1 Actuarial and Accounting Issues Surrounding FASB Statement No. 113 Accounting and Reporting for...

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Actuarial and Accounting Issues Surrounding FASB Statement No. 113

Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts

Actuarial and Accounting Issues Surrounding FASB Statement No. 113

Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts

Panelists:Panelists:Jerry DegernessJerry DegernessEd HardyEd HardyPeter WildmanPeter Wildman

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FASB Statement No. 113FASB Statement No. 113MAJOR PROVISIONSMAJOR PROVISIONS

• Applicable for financial statements prepared under Applicable for financial statements prepared under Generally Accepted Accounting Principles in the U.S.Generally Accepted Accounting Principles in the U.S.

• Defined Risk TransferDefined Risk Transfer• Segregated Retroactive and Prospective ContractsSegregated Retroactive and Prospective Contracts• Grossed-up balance sheetGrossed-up balance sheet

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FASB Statement No. 113 – Risk TransferFASB Statement No. 113 – Risk Transfer

Risk transfer requires both of the following:Risk transfer requires both of the following:• Paragraph 9a - The reinsurer assumes significant Paragraph 9a - The reinsurer assumes significant

insurance risk under the reinsured portion of the insurance risk under the reinsured portion of the underlying contractsunderlying contracts

• Requires both underwriting and timing riskRequires both underwriting and timing risk• No delayed payment clauses allowedNo delayed payment clauses allowed• Adjustable feature must be considered Adjustable feature must be considered

• Paragraph 9b - It is reasonably possible that the reinsurer Paragraph 9b - It is reasonably possible that the reinsurer may realized a significant loss from the transactionmay realized a significant loss from the transaction

• Defined present value testDefined present value test• Did not define “significant”Did not define “significant”

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FASB Statement No. 113FASB Statement No. 113• It is easy to understand how the 9a is met:It is easy to understand how the 9a is met:

• With a straight quota share agreement. With a straight quota share agreement. • With a plain vanilla, one-year, excess of loss agreement.With a plain vanilla, one-year, excess of loss agreement.

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Transfer of Insurance RiskTransfer of Insurance Risk

The analysis becomes more difficult to conclude that 9a is met The analysis becomes more difficult to conclude that 9a is met when when

• ““Horizontal protection” is introduced in a multiple – year Horizontal protection” is introduced in a multiple – year contract.contract.

• As contractual features are added that limit the amount of As contractual features are added that limit the amount of insurance risk assumed, (e.g. adjustable features, insurance risk assumed, (e.g. adjustable features, contingents, etc. )contingents, etc. )

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Contractual Provisions That Limit Risk Transfer:Contractual Provisions That Limit Risk Transfer:

• Experience refundsExperience refunds• Cancellation provisionsCancellation provisions• Profit commissionsProfit commissions• Retrospective premiumsRetrospective premiums• Reinstatement premiumsReinstatement premiums• Reductions or changes in coverageReductions or changes in coverage• Additions of profitable lines of businessAdditions of profitable lines of business

to the reinsurance contract to the reinsurance contract

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Transfer of Insurance RiskTransfer of Insurance RiskSignificance of a loss is evaluated by:Significance of a loss is evaluated by:• Comparing the present value of all cash inflows with the Comparing the present value of all cash inflows with the

present value of all cash outflows or amounts deemed to present value of all cash outflows or amounts deemed to have been paid to the reinsurer under reasonably possible have been paid to the reinsurer under reasonably possible outcomes.outcomes.

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The Unanswered QuestionsThe Unanswered Questions• What constitutes significant insurance risk?What constitutes significant insurance risk?

• What is the definition of reasonably possible?What is the definition of reasonably possible?

• What constitutes a significant loss?What constitutes a significant loss?

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Considerations For Developing A Reasonable Risk Transfer AnalysisConsiderations For Developing A Reasonable Risk Transfer Analysis

• Complexity of adjustable featuresComplexity of adjustable features• Sub limits for various lines of businessSub limits for various lines of business• Complexity in modeling certain features in the contractComplexity in modeling certain features in the contract• Uncertainty around the speed of settlementUncertainty around the speed of settlement• Uncertainty around ultimate covered lossesUncertainty around ultimate covered losses• Probabilistic modelingProbabilistic modeling

• Ultimate loss picksUltimate loss picks• Payout VolatilityPayout Volatility

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Best Practices for Developing Risk Transfer Analysis Best Practices for Developing Risk Transfer Analysis

• Understand all terms of the contractUnderstand all terms of the contract• What terms are fixed and what terms are (open)What terms are fixed and what terms are (open)• Test risk stochastic or deterministicTest risk stochastic or deterministic• Test over a range of valuesTest over a range of values• When testing a range of values, understanding correlation When testing a range of values, understanding correlation

among lines of business.among lines of business.

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Risk Transfer Considerations Risk Transfer Considerations • Certain terms in the contract may cause the contract to fail Certain terms in the contract may cause the contract to fail

the conditions of risk transfer before even evaluating the 9b the conditions of risk transfer before even evaluating the 9b tests;tests;

• failure to transfer significant timing and underwriting risk failure to transfer significant timing and underwriting risk is not overcome by the possibility of significant loss to is not overcome by the possibility of significant loss to the reinsurer. (FAS 113 Q&A # 21)the reinsurer. (FAS 113 Q&A # 21)

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Prospective vs. Retroactive ContractsProspective vs. Retroactive ContractsProspective reinsurance contracts cover losses incurred as a Prospective reinsurance contracts cover losses incurred as a

result of future insurable eventsresult of future insurable events

Retroactive reinsurance contracts cover losses incurred as a Retroactive reinsurance contracts cover losses incurred as a result of past insurable eventsresult of past insurable events

A reinsurance contract may be bothA reinsurance contract may be both

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Prospective Reinsurance ContractsProspective Reinsurance Contracts• Amounts paid reported as “prepaid reinsurance”Amounts paid reported as “prepaid reinsurance”• Prepaid Reinsurance is amortized over the remaining Prepaid Reinsurance is amortized over the remaining

contract period in proportion to the amount of insurance contract period in proportion to the amount of insurance protection providedprotection provided

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Retroactive Reinsurance ContractsRetroactive Reinsurance Contracts• Amounts paid are reported as reinsurance receivables to the extent Amounts paid are reported as reinsurance receivables to the extent

those amounts do not exceed the Underlying liabilitiesthose amounts do not exceed the Underlying liabilities• If the underlying liabilities exceed the amounts paid, a deferred gain is If the underlying liabilities exceed the amounts paid, a deferred gain is

recorded and amortized over the remaining settlement period.recorded and amortized over the remaining settlement period.• The interest rate used in amortizing the deferred gain should reflect the The interest rate used in amortizing the deferred gain should reflect the

timing of payments to the reinsurer and the duration over which the timing of payments to the reinsurer and the duration over which the reinsurer can invest the cash flowsreinsurer can invest the cash flows

• If the timing of the reinsurance recoveries cannot be estimated, If the timing of the reinsurance recoveries cannot be estimated, amortize the deferred gain using the recovery method.amortize the deferred gain using the recovery method.

• Changes in estimate of recoveries should be a cumulative amortization Changes in estimate of recoveries should be a cumulative amortization adjustment recognized in the period of the change, with the deferred 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.gain revised to reflect the new amount as if it had existed at inception.

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(Interest Method)(Interest Method)

Book of Business:Book of Business: Commercial Lines ReservesCommercial Lines Reserves

Carried Loss Reserves:Carried Loss Reserves: $500 million$500 million

Attachment Point:Attachment Point: $400 million$400 million

Premium:Premium: $75 million$75 million

Coverage:Coverage: $150 million$150 million

Retroactive Stop Loss ExampleRetroactive Stop Loss ExampleRetroactive Stop Loss ExampleRetroactive Stop Loss Example

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(1)(1) (2) (2) (3) (3) (4) (4) (5) (5) PV ofPV of UnamortizedUnamortized Annual Annual

YearYear ReserveReserve ReserveReserve Deferred GainDeferred Gain AmortizationAmortizationInceptionInception $100.0 $55.0 $100.0 $55.0 $25.0 $25.0 -------- --------End 1End 1 $100.0 $57.8 $100.0 $57.8 $23.5 $23.5 1.5 1.5End 2End 2 $100.0 $60.7 $100.0 $60.7 $21.9 $21.9 1.6 1.6 End 3End 3 $100.0 $63.7 $100.0 $63.7 $20.2$20.2 1.7 1.7End 4End 4 $99.7 $99.7 $66.6 $66.6 $18.4$18.4 1.8 1.8End 5End 5 $91.2 $91.2 $61.2 $61.2 $16.7$16.7 1.7 1.7

TotalTotal $45.0 $45.0 25.0 25.0

FootnotesFootnotesGeneral - this example assumes there is no change in the ultimate reservesGeneral - this example assumes there is no change in the ultimate reservesColumn (2) is Ultimate Reserves less paid losses in layerColumn (2) is Ultimate Reserves less paid losses in layerColumn (3) is PV of Reserves at time less any paid lossesColumn (3) is PV of Reserves at time less any paid lossesColumn (4) is Amortization of Deferred Gain on Pro-Rata Basis (I.e., Column (2)-Column (3) divided by 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 $25Total of Column (3). Multiplied by the $25Column (5) is {Column(4)n minus Column(4)n-1}

Retroactive Stop Loss Example Interest Rate Method Retroactive Stop Loss Example Interest Rate Method

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Retroactive Stop Loss Example Interest Rate Method - Change in UltimateRetroactive Stop Loss Example Interest Rate Method - Change in Ultimate

Presentation of Deferred Gain as if known at inceptionPresentation of Deferred Gain as if known at inception

((1)1) (2) (2) (3) (3) (4) (4) (5) (5) PV ofPV of Unamortized Unamortized Annual Annual

YearYear ReserveReserve Reserve Reserve Deferred Gain Deferred Gain Amortization AmortizationInceptionInception $150.0 $150.0 $89.2$89.2 $75.0$75.0 -------- --------End 1End 1 $150.0 $150.0 $93.7$93.7 $69.5$69.5 5.5 5.5End 2End 2 $150.0 $150.0 $98.4$98.4 $63.7$63.7 5.8 5.8 End 3End 3 $144.9 $144.9 $98.0$98.0 $57.8$57.8 5.9 5.9End 4End 4 $128.6 $128.6 $86.2 $86.2 $52.3 $52.3 5.5 5.5End 5End 5 $116.1 $116.1 $77.8$77.8 $47.3$47.3 4.9 4.9

TotalTotal $60.8 $60.8

FootnotesFootnotesGeneral – in year 2, estimated ultimate increased to $150.General – in year 2, estimated ultimate increased to $150.Column (2) is Ultimate Reserves less paid losses in layerColumn (2) is Ultimate Reserves less paid losses in layerColumn (3) is PV of Reserves at time less any paid lossesColumn (3) is PV of Reserves at time less any paid lossesColumn (4) is Amortization of Deferred Gain on Pro-Rata Basis (I.e., Column (2)-Column (3) divided by Total of Column (3) 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.multiplied by $75M.Column (5) is {Column(4)n minus Column(4)n-1}

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Retroactive Stop Loss Example Interest Rate Method - Change in UltimateRetroactive Stop Loss Example Interest Rate Method - Change in Ultimate

FootnotesFootnotesGeneral – during the second year, estimated ultimate increased to $150.General – during the second year, estimated ultimate increased to $150.Column (2) is Ultimate Reserves less paid losses in layerColumn (2) is Ultimate Reserves less paid losses in layerColumn (3) is PV of Reserves at time less any paid lossesColumn (3) is PV of Reserves at time less any paid lossesColumn (4) is the Cumulative adjustment required to record the appropriate amount of deferred gain in the income statement based on the revised ultimate 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.estimate.Column (5) is Amortization of Deferred Gain on Pro-Rata Basis (see previous slides).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}

(1) (2) (3) (4) (5) (6) PV of Cumulative Unamortized Amortization

Year Reserve Adjustment Deferred Gain for the Period

Inception $100.0 $55.0 $25.0 -------- End 1 $100.0 $57.8 $23.5 $1.5

End 2 $150.0 $98.4 $4.0 $63.7 $9.8

End 3 $144.9 $98.0 $57.8 $5.9

End 4 $128.6 $52.3 $52.3 $5.5End 5 $116.1 $47.3 $47.3 $4.9

Reserve

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Retroactive Stop Loss Example Recovery MethodRetroactive Stop Loss Example Recovery Method

(Settlement Method)(Settlement Method)

• Recognize deferred gain based on percent of cash Recognize deferred gain based on percent of cash recovered. recovered.

• With previous example ($100M reserves and $25M deferred With previous example ($100M reserves and $25M deferred gain)gain)

• Assume the Company received $10M in cash recoveries; then Assume the Company received $10M in cash recoveries; then $2.5M of the deferred gain would be released.$2.5M of the deferred gain would be released.

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Type: Insurance Company

Policyholders Surplus:

$500 million

Book of Business:

Multiline (P&C)

Expected Premium:

$500 million

Expected Loss Ratio:

70.0%

Case Study #1 - Prospective Accident Year Stop Loss

Company InformationCompany Information

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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)

Case Study #1 - Prospective Accident Year Stop Loss – Continued

Stop Loss TermsStop Loss Terms

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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 (M&D above is net)

Reinsurer’s Margin: 7.5% of ceded Premium

Case Study #1 - Prospective Accident Year Stop Loss – Continued

Stop Loss TermsStop Loss Terms

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Case Study #1 - Prospective Accident Year Stop Loss - Continued

Stop Stop LossLoss Terms 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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Accounting Accounting RResultsesults

1) Expected - No losses excess of budgetExpected - No losses excess of budgetSNEP = $500MSubject Losses = $350M (70% L/R)

Calculations:Attachment = 65.2% x $500M=

326.0MLimit = 18% x 500M=

90.0MCeded Losses = 350M - 326M=

24.0MNet Ceded Premium = 4.8%x500M=

24.0MUnderwriting Income = 24M - 24M=

0.0M

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AccountingAccounting Results Results

2) Full Use - $66M other xs of budgetFull Use - $66M other xs of budgetSNEP = $500MSubject Losses = $416M (83.2% L/R)

Calculations:Attachment = 65.2% x $500M= 326.0MLimit = 18% x 500M=

90.0MCeded Losses = 416M - 326M= 90.0MNet Ceded Premium = 4.8% x 500M= 24.0MAdd’l Premium=52.5%x(416M-376M)= 21.0MTotal Premium = 24.0M + 21.0M=

45.0MUnderwriting Income=90M - 45M=

45.0M

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Accounting ResultsAccounting Results

3) Favorable - $10M improvement over budgetFavorable - $10M improvement over budgetSNEP = $500MSubject Losses = $340M (68% L/R)

Calculations:Attachment = 65.2% x $500M= 326.0MLimit = 18% x 500M=

90.0MCeded Losses = 340M - 326M= 14.0MCeded Premium = 4.8% x 500M=

24.0MProfit Sharing Accrual* = 9.8MU/W Income=14M - 24M + 9.8M=

-0.2M* Accrual=net of Interest Credit

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Key Risk Transfer Determinants

Ultimate losses - historical and projected

Payout pattern projections and support

Mix of business - historical and projected

Catastrophe exposure information/modeling

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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)


Reinsurer’sReinsurer’s Results Results

Expected Payout - Scenario 1

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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% 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)


Reinsurer’s ResultsReinsurer’s Results

Expected Payout - Scenario 2

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Reserve Management ConsiderationsReserve Management Considerations• Classify Contracts for Reserving PurposesClassify Contracts for Reserving Purposes• Examine Larger Contracts for Indications of BiasExamine Larger Contracts for Indications of Bias• Consider Historical Experience on Similar ContractsConsider Historical Experience on Similar Contracts• Consider the Range of Possible OutcomesConsider the Range of Possible Outcomes• Set Your IBNR AccordinglySet 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 examplePlease refer to Attachment A for a numerical example

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Other Reinsurance Accounting IssuesOther Reinsurance Accounting Issues• Use of long-duration reinsurance contracts to reinsure short-duration Use of long-duration reinsurance contracts to reinsure short-duration

contracts.contracts.• Reinsurance contracts with uncertain terms or terms to be negotiated in Reinsurance contracts with uncertain terms or terms to be negotiated in

the future.the future.• Reinsurance contracts with embedded written optionsReinsurance contracts with embedded written options• Structured notes with principal tied to industry loss ratios or Structured notes with principal tied to industry loss ratios or

catastrophic events.catastrophic events.• Parent company reinsurance arrangements.Parent company reinsurance arrangements.• EITF D-54 prospective accounting for certain purchase-sale EITF D-54 prospective accounting for certain purchase-sale

transactionstransactions• Fair value accounting for reserves relating to a purchase acquisition.Fair value accounting for reserves relating to a purchase acquisition.

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FASB Standard No. 113 Comparison to Statutory - SimilaritiesFASB Standard No. 113 Comparison to Statutory - Similarities

• SimilaritiesSimilarities• Risk Transfer GuidanceRisk Transfer Guidance• Prospective and Retroactive Provisions Within a Single Prospective and Retroactive Provisions Within a Single

Contract Should be Accounted for SeparatelyContract Should be Accounted for Separately• Accounting for Costs of Prospective Reinsurance ContractsAccounting for Costs of Prospective Reinsurance Contracts• Retroactive Contracts:Retroactive Contracts:

• Deferred Gain Amortized Over the Settlement PeriodDeferred Gain Amortized Over the Settlement Period• Immediate Loss RecognitionImmediate Loss Recognition• Accounting for Changes in EstimatesAccounting for Changes in Estimates

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FASB Standard No. 113 Comparison to Statutory - DifferencesFASB Standard No. 113 Comparison to Statutory - Differences

• DifferencesDifferences• Balance Sheet Amounts Related to Prospective Contracts Balance Sheet Amounts Related to Prospective Contracts

May be NettedMay be Netted• Retroactive Recoveries are Reflected as a Contra Liability as Retroactive Recoveries are Reflected as a Contra Liability as

“Other Aggregate Write –In” on Page 3, Reducing Liabilities“Other Aggregate Write –In” on Page 3, Reducing Liabilities• Immediate Recognition of Gain on Retroactive Recoveries is Immediate Recognition of Gain on Retroactive Recoveries is

Included in Other Income. Included in Other Income. • Contracts Must Be Signed within 9 Months of the Effective Contracts Must Be Signed within 9 Months of the Effective

Date – If Not - Considered RetroactiveDate – If Not - Considered Retroactive

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FASB Standard No. 113 Comparison to Statutory – Differences (Continued)FASB Standard No. 113 Comparison to Statutory – Differences (Continued)

• Differences (Continued)Differences (Continued)• Retroactive Contracts Require the Following for Reinsurance Retroactive Contracts Require the Following for Reinsurance

Accounting:Accounting:• Insolvency ClauseInsolvency Clause• May Not be Cancelled or Rescinded without May Not be Cancelled or Rescinded without

Commissioner ApprovalCommissioner Approval• Premiums and Losses Must be Reported at Least Premiums and Losses Must be Reported at Least

QuarterlyQuarterly• Consideration Paid by Ceding Company Must be Sum Consideration Paid by Ceding Company Must be Sum

CertainCertain

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QUESTIONSQUESTIONS

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