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8.7 Deposit accounting contracts – short-duration reinsurance
Publication date: 30 Sep 2020
us Insurance guide
When a contract does not transfer significant insurance risk due to risk-limiting features or other reasons, the entire reinsurance contract must be accounted for using deposit accounting. ASC 340-30-05-2 requires the transfer of significant insurance risk to include both timing risk and underwriting risk. As a result, there are four possible categories used to classify deposit contracts.
- A contract that transfers only significant timing risk (see IG 8.7.1)
- A contract that transfers only significant underwriting risk (see IG 8.7.2)
- A contract that transfers neither significant timing nor significant underwriting risk (see IG 8.7.1)
- A contract with indeterminate risk (see IG 8.7.3)
For a contract to be considered to have transferred significant timing risk, the timing of the loss reimbursement under the contract must be based on the timing of the loss event. For a contract to be considered to have transferred significant underwriting risk, the probability of a significant variation in the amount of payments under the contract must be more than remote. Both the ceding and assuming entity in a reinsurance contract are required to apply the deposit accounting guidance. Under deposit accounting, the contract is recorded as a financing, with no impact on premiums, losses incurred, or related insurance income statement ratios.
At inception, a reporting entity would record a deposit asset or liability based upon the consideration paid or received, less any explicitly identified premiums or fees to be retained by the reinsurer, irrespective of the experience of the contract. These are typically called nonrefundable fees. The deposit assets and liabilities should be reported on a gross basis, unless the right of setoff exists per ASC 210-20, Balance Sheet Offsetting. The subsequent measurement of the deposits varies based on the category of deposit contract.
8.7.1 Deposit accounting when underwriting risk is not transferred
When a contract transfers only significant timing risk or transfers neither significant timing nor significant underwriting risk, the recorded deposit asset or liability is accreted in subsequent reporting periods using the interest method. The effective yield is calculated using the estimated amount and timing of cash flows. If a difference arises between actual and estimated future cash flows, a new effective yield should be calculated to reflect the revised actual and estimated future cash flows. The prior deposit balance would be adjusted to the amount that would have existed had the new effective yield been applied from inception of the contract. A corresponding charge or credit to interest income or expense would be recognized.
Given the nature of these contracts, changes in the expected amount of cash flows are unlikely. If the variations are significant, the entity should reassess whether the contract has significant underwriting risk. A contract that is subsequently determined to transfer significant underwriting risk should be accounted for as a contract that only transfers significant underwriting risk (see IG 8.7.2). The contract cannot be reclassified as risk transfer reinsurance if it was originally determined that deposit accounting was appropriate.
8.7.2 Deposit accounting – transfers of significant underwriting risk
Delayed reimbursement features, floating limits, and other timing delays will cause a contact to fail risk transfer but can still transfer significant underwriting risk. The deposit asset or liability for contracts that transfer only significant underwriting risk should be subsequently measured based upon the unexpired portion of the coverage provided until a loss is incurred. Once a loss is incurred that will be reimbursed under the contract, the deposit asset or liability should be measured at the present value of the expected future cash flows arising from the contract plus the remaining portion of the deposit asset or liability related to the unexpired coverage provided. See ASC 340-30-55-8 for an example of this accounting.
The ceding entity should measure the present value of expected future cash flows component of the deposit asset using the current rate on US government obligations (the risk free rate) with similar cash flow characteristics. The assuming entity is also required to use the current rate on US government obligations with similar cash flow characteristics in estimating the deposit liability. In either case, an individual rate must be established at the date each loss is incurred and used for the remaining life of the contract, and is not updated to current rates. As the use of individual rates might be burdensome, the use of average rates is permitted if numerous losses occur.
8.7.3 Deposit accounting – indeterminate risk
Contracts with indeterminate risk are accounted for under the open-year method. The open-year method is required when ultimate underwriting results cannot be reasonably estimated. Under the open-year method, nothing is recognized in the income statement until sufficient information becomes available to reasonably estimate and allocate premiums. Cash received or paid is accumulated and reported in the balance sheet as an aggregated underwriting deposit balance. ASC 340-30-25-5 states that, while an underwriting balance must be accumulated, the open-year method cannot be used to defer losses that otherwise would be recognized under ASC 450-20, Loss contingencies.
When sufficient information becomes available to reasonably estimate and allocate premiums, the insurance or reinsurance contract with indeterminate risk is required to be reclassified into one of the other three categories of deposit contracts. The change in deposit assets and liabilities that result when sufficient information becomes available is treated as a change in accounting estimate.
8.7.4 Deposit accounting – nonrefundable fees
Nonrefundable fees are not included as part of the initial deposit and are recognized based on the terms of the contract. Reporting entities should consider whether it would be more appropriate to amortize the nonrefundable fee over the coverage period or the settlement period. If the contract has timing risk, it may be more appropriate to amortize the fee over the settlement period. However, if the contract has underwriting risk, it may be appropriate to amortize the fee over the coverage period. The amortization should not be included as part of premium revenue or premium revenue ceded.
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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