Reinsurance

Question 1

Reinsurance has the following benefits

Answer 1

expands capacity, share large risks, spread the risk of catastrophes and stabilize UW results, finance expanding volume (by sharing the reserves), aid withdrawing from a line, reduce the net liability to amounts appropriate to its financial resources

Question 2

There are 2 classes of reinsurance contracts

Answer 2

Treaty = transfers the whole class or type of business written

Facultative = transfers individual risks

Question 3

Contract provisions that affect accounting practices

Answer 3

• Reporting responsibility of the ceding entity: contains the details required & time schedules to report losses
• Payment terms: contains time schedules to make payments, currencies that the payments must be made in, and the rights of parties to withhold funds
• Payment of premium taxes: indicates which party needs to pay the premium taxes (usually the ceding company)
• Termination: either be on a cut-off or run-off basis
• Cut-off: reinsurer will not be responsible for losses incurred after termination of the contract
• Run-off: reinsurer will be responsible for losses from reinsured policies in force at time of termination of the contract
• Insolvency clause: claims that the reinsurer’s obligations will be maintained (without any reduction) in the event of insolvency of the ceding company
• Reinsurance contracts may not treat the rehabilitation/ liquidation of the ceding insurer as a grounds to deny claims/ retroactively cancel the contract

Question 4

Required Terms for Reinsurance Agreements

Answer 4

• reinsurance agreement must contain an insolvency clause
• recoveries due to the ceding company must be available without delay in a manner that will allow orderly payment of policy obligations by the ceding co
• agreement should provide no guarantee of profit for either party
• agreement must provide for reporting of premiums & losses at least quarterly, unless there is no activity
• if the reinsurer is certified, the agreement must include a proper funding clause

Question 5

For retroactive reinsurance, the following conditions apply in addition

Answer 5

• premium paid must be a specific, fixed amount stated in the agreement
• direct or indirect compensation to the ceding company or reinsurer is prohibited
• prohibited is a provision for adjustment based on the actual experience, (except in the case where the ceding company can participate in the reinsurer’s profit)
• Contract can’t be cancelled or rescinded without approval of the commissioner of the domiciliary state of the ceding company

Question 6

Reinsurance Contracts must include

Answer 6

Transfer of Risk

Question 7

Transfer of Risk

Answer 7

• transfer of risk is the essential ingredient in a reinsurance contract
• Insurance risk involves uncertainty about: the ultimate amount of net cash flows (underwriting risk) & the timing of those cash flows (timing risk)
• requires that both the timing and amount of payments are directly related to the claims paid by the ceding company
• investment returns are not an element of insurance risk
• necessary to examine reinsurance contracts to determine whether or not they do transfer risk

Question 8

In order to determine whether or not contracts do transfer risk, evaluate all contractual features that

Answer 8

limit the amount of reinsurance risk to which an insurer is subject (eg experience refunds, cancellation provisions, adjustable features, or additions of profitable lines of business to the reinsurance contract) & delay the timely reimbursement (features that impact timing need to be reviewed)

Question 9

to be treated as reinsurance, it needs to be reasonably possible

Answer 9

for the reinsurer to realize a significant loss (we can determine by looking at the PV of the cash flows between the ceding and assuming enterprise)

-can also be satisfied if substantially all of the insurance risk related to reinsured portion has been assumed by the reinsurer

Question 10

Accounting unique to Prospective Reinsurance Agreements

Answer 10

• Prospective reinsurance covers future insurable events
• Amounts paid for reinsurance = reduction to WP & EP
• Reinstatement premiums should be earned over the period from the reinstatement to the expiration of the agreement
• Changes in the estimated reinsurance recoverables are recognized as changes in losses incurred in the income statement
• Reinsurance recoverable on payments is an admitted asset (“reinsurance recoverable on loss and loss adjustment expense payments”)
• Reinsurance recoverable on unpaid losses is recognized by reducing the respective reserves

Question 11

Accounting unique to Retroactive Reinsurance Agreements

Answer 11

• Retroactive reinsurance covers past insurable events
• These contracts require special treatment bc can be used by insurers to manipulate UW results
• Portfolio reinsurance (transfer of entire segments of business) is treated as retroactive reinsurance

How does ceding company reflect contract:

• loss reserve unchanged (loss reserves are recorded on gross basis without recognition of retroactive reinsurance)
• write-in contra-liab established for ceded reserves “Retroactive Reinsurance Ceded or Assumed”, decreases total liab
• cash decreased by consideration paid
• any gain is restricted as special surplus write-in, not unassigned funds
• gains are transferred to unassigned surplus when recoveries exceed the consideration paid or when the contract is eliminated, remaining amount transferred
• gain is write-in item, “Retroactive Reinsurance Gain”, for other income, does not affect UW income

How does assuming company reflect contract:

• loss reserves unchanged
• write-in contra-liab established for ceded reserves “Retroactive Reinsurance Ceded or Assumed”, increases total liab
• cash increased by consideration received
• any loss decreases surplus
• loss is write-in, “Retroactive Reinsurance Loss”, for other income, does not affect UW income

Question 12

Accounting principles for retroactive reinsurance do not apply

Answer 12

types of contracts that may cover liabilities that occurred prior to the effective date of the contract, but are accounted for as prospective reinsurance:

• Structured Settlement annuities = when an annuity is set up to settle past claims
• Novation = extinguishes liabilities for primary company and transfers portfolio to another entity
• the termination of, or reduction of participation in reinsurance treaties that are entered into in the ordinary course of business.
• intercompany reinsurance agreements where there is no surplus
• intercompany reinsurance agreements where there is no surplus gain between affiliates
• Run off agreements
• Reinsurance of a Claim Made policy when a loss occurred after retroactive date, but before the effective date of the contract

Question 13

Retroactive reinsurance agreements between affiliates resulting in gain to surplus to the ceding company need to use

Answer 13

• regardless of whether there is risk transfer or not
• consideration paid by the ceding is recorded as a deposit (nonadmitted asset)
• No deduction can be made to the ceding insurer’s reserves

Question 14

Novation

Answer 14

• where the original insurer’s obligations are completely extinguished, no more exposure to loss
• parties are not affiliates (in the case where they are affiliates, the novation needs to receive approval from the regulators)
• amounts paid recorded as a reduction of WP or EP
• novated balances shall be written off the accounts where they were originally recorded
• assuming insurer shall report the amounts received as WP or EP and obligations assumed as incurred losses.

Question 15

Assumed Reinsurance

Answer 15

• Funds held or deposited with reinsured companies is an admitted asset as long as: they do not exceed the liabilities that they secure & reinsured is solvent -> else nonadmitted
• Interest earned on these funds is treated as an aggregate write in for miscellaneous income (Other Income)
• Reinsurance premiums receivable are combined with the receivables from the direct business, and total = agent’s balances
• If the assuming insurer receives the premium prior to the effective date, it needs to record it as a liability, and cannot consider it as income until the effective date
• If premium is received after the effective date but prior to the due date, it is recorded as a reduction to the deferred but not yet due asset (it will also result in an increase to cash)
• Reinsurance premiums over 90 days overdue = nonadmitted unless reinsurer maintains UEPR and reserves due to the ceding entity or ceding entity is licensed and in good standing
• Lag between transactions being entered into the books of the ceding company and the transfer of information and entry into the books of the assuming entity->need to estimate the unreported premiums and related costs in order to prevent distortions

Question 16

Ceded Reinsurance

Answer 16

Ceded premiums payable net of associated ceding commissions need to be recorded as a liability

• If reinsurance premium is paid prior to the effective date of the contract, the ceding company reflect the prepaid item as an admitted asset
• should only be recognized in the income statement as reinsurance premium on the effective date of the policy. Impairment must be recognized if necessary
• Amounts withheld by the ceding company need to be recorded as funds held by the entity under reinsurance treaties
• Interest due or payable is recorded as an aggregate write in for miscellaneous income
• Ceded retroactive reinsurance premiums need to be excluded from all schedules

Question 17

Commissions

Answer 17

• Commissions payable on ceded business are treated as an offset to Agents’ Balances
• Commissions receivable on ceded business are treated as an offset to Ceded Reinsurance Balances payable
• ceding commission is designed to cover acquisition costs
• If Ceding commission > Anticipated Acquisition Costs, ceding company needs to establish a liability equal to the difference between the two. This liability is amortized prorata over the effective period of the reinsurance agreement

Question 18

accounting for National Flood Insurance Program (NFIP)

Answer 18

• FEMA is treated like a reinsurer for accounting purposes: balances due from or to FEMA are recorded as ceded reinsurance balances receivable or payable
• Commissions received are treated as regular reinsurance commissions

Question 19

Commutations

Answer 19

• commutation is a transaction which results in the settlement and discharge of all (or a portion) of future obligations between the reinsurer and ceding company
• the ceding company eliminates the reinsurance recoverable, and records the cash received as a negative paid loss
• Any gain/ loss is treated as UW income
• reinsurer will eliminate the reserves, and record the payment made to the ceding
• recognizes the gain/ loss as UW income. The commuted balances are written off the exhibits in which they were initially recorded.

Question 20

Deposit Accounting

Answer 20

• If the reinsurance agreement does not transfer both components of insurance risk, accounted for as a deposit
• The ceding entity records the amount paid as a deposit
• The assuming entity records it as a liability
• The deposit is an admitted asset for the ceding entity if the assuming entity is licensed/ accredited/ or otherwise qualified in the ceding company’s state of domicile, or there are funds held by the ceding company
• The ceding company can’t reduce the reserves
• The assuming company will record the consideration to be returned to the ceding company as a liability
• At each reporting date, the amount of the deposit is adjusted to reflect both the payments made to date, and expected future payments (amount & timing)
• If the total losses are valued upwards, assuming company will record interest expense & ceding company will increase the deposit, increase the outstanding loss liability, increase the interest income, increase the incurred losses

Question 21

Run Off Agreements

Answer 21

Run-off agreements are reinsurance or retrocession agreements intended to transfer almost all the risk of a line of business that is no longer actively marketed

• transferring insurer is still primarily liable
• transaction must be approved by the domiciliary regulators of the transferring insurer and of the assuming insurer
• agreement should not contain any adjustable features, profit sharing or retrospective rating, agreement must meet the requirements of risk transfer, assuming reinsurer must receive financial strength ratings from at least 2 different agencies that is at least equal to that of the transferring insurer, assuming reinsurer is responsible for all assessments on the business being, Neither party can cancel the agreement for any reason

Transferring entity:

• payment to the reinsurer = paid loss
• if the payment < reserves transferred, the difference is decrease in the losses incurred
• reinsurance recoverable contra-liability increases by the amount of the transferred reserve

Reinsurer:

• the transactions need to be recorded in the same line of business, and in the same level of detail as recorded by the transferring entity
• premium received is = negative paid loss

Question 22

Surplus Benefit / surplus relief

Answer 22

Surplus Benefit

Surplus benefit = surplus after reins - surplus before reins

Surplus relief

Compare NWP/ S

Question 23

Qualify for reinsurance accounting treatment

Answer 23

-must be timing and underwriting risk, or any risk of significant loss

Question 24

Conditions that would prevent the policy from being accounted for as reinsurance

Answer 24

• A loss ratio cap which guarantees profits for the reinsurer would violate the significant loss requirement
• A payment timing clause to prevent immediate availability of funds violates timing risk; -If contract says reinsurer makes all the payments on 12/31, as there would be no timing risk.

Question 25

Commutation pt 2

Answer 25

• process where the future value of an unpaid claim and associated expenses is “current valued”, taking into account financial and non-financial aspects, to accelerate payment and close the cases
• reinsurer would make a premium payment to the ceding company, and in return, the reinsurer will no longer be responsible for the claims or policies covered by the agreement
• ceding company is considered the buyer, as it is buying the liabilities

Question 26

Commutation motivations

Answer 26

1. reinsurer or insurer may wish to exit a line of business
   - reinsurer that wishes to exit can enter into a commutation to extinguish its liabilities from the line
   - the insurer that wishes to exit can make the exit procedure easier by entering into a commutation
2. there may be concerns about the other party’s solvency
   - if ceding company is in difficulty, it will benefit from the cash infusion
   - reinsurer will not have to deal with the problems associated with liquidation of the ceding company
   - if the reinsurer is in difficulty, the ceding company can eliminate the credit risk
3. parties may wish to end a troubled relationship
4. Each side may believe that they are benefiting from the commutation, due to different ultimate loss projections

Question 27

commutation pricing

Answer 27

• each side has to first estimate the future claim payments from the reinsurer to the ceding (ignoring the commutation):
• Note that two party’s estimates are most likely going to be different.
• Estimate the timing of the payments.
• Apply a discount factor that accounts for both the time value of money and risk

Distortions

• commutation results in distortions to the loss triangles
• Primary: downwards development of paid losses, ceded reserves fall to 0, net ultimate losses increase, despite a constant gross ultimate
• Re: jump in paid losses, ultimate loss decrease purely due to the commutation price being lower than the reserve, jump in claims closure count
• Actuaries need to account for the distortions when conducting analysis
• insurer’s Reinsurance Notes to the AS will disclose whether the company has entered into a commutation with a reinsurer

Question 28

Mutually beneficial commutation price

Answer 28

Insurer’s benefit = Commutation Price – Discounted Ceded Reserves + Tax Benefit = L – disc ceded reserves +tax*(ceded reserves*avg disc factor - L)

Reinsurer’s benefit = ‐ Commutation Price + Discounted Ceded Reserves – Tax Loss= -H + disc ceded reserves -tax*(ceded reserves*avg disc factor - H)

• any price between L & H
• change in taxable income = prem received – reserves assumed*discount factor

Question 29

1yr development & adjusted PHS for commutation

Answer 29

• adjusted PHS = PHS + (prem received – reserves assumed) = PHS + (prem received – reserves assumed)*(1-tax) if recognizing tax relief to ceding co due to reserves assumed > prem received
• 1yr development = 1yr development – prem received + reserves assumed