share contracts with an inception at the beginning of the underwriting year and most facultative reinsurance. Fronting arrangements would also likely meet the spirit of the exception. However, the existence of loss ratio caps, retrospective rating provisions, adjustable ceding commissions, excess provisions, or other risk-limiting features could violate the virtually equivalent economic position criteria.
Question IG 8-5 addresses the impact of differences between a ceding commission and the direct acquisition costs on the “stepping in the shoes” exception to risk transfer.
Question IG 8-5
Ceding Company entered into a quota share reinsurance contract with Assuming Company.
To what extent do differences between a ceding commission and the direct acquisition costs incurred by Ceding Company related to the portions of underlying contracts reinsured impact the “stepping in the shoes” exception to risk transfer? For instance, assume the ceding commission is 25% and the portion of direct acquisition costs incurred by the insurer is 35%.
Ceding Company entered into a quota share reinsurance contract with Assuming Company.
To what extent do differences between a ceding commission and the direct acquisition costs incurred by Ceding Company related to the portions of underlying contracts reinsured impact the “stepping in the shoes” exception to risk transfer? For instance, assume the ceding commission is 25% and the portion of direct acquisition costs incurred by the insurer is 35%.
PwC response
The variance in the ceding commission could prohibit application of the “stepping in the shoes” exception. Although the commission on a “pure” quota share contract is the only area allowing for negotiation between the two parties, a commission less than the portion of direct acquisition costs incurred by the insurer could mean the reinsurer has not assumed “substantially all” of the insurance risk related to the underlying insurance contracts.
Ceding Company may incur an underwriting loss on the direct policies but Assuming Company could still recognize a profit on the reinsurance contract based on the excess ceding commission. Alternatively, if Assuming Company assumed all of the insurance risk, as well as some additional risk, an excess ceding commission may not be an issue.
Failing this exception does not automatically fail the risk transfer assessment, but a full analysis of the reinsurance contract and consideration of all contract provisions would be required.
8.5.7 “Reasonably self-evident” risk transfer – short-duration reinsurance
The phrase “reasonably self-evident” risk transfer has been developed in the sector to address certain reinsurance contracts that do not require cash flow projections and present value calculations to determine that risk has been transferred under the contract. This term arose from US statutory guidance around risk transfer documentation requirements, with such guidance clarifying that documentation of risk transfer is only required to be maintained when risk transfer is not self-evident. Reporting entities generally use this concept when applying US GAAP as well.
The concept of “reasonably self-evident” is meant to address certain reinsurance contracts where the fundamental structure and substance of the contract would obviously result in compliance with the criteria defined in IG 8.5.2 above. Agreements that have reasonably self-evident risk transfer typically have a potential loss to the reinsurer much larger than the premium for the coverage provided, terms and conditions of coverage are standard for the class of business being reinsured, and the contract does not include provisions that enable the reinsurer to recover all or a significant portion of the covered losses.
1 2,000,000 × (1.20 + .15 – 1.30)
* 2,000,000 × (1.20 + .15 – 1.10)
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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