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8.8 Multiple-year retrospectively rated reinsurance contracts
Publication date: 30 Sep 2020
us Insurance guide
A multiple-year retrospectively rated reinsurance contract (RRC) has features in which events in one period of the contract create rights and obligations in another. A funded catastrophe cover is a common example of these types of contracts. Economically, the contract features decrease the overall risk covered under a contract and fund some of claim payments in a period under the contract with obligations to pay more cash in the future, or result in the loss of an experience refund asset that would have been owed in the future. RRC accounting recognizes the new obligations (or loss of assets) in the period of the loss experience rather than smoothly over the life of the contract.
RRCs provide for at least one of the following based on contract experience:
- Changes in the amount or timing of future contractual cash flows, including premium adjustments, settlement adjustments, or refunds to the ceding enterprise
- Changes in the contract’s future coverage
A critical distinguishing feature of these contracts is that part or all of the retrospective rating provision is obligatory, such that the retrospective rating provision creates rights and obligations for cash in the future as a result of past events. Experience refund accounts and obligatory reinstatement premiums would be examples of such features.
Although the guidance refers to multiple-year contracts, the concepts may also be applicable in quarterly reporting of yearly contracts.
8.8.1 Scope for retrospectively rated reinsurance contracts accounting
RRCs are accounted for using deposit accounting unless the three criteria in ASC 944-20-15-55 are met.
Excerpt from ASC 944-20-15-55
To be accounted for as reinsurance, a contract that reinsures risks arising from short-duration insurance contracts must meet all of the following conditions:
- The contract shall qualify as a short-duration contract under paragraph 944-20-15-7.
- The contract shall not contain features that prevent the risk transfer criteria in this Subsection from being reasonably applied and those risk transfer criteria shall be met.
- The ultimate premium expected to be paid or received under the contract shall be reasonably estimable and allocable in proportion to the reinsurance protection provided as required by paragraphs 944-605-25-2 and 944-605-35-8.
If any of these conditions are not met, a deposit method of accounting shall be applied by the ceding and assuming entities.
The reinsurer’s accounting should be symmetrical to that of the ceding insurer although estimates of incurred losses could be different.
8.8.1.1 Classification of retrospectively rated reinsurance contracts
Short-duration considers the length of the underlying covered insurance contracts and the length of the reinsurance contract itself. In practice, contracts with a term longer than three to five years are not considered short duration. RRCs with a term of three years or less typically qualify as short-duration. Longer term contracts require judgment and analysis to classify as long or short duration. In addition, the longer the term of a contract with a retrospective adjustment provision, the less likely it transfers significant insurance risk. Contracts that were negotiated separately for each underwriting year could have a feature within each contract (such as an experience refund or profit commission) linking these contracts together. This could lead to a contract that has a stated term of one year but, because of the contractual feature, may actually be a multi-year contract.
8.8.1.2 Indeterminate cash flows for retrospectively rated contracts
An RRC must not contain features that prevent an entity from applying the risk transfer criteria. The ultimate premium expected to be paid or received under the contract must be reasonably estimable and allocable in proportion to the reinsurance protection provided. In assessing risk transfer in RRCs, an analysis of expected contractual cash flows is essential. An inability to measure contractual cash flows under a contract is an indication that the ultimate premium may not be reasonably estimable, and may prevent application of the risk transfer criteria, which would result in the RRC being accounted for as a deposit. Additionally, ASC 944-20-15-56 notes that, when assessing whether the contract transfers significant insurance risk, the coverages in an agreement with a reinsurer that consist of both risk transfer and non-risk transfer coverages that have been combined into a single legal document must be assessed separately for accounting purposes.
In practice, there are at least two types of contracts that may preclude analysis of expected contractual cash flows: indefinite term RRCs and variable premium RRCs. Under indefinite term RRCs, the cash flows and ultimate premium expected cannot be determined without making significant assumptions regarding the timing of contract termination. Similarly, certain RRCs with variable-based premiums may also preclude a reasonable assessment of cash flows and/or ultimate premiums (e.g., a reinsurance contract with premiums stated as a percentage of the underlying business written), due to an inability to establish a stated premium base.
8.8.2 Accounting for retrospectively rated reinsurance contracts
For RRCs that meet the three criteria in ASC 944-20-15-55, the ceding entity recognizes a liability and the assuming entity recognizes an asset to the extent that the cedant has an obligation to pay cash, or other consideration, to the reinsurer that would not have been required absent losses experienced to date under the contract. Conversely, the cedant recognizes an asset and the assuming entity recognizes a liability to the extent that any cash or other consideration is payable from the reinsurer to the cedant based on contract experience to date. “Other consideration” includes changes in coverage and are accounted for in the same manner as changes in contractual cash flows.
8.8.2.1 Initial recognition – retrospectively rated reinsurance contracts
At the beginning of a contract, experience refunds owed at the end of a contract are assets recorded by the ceding entity until a loss event has occurred, rather than contingent assets, which are not recorded until the end of the contract. Assets and liabilities for the retrospective adjustment features are measured using experience to date, which essentially eliminates the smoothing of non-transferred risks over the life of the contract.
Experience refund receivable assets are not considered contingent assets as they represent a probable future economic benefit under the control of the ceding entity, in which case they meet the definition of an asset. Events, such as a future loss, impair their value when they occur. Even if it is likely that a loss will occur, the decrease in value cannot be recognized in the current period, as the event has not yet occurred. Additionally, the ceding entity will receive the cash represented by the initial experience refund asset either through loss recoveries from the reinsurer or as part of its experience refund. Upon a loss in a future period, the character of the asset simply changes from experience refund to reinsurance recoverable.
8.8.2.2 Subsequent accounting – retrospectively rated reinsurance
The amount of the asset or liability recorded in the current period under an RRC is computed using the with-and-without method. Under the with-and-without method, the amount of the asset or liability is the difference between the ceding entity’s total contract costs before and after the experience under the contract as of the reporting date. Contract costs include premium adjustments, settlement adjustments, and impairments of coverage.
An entity is required to determine the amount of premium expense related to impairments of coverage in relation to the original contract terms. ASC 944-20-35-4 prohibits future experience under the contract (i.e., future losses and future premiums that would be required to be paid regardless of past experience) from being considered in measuring premium expense or earned revenue.
In an RRC in which coverage is depleted as losses are incurred, premium expense related to coverage impairment is also measured in relation to the original contract terms. For example, consider a three-year RRC that provides for an annual premium of $1,000,000 and an aggregate coverage limit of $6,000,000 over the three years. If no losses occur, premiums will be expensed pro rata as the coverage expires (e.g., on a straight-line basis over the three-year period). If losses are incurred and coverage is diminished, premiums are expensed proportionate to the coverage used. For example, if a loss of $3,000,000 occurs in year one, one half of total contractual premiums would be expensed in year one.
In an RRC contract in which (a) the cedant could terminate the contract before the end of its term and (b) termination would change the amounts paid, the measurement of the cedant’s liability would be based on whether the cedant has decided to terminate the contract. Under ASC 944-20-35-18, if a decision to terminate the contract has been made, the measurement is required to be based on the assumption that the contract will be terminated and experience to date. If a decision to terminate has not been made, the measurement will be based on the lesser of (1) the total incremental cost that would be paid based on the with-and-without calculation, assuming experience to date and assuming termination, and (2) the total incremental cost that would be based on the with-and-without calculation, assuming experience to date and assuming no termination. In either scenario, the effects of future losses and future premiums are excluded.
Example IG 8-9 illustrates the recognition of ceded premium associated with a quota share reinsurance contract with an experience account.
EXAMPLE IG 8-9
Initial and subsequent recognition of ceded premium associated with a quota share reinsurance contract with an experience account
Initial and subsequent recognition of ceded premium associated with a quota share reinsurance contract with an experience account
Ceding Company entered into a three-year term property catastrophe excess of loss reinsurance contract with Assuming Company beginning January 1, 20X6. It is in effect until December 31, 20X8. The contract passes risk transfer. Each 12-month period from January 1 to December 31 represents a “contract year.”
The following table summarizes some of the key contract terms.
Contract term
|
Description
|
Exposure
|
|
Premium
|
|
Experience account
|
|
Cancellation provision
|
|
Analysis
Ceding Company’s premium expense for 20X6 is $5,000 (75% of the $20,000 year one premium payment). The entry for 20X6 would be:
Dr. Experience refund receivable
|
$15,000
|
|
Dr. Ceded premium expense (contra revenue)
|
$5,000
|
|
Cr. Cash
|
$20,000
|
If a limit loss of $145,000 occurred in the first year, an additional $45,000 of premium expense would be accrued by Ceding Company, representing the additional incremental premium to be paid as a result of the loss. This is calculated using the with-and-without method. The $15,000 total three-year premium ($60,000 less 75% refund) if there is no loss is compared to $60,000 total three-year premium with the experienced loss. The difference is $45,000. Another way to think about it is the experience refund balance changes from an asset of $15,000 to a liability of $30,000 for the two $15,000 premium payments in 20X7 and 20X8, which will no longer be refunded. The additional entry in 20X6 to reflect the limit loss would be:
Dr. Reinsurance claims recoverable
|
$145,000
|
|
Dr. Ceded premium expense
|
$45,000
|
|
Cr. Ceded claims expense
|
$145,000
|
|
Cr. Experience refund receivable
|
$15,000
|
|
Cr. Experience refund payable
|
$30,000
|
The proportion of the aggregate limit of the contract used in year one also causes additional expense in 20X6. $145,000 of losses is 71% of the aggregate limit of the contract of $205,000. As $15,000 is the total three-year premium if there is no loss, Ceding Company would recognize a loss of future coverage of $10,610 (71% of the $15,000 of premium). Only $5,000 has been recognized, requiring an additional entry for $5,610 of ceded premium expense.
Dr. Ceded premium expense
|
$5,610
|
|
Cr. Ceded premium payable
|
$5,610
|
8.8.2.3 Reinstatement premiums – retrospectively rated reinsurance
While the RRC guidance explicitly applies to multi-year contracts with obligatory retrospective payment provisions, we believe that the concepts can also apply to multi-period reporting (e.g., quarterly) for single year contracts with obligatory retrospective payment provisions. Such retrospectively rated contracts often include mandatory reinstatement provisions that obligate the ceding insurer to pay additional premium amounts (or to pay a termination amount, if termination is elected) if a certain loss level occurs, in order to continue coverage under the contract. This provision is common in single year and multi-year catastrophe covers.
Upon a loss event when the reinstatement premium is obligatory, the ceding insurer recognizes a liability and the reinsurer recognizes an asset to the extent that the ceding insurer has an obligation to pay cash or other consideration to the reinsurer that would not have been required absent the loss experience to date. Additionally, the cedant recognizes the entire additional reinstatement premium as an immediate expense, as it is an obligatory payment that would not have been required absent losses under the contract. The original ceded premium that is in part unearned would continue to be recognized over the remaining coverage period.
For assuming entities, there is an alternative view that the guidance for short-duration contracts (refer to ASC 944-605-25-2) on premium revenue recognition is applicable. That guidance requires that, for retrospectively rated or other experience-rated insurance contracts for which the premium is determined after the period of the contract based on claim experience and for which the ultimate premium is reasonably estimable, the estimated ultimate premium shall be recognized as revenue over the period of the contract. The estimated ultimate premium is revised to reflect current experience. This method results in a delayed rather than immediate recognition of premium income.
If the ceding entity can terminate the contract and not be required to pay any further amounts, the reinstatement premium is not obligatory. There would be no immediate expense for a reinstatement premium. However, if existing coverage limits have been exhausted and a prepaid reinsurance asset remains, the asset is impaired. If the ceding entity elects to pay the reinstatement premium, a new prepaid reinsurance premium would be recognized for the reinstatement premium, which would then be expensed over the new remaining coverage period. Similar accounting would apply for the assuming entity.
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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