How Should Insurers Account for Reinsurance Commutations Under Statutory Accounting?

In the Property Casualty realm, a commutation is the common contingency for discharging an existing reinsurance arrangement. Every commutation transaction should be carefully assessed as the financial components are reversed through the various accounts and schedules of the statutory financial statements.  JLKR associate Felipe Jimanez takes us on a simplified tour and example for applying the commutation elements through the statutory financial presentation.

A commutation is an agreement between the insurer and reinsurer to terminate all or part of a reinsurance contract in exchange for a cash payment or other considerations. Pricing may depend on the tail length of the reinsured line, with a discount applied for risk and the time value of money. Through commutation, the insurer reassumes the risk of liabilities for losses that were previously ceded to the reinsurer. Under a commutation, the reinsurer is generally released from its obligation to pay for both known and unknown losses, as well as uncertainties related to the severity of these losses. As a result, the insurer becomes fully responsible for both investment risk and loss reserve risk.

The primary business reasons insurers initiate commutations are:

• The reinsurer is having trouble meeting the agreement’s terms or has had similar issues in the past.
• There are serious concerns about the reinsurers’ or insurers’ financial stability.
• The assuming entity disputes the loss development
• Both parties believe it is better to end their relationship, as they both can benefit from potential tax advantages.

Regardless of the motivation, a commutation involves significant risks. Both parties must carefully evaluate and negotiate the settlement amount. Some key factors that are typically considered when determining a fair commutation price include:

• Present value of cash in the current investment environment
• Tax effect based on both the internal effective tax rate and the value of the IRS discount unwind
• Risk of adverse development in loss reserves to be reassumed, factoring in worst case scenarios to account for the uncertainty of the severity of loss

Now that we have determined to commute the agreement and settled on a price, how would we account for the commutation of the reinsurance agreement? We would refer to SSAP No. 62, Property and Casualty Reinsurance, specifically paragraphs 94 to 97, as summarized below:

1. The reinsurer pays the ceding entity the agreed-upon amount. The insurer eliminates the reinsurance recoverable recorded against the ultimate loss reserve and records the cash received as a reduction of paid losses. Any resulting net gain or loss is reported under underwriting income within the statement of income.
2. The reinsurer eliminates the loss reserves carried at ultimate cost in exchange for the cash payment, which is calculated at present value. Any net gain or loss is also reported in underwriting income within the statement of income
3. Commuted balances are written off through the same accounts, exhibits, and schedules where they were originally recorded.

Question I-1 addresses the accounting impact of a reporting entity reassuming its own risk from a third-party reinsurer.

Question I-1

Start Insurance Company (SIC) cedes financial guarantee business with an approximate 10-year life on a quota share basis (50%) to End Reinsurance Company (ERC).

Seven years later, SIC and ERC decide to part ways. They agree on a commutation settlement value of $9, which considers both time value of money and expected future loss payments. Prior to commutation, SIC ceded ultimate loss reserves of $10 to ERC.

The parties would record the following entry at commutation:

Note: For purposes of the explanation below, premiums are assumed to be fully earned, with no remaining unearned premium reserves or other account balances, other than remaining loss and loss adjustment expense reserves.

SIC – Journal Entries

ERC – Journal Entries

The impact on the financial statements is as follows: Increase (Decrease)

We’re here to help

Commutations are complex transactions that involve careful evaluation of multiple factors, detailed analysis, strategic pricing decisions, and a clear understanding of the long-term implications for both parties. Fortunately, the insurance experts at JLK Rosenberger are here to guide you through the complexities of commutation.