Risk Transfer for Mortgage Captive Reinsurance Contracts

1
Risk Transfer for Mortgage Captive Reinsurance
Contracts

• FASB 113 - Concepts
• March 6, 2002

2
Scope

• FASB 113 applies to all insurance enterprises to
  which FASB 60 applies
• Regardless of its form, any transaction that
  indemnifies an insurer against loss or liability
  relating to insurance risk shall be accounted for
  under FASB 113
• (unless specifically excluded).

3
Definition of a Contract

• Determining whether a contract with a reinsurer
  provides indemnification against loss or
  liability relating to insurance risk requires a
  complete understanding of that contract and other
  contracts or agreements between the ceding
  enterprise and related reinsurers. (FASB 113,
  para. 8)

4
Definition of a Contract

• Per FASB 113, par. 58
• A contract does not meet the conditions for
  reinsurance accounting if features of the
  reinsurance contract or other contracts or
  agreements directly or indirectly compensate the
  reinsurer or related reinsurers for losses.
• That compensation may take many forms, and an
  understanding of the substance of the contracts
  or agreements is required to determine whether
  the ceding enterprise has been indemnified
  against loss or liability relating to insurance
  risk.

5
Contract Amendments

• FASB 113 applies to reinsurance contracts
• entered into, renewed, or amended
• Risk transfer should be reassessed when
  contractual terms are amended (EITF D-34, Q 11)
• No specific guidance on how to assess risk
  transfer after a contract amendment
• (EITF D-34, Q 12)

6
What is the Underlying Contract?

• For reinsurance accounting, it must first be
  determined whether the contract is short or
  long-duration before risk transfer can be applied
• The determination is based on the underlying
  contract
• If the underlying contract is determined to be
  short-duration, the reinsurance contract is also
  short-duration
• If the underlying contract is determined to be
  long-duration, the reinsurance contract could be
  either long or short-duration

7
Short-Duration Contracts

• Short-duration contracts provide insurance
  protection for a fixed period of short duration
  and enables the insurer to cancel the contract or
  to adjust the provisions of the contract at the
  end of any contract period, such as adjusting the
  amount of premiums charged or coverage provided.
  (FASB 60, Para 7a)
• examples most property and liability insurance
  contracts, and credit life insurance

8
Long-Duration Contracts

• Long-duration contracts generally are not
  subject to unilateral changes in its provisions,
  such as ability to cancel or guaranteed renewable
  provisions, and requires the performance of
  various functions and services (including
  insurance protection) for an extended period.
  (FASB 60, Para 7b)
• examples whole-life contacts, guaranteed
  renewable term life contracts, and annuity
  contracts

9
Short-Duration ContractsRisk Transfer Tests

• To be considered reinsurance, indemnification of
  the ceding enterprise against loss or liability
  relating to insurance risk in reinsurance of
  short-duration contracts, requires both the
  paragraph 9a and paragraph 9b tests of FASB
  113 have to be met, unless the condition in
  paragraph 11 is met.

10
Short-Duration Contracts Risk Transfer Tests

• In addition to 9a and 9b tests
• a reinsurer shall not be considered to have
  assumed significant insurance risk under the
  reinsured contracts if the probability of a
  significant variation in either the amount or
  timing of payments by the reinsurer is remote...
  (FASB 113 para 9)

11
Short-Duration Contracts Risk Transfer - 9a Test

• Paragraph 9a test
• The reinsurer assumes significant insurance risk
  under the reinsured portions of the underlying
  insurance contracts
• Transfer of insurance risk requires transferring
  both
• Underwriting risk
• Timing risk

12
Short-Duration Contracts Risk Transfer - 9a Test

• Definition of Underwriting Risk
• Underwriting risk is defined as the uncertainty
  at the inception of the contract of the ultimate
  amount of cash flow from premiums, commissions,
  claims and claim settlement expenses. (EITF D-34,
  Q 21)
• The amount of a reinsurers payments should
  depend on and vary directly with the amount of
  claims settled under the reinsured contracts.
• (FASB 113, Para 62)

13
Short-Duration Contracts Risk Transfer - 9a Test

• Definition of Timing Risk
• The timing of the receipt and the payment of cash
  flows made to the ceding company from the
  reinsurer must be uncertain at the origination of
  the contract.
• FASB 113 requires both significant variation in
  the timing of claim payments and timely
  reimbursement.
• (EITF D-34, Q 22 and FASB 113, para 9)
• A reinsurers payments should depend on and vary
  directly with the timing of the claims settled in
  the underlying insurance policies. (EITF D-34, Q
  20)

14
Short-Duration Contracts Risk Transfer - 9b Test

• Paragraph 9b test
• It is reasonably possible that the reinsurer may
  realize a significant loss from the transaction
• Frequency and severity of losses associated with
  the reinsurance contract are considered

15
Short-Duration Contracts Risk Transfer - 9b Test

• Reasonable Possibility of a Significant Loss
• The ceding enterprise's evaluation of whether it
  is reasonably possible for a reinsurer to realize
  a significant loss from the transaction shall be
  based on the present value of all cash flows
  between the ceding and assuming enterprises under
  reasonably possible outcomes, without regard to
  how the individual cash flows are
  characterized...
• (FASB 113 para. 10)

16
Short-Duration Contracts Risk Transfer - 9b Test

• Reasonable Possibility of a Significant Loss
• FASB 113 does not provide definitions of
  significant or reasonably possible to be used
  in evaluating the results of the test
• What is reasonably possible?
• What is a significant loss?

17
Short-Duration Contracts Risk Transfer - 9b Test

• Definition of Reasonably Possible
• Per FASB 5, the term reasonably possible is used
  to mean that the scenario's probability is more
  than remote.
• Per EITF D-34, the test is applied to a
  particular scenario, not to the individual
  assumptions used in the scenario.
• a scenario is not reasonably possible unless the
  likelihood of the entire set of assumptions used
  in the scenario occurring together is reasonably
  possible

18
Short-Duration Contracts Risk Transfer - 9b Test

• Definition of Significant Loss
• Per EITF D-34, to determine the significance of
  the reinsurers loss
• PV of all cash flows (related to the contract)
  between the ceding and assuming enterprises under
  reasonably possible outcome,
• divided by
• PV of gross premiums

19
Short-Duration ContractsParagraph 11 Exception

• If based on the evaluation of present value of
  cash flows between the ceding and assuming
  enterprise the reinsurer is not exposed to the
  reasonable possibility of significant loss, the
  ceding enterprise shall be considered indemnified
  against loss or liability relating to insurance
  risk only if
• substantially all of the insurance risk
  relating to the reinsured portions of the
  underlying insurance contracts has been assumed
  by the reinsurer .
• (FASB 113, par. 11)

20
Long-Duration Contracts Risk Transfer Tests

• Indemnification of the ceding enterprise against
  loss or liability relating to insurance risk in
  reinsurance of long-duration contracts requires
• the reasonable possibility that the reinsurer
  may realize significant loss from assuming
  insurance risk

21
Long-Duration Contracts Risk Transfer

• Generally, long-duration contracts with mortality
  and morbidity risk are deemed to have insurance
  risk (term life, whole life)
• Other contracts that do not have mortality and
  morbidity risk, may have insurance risk (title
  insurance)

22
Long-Duration Contracts Risk Transfer Tests

• A contract that does not subject the reinsurer to
  the reasonable possibility of significant loss
  from the events insured by the underlying
  insurance contracts does not indemnify the ceding
  enterprise against insurance risk (FASB 113 para
  12)

23
No Transfer of Insurance Risk

• If a reinsurance contract does not transfer
  insurance risk, Deposit Accounting (SOP 98-7) is
  applied
• Task Force is discussing how SOP 98-7 should be
  applied