ASU 2016-13 – Financial Instruments-Credit Losses: Accounting for Reinsurance Recoverable

Reinsurance recoverable is measured at amortized cost and subject to Topic 326. While the NAIC rejected ASU 2016-13, publicly traded insurance companies, holding companies, and agencies that prepare GAAP financial statements must understand the implementation of ASU 2016-13.

This article provides the accounting for credit losses for reinsurance recoverable and includes sample financial statement disclosures.

Measurement. When assessing reinsurance contracts, insurance companies must evaluate factors like the reinsurer’s solvency and collateral arrangements to gauge potential credit losses. If an insurer holds numerous reinsurance contracts, it may opt for a pooled approach to estimating expected credit losses, grouping contracts based on standardized terms, similar insured risks, or geographical concentrations. However, individual assessment of expected credit losses is necessary if the reinsurance recoverable lacks uniform risk characteristics. Entities should utilize historical data, current market conditions, and reasonable and supportable forecasts to determine the collectability of cash flows and establish an allowance for credit losses on reinsurance recoverable.

Application. The guidance provides flexibility in choosing an estimation method for determining the expected credit loss as long as the method is consistent year over year, represents the entity’s historical experience, and assesses future economic conditions.

Probability-of-default Method. The probability-of-default method appears to be the preferred approach for calculating expected credit losses concerning reinsurers. This method employs statistical analysis within credit risk modeling to predict the probability of a borrower defaulting on a loan within a specified period, often within one year.

A.M. Best Rating Service, Inc. (AM Best) is a resource and maintains a general impairment database and historical rating records, enabling annual studies on long-term impairment rates. These studies aim to assess the relative default risk of insurers with interactive Best’s Financial Strength Rating (FSR) and Best’s Issuer Credit Ratings (ICR). Recognized as a Nationally Recognized Statistical Rating Organization (NRSRO), AM Best publishes Form NRSRO: Exhibit 1 Rating Performance Measurement Statistics, which offers insights into insurer default rates. Using the probability-of-default method, these default rates can be utilized to calculate expected credit losses for reinsurers.

JLKR Insight

We can anticipate insurance companies asserting that they exclusively work with highly rated reinsurers, typically with ratings of A- or better, thereby mitigating, if not eliminating, default risk. Reinsurance agreements may grant insurance companies the option to terminate or substitute participating reinsurers in case of rating downgrades or reduced surplus. Nevertheless, insurers are required to prepare an assessment of reinsurer credit risk. If expected credit losses are deemed immaterial, it may be appropriate to establish a zero allowance.

Funds withheld, trust accounts, letters of credit, and other collateral provisions. The assessment of these embedded provisions should be conducted like the assessment of collateral and credit enhancement provisions outlined in ASC 326. These standards emphasize that an entity should not assume the nonpayment risk of the amortized cost basis to be zero solely based on the present value of collateral securing the financial asset(s). Instead, entities must also consider factors such as the characteristics of the collateral, potential fluctuations in collateral values over time, and historical loss data related to financial assets secured by similar collateral.

Transition. The update should be applied using a modified retrospective transition approach that would require a cumulative effect adjustment to the opening retained earnings as of the date of adoption.

Disclosures. The first set of disclosures below illustrate cases where reinsurer credit risk is deemed to be insignificant. The subsequent set pertains to instances where an allowance for credit losses is estimated.

Financial statement presentation and disclosure when a company determines reinsurer credit risk is inconsequential:

Financial statement presentation and disclosure when a company provides an allowance for credit losses:

Related topics:
ASU 2016-13 – Financial Instruments-Credit Losses: An Overview
ASU 2016-13 – Financial Instruments-Credit Losses: Premium Receivable
ASU 2016-13 – Financial Instruments-Credit Losses: Accounting for Available-for-Sale Debt Securities