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Accounting for Ceded Reinsurance Under LDTI—Existing Business

By Steve Malerich

The Financial Reporter, July 2021

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Author’s note: This is the fifth and final article in a series looking at accounting for ceded reinsurance under GAAP’s Targeted Improvements to the Accounting for Long-Duration Contracts (LDTI).[1]

This article examines the accounting for reinsurance of previously issued blocks of business. These arrangements raise additional concerns to those seen earlier. The focus remains on long-duration reinsurance of products that require net premium reserves and on objectives of compliance, performance and simplicity.

Before turning to existing business, I’ll address an additional concern for limited-payment contracts that came to my attention after I wrote about Unique Concerns—protecting equity as well as income.

Addendum to Unique Concerns

For limited-payment contracts, protecting equity does not follow automatically from protecting income. As with other questions about reinsurance, the dearth of explicit guidance means that different interpretations are possible. To include equity in performance objectives requires careful alignment between reinsurance recoverable, cost of reinsurance, and their direct counterparts.

Alignment between the liability for future policy benefits and reinsurance recoverable is most effective when they accrue for future benefits and future net costs, respectively, over the same direct premium base.[2] Remeasurement of both at current discount rates will preserve that alignment for balance sheet measurement.

Then, the level percent of premium margin and reinsurance cost can both be deferred and amortized on a consistent basis over the life of the business. In this way, the deferred cost of reinsurance will offset the deferred profit liability to the extent reinsurance reduces the net profit margin. In contrast to the liability for future policy benefits and reinsurance recoverable, deferred profit and deferred cost of reinsurance are not remeasured at current discount rates.

Though other methods won’t perform as well, I expect that for most companies the differences between methods will be immaterial to the balance sheet and insignificant compared to the differences between balance sheet measurement of liabilities and the assets supporting them.

Initial Measurement for Existing Business

According to Accounting Standards Codification (ASC) paragraph 944-605-30-4, “The difference, if any, between amounts paid for a reinsurance contract and the amount of the liabilities for policy benefits relating to the underlying reinsured contracts is part of the estimated cost to be amortized.”

LDTI added a wrinkle to this measurement—for new reinsurance of existing traditional contracts, the ceding company will have two liability values. The first, calculated by discounting cash flows at rates that were fixed at issue of the underlying contracts, is used for measuring net income. The second, calculated by discounting at current rates, is reported in the balance sheet.

The American Institute of Certified Public Accountants (AICPA) advises in its Life & Health Insurance Guide (Audit Guide), that “the reinsurance recoverable and the cost of reinsurance should be measured using the liabilities … as remeasured using the … discount rate assumption at the date the reinsurance contract is recognized in the financial statements.”[3] Simply stated—use the balance sheet liability.

Implicit in ASC 944-605-30-4 is a presumption that a company will establish an initial reinsurance recoverable asset equal to its direct liability. Though sensible for 100 percent coinsurance, other arrangements are possible. For coinsurance of less than 100 percent, I expect the initial reinsurance recoverable asset to equal the ceded share of the direct liability. For yearly renewable term, I expect an initial reinsurance recoverable asset equal to zero.

To “not result in immediate recognition of gains” (ASC 944-40-25-33), the initial cost of reinsurance must equal the difference between the initial amount paid for the reinsurance and the initial reinsurance recoverable.

Discount Rates

The Audit Guide also advises that subsequent measurement for net income requires “use of the interest rate at the date the ceded reinsurance contract is recognized.”[4] As with direct liability measurement, “the current upper-medium grade fixed-income instrument yield discount rate assumption would be used for balance sheet remeasurement purposes. …”[5]

The fixing of initial discount rates different from the original discount rates of the underlying contracts will produce some misalignment between direct and ceded accruals, a fact recognized in the Audit Guide.[6] Compared to other misalignments identified throughout these articles, I expect that those produced by different discount rates will be less significant in amount but more significant in that they are unavoidable.

Assumption Updates

According to the Audit Guide, “the recognition of ceded reinsurance recoverables … should also employ a net premium approach with retrospective updating of cash flows.”[7]

Complicating remeasurement for reinsurance of existing contracts, however, is an initial balance that does not accrue directly from premiums. GAAP does not specify a technique for handling this balance.

Something akin to the modified retrospective method in ASC 944-40-65-2(d)(2) could handle this complication but would fail to achieve performance objectives. Invariably, remeasurement would recognize in current income a larger proportion of unexpected benefits than of the associated recoveries. Similarly, an assumption change would have a proportionately larger effect on the direct liability than on reinsurance recoverable.

I know of two methods to handle the initial balance with consistent results in subsequent remeasurements. If it weren’t for the different discount rates recognized earlier, the “dynamic retrospective” and “attributed retrospective” remeasurement methods would produce identical results and remeasurement of the reinsurance would align perfectly with remeasurement of the direct liability to the extent that cash flows are reinsured. In principle, I don’t see either of these methods as superior to the other but there are some practical differences.

The dynamic retrospective method uses the familiar modified retrospective formula for calculating the net premium ratio. Remeasurement, however, requires an extra step—remeasurement of the direct liability as of the treaty date.

The attributed retrospective method requires additional calculations at inception of the reinsurance but then uses the results as if they were actual cash flows. Remeasurement uses the same calculations as any other reinsurance treaty. This method can also be used effectively with forms of reinsurance other than quota-share coinsurance.

Dynamic Retrospective Remeasurement

Dynamic retrospective remeasurement links the consistent manner requirement of ASC 944-40-25-34 with the fact that remeasurement of the liability for the underlying contracts reflects all direct cash flows since the underlying contracts were first issued. In effect, remeasurement of the direct net premium ratio produces remeasurement of the direct liability as of treaty inception. This method makes that explicit and uses the remeasured balance in place of the original reinsurance recoverable in a modified retrospective remeasurement formula.

When using, for example, the net cost method for reinsurance recoverable:
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Where rNPRt is the remeasured recoverable net premium ratio, T is the inception date of the reinsurance, RR is reinsurance recoverable, and the tilde (~) indicates a balance retrospectively remeasured using actual experience to the current reporting date (t) and current assumptions beyond.

Remeasuring the initial reinsurance recoverable in this way raises a question of whether the corresponding initial cost of reinsurance should also be remeasured. This is neither necessary nor desirable.

Unlike reinsurance recoverable, there is no requirement for the cost of reinsurance to be measured in a manner consistent with the underlying direct liability. And remeasuring the initial cost of reinsurance would undo the alignment that is achieved by remeasurement of the initial reinsurance recoverable.

Attributed Retrospective Remeasurement

Attributed retrospective remeasurement recognizes that the initial reinsurance recoverable asset (RRT) is, in part, a function of cash flows that preceded the effective date of the reinsurance. In effect, setting the initial reinsurance recoverable equal to the direct liability at treaty inception attributes some cash flow history to measurement of the reinsurance. This method splits that attribution into its premium and benefit parts. Once determined at inception of the reinsurance, attributed premiums and benefits remain in the recoverable net premium calculations as if they were actual premiums and benefits.

To align reinsurance remeasurement with direct remeasurement, the attributed premium at inception of the treaty (AP) must satisfy this equation:
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Where Premium represents whatever premium is used in the denominator of the recoverable net premium ratio and where h, measured at inception of the reinsurance, is the ratio of actual direct premium to lifetime direct premium (actual premium to date and expected future premium):[8]
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Solving for attributed premium:
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Using again the example of the net cost method, attributed recovery (AR) must satisfy the equation:
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Where:
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Solving for attributed recovery:
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Though details would vary, set up would be similar for other reinsurance recoverable calculation methods.

If the cost of reinsurance liability (COR) will also use retrospective assumption updates, it must be similarly split into attributed premium and cost parts.[9] Attributed premium for cost of reinsurance would use the same formula as attributed premium for reinsurance recoverable, though the premium used here must be direct premium for the cohort; reinsurance premium is not an option.

Whatever is included in recurring reinsurance cost (Reinsurance Cost), attributed cost (AC) must satisfy the equation:
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Where:
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Solving for attributed cost:
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Conclusion

I began this series with an Introduction, recognizing the limited guidance for reinsurance accounting and the diverse interpretations and practices that arose under existing standards.

A Fresh Look then recognized some objectives, in addition to compliance, to help frame the challenge and described some simple approaches to achieving those objectives. One objective is for earnings to emerge as a constant percent of revenue after reinsurance. Another is for remeasurement of reinsurance to align with remeasurement of direct liabilities to the extent cash flows are reinsured. To keep it simple, we look for a technique that can be used for a variety of reinsurance arrangements.

Looking at Precedent, we saw that most existing methods can be modified or supplemented to satisfy these objectives under LDTI. We also saw, however, that the complexity of calculations needed to achieve performance objectives varies significantly among the methods.

Keeping objectives in mind, we addressed some Unique Concerns for reinsurance that arise from its relationship to the underlying reinsured contracts.

Finally, we recognize in this article that the same objectives and methods apply also to reinsurance of Existing Business, but with the added complications of different inception dates.

Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the editors, or the respective authors’ employers.

I would like to thank Nicole Kim, FSA, MAAA, for her suggestion that performance objectives might consider effects on equity, as well as income.


Steve Malerich, FSA, MAAA, is a director at PwC. He can be reached at steven.malerich@pwc.com.


Endnotes

[1] The first four articles are: “Accounting for Ceded Reinsurance under LDTI—Introduction” by Malerich, The Financial Reporter, September 2020; “Accounting for Ceded Reinsurance under LDTI—A Fresh Look” by Malerich, The Financial Reporter, November 2020; “Accounting for Ceded Reinsurance under LDTI—Precedent” by Malerich, The Financial Reporter, February 2021; and “Accounting for Ceded Reinsurance under LDTI—Unique Concerns” by Malerich, The Financial Reporter, April 2021.

[2] For a description of net cost and other measurement methods, see “Accounting for Ceded Reinsurance under LDTI—Precedent.”

[3] AICPA Audit and Accounting Guide: Life and Health Insurance Entities, Appendix G — FASB ASU No. 2018-12, Financial Services — Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts, Accounting Implementation Papers, paragraph 77.

[4] Ibid, paragraph 78.

[5] Ibid, paragraph 79.

[6] Ibid, paragraph 79.

[7] Ibid, paragraph 73.

[8] For more about “h” and retrospective updates, see “GAAP Targeted Improvement—Traditional Contract Analytics” by Malerich, Scotchie and Winawer, The Financial Reporter, December 2018.

[9] For reasons that cost of reinsurance might also use retrospective updates, see “Accounting for Ceded Reinsurance under LDTI—Precedent.”