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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. Panelists: Jerry Degerness Ed Hardy Peter Wildman. FASB Statement No. 113. MAJOR PROVISIONS

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slide1

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

fasb statement no 113
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
fasb statement no 113 risk transfer
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”
fasb statement no 1134
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.
transfer of insurance risk
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. )
contractual provisions that limit risk transfer
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
transfer of insurance risk7
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.
the unanswered questions
The Unanswered Questions
  • What constitutes significant insurance risk?
  • What is the definition of reasonably possible?
  • What constitutes a significant loss?
considerations for developing a reasonable risk transfer analysis
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
best practices for developing risk transfer analysis
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.
risk transfer considerations
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)
prospective vs retroactive contracts
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

prospective reinsurance contracts
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
retroactive reinsurance contracts
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.
retroactive stop loss example
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

slide16

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}

retroactive stop loss example interest rate method change in ultimate
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}

retroactive stop loss example interest rate method change in ultimate18
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

retroactive stop loss example recovery method
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.
slide23

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%
slide24

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

slide25

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

slide26

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

slide27

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
slide28

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

Reinsurer’s Results

Expected Payout - Scenario 1

slide29

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

Reinsurer’s Results

Expected Payout - Scenario 2

reserve management considerations
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

other reinsurance accounting issues
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.
fasb standard no 113 comparison to statutory similarities
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
fasb standard no 113 comparison to statutory differences
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
fasb standard no 113 comparison to statutory differences continued
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