Actuarial and Accounting Issues
Surrounding FASB Statement No. 113
Accounting and Reporting for Reinsurance of ShortDuration and Long-Duration Contracts
Panelists:
Jerry Degerness
Ed Hardy
Peter Wildman
1
FASB Statement No. 113
MAJOR PROVISIONS
• Applicable for financial statements prepared under
Generally Accepted Accounting Principles in the U.S.
• Defined Risk Transfer
• Segregated Retroactive and Prospective Contracts
• Grossed-up balance sheet
2
FASB Statement No. 113 – Risk
Transfer
Risk transfer requires both of the following:
• Paragraph 9a - The reinsurer assumes significant
insurance risk under the reinsured portion of the
underlying contracts
• Requires both underwriting and timing risk
• No delayed payment clauses allowed
• Adjustable feature must be considered
• Paragraph 9b - It is reasonably possible that the reinsurer
may realized a significant loss from the transaction
• Defined present value test
• Did not define “significant”
3
FASB Statement No. 113
• It is easy to understand how the 9a is met:
• With a straight quota share agreement.
• With a plain vanilla, one-year, excess of loss agreement.
4
Transfer of Insurance Risk
The analysis becomes more difficult to conclude that 9a is met
when
• “Horizontal protection” is introduced in a multiple – year
contract.
• As contractual features are added that limit the amount of
insurance risk assumed, (e.g. adjustable features,
contingents, etc. )
5
Contractual Provisions That Limit
Risk Transfer:
•
•
•
•
•
•
•
Experience refunds
Cancellation provisions
Profit commissions
Retrospective premiums
Reinstatement premiums
Reductions or changes in coverage
Additions of profitable lines of business
to the reinsurance contract
6
Transfer of Insurance Risk
Significance of a loss is evaluated by:
• Comparing the present value of all cash inflows with the
present value of all cash outflows or amounts deemed to
have been paid to the reinsurer under reasonably possible
outcomes.
7
The Unanswered Questions
• What constitutes significant insurance risk?
• What is the definition of reasonably possible?
• What constitutes a significant loss?
8
Considerations For Developing A
Reasonable Risk Transfer Analysis
•
•
•
•
•
•
Complexity of adjustable features
Sub limits for various lines of business
Complexity in modeling certain features in the contract
Uncertainty around the speed of settlement
Uncertainty around ultimate covered losses
Probabilistic modeling
• Ultimate loss picks
• Payout Volatility
9
Best Practices for Developing Risk
Transfer Analysis
•
•
•
•
•
Understand all terms of the contract
What terms are fixed and what terms are (open)
Test risk stochastic or deterministic
Test over a range of values
When testing a range of values, understanding correlation
among lines of business.
10
Risk Transfer Considerations
• Certain terms in the contract may cause the contract to fail
the conditions of risk transfer before even evaluating the 9b
tests;
• failure to transfer significant timing and underwriting risk
is not overcome by the possibility of significant loss to
the reinsurer. (FAS 113 Q&A # 21)
11
Prospective vs. Retroactive Contracts
Prospective reinsurance contracts cover losses incurred as a
result of future insurable events
Retroactive reinsurance contracts cover losses incurred as a
result of past insurable events
A reinsurance contract may be both
12
Prospective Reinsurance Contracts
• Amounts paid reported as “prepaid reinsurance”
• Prepaid Reinsurance is amortized over the remaining
contract period in proportion to the amount of insurance
protection provided
13
Retroactive Reinsurance Contracts
•
•
•
•
•
Amounts paid are reported as reinsurance receivables to the extent
those amounts do not exceed the Underlying liabilities
If the underlying liabilities exceed the amounts paid, a deferred gain is
recorded and amortized over the remaining settlement period.
The interest rate used in amortizing the deferred gain should reflect the
timing of payments to the reinsurer and the duration over which the
reinsurer can invest the cash flows
If the timing of the reinsurance recoveries cannot be estimated,
amortize the deferred gain using the recovery method.
Changes in estimate of recoveries should be a cumulative amortization
adjustment recognized in the period of the change, with the deferred
gain revised to reflect the new amount as if it had existed at inception.
14
Retroactive Stop Loss Example
(Interest Method)
Book of Business:
Commercial Lines Reserves
Carried Loss Reserves:
$500 million
Attachment Point:
$400 million
Premium:
$75 million
Coverage:
$150 million
15
Retroactive Stop Loss Example
Interest Rate Method
(1)
Year
Inception
End 1
End 2
End 3
End 4
End 5
Total
(2)
Reserve
$100.0
$100.0
$100.0
$100.0
$99.7
$91.2
(3)
PV of
Reserve
$55.0
$57.8
$60.7
$63.7
$66.6
$61.2
$45.0
(4)
Unamortized
Deferred Gain
$25.0
$23.5
$21.9
$20.2
$18.4
$16.7
(5)
Annual
Amortization
-------1.5
1.6
1.7
1.8
1.7
25.0
Footnotes
General - this example assumes there is no change in the ultimate reserves
Column (2) is Ultimate Reserves less paid losses in layer
Column (3) is PV of Reserves at time less any paid losses
Column (4) is Amortization of Deferred Gain on Pro-Rata Basis (I.e., Column (2)-Column (3) divided by
Total of Column (3). Multiplied by the $25
Column (5) is {Column(4)n minus Column(4)n-1}
16
Retroactive Stop Loss Example
Interest Rate Method - Change in Ultimate
Presentation of Deferred Gain as if known at inception
(1)
Year
Inception
End 1
End 2
End 3
End 4
End 5
Total
(2)
Reserve
$150.0
$150.0
$150.0
$144.9
$128.6
$116.1
(3)
PV of
Reserve
$89.2
$93.7
$98.4
$98.0
$86.2
$77.8
(4)
Unamortized
Deferred Gain
$75.0
$69.5
$63.7
$57.8
$52.3
$47.3
(5)
Annual
Amortization
-------5.5
5.8
5.9
5.5
4.9
$60.8
Footnotes
General – in year 2, estimated ultimate increased to $150.
Column (2) is Ultimate Reserves less paid losses in layer
Column (3) is PV of Reserves at time less any paid losses
Column (4) is Amortization of Deferred Gain on Pro-Rata Basis (I.e., Column (2)-Column (3) divided by Total of Column
(3) multiplied by $75M.
Column (5) is {Column(4)n minus Column(4)n-1}
17
Retroactive Stop Loss Example
Interest Rate Method - Change in Ultimate
(1)
Year
Inception
End 1
End 2
End 3
End 4
End 5
(2)
(3)
PV of
Reserve
$100.0
$100.0
$150.0
$144.9
$128.6
$116.1
Reserve
$55.0
$57.8
$98.4
$98.0
$52.3
$47.3
(4)
(5)
(6)
Cumulative
Unamortized
Amortization
Adjustment
$4.0
Deferred Gain for the Period
$25.0
$23.5
$63.7
$57.8
$52.3
$47.3
-------$1.5
$9.8
$5.9
$5.5
$4.9
Footnotes
General – during the second year, estimated ultimate increased to $150.
Column (2) is Ultimate Reserves less paid losses in layer
Column (3) is PV of Reserves at time less any paid losses
Column (4) is the Cumulative adjustment required to record the appropriate amount of deferred gain in the income statement
based on the revised ultimate estimate.
Column (5) is Amortization of Deferred Gain on Pro-Rata Basis (see previous slides).
Column (6) is {Column(5)n minus Column(5)n-1}
18
Retroactive Stop Loss Example
Recovery Method
(Settlement Method)
• Recognize deferred gain based on percent of cash
recovered.
• With previous example ($100M reserves and $25M deferred
gain)
• Assume the Company received $10M in cash recoveries; then
$2.5M of the deferred gain would be released.
19
Case Study #1 - Prospective Accident
Year Stop Loss
Company Information
Type:
Insurance Company
Policyholders Surplus:
$500 million
Book of Business:
Multiline (P&C)
Expected Premium:
$500 million
Expected Loss Ratio:
70.0%
20
Case Study #1 - Prospective Accident
Year Stop Loss – Continued
Stop Loss Terms
Type:
Aggregate Excess of Loss
Term:
Single Accident Year
Subject Business: Whole Account
SNEP:
$500 million
Attachment:
65.2% (U/W neutral)
Limit:
$90 million (18% of SNEP)
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Case Study #1 - Prospective Accident
Year Stop Loss – Continued
Stop Loss Terms
Minimum & Deposit: 4.8% of SNEP (est. $24
million)
Additional Premium: 52.5% of UNL xs of 75.2% L/R
Maximum Premium:
9.0% of SNEP (est. $45
million)
Ceding Commission: 27.5% of M&D
Reinsurer’s Margin:
(M&D above is net)
7.5% of ceded Premium
22
Case Study #1 - Prospective Accident
Year Stop Loss - Continued
Stop Loss Terms
• F/W balance =
All Premium; less
Ceding Commission paid; less
Reinsurer’s Margin; less
UNL Paid by Reinsurer; plus
Interest Credit.
• Premium & Loss reporting - Quarterly bordereaux.
• UNL Settlements - From F/W account first until
depleted, then from reinsurer’s funds.
• Funds Withheld - Interest Credit of 7.0%
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Case Study #1 - Prospective Accident
Year Stop Loss - Continued
Accounting Results
1) Expected - No losses excess of budget
SNEP = $500M
Subject Losses = $350M (70% L/R)
Calculations:
Attachment = 65.2% x $500M=
Limit = 18% x 500M=
Ceded Losses = 350M - 326M=
Net Ceded Premium = 4.8%x500M=
Underwriting Income = 24M - 24M=
326.0M
90.0M
24.0M
24.0M
0.0M
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Case Study #1 - Prospective Accident
Year Stop Loss - Continued
Accounting Results
2) Full Use - $66M other xs of budget
SNEP = $500M
Subject Losses = $416M (83.2% L/R)
Calculations:
Attachment = 65.2% x $500M=
Limit = 18% x 500M=
Ceded Losses = 416M - 326M=
Net Ceded Premium = 4.8% x 500M=
Add’l Premium=52.5%x(416M-376M)=
Total Premium = 24.0M + 21.0M=
Underwriting Income=90M - 45M=
326.0M
90.0M
90.0M
24.0M
21.0M
45.0M
45.0M
25
Case Study #1 - Prospective Accident
Year Stop Loss - Continued
Accounting Results
3) Favorable - $10M improvement over budget
SNEP = $500M
Subject Losses = $340M (68% L/R)
Calculations:
Attachment = 65.2% x $500M=
Limit = 18% x 500M=
Ceded Losses = 340M - 326M=
Ceded Premium = 4.8% x 500M=
Profit Sharing Accrual* =
U/W Income=14M - 24M + 9.8M=
326.0M
90.0M
14.0M
24.0M
9.8M
-0.2M
* Accrual=net of Interest Credit
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Case Study #1 - Prospective Accident
Year Stop Loss - Continued
Key Risk Transfer Determinants

Ultimate losses - historical and projected

Payout pattern projections and support

Mix of business - historical and projected

Catastrophe exposure information/modeling
27
Case Study #1 - Prospective Accident
Year Stop Loss - Continued
Reinsurer’s Results
Subject
Losses
Deviation from
Expected
Ceded Losses
Reinsurer’s
PV Cash
Flows
Return on
Premium
PV (ending
F/W)
70%
0%
24,000
1,800
7.5%
13,555
75%
5%
49,000
1,800
7.5%
1,515
79%
9%
69,000
2,545
7.5%
0
84%
14%
90,000
0
0.0%
(3,375)
88%
18%
90,000
(4,500)
-10.0%
(7,870)
Expected Payout - Scenario 1
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Case Study #1 - Prospective Accident
Year Stop Loss - Continued
Reinsurer’s Results
Deviation
Reinsurer’s
PV
Subject
from
Ceded
PV Cash
Return on
(ending
Losses
Expected
Losses
Flows
Premium
F/W)
70%
0%
24,000
1,800
7.5%
12,950
75%
5%
49,000
1,800
7.5%
0
80%
10%
74,000
0
0.0%
(2,750)
85%
15%
90,000
(4,505)
-10.0%
(7,880)
90%
20%
90,000
(9,890)
-22.0%
(13,265)
Expected Payout - Scenario 2
29
Reserve Management Considerations
•
•
•
•
•
Classify Contracts for Reserving Purposes
Examine Larger Contracts for Indications of Bias
Consider Historical Experience on Similar Contracts
Consider the Range of Possible Outcomes
Set Your IBNR Accordingly
Question: What is the value of an additional year’s worth of
information?
Answer: the pricing information and mix of business is fixed and known;
and there is one period of known loss development.
Please refer to Attachment A for a numerical example
30
Other Reinsurance Accounting Issues
•
•
•
•
•
•
•
Use of long-duration reinsurance contracts to reinsure short-duration
contracts.
Reinsurance contracts with uncertain terms or terms to be negotiated in
the future.
Reinsurance contracts with embedded written options
Structured notes with principal tied to industry loss ratios or
catastrophic events.
Parent company reinsurance arrangements.
EITF D-54 prospective accounting for certain purchase-sale
transactions
Fair value accounting for reserves relating to a purchase acquisition.
31
FASB Standard No. 113 Comparison
to Statutory - Similarities
• Similarities
• Risk Transfer Guidance
• Prospective and Retroactive Provisions Within a Single
Contract Should be Accounted for Separately
• Accounting for Costs of Prospective Reinsurance Contracts
• Retroactive Contracts:
• Deferred Gain Amortized Over the Settlement Period
• Immediate Loss Recognition
• Accounting for Changes in Estimates
32
FASB Standard No. 113 Comparison
to Statutory - Differences
• Differences
• Balance Sheet Amounts Related to Prospective Contracts
May be Netted
• Retroactive Recoveries are Reflected as a Contra Liability as
“Other Aggregate Write –In” on Page 3, Reducing Liabilities
• Immediate Recognition of Gain on Retroactive Recoveries is
Included in Other Income.
• Contracts Must Be Signed within 9 Months of the Effective
Date – If Not - Considered Retroactive
33
FASB Standard No. 113 Comparison to
Statutory – Differences (Continued)
• Differences (Continued)
• Retroactive Contracts Require the Following for Reinsurance
Accounting:
• Insolvency Clause
• May Not be Cancelled or Rescinded without
Commissioner Approval
• Premiums and Losses Must be Reported at Least
Quarterly
• Consideration Paid by Ceding Company Must be Sum
Certain
34
QUESTIONS
35