Actuarial and Accounting Issues Surrounding FASB Statement No. 113 Accounting and Reporting for Reinsurance of Short-Dur

1. Actuarial and Accounting Issues Surrounding FASB Statement No. 113Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts Panelists: Jerry Degerness Ed Hardy Peter Wildman

2. 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

3. 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”

4. 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.

5. 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. )

6. 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

7. 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.

8. The Unanswered Questions • What constitutes significant insurance risk? • What is the definition of reasonably possible? • What constitutes a significant loss?

9. 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

10. 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.

11. 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)

12. 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

13. 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

14. 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.

15. 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

16. Retroactive Stop Loss Example Interest Rate Method (1) (2) (3) (4) (5) PV of Unamortized Annual Year ReserveReserve Deferred Gain Amortization Inception $100.0 $55.0 $25.0 -------- End 1 $100.0 $57.8 $23.5 1.5 End 2 $100.0 $60.7 $21.9 1.6 End 3 $100.0 $63.7 $20.2 1.7 End 4 $99.7 $66.6 $18.4 1.8 End 5 $91.2 $61.2 $16.7 1.7 Total $45.0 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}

17. Retroactive Stop Loss Example Interest Rate Method - Change in Ultimate Presentation of Deferred Gain as if known at inception (1) (2) (3) (4) (5) PV of Unamortized Annual Year Reserve Reserve Deferred Gain Amortization Inception $150.0 $89.2 $75.0 -------- End 1 $150.0 $93.7 $69.5 5.5 End 2 $150.0 $98.4 $63.7 5.8 End 3 $144.9 $98.0 $57.8 5.9 End 4 $128.6 $86.2 $52.3 5.5 End 5 $116.1 $77.8 $47.3 4.9 Total $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}

18. Retroactive Stop Loss Example Interest Rate Method - Change in Ultimate 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} (3) (4) (6) (2) (5) (1) PV of Unamortized Cumulative Amortization Reserve Adjustment Deferred Gain for the Period Year Reserve Inception $100.0 $55.0 -------- $25.0 End 1 $100.0 $57.8 $1.5 $23.5 End 2 $150.0 $98.4 $4.0 $9.8 $63.7 End 3 $144.9 $98.0 $5.9 $57.8 End 4 $128.6 $52.3 $5.5 $52.3 End 5 $116.1 $47.3 $4.9 $47.3

19. 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.

20. Case Study #1 - Prospective Accident Year Stop Loss Company Information

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

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

23. 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%

24. 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= 326.0M Limit = 18% x 500M= 90.0M Ceded Losses = 350M - 326M= 24.0M Net Ceded Premium = 4.8%x500M= 24.0M Underwriting Income = 24M - 24M= 0.0M

25. 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= 326.0M Limit = 18% x 500M= 90.0M Ceded Losses = 416M - 326M= 90.0M Net Ceded Premium = 4.8% x 500M= 24.0M Add’l Premium=52.5%x(416M-376M)= 21.0M Total Premium = 24.0M + 21.0M= 45.0M Underwriting Income=90M - 45M= 45.0M

26. 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= 326.0M Limit = 18% x 500M= 90.0M Ceded Losses = 340M - 326M= 14.0M Ceded Premium = 4.8% x 500M= 24.0M Profit Sharing Accrual* = 9.8M U/W Income=14M - 24M + 9.8M= -0.2M * Accrual=net of Interest Credit

27. 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

28. Case Study #1 - Prospective Accident Year Stop Loss - Continued Reinsurer’s Results Expected Payout - Scenario 1

29. Case Study #1 - Prospective Accident Year Stop Loss - Continued Reinsurer’s Results Expected Payout - Scenario 2

30. 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

31. 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.

32. 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

33. 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

34. 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

35. QUESTIONS ?