Financialreportingdevelopments Bb2433 Reinsurance November2012

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Financial reportingdevelopments

A comprehensive guide

Accounting forreinsuranceNovember 2012


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Financial reporting developments Accounting for reinsurance

To our clients and other friends

In December 1992, the FASB issued FASB Statement No. 113, Accounting and Reporting for Reinsuranceof Short-Duration and Long-Duration Contracts (Statement 113) to amend the reinsurance accountingguidance in FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises (Statement 60),which was issued in June 1982. In addition, the Emerging Issues Task Force (EITF) of the FASB addressedIssue 93- 6, Accounting for Multiple -Year Retrospectively Rated Reinsurance Contracts by Ceding andAssuming Enterprises(EITF 93 -6).

This publication is the successor to the December 1993 edition of our Financial Reporting Developmentspublication, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts FASB Statement 113 (FAS 113 FRD).

This edition has been updated to include the excerpts from and references to the FASB Accounting

Standards Codification. The reinsurance guidance in Statement 113 and EITF 93-6 was primarily codifiedin the Reinsurance Contracts Subsections of ASC 944, Financial Services Insurance . In addition, thedeposit accounting section has been updated to include references to ASC 340-30 that includes guidancefrom SOP 98-7, Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do NotTransfer Insurance Risk , which was issued subsequent to our December 1993 FAS 113 FRD. And, finally,we have updated the chapter on long-duration contracts,

We hope this publication will help you understand and apply the accounting requirements relating toreinsurance accounting. We are available to assist you in understanding and complying with theserequirements and are ready to answer your particular concerns and questions.

November 2012


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Contents

1 Overview ................................................................................................................... 11.1 Introduction .......................................................................................................................... 1

2 Basic provisions ......................................................................................................... 22.1 Scope .................................................................................................................................... 22.2 Definitions ............................................................................................................................. 42.3 Assessing risk transfer ........................................................................................................... 5

2.3.1 Reinsurance of short-duration contracts......................................................................... 62.3.2 Reinsurance of long-duration contracts .......................................................................... 72.3.3 Prospective short-duration contracts ............................................................................. 72.3.4 Retroactive short-duration contracts ............................................................................ 102.3.5 Subsequent loss development under retroactive contracts ............................................ 122.3.6 Short-duration contracts with both retroactive and prospective provisions ..................... 122.3.7 Long-duration contracts .............................................................................................. 13

2.4 Reporting gross amounts ..................................................................................................... 132.5 Disclosures .......................................................................................................................... 14

3 Short-duration contracts .......................................................................................... 153.1 Accounting for reinsurance of short-duration contracts ......................................................... 153.2 Classification of reinsurance of short-duration contracts ........................................................ 163.3 Risk transfer criteria ............................................................................................................ 173.4 Assumption of significant insurance risk ................................................................................ 19

3.4.1 Timely reimbursement of claims .................................................................................. 20

3.5 Determination of a significant loss ........................................................................................ 203.5.1 Cash flow analyses ...................................................................................................... 213.5.2 Amounts paid to the reinsurer ..................................................................................... 253.5.3 Exception to reasonable possibility of significant loss .................................................... 26

3.6 When to evaluate if risk transfer exists .................................................................................. 273.6.1 Amended contracts ..................................................................................................... 28

3.7 Prospective and retroactive contracts ................................................................................... 293.8 Prospective contracts .......................................................................................................... 293.9 Retroactive contracts ........................................................................................................... 30

3.9.1 Accounting when the liabilities reinsured exceed the amounts paid ................................ 303.9.2 Accounting when the amounts paid exceed the liabilities reinsured ................................ 313.9.3 Accounting for a change in the estimate of the liabilities reinsured ................................. 323.9.4 Application of the interest method ............................................................................... 36

3.10 Contracts with both prospective and retroactive provisions .................................................... 393.11 Multiple-year retrospectively rated contracts ........................................................................ 40

3.11.1 Conditions for reinsurance accounting ......................................................................... 413.11.2 Recognition of obligatory assets and liabilities .............................................................. 42


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4 Long-duration contracts ........................................................................................... 474.1 Reinsurance of long-duration contracts ................................................................................. 47

4.1.1 Indemnification of ceding company .............................................................................. 474.1.2 Cost of reinsurance ..................................................................................................... 474.1.3 Recognition of cost of reinsurance ............................................................................... 48

4.1.4 Reinsurance contracts that are short duration in nature ................................................ 484.2 Evaluating transfer of risk .................................................................................................... 484.2.1 Financial reinsurance .................................................................................................. 49

4.3 Recognition of revenues and costs ........................................................................................ 504.3.1 Cost of reinsurance ..................................................................................................... 504.3.2 Accounting for the cost of reinsurance ......................................................................... 514.3.3 Accounting for YRT contracts ...................................................................................... 524.3.4 Accounting for coinsurance contracts .......................................................................... 564.3.5 Reinsurance of existing blocks of business .................................................................... 604.3.7 Accounting for mod-co contracts ................................................................................. 604.3.8 Accounting for annuity contracts ................................................................................. 61

4.3.9 Other issues ................................................................................................................ 615 Deposit accounting .................................................................................................. 62

5.1 Overview ............................................................................................................................. 625.2 Risk not transferred ............................................................................................................. 625.3 Types of deposit arrangements ............................................................................................ 625.4 Risk transferred ................................................................................................................... 64

6 Business combinations ............................................................................................. 666.1 Overview ............................................................................................................................. 666.2 Classification of a reinsurance contract ................................................................................. 666.3 Measurement ...................................................................................................................... 66

7 Presentation and disclosure ..................................................................................... 687.1 Balance sheet presentation .................................................................................................. 687.2 Income statement presentation ............................................................................................ 687.3 Footnote disclosures ............................................................................................................ 69

A Implementation guidance ........................................................................................ A-1B Abbreviations used in this publication ...................................................................... B-1C Glossary ................................................................................................................. C-1D Index of ASC references in this publication ............................................................... D-1


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Notice to readers:

This publication includes excerpts from and references to the FASB Accounting Standards Codification(the Codification or ASC). The Codification uses a hierarchy that includes Topics, Subtopics, Sectionsand Paragraphs. Each Topic includes an Overall Subtopic that generally includes pervasive guidance forthe topic and additional Subtopics, as needed, with incremental or unique guidance. Each Subtopicincludes Sections that in turn include numbered Paragraphs. Thus, a Codification reference includes theTopic (XXX), Subtopic (YY), Section (ZZ) and Paragraph (PP).

Throughout this publication references to guidance in the codification are shown using these referencenumbers. References are also made to certain pre-codification standards (and specific sections orparagraphs of pre-Codification standards) in situations in which the content being discussed is excludedfrom the Codification.

This publication has been carefully prepared but it necessarily contains information in summary form andis therefore intended for general guidance only; it is not intended to be a substitute for detailed researchor the exercise of professional judgment. The information presented in this publication should not beconstrued as legal, tax, accounting, or any other professional advice or service. Ernst & Young LLP canaccept no responsibility for loss occasioned to any person acting or refraining from action as a result ofany material in this publication. You should consult with Ernst & Young LLP or other professionaladvisors familiar with your particular factual situation for advice concerning specific audit, tax or othermatters before making any decisions.

Portions of FASB publications reprinted with permission. Copyright Financial Accounting Standards Board, 401 Merritt 7, P.O.Box 5116, Norwalk, CT 06856-5116, U.S.A. Portions of AICPA Statements of Position, Technical Practice Aids, and other AICPApublications reprinted with permission. Copyright American Institute of Certified Public Accountants, 1211 Avenue of the Americas,New York, NY 10036-8875, USA. Copies of complete documents are available from the FASB and the AICPA.


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1 Overview

1.1 IntroductionThe Reinsurance Contracts Subsections of ASC 944:

Establish the conditions required for reinsurance contracts to satisfy the transfer of risk criteria

Requires insurance enterprises to report their liabilities gross of reinsurance ceded and also requirethat reinsurance receivables and recoverables (i.e., ceded liabilities) and prepaid reinsurancepremiums (i.e., ceded unearned premiums) be reported as assets

Require classification between short-duration and long-duration reinsurance contracts, and, withrespect to short-duration contracts, between prospective and retroactive contracts

Prescribe accounting and reporting standards for reinsurance contracts. Among other matters,immediate recognition of gains from ceded reinsurance transactions are precluded, unless the cedingenterprises obligations to its policyholders are extinguished

Expand the required disclosures for reinsurance transactions in the financial statements of cedingand assuming enterprises, including disclosures for concentrations of credit risk with respect toreinsurance receivables and recoverables

In this booklet, the terms risk transfer and transfer of risk are used as being equivalent to the phraseindemnification of the ceding enterprise against loss or liability relating to insurance risk in reinsurance,as that phrase is used and defined in ASC 944-20-15-41 (formerly paragraph 9 of Statement 113) forshort-duration contracts and in ASC 944-20-15-59 for long-duration contracts.

This booklet is designed to assist in analyzing the reinsurance accounting and contains guidance on thefollowing matters:

The application of the accounting requirements and reporting illustrations of reinsurance of short-duration and long-duration contracts, including questions and answers developed by the FASB andEITF subsequent to the issuance of Statement 113 and EITF 93-6. These questions and answers arecodified in the Reinsurance Contracts Subsections of ASC 944, Financial Services Insurance andwere formerly issued under Topic 34 and 35 in Appendix D of EITF Abstracts

The accounting and reporting for multiple-year retrospectively rated reinsurance contracts

Deposit accounting requirements for those reinsurance contracts that do not qualify for reinsuranceaccounting


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2.1 ScopeExcerpt from Accounting Standards CodificationReinsurance Contracts

944-20-05-38

The Reinsurance Contracts Subsections provide guidance on accounting for and financial reporting ofreinsurance contracts, including those that reinsure short-duration insurance contracts and long-duration insurance contracts.

944-20-05-39

Insurers may enter into various types of contracts described as reinsurance, including those commonly

referred to as fronting arrangements.944-20-05-39A

An insurance entity may purchase reinsurance to reduce exposure to losses from the events it hasagreed to insure, similar to a direct insurance contract purchased by an individual or noninsuranceentity. The insurance entity also may contract with a reinsurer to facilitate the writing of contractslarger than those normally accepted, to obtain or provide assistance in entering new types of business,or to accomplish tax or regulatory objectives.

944-20-05-40

Insurance provides indemnification against loss or liability from specified events and circumstancesthat may occur or be discovered during a specified period. In exchange for a payment from the

policyholder, an insurance entity agrees to pay the policyholder if specified events occur or arediscovered. Similarly, the insurance entity may obtain indemnification against claims associated withcontracts it has written by entering into a reinsurance contract with another insurance entity (thereinsurer or assuming entity). The insurer (or ceding entity) pays (cedes) an amount to the reinsurer,and the reinsurer agrees to reimburse the insurer for a specified portion of claims paid under thereinsured contracts. However, the policyholder usually is unaware of the reinsurance arrangement,and the insurer ordinarily is not relieved of its obligation to the policyholder. The reinsurer may, inturn, enter into reinsurance contracts with other reinsurers, a process known as retrocession.

The Reinsurance Contracts Subsections of ASC 944 apply to short-duration and long-duration insurancecontracts of property/casualty insurance entities (including stock entities, mutual entities, andreciprocals or interinsurance exchanges), title insurance entities, mortgage guaranty insurance entities,and stock life insurance entities.

The Reinsurance Contracts Subsections establish the conditions that are to be met for a contract with areinsurer to transfer insurance risk and therefore to qualify for reinsurance accounting.


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Excerpt from Accounting Standards CodificationASC 944-20-20

Insurance risk

The risk arising from uncertainties about both underwriting risk and timing risk. Actual or imputedinvestment returns are not an element of insurance risk. Insurance risk is fortuitous; the possibility of

adverse events occurring is outside the control of the insured.

Deposit accounting is prescribed for reinsurance contracts that do not provide for indemnification of theceding enterprise by the reinsurer against loss or liability against insurance risk.

Any transaction, regardless of form, that indemnifies an insurer against loss or liability relating toinsurance risk is within the scope. Therefore, certain insurance-related guarantees (e.g., a guaranteefrom a seller to reimburse a buyer for all insurance-related losses in excess of a stated amount inconnection with a purchase of an insurance company or a portion of an insurance business) could besubject to the provisions of the Reinsurance Contracts Subsections. If a contract does not meet the risktransfer conditions, then both the ceding and assuming companies generally should follow depositaccounting for the contract.

The financial statement disclosure requirements for reinsurance transactions apply to both ceding andassuming entities.

Multiple-year retrospectivel y rated reinsurance contracts (RRC) contracts, commonly are referred toas funded covers or funded catastrophe covers; the guidance includes the appropriate accounting forthe adjustable features when those contracts qualify for reinsurance accounting. A critical distinguishingfeature of those contracts is that part or all of one or more retrospective rating provisions is obligatoryand, as such, creates future rights and obligations as a result of past events that cannot be avoided bycancellation of the contract.

To provide for a more consistent evaluation and accounting for those RRC contracts, the contracts mustsatisfy three conditions to be considered for reinsurance accounting, otherwise, the deposit method ofaccounting should be applied by both the ceding and assuming companies.

Excerpt from Accounting Standards CodificationMultiple-Year Retrospectively Rated Contracts by Ceding and Assuming Entities

944-20-15-55

To be accounted for as reinsurance, a contract that reinsures risks arising from short-durationinsurance contracts must meet all of the following conditions:

a. The contract shall qualify as a short-duration contract under paragraph 944-20-15-7.

b. The contract shall not contain features that prevent the risk transfer criteria in this Subsection

from being reasonably applied and those risk transfer criteria shall be met.c. The ultimate premium expected to be paid or received under the contract shall be reasonably

estimable and allocable in proportion to the reinsurance protection provided as required byparagraphs 944-605-25-2 and 944-605-35-8.

If any of these conditions are not met, a deposit method of accounting shall be applied by the cedingand assuming entities.


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2.2 DefinitionsThe appropriate financial reporting for any given reinsurance contract depends on whether thereinsurance contract meets certain risk transfer conditions, whether the reinsurance contract reinsuresshort-duration or long-duration insurance policies, and whether the reinsurance contract is prospectiveor retroactive.

Guidance from ASC 944 that applies only to a specific contract type has been divided into threesubsections: Short-Duration Contracts, Long-Duration Contracts and Reinsurance Contracts. Forreference purposes, the definitions below of Short-Duration, Long-Duration and Reinsurance Contractsare paraphrased.

Short-Duration Contracts are insurance policies that provide insurance protection for a fixed period ofshort duration and enable the insurer to cancel the contract or to adjust the provisions of the contract atthe end of any contract period, such as adjusting the amount of premiums charged or the coverageprovided. Examples of short-duration contracts include most property and liability insurance policies andcertain term life insurance policies (e.g., credit life insurance) (ASC 944-20-15-5 through 15-7).

Long-Duration Contracts are insurance policies that generally are not subject to unilateral changes intheir provisions, such as a noncancellable or guaranteed renewable contract, and requires theperformance of various functions and services (including insurance protection) for an extended period.Examples of long-duration contracts include universal life-type contracts, limited-payment contracts,certain participating life insurance contracts, whole-life and term life insurance (ASC 944-20-15-8through 15-14).

Reinsurance Contracts are contracts for transactions between a reinsurer (assuming entity), for aconsideration (premium), to assume all or part of a risk undertaken originally by another insurer (cedingentity). For indemnity reinsurance, the legal rights of the insured are not affected by the reinsurancetransaction and the insurance entity issuing the insurance contract remains liable to the insured forpayment of policy benefits. Assumption or novation reinsurance contracts that are legal replacements ofone insurer by another extinguish the ceding entitys liability to the policyholder ( ASC 944-605-20 andASC 944-20-15-34 through 15-34C).

For reference purposes, additional definitions are provided below.

Excerpt from Accounting Standards Codification944-605-20 Glossary

Ceding Entity

The party that pays a reinsurance premium in a reinsurance transaction. The ceding entity receivesthe right to reimbursement from the assuming entity under the terms of the reinsurance contract.

Contract Period

The period over which insured events that occur are covered by the reinsured contracts. Commonlyreferred to as the coverage period or period that the contracts are in force.

Deposit Method

A revenue recognition method under which premiums are not recognized as revenue and claim costsare not charged to expense until the ultimate premium is reasonably estimable, and recognition ofincome is postponed until that time.


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Insurance Risk

The risk arising from uncertainties about both underwriting risk and timing risk. Actual or imputedinvestment returns are not an element of insurance risk. Insurance risk is fortuitous; the possibility ofadverse events occurring is outside the control of the insured.

Probable

The future event or events are likely to occur.

Prospective Reinsurance

Reinsurance in which an assuming entity agrees to reimburse a ceding entity for losses that may beincurred as a result of future insurable events covered under contracts subject to the reinsurance. Areinsurance contract may include both prospective and retroactive reinsurance provisions.

Retroactive Reinsurance

Reinsurance in which an assuming entity agrees to reimburse a ceding entity for liabilities incurred as aresult of past insurable events covered under contracts subject to the reinsurance. A reinsurancecontract may include both prospective and retroactive reinsurance provisions.

Settlement Period

The estimated period over which a ceding entity expects to recover substantially all amounts due fromthe reinsurer under the terms of the reinsurance contract.

2.3 Assessing risk transferThe issue of what constitutes risk transfer under a reinsurance contract has been debated within theinsurance industry for years. Judgment plays a significant role in the determination of whether the risktransfer conditions have been met, as comprehensive implementation guidance on risk transfer is notprovided. This section addresses the basic concepts of the risk transfer provisions. The Short-durationcontracts and the Long-duration contracts sections of this booklet provide additional guidance on theevaluation of risk transfer and include examples to illustrate the application of the conditions for risktransfer to reinsurance of short-duration and long-duration contracts.

The determination of whether a contract with a reinsurer does or does not meet the risk transferconditions requires a complete understanding of the reinsurance contract and knowledge of othercontracts or agreements between the ceding company and its reinsurers. In evaluating whether areinsurance contract satisfies the risk transfer conditions, special attention should be given tocontractual features that:

Limit the amount of insurance risk to which the reinsurer is subject (such as experience refunds,cancellation provisions, adjustable features, or required additions of profitable lines of business tothe reinsurance contract).

Delay the timely reimbursement of claims by the reinsurer (such as payment schedules or calendar-year retentions that accumulate over multiple years of coverage). In this context, timely refers tothe relationship between the date that a ceding company pays a claim covered by a reinsurancecontract and the date of actual cash reimbursement by the reinsurer.

Often, a ceding companys reinsurance program consists of several reinsurance contracts that cover anumber of different layers of exposure. Those reinsurance contracts can be with one reinsurer or withseveral reinsurers. ASC 944-20-15-40A states that the evaluation of risk transfer should be based on theprovisions of the individual contract being evaluated (an approach that is consistent with the National


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Association of Insurance Commissioners (NAIC) requirement to evaluate reinsurance contracts on anindividual contract basis). However, it does not define what constitutes a contract, which essentially isa question of substance. Therefore, for purposes of assessing the risk transfer provisions, companiesmay have to combine multiple contracts that have interlocking provisions into one overall transaction todetermine whether risk transfer exists. In other words, the assessment of risk transfer requires that allthe features of a reinsurance contract or other related contracts that directly or indirectly compensatethe reinsurer or related reinsurers (i.e., affiliated entities) for losses are to be considered in evaluatingwhether a particular reinsurance contract transfers risk.

In some circumstances, it may be difficult to determine the boundaries of a contract. For example, anindividual contract within a program should pass the risk transfer tests on its own to be accounted for asreinsurance. And, even though the program as a whole may transfer risk, individual contracts within theprogram may not be accounted for as reinsurance if they do not, by themselves, transfer risk. Conversely,an individual contract may transfer risk on a stand-alone basis, but, that contract, in concert with othercontracts with the same or related reinsurers, may not transfer risk in the aggregate; in that case, each ofthe individual contracts with the same or related reinsurers should not be accounted for as reinsurance.

2.3.1 Reinsurance of short-duration contractsTo reduce varied interpretations of what constitutes risk transfer in a reinsurance transaction, the FASBestablished criteria for assessing whether a reinsurance contract transfers risk. ASC 944-20-15-41requires that both the following conditions be met for a ceding enterprise to be indemnified against lossor liability from reinsurance of short-duration contracts 1:

Significant insurance risk (41a test) the reinsurer assumes significant insurance risk under thereinsured portions of the underlying insurance policies (i.e., the transfer of risk test, formerlyknown as the 9a test) ( ASC 944-20-15-41a)

Significant loss (41b test) it is reasonably possible that the reinsurer may realize a significantloss from the transaction (i.e., the significant loss test, formerly known as the 9b test)(ASC 944-20-15-41b)

The transfer of risk test (41a test), in essence, requires that the business ceded under a reinsurancecontract should be subject to some degree of variability with respect to both the amount and timing ofunderwriting results. Further, the reinsurers financial results should vary, to some extent, with theceding companys results. Although the relationship between the ceding compa ny and the reinsurer doesnot have to be directly proportional, when the ceding company incurs a claim that is covered by thereinsurance contract, the reinsurers financial results should be negatively affected by that claim. Inother words, if the claims that are subject to the reinsurance contract are not inherently variable, both asto amount and timing, or if the reinsurers results are not affected negatively by adverse experience,then the contract does not transfer significant insurance risk.

Under the significant loss test (41b test), the significance of loss is determined by comparing, under one

or more reasonably possible outcomes, the present value of all the expected cash flows (e.g., premiums,claim recoveries, ceding commissions, experience refunds, and cancellation penalties) between theceding company and the reinsurer to the present value of the amount paid or deemed to be paid to thereinsurer. If more than one reasonably possible outcome is evaluated, the same interest rate is to beused to compute the present value of the cash flows for each reasonably possible outcome.

1 Because of their paragraph numbers in the original Statement 113, these two conditions frequently were referred to as the 9aand 9b tests.


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If the comparison of the present value of all cash flows to the present value of amounts paid to thereinsurer under the reinsurance contract indicates that the reinsurer is not exposed to a reasonablepossibility of significant loss, the 41b test has not been met, unless substantially all of the insurance riskrelated to the reinsured portions of the underlying insurance contracts has been assumed by the reinsurer(i.e., the ceding enterprise retains only insignificant insurance risk for the portions of the underlying policiesreinsured). It implies that the ability of a ceding company to use that exception (and therefore satisfy the41b test criteria) would be limited b ecause the reinsurers economic consequences should be virtuallyequivalent to writing the business directly; accordingly, the inclusion of any adjustable feature within areinsurance contract may prevent the use of this exception. Examples of reinsurance contracts that aredeemed to indemnify the ceding company even though the reinsurer is not exposed to the possibility of asignificant loss would include straightforward quota -share reinsurance contracts (i.e., contracts withoutadjustable features), historically profitable reinsurance contracts in which substantially all of the reinsuredinsurance risk has been assumed by the reinsurer, and facultative certificates.

Contracts that do not meet the risk transfer conditions do not qualify for reinsurance accounting and areto be accounted for as deposits. The Deposit accounting section of this booklet addresses accounting forreinsurance contracts that do not transfer significant insurance risk.

Considerations for multiple-year contracts: Should a ceding company accrue a liability when it records recoveries under a reinsurance contract

but is obligated to make future payments to the reinsurer because the recoveries cause adjustablefeatures of the reinsurance contract to be invoked?

Should a ceding company record an asset if there is favorable experience under the reinsurancecontract and the assuming company is or will be obligated to make a payment to the ceding companybecause of the favorable experience?

How should the ceding and assuming companies account for adjustments to the level of reinsurancecoverage provided if specified experience under a contract is either exceeded or not met?

Included in the Multiple-Year Contracts section of this booklet is an in-depth discussion of the foregoingissues and the conclusions that were reached.

2.3.2 Reinsurance of long-duration contractsThe indemnification of the ceding enterprise against loss or liability in reinsurance of long-durationcontracts requires the reasonable possibility that the reinsurer may realize a significant loss fromassuming insurance risk. Long-duration contracts that do not subject the insurer to mortality ormorbidity risks are investment contracts and should not be accounted for as insurance contracts(ASC 944-20-15-14). Consequently, reinsurance of investment contracts is not considered reinsurance.

The Long-duration contracts section of this booklet provides a further discussion of matters to considerin evaluating the risk transfer criteria with respect to reinsurance of long-duration contracts.

2.3.3 Prospective short-duration contractsAmounts paid to a reinsurer under a short-duration reinsurance contract that is deemed to beprospective (i.e., related to future insurable events) are reported by the ceding company as prepaid(i.e., unearned) reinsurance premiums and are amortized in proportion to the amount of insuranceprotection provided. Depending on the circumstances, the amortization period may relate to thereinsurance contract period or to the coverage period of the unde rlying reinsured policies. Amountspaid include amounts deemed to have been paid (ASC 944-20-15-51). As a result, amounts paid wouldinclude, among other items, the gross premium amounts for reinsurance contracts that are settled on anet basis and any amounts withheld by the ceding enterprise as collateral.


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To the extent that the reinsurance premium amounts paid are subject to adjustment, ASC 944-20-15-50specifies that all cash flows should be included in the calculation because payments that effecti velyrepresent premiums or refunds of premiums may be described in various ways under the terms of areinsurance contract. The basis for amortization of the prepaid reinsurance premium ceded should bethe estimated ultimate amount to be paid, provided that such amounts are reasonably estimable(ASC 944-605-25-20 and ASC 944-605-35-8).

Illustration 2-1

Assume that Company A enters into a reinsurance contract on 1 January 2009 that indemnifiesCompany A from losses in excess of $500,000 for the underlying individual policies written between 1January 2009 and 31 December 2009.

The individual policies have a coverage period of one year.

The reinsurance premium for such coverage is 15% of Company As written premium, subject to aminimum premium of $1,500,000.

The $1,500,000 reinsurance premium paid is reported by the ceding company as prepaidreinsurance and is amortized over the one-year coverage period of the underlying policiesreinsured (that coverage period would encompass two calendar years 2009 and 2010).

If the reinsurance premium included an adjustment (e.g., a reduction of the ceded premium rate to12.5% if written premium exceeds $12 million), Company A would calculate the amortization of theprepaid reinsurance premium using its best estimate of the ultimate reinsurance premiums to be paidunder the contract.

Accordingly, if the ceding company estimated the total written premium to be $15 million, thereinsurance premium that should be amortized over the coverage period is $1,875,000 (i.e., $15million times 12.5%).

If Company A could not reasonably estimate the ultimate premium, Company A would initiallyamortize the actual premium paid (i.e., in this example, the minimum premium of $1,500,000) overthe coverage period.

In subsequent periods, Company A would adjust the actual paid to its best estimate when it hadsignificant information to reasonably estimate the ultimate.

Assuming that the risk transfer and significant loss tests can be met, if subsequent to the initiation of areinsurance contract, the ceding company can reasonably estimate the ultimate amount to be paid, theceding company would recognize a catch -up adjustment. That adjustment, which is to be recognized inthe period in which the ultimate amount becomes reasonably estimable, would adjust the amountpreviously amortized to an amount that equals the amount that would have been amortized if the ceding

company had been able to estimate the expected ultimate amount at the time that the reinsurancecontract was initiated.


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Illustration 2-2

Assume the same facts as in Illustration 2-1 and that the underlying policies were written ratably overthe year.

The first two columns of the following table show the amortization, using the rule of 24ths, of the

prepaid reinsurance premium, using both a $1,500,000 and a $1,875,000 reinsurance premium.

The third column shows the amortization pattern as if Company A had initially assumed a $1,500,000reinsurance premium and then adjusted that estimate in the fourth quarter to $1,875,000.

Reinsurance premium amortization

$ 1,500,000 $ 1,875,000 Recorded(in 000s)

20091st quarter $ 47 $ 59 $ 472nd quarter 141 176 1413rd quarter 234 293 234

4th quarter 328 410 516*

20101st quarter 328 410 4102nd quarter 234 293 2933rd quarter 141 176 1764th quarter 47 58 58Total $ 1,500 $ 1,875 $ 1,875

* As indicated, there is a catch -up adjustment in the recorded amortization in the period that the estimate of ultimatepremium is revised upward. However, as a practical matter, except in instances where the revised estimate of the ultimatepremium causes either the minimum or maximum reinsurance premium to be applicable, such amortization should correlateto the corresponding increase in the ceding companys gross earned premiums.

Although the Reinsurance Contracts Subsections of ASC 944 requires ceding companies to developreasonably possible outcomes to determine whether the reinsurer could be exposed to a significant loss,the likelihood that any one of those outcomes will occur may be no greater than the likelihood that someother outcome will occur. Because ceding companies are required to use their best estimate of theultimate premium to determine the amount that should be amortized over the contract period, contractsthat have reasonably possible outcomes that result in significantly different ultimate premiums becauseof adjustable premium provisions can make the determination of a best estimate of the ultimate premiumdifficult. In evaluating contracts that include adjustable premium features, when none of the reasonablypossible outcomes has a higher likelihood of occurring than the other outcomes, the provisionalreinsurance premium paid should be used as the ceding companys best estimate; when the ultimatepremium becomes estimable, a catch -up adjustment would be recognized.

Incurred claims on underlying policies, to the extent covered by a prospective reinsurance contract,generally will not have a net impact on the ceding companys income statement. The amount of theincurred claim that is charged to income and recognized as a gross liability by the ceding company isoffset by a reinsurance recoverable asset and a corresponding credit in the income statement.

Subsequent adjustments to the reinsured claim estimate would result in similar adjustments to thereinsurance recoverable amount with no net income effect, unless the adjusted claim estimate exceedsor falls below the reinsurance coverage.


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2.3.4 Retroactive short-duration contractsExcerpt from Accounting Standards CodificationDistinguishing Prospective Provisions from Retroactive Provisions

944-605-25-21

If practicable, prospective and retroactive provisions included within a single contract shall beaccounted for separately. The Reinsurance Contracts Subsections of this Subtopic do not require anyspecific method for allocating reinsurance premiums to the prospective and retroactive portions of acontract. However, separate accounting for the prospective and retroactive portions of a contract maytake place only when an allocation is practicable. Practicability requires a reasonable basis forallocating the reinsurance premiums to the risks covered by the prospective and retroactive portionsof the contract, considering all amounts paid or deemed to have been paid regardless of the timing ofpayment. If separate accounting for prospective and retroactive provisions included within a singlecontract is impracticable, the contract shall be accounted for as a retroactive contract provided theconditions for reinsurance accounting are met. Impracticable is used in the sense used in paragraph825-10-50-17 to mean that the prospective and retroactive provisions can be accounted forseparately without incurring excessive costs.

Reinsurance of Short-Duration Contracts

Retroactive Reinsurance

944-605-35-8

Prepaid reinsurance premiums recognized under paragraph 944-605-25-20 shall be amortized overthe remaining contract period in proportion to the amount of insurance protection provided. If theamounts paid are subject to adjustment and can be reasonably estimated, the basis for amortizationshall be the estimated ultimate amount to be paid.

944-605-35-9

Any gain deferred under paragraph 944-605-25-22 shall be amortized over the estimated remainingsettlement period. If the amounts and timing of the reinsurance recoveries can be reasonablyestimated, the deferred gain shall be amortized using the effective interest rate inherent in theamount paid to the reinsurer and the estimated timing and amounts of recoveries from the reinsurer;that is, the interest method. Otherwise, the proportion of actual recoveries to total estimatedrecoveries (the recovery method) shall determine the amount of amortization.

944-605-35-10

Amortization of deferred amounts arising from retroactive reinsurance under both the interestmethod and the recovery method is based on the ceding entity's estimates of the expected timing andtotal amount of cash flows. The timing of changes in those estimates shall not alter the recognition ofthe revenues and costs of reinsurance. Therefore, changes in estimates of the amount recoverablefrom the reinsurer shall be accounted for consistently both at the inception of and after thereinsurance transaction.

The recognition of revenues and costs related to retroactive reinsurance contracts (i.e., the coverageprovided relates to past insurable events) is significantly different from the recognition of revenues andcosts related to prospective reinsurance contracts. At the inception of a retroactive contract, the amountpaid to a reinsurer is not to be accounted for as reinsurance premiums ceded by the ceding company.The amounts paid by the ceding company to the reinsurer for coverage at the inception of a retroactivereinsurance contract can be greater than, equal to, or, as is typically the case for reserves that are not


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discounted, less than the related liabilities reinsured. At the inception of a retroactive reinsurancecontract, a reinsurance recoverable asset is recognized on the ceding companys b alance sheet for theamount paid to the reinsurer.

The reinsurance recoverable amount, at any point when the retroactive reinsurance contract is in effect,should equal the amount of the reported direct liabilities covered by the reinsurance contract.

If the amounts paid by the ceding company to the reinsurer equal the ceded reserves for unpaid claims,there is no gain or loss at the inception of the reinsurance contract; however, income statementrecognition of subsequent recoveries under such agreements generally is limited to the amount availableunder the recovery method.

The FASB characterized the amounts paid by the ceding company in excess of the reported liabilities asthe minimum liability for potential future adverse development that should be ac crued. As such, excessamounts paid to the reinsurer are charged to expense at the inception of the reinsurance contract to theextent that the ceding company did not increase the reserves covered by the reinsurance contract.Based on the facts and circumstances, the ceding company could either increase its liability for unpaidclaims, decrease its asset for reinsurance recoverable, or a combination thereof. Regardless of which

method is used to account for the amount paid in excess of the reported liabilities (i.e., an increase inunpaid claims or earned premiums ceded), the ceding company will incur a charge to income equal to theexcess amount.

If the amounts paid by the ceding company to the reinsurer are less than the related ceded liabilities atthe time that the retroactive reinsurance contract is initiated, the excess of the reinsurance recoverableover the amounts paid is deferred and amortized into income over the estimated remaining settlementperiod of the ceded unpaid claims. ASC 944-40-25-33 prohibits the immediate recognition of gains forthe reinsurance transaction unless the ceding entitys liability to its policyholders is extinguished. Forgain amortization purposes, the settlement period of the unpaid claims is used because, in a retroactivereinsurance contract, the coverage periods of the underlying policies generally are closed (i.e., the periodof time that the insurance coverage was provided for those reinsured policies has expired).

Illustration 2-3a

Assume that Company A has reported claim liabilities, including reserves for incurred but not reported(IBNR) claims, of $10 million and purchases reinsurance coverage for those claim liabilities for $10million. The amount paid ($10 million) is reported as reinsurance recoverable. Because theconsideration paid is equal to the reported claim liabilities, no charge to income and no deferred gainwould be reported at the inception of the contract.

Illustration 2-3b

Assume the same facts as Illustration 2-3a, except that the amount paid was $7 million. Thereinsurance recoverable would be reported as $10 million, on a basis consistent with the underlyingreinsured liabilities, and the $3 million difference would be reported as a deferred credit (i.e., thedeferred gain) and amortized to income over the related settlement period of the unpaid claims.


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Illustration 2-3c

Assume the same facts as Illustration 2-3a, except that the amount paid was $12 million. In thatsituation, Company A would record a charge to income for the excess of the cash paid over theadjusted liabilities covered (in this case, a charge of not less than $2 million). Assume further thatCompany A increased its liability for unpaid claims for the excess amount paid. Company As liabilityfor unpaid claims would then be reported as $12 million and its reinsurance recoverable also would be$12 million. Company A also would have incurred a $2 million charge to income from recognizing theincrease in its liability for unpaid claims.

Conversely, if Company A determined that the $10 million liability for unpaid claims was appropriate,then Company A would report $10 million as its reinsurance recoverable and charge income for $2million (i.e., the difference between the consideration paid of $12 million and the estimated reinsuredliability of $10 million). ASC 944 does not provide guidance with respect to the specific incomestatement account that the $2 million amount should be charged. Therefore, the $2 million charge toincome could be reported as either earned ceded premiums or incurred claims.

ASC 944-605-35-9 describes two methods for a ceding company to amortize the excess of therecoverable amounts over the amounts paid (i.e., the gain amortization) for retroactive contracts,those are the interest method and the recovery method.

Interest method should be used when the amounts and timing of those reinsurance recoveries underthe most likely outcome can be reasonably estimated. The interest method uses the interest ratethat is inherent in the calculation of the amount paid to the reinsurer and the estimated timing andamount of recoveries from the reinsurer to amortize any benefit related to the reinsurance contract.

Recovery method should be used when the timing and amount of the reinsurance recoveries are notreasonably estimable. The recovery method uses the proportion of actual recoveries to totalestimated recoveries to determine the amount of gain amortization in any given accounting period.

2.3.5 Subsequent loss development under retroactive contractsASC 944-605-35-13 requires that subsequent changes in the estimated timing and amount of recoveriesfrom the reinsurer are to be recognized in income in the period of the change as a catch -upadjustment. Consequently, the amount of the gain, if any, that was deferred at the inception of thereinsurance contract, taking into effect any subsequent amortization, is to be adjusted as if the revisedinformation had been available at the inception date of the reinsurance contract. ASC 944-605-55-6through 55-9 provides an example of the effect of a catch-up adjustment on revenue recognition.

2.3.6 Short-duration contracts with both retroactive and prospective provisionsAs stated in ASC 944-605-25-21, an entity is required to bifurcate short-duration contracts with bothretroactive and prospective features, if practicable (i.e., contract amounts should be allocated between

the retroactive and prospective elements). However, if an allocation to the separate elements is notpracticable, the entire contract must be accounted for as a retroactive contract, even if the predominantcharacteristics of the contract are prospective in nature. As such, any amounts recovered or recoverableby the ceding company in excess of the premiums paid for any such unbifurcated combination contractsare to be deferred and amortized over the estimated settlement period of the unpaid claims.

The determination of the allocation between the retroactive and prospective elements of a singlereinsurance contract is a matter of judgment that requires a consideration of all of the facts andcircumstances. Although the FASB acknowledged the difficulties associated with such a determination,the Reinsurance Contracts Subsections of ASC 944 does not provide detailed guidance or criteria for


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bifurcating a reinsurance contract. One approach to making such an allocation could be to bifurcate thereinsurance premium by estimating what the pricing would have been if the prospective and retroactiveelements were separate contracts (e.g., for the retroactive element of the contract, an estimate wouldbe made of the present value of the estimated loss recoveries plus an appropriate risk charge). Becausethe actual pricing of the combination reinsurance contract generally will assume that all possible negativeevents do not occur at the same time, the pricing of the combined contract may be lower than thecombined estimated pricing of the prospective and retroactive elements. Accordingly, to bifurcate thepremium for a combination contract, the ceding company may need to apply a ratio (e.g., a pro rataamount) to the separate pricing elements of the single premium.

2.3.7 Long-duration contractsThe accounting model for reinsurance of long- duration contracts is based on determining the cost ofreinsurance and then amortizing that cost over the entire period that the underlying reinsured policiesare inforce in a similar manner to that used to amortize the deferred policy acquisition costs. Althoughnot specifically defined in ASC 944, cost of insurance is a term that is used to describe the net cashflows between the ceding and assuming companies. Those net cash flows include, among other items,reinsurance premiums, ceding commissions, reinsurance recoverables, investment income, and

experience refunds.ASC 944-605-30-4 requires that any difference between the reinsurance premium paid for a reinsurancecontract and the amount of the liability for policy benefits relating to the underlying reinsured policies atthe time that the reinsurance contract is entered into is to be included as part of the estimated cost tobe amortized.

The result of excluding certain amounts that gave rise to immediate gain recognition from the cost ofreinsurance, in effect, provided a mechanism to unlock the GAAP reserving assumptions of theunderlying reinsured policies. Because unlocking of the reserving assumptions for short-duration policiesand traditional long-duration policies are prohibited, the unlocking of those reserving assumptions arealso prohibited, for short-duration and traditional long-duration products, through the use of areinsurance contract. Although certain reserve assumptions are to be periodically reevaluated for certainlong-duration contracts, and adjusted when appropriate, the use of a reinsurance contract for thoseinsurance policies generally would affect the accounting for those policies to a lesser extent than short-duration and traditional long-duration policies.

Certain reinsurance contracts covering long-duration policies may be deemed to be short duration innature (e.g., certain annually renewable life insurance policies). If a reinsurance contract covering long-duration insurance policies is long duration in nature, the estimated cost of reinsurance is amortized overthe remaining life of the underlying reinsured policies. If a reinsurance contract covering long-durationinsurance policies is short duration in nature, the amortization period for the reinsurance cost is thecontract period of the reinsurance. (ASC 944-605-35-14)

2.4 Reporting gross amountsAssets and liabilities relating to reinsured policies are required to be recorded at their gross amounts andnot net of the effects of reinsurance. Reinsurance recoverables (i.e., ceded reserves for unpaid claims,including amounts related to IBNR and ceded life benefit reserves) and prepaid reinsurance (i.e., cededunearned premiums) are required to be reported separately as assets. However, the guidance neitherprohibits nor requires a separate classification of reinsurance recoverables between amounts applicableto ceded life benefit reserves, paid claims, and unpaid claims, including recoverable amounts applicableto IBNR claims. Amounts recoverable and payable between a ceding enterprise and a reinsurer should beoffset and reported on a net basis only when a right of setoff exists, as defined in ASC 210-20 foroffsetting of balance sheet items.


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Gross reporting is not required in the income statement. However, ceded earned premiums andrecoveries recognized under reinsurance contracts are to be either reported in the income statement(e.g., separate line items, parenthetically) or disclosed in the notes to the financial statements. Inaddition, deferred policy acquisition costs may be reported on the balance sheet net of commission andexpense allowances related to reinsurance ceded.

The Presentation and disclosure section of this booklet provides illustrations of the gross reportingrequirements.

2.5 Disclosures

Insurance enterprises (both ceding and assuming companies) are required to disclose the followingreinsurance-related matters in their financial statements:

The nature, purpose, and effect of ceded and assumed reinsurance transactions on the insuranceenterprises operations (ceding enterprises also should disclose the fact that the insurer is notrelieved of its primary obligation to the policyholder in a reinsurance ceded transaction).

For short-duration contracts, premiums from direct business, reinsurance assumed, and reinsurance

ceded, on both a written and an earned basis, if the difference between the written and earnedpremiums is significant.

For long-duration contracts, premiums and amounts assessed against policyholders from directbusiness, reinsurance assumed and reinsurance ceded, and premiums and amounts earned.

The accounting methods used for income recognition on reinsurance contracts.

Concentrations of credit risk associated with reinsurance recoverables and prepaid reinsurancepremiums.

The Presentation and disclosure section of this booklet provides illustrations of the disclosure requirements.


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3 Short-duration contracts

3.1 Accounting for reinsurance of short-duration contractsTo be accounted for as reinsurance, the ceding company is required to determine whether thereinsurance of short-duration contracts provides the ceding company with indemnification against loss orliability (i.e., risk transfer). Contracts that that do not qualify as reinsurance and are deemed to befinancing arrangements will continue to be accounted for as deposits. There is different accounting forreinsurance of short-duration contracts, depending on whether a reinsurance contract is prospective orretroactive. ASC 944-20-15-41 specifically requires the indemnification of loss or liability to encompassinsurance risk with insurance risk being defined as both underwriting risk and timing risk for acontract to qualify as reinsurance. Considerable judgment is necessary when determining whether areinsurance contract does or does not qualify for reinsurance accounting.

Excerpt from Accounting Standards Codification944-20-20

Insurance Risk

The risk arising from uncertainties about both underwriting risk and timing risk. Actual or imputedinvestment returns are not an element of insurance risk. Insurance risk is fortuitous; the possibility ofadverse events occurring is outside the control of the insured.

Timing Risk

The risk arising from uncertainties about the timing of the receipt and payments of net cash flows frompremiums, commissions, claims, and claim settlement expenses paid under a contract.

Underwriting RiskThe risk arising from uncertainties about the ultimate amount of net cash flows from premiums,commissions, claims, and claim settlement expenses paid under a contract.


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3.2 Classification of reinsurance of short-duration contracts

___________________________

* Assumes that multiple-year retrospectively rated reinsurance contracts meet the three conditions of EITF 93-6; those multiple-year contracts that do not meet those conditions would be accounted for using deposit accounting.

** The contract may qualify as reinsurance if the reinsurer assumes substantially all of the insurance risk relating to the reinsuredportions of the underlying contracts.

The NAIC adopted substantially similar guidance for reinsurance of short-duration contracts that issubstantially as US GAAP. Both ASC 944 and Statement of Statutory Accounting Principle (SSAP)No. 62, Property and Casualty Reinsurance , require the transfer of insurance risk and include the samerisk transfer criteria, as discussed in the succeeding section.

The decision tree on the preceding page is intended to provide a logical sequence of questions that needto be answered when determining the appropriate accounting for a short-duration reinsurance contract.

Reinsurance ofshort-duration contracts*

Can the contractbe bifurcated?

Entire contract isaccounted for as

retroactive reinsurance

Accounting for thecontract is split intoits prospective and

retroactive elements

Does the contractcontain prospective

elements?

Contract is accountedfor as a retroactive

reinsurance contract

Does the contractcontain retroactive

elements?

Contract is accounted foras a prospective

reinsurance contract

Has the reinsurerassumed significant

insurance risk?

Contract does not qualifyas reinsurance; deposit

accounting required

Is there a reasonablepossibility that the

reinsurer may realize asignificant loss?

Contract does not qualifyas reinsurance**; deposit

accounting required

No

No

Yes

Yes

Yes

Yes

Yes

No

No

No


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3.3 Risk transfer criteria

Excerpt from Accounting Standards Codification944-20-15-41

Unless the condition in paragraph 944-20-15-53 is met, indemnification of the ceding entity againstloss or liability relating to insurance risk in reinsurance of short-duration contracts exists underparagraph 944-20-15-37(a) only if both of the following conditions are met:

a. Significant insurance risk. The reinsurer assumes significant insurance risk under the reinsuredportions of the underlying insurance contracts. Implicit in this condition is the requirement thatboth the amount and timing of the reinsurer's payments depend on and directly vary with theamount and timing of claims settled under the reinsured contracts.

b. Significant loss. It is reasonably possible that the reinsurer may realize a significant loss from thetransaction.

The conditions are independent and the ability to meet one does not mean that the other has beenmet. A substantive demonstration that both conditions have been met is required for a short-durationcontract to transfer risk.

The FASB intended that those two conditions are to be separately evaluated. Therefore, any analyses orreasoning that supports that one of the two conditions is satisfied, in and of itself, cannot be viewed asevidence that the other condition is met. That point is illustrated as follows:

A ceding company determined that the probability of a significant variation in the amount of thepayments by the reinsurer is remote and, therefore, the reinsurer has not assumed significantinsurance risk. However, because of the possible variations in the payment patterns, the cedingcompanys analysis of the present value of cash flows between the ceding and assuming companiesindicates that, under at least one reasonably possible outcome, the reinsurer could incur a significantloss. Regardless of the size of the possible loss under the cash flow analyses, the ceding companycannot use the cash flow analyses to support that the reinsurer has assumed significant insurance risk.Therefore, the contract satisfies only one of the two required conditions. In other words, the reinsurermay realize a significant loss, but the contract does not qualify for reinsurance accounting because thecontract does not meet the condition that requires the reinsurer to assume significant insurance risk.

Evaluating risk transfer under ASC 944-20-15-41 usually is not difficult when the contract has fixedterms with no adjustable contract features (e.g., experience refunds, retrospective premium orcommission adjustments, coverage adjustments, or any other type of adjustable feature) that may limitor alter the amount and timing of cash flows between the ceding and assuming companies. In addition tounderstanding and evaluating the financial effect of adjustable features, determining that the risktransfer criteria are met also requires a complete understanding of each contract and any other affectedcontracts or agreements between the ceding company and the assuming company.

Under some reinsurance programs, a complete understanding of all contracts and agreements betweenthe ceding company and the assuming company may be necessary because the insurance risk assumedby the reinsurer under a given reinsurance contract could be reduced through provisions in othercontracts or agreements that directly or indirectly compensate the reinsurer for losses under thereinsurance contract that transfers insurance risk. However, the requirement to look to other contractswith the same reinsurer for possible provisions that reduce insurance risk does not necessarily mean thatmultiple contracts with one reinsurer are evaluated on a collective basis in all instances. Rather, whenevaluating multiple contracts with one reinsurer, a ceding company should evaluate each contractindividually, while remaining alert to the provisions that may tie the results under one contract to anadjustable feature of another contract.


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Illustration 3-1

A ceding company has $1 million retention and reinsures, on an excess-of-loss basis, three layers of itsexposures on the underlying insurance policies with a maximum exposure of $10 million. The threelayers reinsured under three separate contracts, with the same reinsurer, are as follows:

Layer 1 Contract A $2 million excess $1 million.

Layer 2 Contract B $3 million excess $3 million.

Layer 3 Contract C $4 million excess $6 million.

The reinsurance for each layer is provided through separate reinsurance contracts and there are noprovisions in any of the contracts that affect the amount of insurance risk in any other contract.

In determining whether the ceding company is indemnified against loss or liability, the ceding companymust evaluate Contracts A, B, and C individually.

If Contracts A and B transfer risk, but Contract C does not transfer risk, then only Contracts A and B

would qualify for reinsurance accounting. However, if the terms of Contract C were favorable to thereinsurer and it is determined that those terms were intended to offset any potential negativeoutcomes from either Contract A or B, then the three contracts may have to be evaluated for risktransfer on a collective basis.

Illustration 3-2

Assume the same basic contract coverages as in Illustration 3-1, except that Contract B has aprovision that reduces the insurance risk assumed by the reinsurer under Contract A (e.g., anexperience refund, a provision that increases the premium under Contract A for adverse results under

Contract B, a cancellation provision, or an accumulating retention).Under those circumstances, when evaluating whether Contract A qualifies as reinsurance, the cedingcompany is required to consider the mitigating provision in Contract B. Again, the ceding companymay have to test the combined expectations for Contracts A and B to determine whether bothcontracts qualify for reinsurance accounting.

Illustrations 3-1 and 3-2 highlight how companies could evaluate individual contracts that have interrelatedadjustable features. Another factor that ceding and assuming companies need to consider when evaluatingwhether a contract qualifies for reinsurance accounting is whether the reinsurance contract, in essence,consists of two independent contracts. Specifically, the minutes with respect to EITFs consensus onmultiple-year retrospectively rate reinsurance contracts (EITF 93-6) indicate that contracts that combine

two or more reinsurance contracts that are truly independent of each other ( i.e., the underlyingexposures of the reinsured policies are unrelated) into one contract for the sole purpose of obtainingreinsurance accounting treatment for those contracts should be evaluated separately.


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3.4 Assumption of significant insurance riskA reinsurance contract should result in significant insurance risk being assumed by the reinsurer for thecontract to qualify for reinsurance accounting. The definition as to what constitutes insurance risk is quitespecific there has to be both underwriting risk and timing risk. That risk transfer criteria is referred to bysome as the 41a test (formerly known as the 9a test of FAS 113). Companies frequently focus on the 41b

requirement (formerly known as the 9b test of FAS 113), which is the mathematical analysis to determinewhether the reinsurer could incur a significant loss. In ASC 944-20-15-41, the significant insurance riskrequirement (i.e., the 41a test) is presented as being as important as the 41b requirement. In fact, somereinsurance contracts may pass the 41b requirement but fail the 41a requirement.

The 41a test requires an evaluation of the inherent variability of the underwriting experience of thebusiness to be reinsured and then an evaluation of the reinsurers results when the terms of theproposed reinsurance contract are applied to the expected experience of the underlying policies. Thereis not comprehensive guidance on how to determine whether significant insurance risk has beentransferred in a reinsurance contract. However, ASC 944-20-15-46 specifically states that the reinsurerhas not assumed significant insurance risk in any contract where the probability of a significant variationin ei ther the amount or timing of payments by the reinsurer is remote (emphasis added). In that regard,

if a company historically had an accident-year loss ratio in excess of 70% and has an accident-year stop-loss reinsurance contract that provides coverage when the accident-year loss ratio exceeds 60%, butlimits the coverage to a 70% accident-year loss ratio, there is no significant variability in the amount ofthe losses. In that example, the reinsurers primary risk is a timing risk as to when those losses willrequire cash settlements and, as such, the contract would not appear to pass the 41a test.

The absence of specific guidance as to what constitutes a significant insurance risk complicates thedetermination of the likelihood (i.e., probable, reasonably possible, or remote) that a significantvariation will occur in either the amount or timing of payments by the reinsurer. ASC 450,Contingencies , provides a range from probable to remote to evaluate the likelihood of an event.

Excerpt from Accounting Standards Codification944-20-20

Probable The future event or events are likely to occur.

Reasonably Possible The chance of the future event or events occurring is more than remote but lessthan likely.

Remote The chance of the future event or events occurring is slight.

Although the determination of significant variation is unique to each contract and company andinvolves a great deal of judgment, the following common factors should be evaluated when making adetermination as to whether a variation is significant:

The possible variation in the amount of losses ceded to the reinsurer. Companies should usehistorical information with respect to the business to be ceded when making an evaluation for such apossible variation. The historica l information should be the ceding companys experience; however,in situations where the ceding company either does not have its own experience or its experience isinappropriate, industry data could be used.

The possible variation as to the timing of reimbursements to the ceding company for losses reinsured(i.e., the reinsurers loss payment reimbursement practices).

The effect of contract provisions on the amounts and timing of reinsurance recoveries to the cedingcompany, such as unreasonably wide retrospective-rating adjustment corridors, accumulatingretentions or predetermined payment schedules.


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In analyzing whether a reinsurance contract transfers significant insurance risk, companies should usetheir general knowledge and understanding of the type of business reinsured to reach such a conclusion.In situations where the variability is difficult to assess, companies probably will need to prepare someform of financial analysis to demonstrate that significant variability is present.

Companies also are required to consider how the reinsurer is affected by loss experience under the

contract. For example, if the ceding company experiences unfavorable loss experience on the reinsuredpolicies, does the reinsurer also experience unfavorable results? ASC 944 does not require that thereinsurers loss experience be directly proportional to the ceding companys loss experience, but, somecorrelation between losses at the ceding company and the reinsurer normally would be expected tooccur. In other words, as c laims are ceded to the reinsurer, the reinsurers underwriting results under thecontract generally would be expected to decline. Thus, for a reinsurance contract to satisfy the 41a test,there generally should be some correlation of underwriting results between the ceding and assumingcompanies. Therefore, reinsurance contracts that have adjustable features that substantially eliminateunfavorable underwriting results to the reinsurer generally would not pass the 41a risk transfer criteria.

3.4.1 Timely reimbursement of claims

Reinsurance contracts sometimes include provisions (e.g., payment schedules or accumulatingretentions) that delay the reimbursement of claims so that the reinsurer can retain the funds for a longerperiod of time and earn investment income to reduce its exposure to a financial loss under the contract.The FASB believes that those provisions mitigate the reinsurers exposure to the timing risk componentof insurance risk, and the inclusion of such provisions may prevent the contract from meeting therequirement that the reinsurer assume significant insurance risk. Therefore, if a contract includes afeature that delays the timely reimbursement of claims by the reinsurer, the contract may not indemnifythe ceding company against loss or liability and, therefore, does not qualify for reinsurance accounting.As used in this context, timely refers to the length of time between the payment of underlyingreinsured claims and the reimbursement to the ceding company from the reinsurer (ASC 944-20-15-48).

Timely reimbursement does not mean that the reinsurer actually has to transfer funds to the cedingcompany. Contracts can include funds -held provisions that permit the reinsurer to retain the fundsrelating to the ceding companys claim reim bursement for a stated period, provided that those funds arecredited with a reasonable rate of interest. The interest crediting rate should be consistent with a ratethat the ceding company could earn on those funds (e.g., the average yield on the ceding companysinvested assets or the new money rate for investable funds). In the FASBs view, the crediting of interestresults in the ceding company not being economically disadvantaged by the withholding of funds by thereinsurer; thus, a funds-held provision that credits appropriate interest should not be considered asdelaying timely reimbursement to the ceding company.

3.5 Determination of a significant loss

A ceding companys evaluation as to whether the reinsurer may realize a significant loss should be basedon the present value of all cash flows (i.e., premiums, commissions and allowances, losses, and any otherreceipts or payments of cash) between the ceding and assuming companies under reasonably possibleoutcomes (ASC 944-20-15-49 through 15-54).

Reasonably possible outcomes are those situations where the probability of the outcome occurring is morethan remote . The assessment of more than remote is applied to the particular scenario, not to the individualassumptions used to develop that scenario. Accordingly, a scenario cannot be a reasonably possibleoutcome if the likelihood of the entire set of assumptions occurring together is not reasonably possible.


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When developing the reasonably possible cash flow outcomes, historical premium and loss information,as well as planned changes in mixes of business, should be considered. If historical information is notavailable for the type of business ceded, the ceding company should use loss estimates that aresupported by actuarial projections using industry data and likely exposure profiles related to the cedingcompanys operations.

In the context of the FASBs use of the term significant loss, ASC 944 does not provide a benchmarkfor measuring significant, nor does any other relevant authoritative accou nting literature. Therefore,the ceding company must determine judgmentally if it is reasonably possible for the assuming companyto realize a significant loss. Although significant is not defined in current guidance or the FASBsAccounting Standards Codification, there was a footnote to paragraph 8 of Statement 97 that definedthe term insignificant to mean having little or no importance; trivial. However, acknowledging thatthere is a spectrum of adjectives that can fit between the extremes of insignificant and significant, cedingcompanies may find that definition of insignificant useful in determining if a significant loss is possible.

When determining whether a potential loss is significant, the ceding company should relate the presentvalue of that potential loss to the present value of the premiums expected to be paid or deemed to bepaid to the reinsurer. Relationships that might be appropriate in measuring significance in other

circumstances (e.g., relating the present value of the potential loss to the surplus of either the cedingcompany or assuming company or relating the present value of a potential loss to the present value of apotential gain) may not be appropriate in measuring significance of a loss to the reinsurer.

Subsequent to the issuance of Statement 113 in December 1992, some insurance practitioners havedebated whether a threshold level could be used when determining whether a potential loss to thereinsurer is or is not significant. While not authoritative, those discussions have suggested that apotential loss of some percentage, say 10% or greater, should qualify as significant, and potential lossesthat are less than that percentage generally would be in a gray area and would require additionalanalysis to determine whether the potential loss is significant. Although many individuals have found thatthreshold to be useful in evaluating reinsurance contracts, many also have realized that evaluatingcontracts that fall within the gray area can be difficult.

When evaluating a contracts potential for significant loss, those contracts that expose, underreasonably possible outcomes, the reinsurer to more loss than gain scenarios should be contracts inwhich the highest probable loss, as a percentage of premium, could be lower (i.e., below the hypothetical10% threshold) and still expose the reinsurer to a possible significant loss. Correspondingly, contractswith only a single scenario for loss, under a reasonably possible outcome, could require a higher probableloss as a percentage of premium, provided that such a contract could also satisfy the 41a test.

One analysis that could be useful in assessing contracts that fall into the gray area would be to look atthe number of reasonably possible scenarios where the reinsurer would experience a loss relative to thenumber of scenarios where there is a gain to the reinsurer. For example, if the analysis indicates only asingle loss scenario among a number of gain scenarios, and that loss scenario is in the gray area, itmight be reasonable to conclude that a reasonable possibility of a significant loss does not exist. If,instead, there are many loss scenarios within the gray area, and only a few or no gain scenarios, theconclusion might be different.

3.5.1 Cash flow analysesTo evaluate the determination of a significant loss, ceding companies will need to use a financial modelthat schedules and calculates the present value of all cash flows between the ceding and assumingcompanies. Developing such a financial model for contracts with fixed terms should not be as difficult aswhen developing models for contracts that have adjustable features, such as adjustable premiums,


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sliding scale commission rates, reinstatement premiums, and experience accounts. In fact, some cedingcompanies probably will not even have to prepare cash flow analyses for those contracts that have fixedpremiums and provide reinsurance coverage that cannot be adjusted. In this latter situation, the cedingcompany is incurring a fixed cost to protect against an uncertainty.

When cash flow analyses are necessary, the interrelationship between claims incurred under the contract

and the adjustable features of the contract may require companies to develop specifically tailoredfinancial models for such reinsurance contracts. ASC 944-20-15-50 indicates that only cash flowsbetween the ceding and assuming companies should be considered in the analysis; therefore, any otherexpenses (e.g., taxes and general operating expenses) of the reinsurer that are only indirectly related toa reinsurance contract should not be used in the determination of the present value of cash flows forthat contract.

An important consideration when developing cash flow analyses is to determine the period of time thatthe reinsurance contract will be inforce. For example, reinsurance contracts that are continuous orinclude multiple years raise unique questions with respect to determining the contract period. Contractsthat reinsure risks arising from short-duration contracts meet the definition of a short-duration contractin ASC 944-20-15-2 to be accounted for as reinsurance. The guidance states that a short-duration

contract is a contract that provides insurance protection for a fixed period of short duration and enablesthe insurer to cancel the contract or to adjust the provisions of the contract at the end of any contractperiod, such as adjusting the amount of premiums charged or coverage provided. Accordingly, contractsthat reinsure short-duration insurance risks over a significantly longer term or indefinitely would notgenerally qualify as reinsurance contracts. ASC 944-20-15-45 notes that contracts would be consideredfinancing if: premiums are deferred over a longer period than the term of the underlying insurancecontracts, losses are recognized in a different period that the period in which the event causing the losstakes pace, or if both the preceding events occur at different points in time.

Frequently, a reinsurance contract will be entered into by a ceding company with the intent to commutethe contract before all of the claims relating to the underlying insurance policies are settled and paid.When preparing the present value cash flow analyses, the FASB has indicated that the ceding company

should use its best estimate of the period that it expects the contract to remain inforce. This last point isillustrated as follows:

Illustration 3-3

A company reinsures a line of business that has an expected 15 year payout period for the underlyingpolicy losses. The ceding company has estimated that 75% of the underlying losses will be paid withinthe first five years, and the contract permits the ceding company to commute the contract after fiveyears. At contract inception, the ceding

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Financialreportingdevelopments Bb2433 Reinsurance November2012