If an insurance or reinsurance contract does not transfer risk, it falls under the principle of deposit accounting. Under this principle premium is not recorded as income and is instead listed as an asset, which has a direct impact on the company’s leverage. In order to insure that reinsurance is applied towards surplus relief, it is important to examine the contract to see if both timing and underwriting risk have been transferred. Timing risk is the risk of when cash is received or paid, while underwriting risk is the risk of premiums covering losses. Testing reinsurance contracts for risk transfer is necessary as a lack of transfer could have a major impact on surplus and greatly limit how much premium a company can write. There are three criteria for testing if risk is transferred. Compiled below are the three things to pay attention to when reading through a reinsurance contract.
Steps for testing transfer of risk:
- Is the transfer of risk reasonably self-evident? The first step in testing for risk transfer is to filter out contracts where risk transfer is reasonably self-evident. The reason is to remove the need to test every contract when risk may be obvious. This includes individual risk and catastrophe excess of loss contracts, as well as excess of loss contracts that do not have any sensitive features. Similarly, if a contract’s premium is immaterial, it can also be excluded from testing.
- Is all risk substantially transferred through the contract? When reading through the contract, it is important to make note of how the contract affects both the ceding and assuming company. If both parties have the same downside risk, the risk would be deemed substantially transferred and no further test work would need to be done. This can be seen if both parties enter a loss position at the same time. If both parties do not have the same risk, further measures must be taken to test for risk transfer.
- Run an ERD test. If neither of the previous two criteria are met, further testing must be done to determine whether or not risk is substantially transferred. The final step in deciding if deposit accounting should be used comes down to calculating risk metrics. This can be done through calculating the expected reinsurer deficit (ERD), which is a measurement of the probability distribution of multiple economic event outcomes. ERD provides a probability of loss and an estimate of the average severity of those losses. To calculate ERD, multiply the probability of loss by the average severity of loss. If the ERD is above 1% then the risk is substantially transferred; however, if the ERD falls below 1%, then the premiums must be accounted for using deposit accounting. 1% is used as a bright-line standard indicating a 10% chance of a 10% loss. Multiplying the 10% probability by the 10% severity of loss gives you a 1% ERD. (Bright lines can’t be found in accounting literature but are commonly used.)