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Reinsurance recoverables relating to reinsurance of traditional and limited payment contracts are required to be recognized and measured in a manner consistent with the liabilities relating to the underlying reinsured contracts, including using consistent assumptions. As a result, the recognition and measurement of reinsurance recoverables for traditional and limited-payment long duration contracts should, consistent with the direct liabilities, employ a net premium approach with retrospective updating of cash flows. Under the net premium approach, a net premium ratio is used to derive a constant profit margin over the entire life of a group of contracts (i.e., the cohort). Employing this constant margin concept to the reinsurance results in accounting that is consistent with the purpose of the transaction - to act as an economic hedge of the reinsured business.
The cash flow assumptions for the reinsurance, such as estimates of mortality, morbidity, terminations, and expenses, need to be consistent with those for the direct policies, in accordance with ASC 944-40-25-34 and ASC 944-605-35-15. In addition, entities are required to use a locked-in contract issue date upper-medium grade yield in calculating the net premium ratio, ceded benefit expense and interest accretion for income statement purposes, as well as a current upper-medium grade yield for balance sheet remeasurement of the reinsurance recoverable, consistent with the principles applicable to direct insurance contracts.
In many instances, an insurer may enter into a ceded reinsurance contract on a prospective basis, meaning that the reinsurance contract covers direct insurance contracts issued contemporaneously with and/or for some period subsequent to the inception date of the reinsurance contract. In these situations, the reinsurance recoverable is increased as each direct policy is issued. The locked-in contract issue date yield curve used to measure each new portion of the reinsurance contract recognized and for subsequent income statement measurement should be consistent with the locked-in issue date yield curve used to measure each of the direct reinsured contracts. In subsequent periods, the current yield curve (i.e., current upper-medium grade curve) is used for balance sheet remeasurement purposes for both the direct liability for future policy benefits and the reinsurance recoverable.
Reinsurance contracts may also be executed subsequent to the direct contract issue dates, and market interest rates may have changed between the date that the underlying insurance contracts were issued and the date the reinsurance contract is recognized in the financial statements. The yield curve at the date the reinsurance contract is recognized should be used as the locked-in issue date yield curve for initial measurement of the reinsurance recoverable and any cost of reinsurance and for subsequent income statement measurement purposes. This is required to comply with the principle in ASC 944-40-35-6A(b)2 that the discount rate for income statement purposes is the discount rate at the contract issue date; in this case, that is the reinsurance contract issue date. Using the current yield curve also satisfies the ASC 944-40-25-34 requirement that the reinsurance recoverable be recognized in a manner consistent with the liabilities relating to the underlying reinsured contracts, and using consistent assumptions. That is, the direct liabilities that are being referenced in ASC 944-40-25-34 are the direct liabilities as remeasured using the current yield curve at the date the reinsurance contract is recognized in the financial statements. There is no immediate comprehensive income or loss relating to the initial recognition of the reinsurance recoverable.
Example IG 9-1 illustrates the accounting for 100% coinsurance of a block of traditional inforce insurance contracts.
EXAMPLE IG 9-1
Reinsurance of inforce contracts
For simplicity, this example ignores acquisition costs and reinsurer credit risk, assumes use of an equivalent level discount rate and assumes that the reinsurance transaction is executed for initial consideration equal to the GAAP liability for future policy benefits.
A group of direct life insurance contracts was written on 1/1/X1 when the upper-medium grade fixed income discount rate was 5%. Three years later, on 12/31/X3, the direct writer remeasures the liability for future policy benefits using a 3% rate, which represents the current upper-medium grade fixed income discount rate.
On 12/31/X3, the liability for future policy benefits measured using the locked in rate of 5% used to calculate benefit expense and accrete interest expense is $100 million, while the remeasured liability using the current 3% rate is $110 million. A debit balance (unrealized loss) of $10 million exists in accumulated other comprehensive income (AOCI) relating to the direct liability remeasurement.
On the same day, 12/31/X3, the direct writer cedes 100% of the contracts in the group through a coinsurance contract for initial consideration of $110 million, for which the locked-in rate for the reinsurance policy would be 3%, the rate at the recognition date of the reinsurance contract.
What amounts should the direct writer recognize for the reinsurance recoverable and cost of reinsurance in connection with ceding the group of contracts?
Analysis
The direct writer would recognize a ceded reinsurance recoverable of $110 million for the consideration paid of $110 million. The reinsurance recoverable and any cost of reinsurance (in this case $0) would be measured using the discount rate at the date the reinsurance contract is recognized; there is no “day one” accumulated other comprehensive income associated with the reinsurance contract because the 5% locked-in discount rate used to measure benefit expense and interest accretion on the direct liability is not relevant to the reinsurance contract entered into three years later.
In subsequent periods, the direct policies will continue to use 5% while the reinsurance recoverable will use 3% for future income statement interest accretion and benefit expense/ceded benefit expense recognition, resulting in a 2% negative spread differential recognized in income. The direct insurance liability and reinsurance recoverable will be remeasured each period end using the current period-end discount rate, with the difference between the locked-in issue date discount rates (5% for the direct contracts and 3% for the reinsurance contract) and current discount rate measurement of the balances recognized in AOCI. Over time, the starting difference in AOCI between the direct policies and the reinsurance contract of $10 will unwind through OCI as the group of direct contracts approaches maturity in a pattern consistent with the spread differential in the income statement such that on a total comprehensive income basis, the net of the direct and reinsurance transactions will be zero.

Calculating the reinsurance net premium ratio
There may be various approaches utilized in practice to calculate the net premium ratio (NPR) for the reinsurance recoverable. One acceptable approach that may effectively achieve the objective of recognizing a constant margin on a net of reinsurance basis on various types of reinsurance (e.g., coinsurance, yearly renewable term, excess of loss) would be to spread expected benefit reimbursements net of ceded premiums in relation to gross direct premiums of the reinsured policies. That is, the numerator in the NPR calculation would be the present value of expected ceded benefits minus ceded premiums and the denominator would be the present value of expected gross direct premium of the reinsured policies. Some entities may instead calculate the ceded NPR as the present value of ceded benefits in the numerator and either direct premiums or ceded premiums in the denominator. This approach may meet the constant margin objective when ceded premiums are fixed in proportion to direct premiums. However, to the extent that the timing or amount of ceded premiums due are not consistent with that of direct premiums, which are recognized as revenue when due, this methodology may not achieve the constant margin objective of the net premium approach unless additional adjustments are made, for example through a separate cost of reinsurance calculation.
Additionally, a ceding entity should utilize the cohorts of the underlying direct policies when calculating the net premium ratio and related reinsurance recoverable. For example, if the direct writer cedes two different quarterly cohorts, each cohort would be subject to separate reinsurance accounting (i.e., they represent their own units of account subject to their own net premium ratio).
As discussed in more detail in IG 9.7.1.1, there may be differences in the cohorts used by the ceding entity and those used by the assuming entity in a reinsurance arrangement. The ceding entity needs to maintain access to the data at its cohort level for measurement and disclosure purposes, even if the administration of the underlying contracts is transferred to the reinsurer. Those disclosure requirements include detailed roll-forwards (e.g., rollforward of liability for future policy benefits) that are both quantitative and qualitative, which should be presented gross of reinsurance. Refer to IG 10.3 for further information.
Additionally, when the reinsurance contract is a short-duration contract covering long-duration direct policies, such as certain stop-loss reinsurance, the direct claim experience impact will be spread over the life of the direct contracts. As the reinsurance benefit will be recognized during the life of the shorter reinsurance contract, there would be a mismatch in income and expense recognition.
Reinsurance NPR cap
For direct traditional and limited payment long-duration insurance contracts (see IG 5.2.5), an immediate charge is recognized in income for the amount by which the present value of future benefits and expenses exceeds the present value of future gross premiums (i.e., if the NPR exceeds 100%). No specific guidance addresses how this principle relating to direct contract liabilities should be applied to reinsurance recoverables. Following the guidance in ASC 944-40-25-34 that reinsurance recoverables should be recognized in a manner consistent with the direct liabilities being reinsured, to the extent that the insurer has recognized an immediate loss on the reinsured portion of the direct contracts in the current period, the insurer should recognize an immediate gain on the reinsurance ceded contract. However, in accordance with the reinsurance guidance in ASC 944-40-25-33 that prohibits gain recognition upon entering into a reinsurance contract, an insurer should not recognize a gain at inception of a reinsurance transaction to offset a previously recognized loss on direct business.
Judgment will be required in applying this guidance to situations when the insurer has purchased reinsurance on only a portion of a cohort and the cohort is generating a loss, or in situations when the insurer has purchased reinsurance on multiple cohorts, some of which have reached the 100% cap and others have not.
Reinsurance recoverable “floor”
The liability for future benefits on directly written contracts is prohibited from being less than zero (i.e., an asset) at the level of aggregation at which liabilities are measured. The net premium calculation can result in a liability balance of less than zero that must be floored at zero for products when the rate of premium increase exceeds the rate of increase in the assumed mortality rate over the term of the contract, such as yearly renewable term insurance. In these situations, an entity would recognize a charge to income to prevent the recognition of an asset.
There is no specific guidance as to how the” liability floor” guidance for direct contracts impacts the measurement of the reinsurance recoverable. We believe an acceptable interpretation is that in situations when the ceding entity is prohibited from recognizing an asset on the direct contracts in accordance with the liability floor provisions, it may also not recognize a liability relating to the purchased reinsurance contract.
However, there may be certain circumstances when the recognition of a reinsurance liability may be appropriate. For example, a noncancellable yearly renewable increasing premium term or excess of loss reinsurance contract may be purchased to reinsure level premium direct insurance contracts. In that circumstance, following the net premium approach and constant margin principle discussed for the ceded reinsurance transaction, a ceded reinsurance liability may result. Conceptually, a net liability can result in various situations in which cash flows relating to ceded premium are lower (or benefits are higher) in earlier periods but the impact of reinsurance is recognized for accounting purposes on a constant margin basis.
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