There are two topics in FAS 113 that you should focus on: (i) risk transfer and (ii) net accounting. These are the terms used in FAS 113, so we use them here as well.
Risk transfer refers to the following: FAS 113 is going to give rules for reinsurance accounting. To use these rules properly, we must know whether something qualifies as a reinsurance contract. You might say: "That's simple. A reinsurance contract is the agreement whereby an insurance company purchases coverage from a reinsurance company." No, that won't work. Sometimes a reinsurance contract is used to actually transfer the insurance risk from the primary insurer to the reinsurer. Sometimes the reinsurance contract is used as a funding device, but the reinsurer does not accept any of the insurance risk.
Okay, so what constitutes "risk transfer"? FAS 113 gives a two-pronged definition, with complex qualifications to each part. We summarize it first, though ultimately you must know the precise statements in FAS 113.
For an arrangement to be considered reinsurance, (i) there must be a transfer of insurance risk, and (ii) there must be a reasonable possibility of loss to the reinsurer. Let us deal with the first half of this definition.
There are three types of risk in insurance arrangements: (i) underwriting risk, (ii) timing risk, and (iii) investment risk.
Underwriting risk is the risk that the loss liability will be greater than expected.
Timing risk is the risk that the loss will have to be paid sooner than expected.
Insurance risk is the risk that the funds held to pay the loss will not earn as much investment income as expected.
Don't confuse timing risk with investment risk; they are different risks. Let's put numbers on these items to clarify their meaning.
Suppose an insurer collects $10,000 in premium and it expects to pay a loss of $10,000 in three years' time. The insurer has expenses of $1,000, so its underwriting income is a loss of $1,000. Nevertheless, it expects to make a profit on the policy, since it holds $9,000 for three years, and it expects to invest this money at 10% per annum interest. The following are examples of the three types of risk.
Underwriting risk is the risk that the loss liability will be $12,000 instead of $10,000.
Timing risk is the risk that the loss will be paid in two years time, not in three years time.
Investment risk is the risk that the assets will earn only 5% per annum, not 10% per annum.
FAS 113 says that a reinsurance contract must have both underwriting risk and timing risk. The transfer of investment risk is not necessary in a reinsurance contract.
We can restate this as follows: For a contract to be considered reinsurance, the reinsurer's liability must vary directly with both the magnitude of the loss payments and with the timing of the loss payments. Both FAS 113 and Chapter 22 emphasize the following: If the reinsurance contract has a provision specifying the timing of the reinsurance payments, then the contract does not contain sufficient risk transfer to be considered reinsurance.
Let's stop for a moment. You might ask: "Who cares if the contract is considered reinsurance?" Answer: This is an accounting issue. FAS 113 specifies the accounting for reinsurance contracts. If the contract is reinsurance, then GAAP statements follow the FAS 113 rules. If the contract is not reinsurance, then GAAP statements use "deposit accounting," not reinsurance accounting.
What is deposit accounting? FAS 113 doesn't elaborate on the procedures for deposit accounting, since CPA's reading this statement are familiar with deposit accounting. In general, think of the following: An insurer gets $10,000 of premium. It can put the money into a bank account until it pays the losses; that is, the insurer is a depositor, placing the money on deposit with the bank. Alternatively, the insurer can place the money on deposit with a reinsurance company until it pays the loss. If the reinsurer does not accept any of the insurance risk, placing the money with a reinsurance company is like placing the money on deposit with a bank.
We have dealt with the first half of the definition of reinsurance. Let's move on to the second half of the definition.
The second half of the definition is that it is reasonably possible for the insurer to suffer significant loss from the contract. Well, that seems clear enough. But wait: If you think it over, the statement requires explanation.
Let's take a simple example. Suppose the reinsurer gets $10,000 in net premium (i.e., net of expenses), and it agrees to pay $12,000 in losses in five years' time. Assume there is no uncertainty in the amount or timing of the loss payment. This is a 100% probability of a definite $2,000 underwriting loss. But if risk-free interest rates are 7% per annum, this is a 100% probability of an operating gain.
FAS 113 is clear. The underwriting gain or loss is irrelevant. Rather, one must compare the present values of all cash inflows to the reinsurer with the present value of all cash outflows. There must be a reasonable possibility of a significant loss even when present values of cash flows are used to determine the gain or loss.
You might still object: "What interest rate should be used?" There might be a loss if a heavily risk-adjusted discount rate is used, but no loss if a risk-free rate is used, or if the company's investment yield is used. For this problem, FAS 113 has no answer. Question: Why doesn't the AICPA tell us in FAS 113 what interest rate to use? Answer: AICPA says, "The actuaries can't even agree what discount rate to use; how are we supposed to offer guidance on this?" [We are not putting words in AICPA's mouth; this is what the AICPA says regarding this.] So FAS 113 says: "Whatever discount rate you use in your company to do cash flow analyses, use the same discount rate for the reinsurance test."
There are still several other items regarding "risk transfer" in FAS 113, such as the "exception" to the latter part of the definition. But this is enough for an introduction; we cover all the additional material below. Let us move on to "net accounting."
Net Accounting
Let us start with statutory accounting for reinsurance. Page 3, line 1, of the Annual Statement shows outstanding losses. (You cover all this on Exam 7. If you don't yet know Schedule F and certain other parts of the Annual Statement, the reinsurance accounting readings on Exam 6 are a bit tougher.) If the company has $100 million of direct loss reserves, and $20 million of reinsurance recoverables on unpaid losses, the company shows the net amount, or $80 million, on line 1 of page 3. In GAAP terminology, this is called "offsetting of assets and liabilities." (On Exam 7, there is a statutory issue paper on this subject.)
FAS 113 now asks: "Is this proper accounting?" Actually, FAS 113 doesn't even ask this, because everyone knows that this is not proper accounting. ["Everyone" means all public accountants.] So let's start at the beginning: when is offsetting permitted in GAAP financial statements, and when is it not permitted?
Suppose that you are an insurance company, and you owe $1,000 to John. You must record a liability of $1,000 payable to John. That's simple.
Suppose now that you owe $1,000 to John, and John owes you $300. What do you put down as the liability on your balance sheet?
Well, it depends on the legal connection between these two amounts. If John doesn't pay you the $300, can you deduct this from the $1,000 which you owe to John? If the answer is yes, then you can show a net liability of $700 on your balance sheet.
Let's change the scenario a bit. Suppose that you owe John $1,000, and that Sally owes you $300. Can you show on your books a net liability of $700?
Answer: Of course not. If Sally doesn't pay you the $300, you still owe John his $1,000. So you show a $1,000 liability payable to John and a $300 receivable from Sally. This is so trivial, you might wonder why we are spending time on it.
Answer: Consider the reinsurance example. You owe $100 million to claimants. The reinsurer owes you $20 million. If the reinsurer doesn't pay you the $20 million, you still owe the claimants $100 million. This sounds just like the John and Sally example.
As a defender of NAIC statutory accounting, you might say: The $100 million payable to the claimants and the $20 million receivable from the reinsurer relate to the same claims. And if you don't pay the $100 million to the claimants, the reinsurer doesn't have to pay you the $20 million. [Let's be careful on that last sentence. If you don't pay the $100 million because you deny the claims, then the reinsurer doesn't owe you the $20 million. If you don't pay the $100 million because you are insolvent, the reinsurer must still pay you (actually, the receiver, or the state guarantee fund) the $20 million. You must know this well; it will probably be asked on the exam. This is the "no diminution provision" in reinsurance treaties.]
Well, this is all true, but it is irrelevant to GAAP financial statements. So FAS 113 says: No more net accounting. From now on, the GAAP financial statements must show the full liability to the claimants along with a receivable (an asset) from the reinsurer.
By the way, statutory accounting was influenced by this GAAP rule. The statutory balance sheet still shows net accounting. But Schedule F, Part 8, incorporates GAAP type accounting in its restatement of the balance sheet (among other adjustments). Moreover, post codification statutory accounting has adopted a bit more of the GAAP procedure. [This paragraph is not on Exam 6. It is on Exam 7, so you might as well know it.]
We have finished the overview of FAS 113. For the exam, it is not sufficient to know what FAS 113 says; you must know the precise words.
So let's see how FAS 113 is organized. Read paragraphs 1-5 on pages 1 and 2. The first sentence of paragraph 5 lists four problems. Only the first and fourth of these items are discussed in detail in FAS 113. The second item says that FAS 60 doesn't provide sufficient guidance. Fine; FAS 113 provides the missing guidance. The third item says that disclosure requirements are lacking. Fine; FAS 113 says (rather vaguely) that you must disclose certain items.
We are left with the first and fourth of these items. The first is the "risk transfer" issue, and the fourth is the "net accounting" issue. Go now to paragraph 4. The first sentence lists these two items. "(a)" is the net accounting issue, and "(b)" is the risk transfer issue. [You might ask: "What type of game are we playing now?" Answer: Your objective right now is to get comfortable with the terms that FAS 113 uses for these two issues, and the manner in which FAS 113 provides the accounting guidance.]
Paragraph 1 defines reinsurance. Paragraphs 2 and 3 deal with the "net accounting" problem. That's the introduction to FAS 113 (sections 1-5). You should understand the import of these sections from the introduction to this study session. Note a few additional items.
Read carefully the second half of the penultimate sentence of paragraph 1: ". . . and the insurer ordinarily is not relieved of its obligation to the policyholder." When the insurer is relieved of its obligation, called an "assumption and novation" later in FAS 113, then net accounting may be permitted.
"Net accounting" was prescribed by FAS 60, and it is the procedure used in the Audit Guide. FAS 113 is changing the FAS 60 rules. This is paragraph 2 of FAS 113. In other words: FAS 113 is not just explaining GAAP accounting. FAS 113 is changing GAAP accounting.
Paragraph 3 tells you the source documents for "offsetting of assets and liabilities" (Opinion 10 and Interpretation 39). In other words, FAS 113 is not objecting to net accounting because of a logical argument. The problem is that net accounting in statutory statements does not comport with GAAP rules.
Deposit Accounting
Read paragraph 6, "Applicability and Scope." Read carefully the first full sentence beginning on the first line of page 3: "Contracts that meet . . ." In other words, if you meet the requirements to be called a reinsurance contract, then paragraphs 14-26 explain the accounting. If you don't meet the requirements, then deposit accounting is used.
Understand the types of reinsurance contracts, since they have different accounting rules. Contracts may be long duration or short duration. This is the same division as in FAS 60. Check the study session on FAS 60 for further explanation of short and long duration contracts. For simplicity, you can think of long duration contracts as life insurance contracts, or individual health insurance contracts, or disability insurance contracts. Life insurance companies purchase reinsurance on these contracts. Property-casualty contracts are short duration contracts. The distinction depends on whether the insurance company has a unilateral right to cancel or to not renew the contract.
If the contract is a short duration contract, it may be either prospective reinsurance or retroactive reinsurance. Retroactive reinsurance is a loss portfolio transfer. You might say: "Retroactive reinsurance is rare." Not so. In fact, not only is retroactive reinsurance more common than many persons believe, but there are (sometimes) real problems in teasing apart the two types of reinsurance. Suppose that on July 1, 1998, you write a book of business. In December of 1998, you realize that you can not handle the surplus strain, so you reinsure the business pro-rata, with 50% to you and 50% to the reinsurer. You reinsurer the whole book, both the past 6 months and the coming 6 months.
This case is relatively easy. What if you have been writing policies during 1998, and on December 15 you decide to take a 50% pro-rata treaty on this business? The policies have effective dates all over 1998. It now gets quite difficult to determine how much premium is for the retroactive part of the reinsurance and how premium is for the prospective part of the reinsurance. FAS 113 will say how this should be treated. Chapter 22 goes into greater detail on this issue, since it is more important for SAP than for GAAP. GAAP recognizes retroactive reinsurance; SAP doesn't recognize retroactive reinsurance. However, this statement is more form than content. Even GAAP restricts the recognition of profit on the retroactive reinsurance, though it recognizes this profit either pro-rata or through an amortization schedule; SAP recognizes the profit only at the very end. Even if you have read already FAS 113 and Chapter 22, you may not recall these rules. The text of both statements regarding the profit recognition rules is difficult to read.
Assumed Reinsurance
Read paragraph 7. FAS 113 tells us what contracts are considered reinsurance. Now accounting is a logical activity. You might think: "If something is not reinsurance for the ceding company, then it is not reinsurance for the assuming company."
Yes, there is logic in that statement, but that's not the rule in FAS 113. Why not? Answer: For primary insurance contracts, we are not concerned with risk transfer or reasonable possibility of significant loss. If you write an auto insurance policy, it's an auto insurance policy, even if you have subtly structured the contract so that you can not lose money. Many companies treat their assumed reinsurance the same as their direct business. FAS 113 says: Treat the assumed reinsurance with the FAS 60 rules, not the FAS 113 rules.
This contradicts a general GAAP rule, that the two parties to any transaction should have inverse accounting entries. FAS 113 is aware of this (it explicitly notes this in the comments after the text), but the FASB says that this is the lesser of two evils.
Complete Understanding
Read paragraph 8. This section is copied over almost word for word into Chapter 22, so you have double incentive to know it well. [In fact, almost all of the risk transfer definition paragraphs are copied over into Chapter 22.] This is FAS 133's way of saying: "We can tell you the concept, but we can't lay down specific rules. Reinsurance contracts are so varied and so complex that a contract may seem like there is risk transfer, but a careful examination of the policy provisions may show that there is insufficient risk transfer."
Definition of Reinsurance
Memorize the entire paragraph 9, both the bottom of page 3 and the top of page 4. It is good to know the exact words here. If you don't have a photographic memory, read this section over at least a dozen times before the exam date.
There is a two-pronged definition: "a" and "b." The introductory sentence says that both conditions must be satisfied.
Part "a" says "insurance risk." Insurance risk means both underwriting risk and timing risk. This is the first paragraph on page 4. The paragraph is written inversely, so the word "either" in the FAS 113 text has the import of the "both" in the preceding sentence. This confuses many candidates; in fact, some of these candidates will insist that NEAS misunderstands this paragraph. (Oh well.) It is true that the paragraph is awfully vague. [Example: "What is the definition of 'insignificant'?" Answer: "Remote." If you then ask the FASB what "remote" means, the answer is: "Look it up in a dictionary."] By the way, NAIC Chapter 22 explains this paragraph in more detail, though it keeps the same wonderful definition of reasonably possible.
Present Values
Read paragraph 10. This paragraph explains part "b" of the definition on the bottom of page 3. We use present values of cash flows, not nominal dollar amounts.
What does the last clause of the first sentence in this paragraph mean (". . . without regard to how the individual cash flows are characterized")? Suppose a contract says: "Premium is $10,000. Expected losses are $10,000. If losses exceed $10,000, an additional premium equal to the additional losses must be paid to the reinsurer." This is clearly not reinsurance, since there is no possibility of a significant loss to the reinsurer.
So the crafty reinsurer rewords the contract. The additional payment will not be called "premium." It is not premium at all, says the reinsurer. Rather, it is a Christmas bonus paid to the reinsurer.
"Knock it off," says FAS 113. "We don't care what you call these cash flows. We are concerned only with cash inflows and cash outflows, not with the names of these cash flows."
The Exception
Read paragraph 11, the "unlikely" exception. Suppose the primary insurer writes a book of business. The total premium is $10 million. Expenses are $2 million. The total losses will vary between $6 million and $7 million.
There is no possibility of a loss to the primary insurer. Is this insurance for GAAP statements? Yes. FAS 113 applies only to reinsurance contracts, not to primary insurance contracts. If you write an insurance policy, then you account for it as an insurance policy.
Now the primary insurer reinsurers the book of business. It pays the reinsurance company $9 million, and it receives a reinsurance commission for its expenses. Is this a reinsurance contract for GAAP financial statements?
The contract fails the test in FAS 113, since there is no possibility of loss to the reinsurer. But the reinsurer says: "I took on the entire insurance risk in this book of business. If it was insurance for the ceding company, it should be reinsurance for me."
"Well," says FAS 113, "That makes sense. If you assume all the insurance risk that the primary carrier had, then it is reinsurance."
We said that this is an "unlikely" exception. NEAS is not commenting that this is unlikely. The NAIC Chapter 22 refers to this scenario as a "narrow circumstance." Why is it so unlikely? Answer: Which nut pays an insurance company to insure something where there is no insurance risk to the insurer? And in the off chance that an insurer found such a risk, why is it reinsuring this risk with a reinsurance company? This exception almost never comes up in practice, but it is here for completeness.