Risk Transfer - What
Changes Are On
The Horizon?
Panelist: Marc Oberholtzer - PwC
CAS Seminar on Reinsurance
June 6-7, 2005
Bermuda
Discussion Topics
 An Audit Firm Actuary’s Perspective on Evaluating Risk
Transfer
 Relevant Accounting Guidance
 Role of Audit Firm Actuary
 Contracts Where Auditors Request Assistance from Audit Firm
Actuary
 Process used to Evaluate Contracts
 Determine Substance of Arrangement
 Evaluate Cash Flows/Scenario Testing
 Thresholds (e.g., 10/10 rule)
 Terms/Conditions Requiring Special Consideration
 Possible Changes to Reinsurance Accounting
 Activity at the NAIC; Possible Changes for US Statutory Accounting:
 Increased Disclosure
 Attestations
 NY Proposal re: Bifurcation
 Activity at the FASB
CAS Seminar on Reinsurance - 2005
2
Evaluating Risk Transfer – Process
Current Relevant US Accounting Guidance
 US GAAP
 FAS 113 – Primary US GAAP guidance on
Reinsurance Accounting.
 Para 9a – “Transfer of Significant Insurance Risk”
 Para 9b – “Reasonable Possibility of Significant
Loss”
 EITF 93-6 – Multi-Year RRC
 Topic D-54 – Reserve Guarantee Accounting
 US Statutory
 SSAP 62 – Similar Guidance to US GAAP; no D-54
Retroactive Exception
CAS Seminar on Reinsurance - 2005
3
Evaluating Risk Transfer – Process
Role of Audit Firm Actuary
 The Auditor (i.e., an Accountant) Considers Input from The
Audit Firm Actuary in his/her Assessment of Risk Transfer
 Such Input Includes:
 A View as to the Economic Substance, as Compared to the
Contractual Form, of the Arrangement
 The Evaluation and Conclusion on Reasonableness of
Projected Cash Flows under Contract, Ensuring Appropriate
Consideration of Historical Losses, Modeling Assumptions
and Contractual Terms
 The Evaluation of Related Disclosures as Applicable
CAS Seminar on Reinsurance - 2005
4
Evaluating Risk Transfer – Process
Which Contracts Is the Auditor More Likely to Seek
the Assistance of the Audit Firm Actuary?
 Those with Various Risk Limiting Features. Typically, this
includes:
 Quota Share Contracts with Corridors and/or Sliding
Scale Commissions and Loss Ratio Caps
 Aggregate Stop Loss or Loss Ratio Covers with
Premium Payments and/or Profit Commissions
 Contracts with Experience Accounts or Similar
Provisions
CAS Seminar on Reinsurance - 2005
5
Evaluating Risk Transfer – Process
Which Contracts Is the Auditor Less Likely to Seek
the Assistance of the Audit Firm Actuary?
 Those without Significant Various Risk Limiting Features.
Typically, this includes:
 Most Traditional Excess of Loss Arrangements
 Quota Share without Risk Limiting Features
 Most Single Year Catastrophe Covers
CAS Seminar on Reinsurance - 2005
6
Evaluating Risk Transfer – Process
 The Substance of Arrangement
 Identify the Contract or Contracts being evaluated
 Obtain and Read Entire Contract and Related
Contracts, if any
 Substance does not Always Follow Form
 Obtain from the Audited Company an Understanding of the
Business Purpose and Substance of the Transaction.
 Obtain and Review as much Background to the Transaction
as Possible
 Obtain and Review Underwriting Memo, Accounting Memo
Risk and/or Risk Transfer Memo
 In unavailable, there might be control implications and
an inability for auditor to conclude on risk transfer
CAS Seminar on Reinsurance - 2005
7
Evaluating Risk Transfer – Process
 Evaluate Company’s Analysis of Cash
Flows/Scenario Testing – Subject Losses
 Conclude on Reasonableness of Company’s Estimates of
Loss Estimates, Payout Patterns, and their Variability over
Reasonably Possible Scenarios
 Company’s Selected Mean, CV and Distribution of
Subject Losses
 Based on Company History? Industry Data? Judgment?
 Payout Patterns
 How Selected?
 What is the basis and methodology used to vary the Payout
Patterns?
CAS Seminar on Reinsurance - 2005
8
Evaluating Risk Transfer – Process
 Evaluate The Audited Company’s Analysis of Cash
Flows/Scenario Testing – Contractual Terms
 Amount and Timing of Additional Premiums, Commissions,
or Related Payments
 Are all contractual terms considered in the risk transfer
calculation?
 Interaction of Loss Payments with Experience Accounts
and/or Funds Held Accounts, including Interest Credits and
Charges
 Determine Impact of Commutation Clauses or Related Terms
 Obtain Management’s Representation as to its Intentions
regarding Such Clauses
CAS Seminar on Reinsurance - 2005
9
Evaluating Risk Transfer – Process
 Evaluate The Audited Company’s Analysis of
Cash Flows/Scenario Testing – Interest Rate
used to Calculate Present Value
 Conclude on Reasonableness of Company’s Selected
Interest Rate Used to Present Value Cash Flows
 Ensure that All Cash Flows are Being Present Valued, and at
the same Interest Rate
 Determine the Expected Timing and Duration of Payments
based on Cash Flow Analysis
 Compare Risk-Free Rates at Expected Duration with those
used in the Risk Transfer Calculation – modify Calculation as
needed to reflect a Risk-Free Rate
CAS Seminar on Reinsurance - 2005
10
Evaluating Risk Transfer – Process
 Common Rule of Thumb – 10/10 Rule
 10% chance of a 10% loss (in present value terms)
 Calculated from the Assuming Company’s perspective
 The present value of net of cash flows for losses and
commissions, divided by
 The present value of net cash flows for premiums
 Appears to be the Industry Standard Regarding the Minimum
Threshold for Risk Transfer
 A higher standard may be appropriate
 There are other considerations
 What happens at other scenarios?
 What is the maximum loss to the Company?
 Does the Company’s suggested accounting reasonably match
the substance of the agreement?
CAS Seminar on Reinsurance - 2005
11
Evaluating Risk Transfer – Process
 Some Terms, Conditions or Circumstances that
Require Close Scrutiny
 Multi-Year Arrangements
 Does Loss Experience under the Contract create Rights for the Assuming Company
that need to be considered?
 Different Interest Rates; For example, Interest Credit on Funds Held
Accounts exceeding the Rate used to Present Value Cash Flows
 The Amount that the Interest Credit Exceeds the Rate used to Present Value Cash
Flows is Considered Additional Consideration in the Risk Transfer Analysis
 Ceding Commission Paid in the Future
 The Time Value Benefit to the Ceding Company is Considered to be Additional
Consideration in the Risk Transfer Analysis
 Maintenance Fees
 Expected Amounts Are Present Valued and Considered Additional Consideration in
the Risk Transfer Analysis
 Commutation Accounts
 Can the Assuming Company Reduce its Losses by Exercising a Right to Commute,
and is such Right Considered in the Evaluation?
CAS Seminar on Reinsurance - 2005
12
Industry Update – Possible Changes
 May 10, 2005 NAIC Meeting – Possible Changes
to SSAP 62 for Year-end 2005:
 Increased Disclosure for certain reinsurance contracts
 Aggregate Stop Loss
 Quota Share with Limiting Features
 Many others with Certain Terms/Conditions
 Attestation from CEO and CFO
 No Side deals
 Documentation exists Supporting Risk Transfer and the
Economic Intent of All Reinsurance contracts
 Bifurcation of Certain Contracts
 Portions of Certain Contracts where there is more than a 90%
Probability that Premiums would be Recovered would be
Accounted for as a Deposit
CAS Seminar on Reinsurance - 2005
13
Industry Update – Possible Changes
 May 10, 2005 NAIC Meeting – Possible Changes
to SSAP 62 for Year-end 2005:
 A Significant Expectation of Documentation within the CEO,
CFO Attestations
 Expectation by Regulators that Documentation Exists
Supporting Risk Transfer and the Economic Intent of All
Reinsurance Contracts – Regulators View Lack of Such
Documentation as Lack of Compliance with SSAP 62 and the
corporate recordkeeping requirements of Foreign Corrupt
Practices Act of 1977 (as Amended) .
 Compliance Would Effectively Require Documentation
Contemporaneous with Entering into Transactions
CAS Seminar on Reinsurance - 2005
14
Industry Update – Possible Changes
 May 10, 2005 NAIC Meeting – Possible Changes
to SSAP 62 for Year-end 2005:
 A Significant Proposal – Bifurcation
 Certain contracts, including quota share with limits,
aggregate stop-loss and retroactive potentially subject
to bifurcation
 Bifurcation is the separation of a contract into financing
and risk transfer components for accounting purposes
 Would require actuarial evaluation to estimate/allocate
premium and related consideration between the risk
transfer and deposit components
CAS Seminar on Reinsurance - 2005
15
Industry Update – Possible Changes
 May 10, 2005 NAIC Meeting – Proposed
Bifurcation
 Possible Benefits
 An Ability to Better Match The Accounting with a
Contract’s Economics
 Would Likely Eliminate the Benefit, and then
eventually the Existence, of Those Contracts
Viewed as Problematic by Regulators, Rating
Agencies and Investors
CAS Seminar on Reinsurance - 2005
16
Industry Update – Possible Changes
 May 10, 2005 NAIC Meeting – Proposed
Bifurcation
 Possible Concerns
 Complexity – Bifurcation Could be Very Complicated, in
particular for Certain Quota Share Arrangements with Risk
Limiting Features
 Potential Unintended Consequences
 Change in Structure, Pricing of Traditional Market
 Bifurcation of Contracts that are not viewed as Problematic
or Viewed to have Significant Risk Limiting Features
 Differences in Accounting between US SAP, US GAAP and
other Accounting Bases
CAS Seminar on Reinsurance - 2005
17
Industry Update – Possible Changes
 Other Recent Regulatory Activity
 New York – Effective March 2005
 For Reinsurance Cessions, NY Insurance Department
will Require the CEO of companies to attest that:
 There are No Side Agreements
 For each Contract, a File exists that Documents the Economic
Intent of the Transaction and the Risk Transfer Analysis Evidencing
the Proper Accounting Treatment, which is Available for Review.
 Massachusetts – Effective May 2005
 Insurer's Audit Committee Chair will be Required to:
 Sign Off on any Finite Reinsurance Contracts
 Certify that there are no Informal or Side Agreements that might
affect Transactions
CAS Seminar on Reinsurance - 2005
18
Industry Update – Possible Changes
 Activity at the FASB – Insurance-Risk Transfer
Project (April 6, 2005 meeting)
 Underlying Purpose - to Improve the Accounting for
Insurance and Reinsurance Contracts by More Clearly
Defining which Contracts or Portions thereof should be
Accounted for as Insurance and which Should be
Accounted for as Deposits (financings).
 Objectives:
 Clarify Transfer of Significant Insurance Risk;
Define Insurance Contracts and Codifying related
Guidance in current FASB and AICPA literature.
 Explore Simple Approaches to Bifurcation
CAS Seminar on Reinsurance - 2005
19