Insurance Accounting

Study guide: Exam 6U

Insurance Accounting — for a reinsurance contract, reinsurance accounting — is the treatment a contract earns when it genuinely indemnifies the cedant against insurance risk: ceded premium reduces written and earned premium, ceded losses reduce losses incurred, and the cedant takes credit for the recoverable. Under statutory accounting (SSAP No. 62R) and GAAP (ASC 944-20) a contract qualifies only if both conditions below hold; otherwise it receives deposit accounting.

$\begin{aligned} \text{Reinsurance accounting} \iff {} & \text{(a) significant insurance risk assumed} \\ \wedge\; & \text{(b) significant loss reasonably possible} \end{aligned}$

$\text{ERD} = \frac{E\left[\max(\text{PV payments} - \text{PV premium},\ 0)\right]}{\text{PV premium}}$

(a) Significant insurance risk means both underwriting risk (amount) and timing risk: the reinsurer's payments must depend on, and vary directly with, the cedant's claim payments. Any feature that can delay timely reimbursement — payment schedules, retentions accumulating over several years — fails this condition outright.
(b) Reasonably possible significant loss compares the present value of all cash flows between the parties, in each outcome that is more than remote, with the present value of the gross premium. One constant, reasonable interest rate applies in every scenario; reinsurer expenses, brokerage and taxes are excluded, while experience refunds, loss corridors, caps, cancellation terms and any side agreement are included.
Neither standard sets a number. Practice supplies two heuristics: the 10-10 rule — at least a $10\%$ chance of a loss of at least $10\%$ of premium — and the expected reinsurer deficit (ERD, above: the probability of a PV loss times its average severity, as a share of premium), conventionally passed at $\text{ERD} \geq 1\%$ to match 10-10. They are rules of thumb for judging condition (b), not accounting rules.
The narrow exception. If the reinsurer assumes substantially all the insurance risk on the reinsured portion — a straight quota share with no risk-limiting features — condition (b) need not be met, so an inherently profitable book can still be reinsured.
Governance. Contracts whose risk transfer is not reasonably self-evident need documented analysis, and the CEO and CFO attest annually that no undisclosed side agreements exist; actuaries usually do the testing. Freihaut and Vendetti catalogue the common pitfalls, and Finite Reinsurance is where the test bites hardest. See also Risk Transfer.
A contract that passes is then classified as prospective or retroactive; retroactive covers (loss portfolio transfers, adverse development covers) get special treatment — a restricted special-surplus gain under SAP, a deferred gain under GAAP.

Testing Risk Transfer with 10-10 and ERD A reinsurer receives premium with present value $\$10$ M. Modelled outcomes for the present value of its payments to the cedant, all at one constant risk-free rate:

probability $60\%$ : $\$4$ M

probability $25\%$ : $\$9$ M

probability $10\%$ : $\$12$ M

probability $5\%$ : $\$16$ M

Does the contract pass the 10-10 rule and the ERD benchmark?
Answer The reinsurer's PV result (premium less payments) is $+6$ , $+1$ , $-2$ and $-6$ .

10-10. A loss occurs with probability $10\% + 5\% = 15\%$ , and each losing outcome loses $20\%$ or $60\%$ of premium — at least a $10\%$ chance of a loss of at least $10\%$ . Pass.

ERD.
 $\begin{align*} \text{ERD} &= \frac{0.10(2) + 0.05(6)}{10} \\ &= \frac{0.50}{10} \\ &= 5\% \end{align*}$ 
Well above $1\%$ . Both heuristics support a reasonably possible significant loss, so with condition (a) also met the contract receives reinsurance accounting.

A Loss Corridor Removes the Risk The same contract is amended so that the cedant retains ceded losses between $\$8$ M and $\$14$ M (in present value, for simplicity; in a real test the corridor applies to nominal losses before discounting). The reinsurer pays the first $\$8$ M and anything above $\$14$ M; premium is unchanged. Re-test.
Answer Reinsurer payments are $\min(L, 8) + \max(L - 14, 0)$ :
 $\begin{align*} L = 4 &\;\Rightarrow\; 4 \\ L = 9 &\;\Rightarrow\; 8 \\ L = 12 &\;\Rightarrow\; 8 \\ L = 16 &\;\Rightarrow\; 10 \end{align*}$ 
The reinsurer's results become $+6$ , $+2$ , $+2$ and $0$ . It loses money in no outcome, so ERD is $0$ and 10-10 fails: the corridor hands back to the cedant exactly the band in which the reinsurer would have lost.

The substantially-all exception is unavailable, because the cedant retains the corridor. The contract is a deposit: no ceded premium, no ceded losses, and no reduction of net reserves. To restore reinsurance accounting, narrow or remove the corridor, or reduce the premium until a significant loss is again reasonably possible.