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CONTENTS Introduction xi Preface xiii Acknowledgments xix About the Authors xxiii

Part One Introduction to Life, Health, and Annuity Reinsurance

1 Basic Terms and Concepts 3

Some Background on Reinsurance 4 Classifications of Reinsurance 7 Uses of Reinsurance 11

Classifications of Reinsurers 19 Effects of Reinsurance on Company Operations 24 2 Automatic Reinsurance 29

Requirements for Automatic Reinsurance 29 Determining Automatic Amounts 41 Using Multiple Automatic Treaties 44 Effecting Automatic Reinsurance 47 Automatic Reinsurance Considerations 47 Inforce Blocks 48 3 Facultative Reinsurance 49

Offer and Acceptance 49 Ceding Company Uses of Facultative Reinsurance 51 Facultative Reinsurance: The Ceding Company 53 Facultative Reinsurance: The Reinsurer 56 Facultative Reinsurance Variations 60

Part Two Methods and Applications of Reinsurance

4 Basic Methods of Reinsurance 65

Yearly Renewable Term Reinsurance 65 Coinsurance 73 Modified Coinsurance 79

Comparative Models 83

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5 Advanced Methods and Structures of Reinsurance 105 Terminology 106 Comparative Model 107 Advanced Methods of Reinsurance 113 An Alternative Structure Using an SPV 150

6 Assumption 157

Strategic Considerations 158 Assumption in the U.S. 160 Assumption in Canada 173

7 Reinsurance of Inforce Risks 175

Use and Objectives of Reinsuring Inforce Risks 175 Terminology 181 Risk Based Capital Effects 183 Advantages & Disadvantages of Different Reinsurance Methods 184 Pricing and Treaty Considerations 191

Part Three

Treaties and Risk Considerations

8 The Reinsurance Treaty 195 Definition of the Agreement 197 Definition of Risks Reinsured: U.S. Automatic 203 Definition of Risks Reinsured: Canada Automatic 206 Definition of Risks Reinsured: Facultative 208 Terms and Specifications 210 Administration: U.S. Accounting & Reporting 215 Administration: Canadian Accounting & Reporting 223 Administration: General 226 Special Provisions 241 Dispute Resolution 252 Preparing the Treaty 255 Reinsurance Risk Management 265 Additional Considerations 267

9 Risk Transfer Considerations 269

Some History 269 Acceptable Risk Transfer 271 Risk Transfer in U.S. GAAP 280 Risk Transfer in U.S. Federal Income Tax 282 Risk Transfer in Jurisdictions Other than the U.S. 283 The Future of Risk Transfer 283

10 Insolvency and Reinsurance 285

Insolvency Regulation in the United States 286 Insolvency Regulation in Canada 303

CONTENTS vii

PART FOUR REINSURANCE REGULATORY, ACCOUNTING,

AND TAX CONSIDERATIONS 11 U. S. Regulation of Reinsurance 313 Regulatory Environment in the U.S. 313

Federal Regulation in the U.S. 318 State Regulations 320 The Future of Regulation in the U.S. 342

12 Canadian Regulation of Reinsurance 345 History and Framework of Regulation in Canada 345

Regulation and Guidelines in Canada 347 The Future of Regulation in Canada 362

13 U.S. Statutory Accounting 363

Regulations and Accounting Standards 363 Balance Sheet 372 Summary of Operations 374 Cash Flow 376 Analysis of Operations by Lines of Business 377 Exhibits 377 Other Annual Statement Items 384 The Role of the Appointed Actuary 385

14 U.S. GAAP Accounting 389

Comparing GAAP and Statutory Accounting 390 Development of GAAP Accounting 391 Statements of Financial Accounting Standards 392 ASC 944-Financial Services-Insurance 400 GAAP for Ceded Reinsurance 405 GAAP for Assumed Reinsurance 409 Reporting for Non-U.S. Companies 414

15 U.S. Tax Considerations 415

State Taxes 415 United States Federal Income Tax 417 FIT Illustrations 431 Assumption and Inforce Tax Considerations 443 Other Tax Related Issues 445 Captive Considerations 448 International Tax Considerations 452 Tax Planning 456 Outlook for the Future 457

16 Canadian Accounting and Tax Considerations 459

Statutory/GAAP Accounting 459 Taxation 468

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PART FIVE ADDITIONAL PRODUCTS AND TOPICS

17 Nonproportional Reinsurance 479

Stop Loss 479 Catastrophe Coverage 482 Spread Loss 483 Reserve Considerations 484

18 Health Reinsurance 487

Accident and Health Reinsurance Methods 487 Disability and Long Term Care Insurance 492 Medical Coverages 497 Other Considerations 508

19 Annuity Reinsurance 511

Annuity Products 511 Reinsurance of Annuity Products 513 Special Considerations 528

20 Captives 533

Background 533 Corporate Risk Management Captives 536 Producer Owned Reinsurance Companies 540 Capital-Driven Reinsurance & SPVs 549 General Considerations — U.S. 549 Administrative Issues 554 Captives in Canada 556

21 Reinsurance Outside Canada and the U.S. 559 Global Reinsurance Market 559 International Reinsurance 560 U.S.-Canadian Relationship 571 Selected International Reinsurance Markets 573

22 Additional Reinsurance Topics 589

Group Life and AD&D Insurance 589 Accelerated or Living Benefit Riders 590 Reinsurance with Affiliates 591 Reinsurance Intermediaries 593 The Dispute Resolution Process 595 Reinsurance Premium Rate Guarantees 598

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PART SIX ADMINISTRATIVE AND MANAGEMENT CONSIDERATIONS

23 Reinsurance Administration 603

Evolution of Reinsurance Administration 603 Basic Reinsurance Administrative Considerations 605 Self-Administration, or Self-Reporting 606 Individual Cession Administration 610 Audits 611 Ceding Company Administration 613 Reinsurer Administration — Indemnity Reinsurance 620 Reinsurer Administration — Assumption 623 Reinsurer Administration — Fronting and Captives 623

24 Managing Reinsurance 625

Retention Limits 626 New Business 638 Managing Continuing Reinsurance 653 Facultative Reinsurance 656 Inforce Blocks 657

Appendix: Sample Treaty 659 Glossary 707 Bibliography 727 Index 741

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AUTOMATIC REINSURANCE Automatic reinsurance is a contractual arrangement of mutual obligations whereby an insurance company is allowed to cede to a specific reinsurer a portion of an insurance policy that the company has issued. This ceding of risk is subject to certain criteria, utilizes a predetermined cost, and does not require the reinsurer’s approval for that specific risk. It is available only for risks issued and placed in force after a date specified in the agreement, unless otherwise stated in the agreement. The reinsurer is obligated to accept risks from all policies or contracts which meet the criteria for automatic reinsurance; the ceding company is obligated to cede all policies which meet the criteria unless the ceding company chooses to submit the risk for facultative underwriting. The ceding company is permitted to cede a case facultatively to the automatic reinsurer or another reinsurer. In that sense, the ceding company may opt out of the mutual obligations of the treaty, but at the cost of losing certain rights. Typically, once a risk is submitted for a facultative underwriting evaluation, the issuing insurer loses forever its right to cede that risk automatically. For life insurance and annuities, automatic reinsurance is a form of proportional reinsurance; that is, the portion of a claim for each policy which is reinsured is determined at issue according to a formula stated in the treaty. Historically, the formula would result in a proportional sharing of the risk throughout the life of the individual policy, subject to recapture. Some reinsurance arrangements provide for the proportion of reinsurance to diminish as the total net amount at risk decreases. For accident and health insurance, non-proportional methods of reinsurance are often used. This chapter discusses the criteria for and practice of automatic reinsurance covering life insurance risks. Provisions specific to annuity and accident and health policies are presented in later chapters. While some criteria noted are rarely used today, they may be applicable in older agreements and are important to understand in the management of ongoing obligations under those agreements.

REQUIREMENTS FOR AUTOMATIC REINSURANCE

An automatic reinsurance treaty contains several requirements which each policy must meet before it qualifies as an automatic cession. These requirements are usually designed to permit the vast majority of risks requiring reinsurance to be ceded automatically. Some requirements concern the amount of risk that the ceding company must retain and place limits on both the maximum amount of automatic reinsurance that can be ceded on a life and on the maximum amount of insurance inforce on the life if it is to qualify for automatic reinsurance. These requirements allow the reinsurer to check its prior exposure on the life and its retrocession capacity.

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Other major requirements cover underwriting and issue rules, residence of the insured, plan of insurance, licensing of the insurer, issue ages for insureds, and, perhaps, the sales distribution method to assure the reinsurer that the business reinsured meets the standards anticipated in its pricing and is legally issued. The purpose of these requirements is to provide a clear understanding of what future risks are entitled to automatic reinsurance coverage. When all automatic requirements are met, the ceding company can bind the reinsurer and the reinsurer is said to be bound. Being bound simply means the reinsurer is obligated to accept the reinsurance according to the terms of the treaty. The typical requirements include the following and are discussed later in this chapter.

1. The ceding company must keep risks up to its retention stated in the reinsurance agreement. The retention limit may vary by issue age, risk rating, product, residency of the insured, distribution system, or other classifications.

2. The risk amount cannot exceed the binding limit in the automatic treaty.

3. The risk amount cannot exceed the jumbo limit in the automatic treaty. If the amount exceeds that, then no automatic reinsurance is available.

4. The ceding company must maintain the agreed underwriting standards.

5. No portion of the policy covered by the automatic agreement may be submitted to any reinsurer for facultative underwriting and remain eligible for automatic reinsurance. As discussed later in this Chapter, this is a general rule in the U.S. and Canada.

6. Each individual cession must meet all other requirements contained in the treaty.

FULL RETENTION Probably the most critical requirement for automatic reinsurance is that the ceding company must keep its full retention at issue on any policy ceded under the treaty. This indicates that the ceding company has evaluated the risk and is willing to accept it under its own underwriting terms. This does not necessarily mean that the risk must be standard, as most companies include substandard risks in their automatic reinsurance. The willingness of the ceding company to put its own surplus at risk by retaining a meaningful portion of the risk is the key component of trust by the reinsurer in the ceding company’s underwriting decision-making. Without the full retention requirement, the ceding company would be free to select against the reinsurer as it pleased, holding a smaller or no retention on poorer risks. The term full retention refers to the established retention schedule of the company. The full retention limit does not have to be the same for all products, but it does need to be mutually agreed between the insurer and the reinsurer and documented clearly in the relevant reinsurance treaties. The retention limit may be expressed as a flat amount such as $100,000 per life. Reinsurance ceded on this basis is often referred to as excess reinsurance. The ceding company’s retention may also be expressed as a specific percentage of the amount issued subject to a maximum retention limit. This reinsurance is referred to as quota share.

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All companies have a schedule of retention limits, usually approved by its Board of Directors. Many companies have scheduled a reduced retention for lower and higher issue ages and for higher substandard ratings where the risks are perceived to be greater or where the number of risks is small. Although grading retention limits is widely accepted in practice, it is not always justifiable in theory. Retention limits may vary by product, by source of business, or by line of business. Retention limits on accidental death coverage or waiver of premium may differ from the basic limits. These scheduled variations in retention limits do not violate the full retention rule. A violation occurs when the actual amount retained deviates from the established schedule for that product, issue age, and rating. The selection of retention limits is discussed in Chapter 24, Managing Reinsurance. The full retention requirement applies to the sum of benefits on all policies issued on any one life by the ceding company. For example, if a company has filled its retention on a given life due to previously issued policies, a new policy may qualify for automatic reinsurance even if no portion of the risk on this policy is retained by the company, provided all of the other automatic coverage conditions are met. In such instances, the reinsurer may require that the rating class of the risk has not deteriorated since the last underwriting. The retention limit requirement applies at the time of policy issue. Under certain conditions, the ceding company may have the right to take out additional reinsurance at a later time. Additional reinsurance might be necessitated for financial reinsurance purposes or to permit the sale of a block of business. Some treaties, however, specifically prohibit the placement of any additional reinsurance on policies covered by that treaty. This prohibition is included to assure that the ceding company retains an interest in the future profitability of the policies. Companies periodically revise their retention schedules. The retention in effect at the date of the current coverage is applicable regardless of any amounts of reinsurance which may have been placed on the same life. In filling the new retention, all insurance currently inforce on the life must be considered. Historically, the ceding company is not allowed to increase its retention and recapture policies in order to cede them to another reinsurer. Recapture accompanied by the purchase of stop-loss reinsurance is generally not allowed. Companies may also have different retention schedules for different products. This may occur if the company is entering a new market, using different underwriting criteria for a product, or choosing to allocate capital to one product over another. A company might, for example, decrease its retention for products with high first year costs to protect its surplus. In order to illustrate how the retention limits and the other limits work; the following example will be used in this chapter.

Retention limits for various products are expressed in terms appropriate to each product. For example, some companies limit their retention or issue amounts on individual annuities to a maximum deposit amount per contract or individual. Disability income retention limits may be expressed as a maximum amount of benefit per month, a reduced benefit period, or a combination of these two. Medical expense insurance may call for retention limits which include both a maximum per occurrence and a maximum per year for each individual.

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Table 2.1 ABC Life Insurance Company

Individual Life Retention Schedule

Issue Age

Standard Through 200%

Extra Mortality

Over 200% Extra Mortality

018 $50,000 $25,000 1965 100,000 50,000 Over 65 50,000 25,000

MINIMUM CESSION Many reinsurance treaties provide that, to qualify for automatic coverage, the cession must be for an amount in excess of a stated minimum cession, or trivial amount. The purpose of this provision is to avoid the disproportionate expense associated with administering very small cessions or claims. Minimum cession standards may also be used for continuance of reinsurance; if the amount of reinsurance on a given risk qualifies initially but drops below a specified level, the reinsurance on that risk is automatically terminated. This practice is more typical of individually administered agreements; it is used to reduce administration by both parties and to avoid claims administration of small amounts. Because this minimum cession concept creates a range or corridor of amounts in excess of the ceding company’s stated retention, such agreements are sometimes referred to as minimum corridor agreements.

Table 2.2 ABC Life Minimum Cession Example

BINDING LIMIT The binding limit, or automatic capacity, is an important element of the automatic reinsurance formula. This is the amount of risk on a given life which the ceding company can

Assumptions: No Previous Inforce

Retention Limit: $100,000 Minimum Cession: $25,000

Policy Amount Amount Reinsured

$100,000 0

$124,999 0

$125,000 $25,000 $150,000 $50,000

AUTOMATIC REINSURANCE 33

cede automatically to the reinsurer and which the reinsurer must accept if all other conditions for automatic reinsurance are met. If the binding limit is expressed in terms of the insured amount, then the binding limit calculation must take into account any amounts of insurance previously issued or applied for on the life by the ceding company plus information regarding any amounts to be replaced and the ultimate amount of any known future contractual increases. If the binding limit is expressed in terms of reinsured amounts, then the binding limit is calculated as the total amount ceded to the reinsurer under this agreement and all other agreements, plus the reinsurance on all amounts applied for, and any coverage to be replaced and any ultimate amount of future known contractual increases. The binding limit may be stated either as a multiple of the ceding company’s retention or as an amount of insurance. It is important to clearly state if the binding includes the amounts retained or not. Special considerations are necessary when quota share reinsurance is used. The binding limit may be reduced at certain issue ages or substandard ratings. Even though the binding limit for the reinsurer is not exceeded, a specific risk may not qualify for automatic reinsurance because of insurance coverage with other carriers, as described in discussion of jumbo limits. The binding limit is determined by the ceding company’s underwriting ability, its retention limit, and its needs. A company with inexperienced underwriters may have a lower binding limit than a company with experienced underwriters, even if the first company has a higher retention limit. A company which writes large policies with great frequency may find it more convenient and desirable to have a higher binding limit than a company where large policies are rarely encountered. In most situations, both the reinsurer and the ceding company would like the binding limit set at a level such that the majority of the policies requiring reinsurance can be ceded automatically. This lowers administrative expenses for both companies and allows the ceding company to issue policies more quickly. Higher binding limits also provide the reinsurer with more reinsurance by eliminating the need to compete with other carriers for facultative business on the larger policies. The advantages of a higher binding limit must be balanced with the reinsurer’s desire to review the larger cases which need specialized underwriting expertise. Automatic binding authority granted by a reinsurer must also be coordinated with the reinsurer’s retention and retrocession arrangements. On a very large case, the reinsurer may need to check its own retention on the insured before accepting the risk or make special retrocession arrangements. Reinsurers also have limits and controls on their retrocession capacity and must follow the rules of their binding authority. Binding limit practices have tended to vary over time. Until roughly 1980, for example, automatic binding limits tended to be three to four times the ceding company’s retention; sometimes a second layer of automatic reinsurance added another three to five times, with different reinsurers. In practice, the binding limit expressed as a multiple of the retention limit tended to be lower as retention limits increased. This was largely to allow the reinsurer to

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review facultatively the larger risks and to protect the reinsurer’s retention on larger risks. Over time, policies have tended to be larger and ceding companies have sought and obtained higher binding limits to lower administrative costs and to shorten the time needed to issue a policy. In the early 1980s, quota share reinsurance of certain products became common with the ceding company retaining 50% up to its normal retention limit. Automatic excess binding limits moved up to as high as nine or ten times the retention limit. As of 2014, 10% retentions for quota share are common, allowing nine times binding limit. Excess binding limits may reach 10 or even 20 times the retention limit. Insurers with well-respected underwriting programs generally are granted higher relative binding limits. Higher limits have, however, brought a requirement for much tighter adherence to underwriting standards in order for a risk to qualify for automatic coverage. This increase in binding authority relative to retention results in the ceding company having proportionately much less at risk. Some practitioners have raised concerns about the lowered sharing of risk and the lower absolute risk retained by ceding companies under these conditions. The binding limits for each agreement are set according to the mutually agreed objectives of the reinsurance program. The handling of amounts in excess of the automatic binding capacity is discussed elsewhere in this Chapter and in Chapter 3, Facultative Reinsurance. If the sum of the amount applied for and the amount already in force with the ceding company exceeds the sum of ceding company’s retention and its binding limit, the risk may still qualify for automatic reinsurance if all other requirements are satisfied. The automatic reinsurer is responsible for only the amount of risk agreed in the treaty; the ceding company is responsible for the remainder of the risk. The cedant may have other automatic reinsurance treaties in place for these excess amounts. Some treaties require that the policy must be issued at the same rating for all insurers and reinsurers, but different ratings have been applied in the past. It may seek facultative reinsurance from any reinsurer, including the automatic reinsurer. In most automatic treaties in the U.S. and Canada, however, any use of facultative reinsurance for any reason normally disqualifies the risk from all automatic coverage. It is not uncommon for a ceding company to increase its automatic issue capacity. This is done by having more automatic reinsurers, either through more quota share reinsurers, as is common today, or through multiple layers of reinsurers, as was more common in the days of individual manual cession administration.

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U.S. STATUTORY ACCOUNTING Until the middle of the 1970s, statutory accounting requirements for reinsurance in the U.S. were relatively simple. For the most part, summary data was either entered directly in the annual statement or embedded in the overall numbers. (In this book, annual statement means the statutory report required to be filed annually with the various state insurance departments, developed in accordance with the NAIC’s Annual Statement Blank. This Blank is also referred to as the convention blank.) As reinsurance became increasingly important to the financial structure and solvency of many insurers, more information has been required to be detailed in the annual statement, as discussed in Chapter 8, The Reinsurance Treaty, and elsewhere in this book. This chapter discusses the reinsurance related entries in the annual statement in the U.S.

REGULATIONS AND ACCOUNTING STANDARDS

Statutory accounting’s primary concern is with the current and future financial condition and the continued solvency of insurers and reinsurers. Accordingly, the principles of statutory accounting are intentionally conservative and focused on liquidation rather than going concern values. The capability to produce timely and accurate statutory financial statements requires an understanding of the appropriate regulations regarding those statements. In particular, a broad understanding of the appointed actuary’s role and responsibilities is important. Reinsurance accounting is similar to that for direct insurance; many elements are identical to that for direct business. The differences exist to highlight the ceding company’s reliance on reinsurance and reinsurers and the different sources of business for the reinsurer.

1. Accounting for ceded business is essentially the application of negative amounts instead of the positive amounts used for direct business.

2. Accounting by the reinsurer for assumed business is essentially the same as for direct business, except the numbers may be different and the amounts frequently are entered on different lines or columns.

3. Accounting for retroceded business is identical to that of ceded business. The principles of accounting for reinsurance assumed that is retroceded are the same as those for direct issues that are ceded.

The insolvencies of several property and casualty insurers due to the failure of their reinsurers caused alarm among regulators. While reinsurance did not cause either the Equity Funding scandal or the Baldwin United insolvency, reinsurance was one of the vehicles utilized to falsify sales growth in Equity Funding, and reinsurance obscured the true financial condition of the Baldwin United Companies. As a result, reinsurance transactions are more visible in the annual statement.

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REGULATION Insurance regulators, actuaries, and accountants have worked, and continue to work, to create uniformity in statutory accounting and to highlight reinsurance transactions in the annual statement appropriately. A desired result is to provide enough scrutiny of reinsurance transactions so that true reinsurance transactions are treated as such, while any transactions that are, in effect, only loans of surplus be treated as loans or financing. A further objective is that an audit trail be established to allow examiners and other interested parties to cross-check between the annual statements of the ceding company and of the reinsurer. That effort led to the Financial Regulations Standards and Accreditation Program in 19891. This program requires that states adopt 18 model regulations as well as the NAIC’s Accounting Practices and Procedures Manual and its Annual and Quarterly Statement Instructions. The Accounting Practices and Procedures Manual documents all of the Statements of Statutory Accounting Principles (SSAP). Because the Accounting Practice and Procedures Manual and Annual Statement Blank formats and specifications change frequently, the entries are discussed in this chapter at a high level without detailed instructions. The reader is urged to check the latest NAIC publications as well as specific state instructions and requirements.2 Unless specifically exempted, a reinsurer must meet the same requirements for statutory reporting as a direct company for all its business. The requirements of the Standard Valuation Law and the Risk-Based Capital (RBC) Model Act, for example, apply to both ceding companies and reinsurers. Model regulations that have particular importance to reinsurance transactions are the focus of this book. Actuarial Opinion and Memorandum Model Regulation3 This model regulation describes the qualifications of the appointed actuary providing the opinion and the content of the opinion concerning the adequacy of reserves based on an asset adequacy analysis performed in accordance with the applicable Actuarial Standards of Practice. The Statement of Actuarial Opinion is attached to Page 1 of an insurer’s annual statement to be filed with the state insurance departments. Reinsurance arrangements must be included in the analysis. The actuary must describe the methodology used to measure the effect of reinsurance on cash flows, including assets and liabilities, in the various scenarios tested. The actuary must state if he or she has relied on information provided by another actuary. The actuary providing information must certify the information provided and include a statement as to the accuracy, completeness, or reasonableness of the items as well as providing contact information. The Actuarial Standards of Practice discussed in this chapter provide guidance to the appointed actuary in performing these responsibilities. 1 National Association of Insurance Commissioners. Financial Standards and Accreditation Program. December 2012. 2 See the NAIC’s website at www.naic.org and the websites of the various state insurance departments. 3 National Association of Insurance Commissioners. Actuarial Opinion and Memorandum Regulation, MDL 822-1. April 2010.

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Life and Health Reinsurance Agreement Model Regulation4 This regulation prohibits a ceding company from taking reserve credit for reinsurance if any one of eleven conditions exists.

1. Renewal allowances do not cover renewal expenses. 2. The reinsurer can deprive the ceding company of assets under certain circumstances. 3. The ceding company is required to reimburse the reinsurer for losses, with certain

exceptions. 4. The ceding company is required to recapture at a specified time. 5. The ceding company is required to pay amounts above those realized from the

policies. 6. The agreement fails to transfer significant risk. 7. Asset risks are significant to the underlying policies and are not transferred or

segregated in a special account. 8. Settlements are made less frequently than quarterly or not paid within 90 days. 9. The ceding company must make guarantees not related to the reinsured business. 10. The ceding company must guarantee the future performance of the business. 11. The agreement is expected to be temporary and does not transfer significant risk.

This regulation includes other significant provisions; failure to meet all of the following conditions can result in the loss of reserve credit.

1. The reinsurance agreement or a letter of intent must be signed by both parties prior to the date of the financial statement for which reserve credit is taken.

2. If a letter of intent is used, the final agreement must be signed by both parties within 90 days of the signing of the letter of intent.

3. The reinsurance treaty must be the entire agreement; there can be no additional understandings or conditions and no side letters.

The discussion of this regulation often revolves around the allowance of ceded reserve credits. Any other enhancement of the ceding company’s surplus, such as taking credit for funds withheld by a reinsurer, should be viewed in the same manner as reserve credits. Failure to pass these tests could result in regulatory action to disallow such credits or requirement for the ceding company to establish additional liabilities. Note that the downside of not meeting the terms of this regulation fall on the ceding company. The reinsurer, most likely, will need to establish liabilities as expected. Credit for Reinsurance Model Regulation5 This regulation defines the criteria a reinsurer must meet in order for a ceding company to take credit for reinsurance ceded to that reinsurer. If the reinsurer does not meet the criteria, the regulation provides that the reinsurer must provide some sort of security in the form of a trust or letter of credit in order for the ceding company to take reserve credit. The regulation

4 National Association of Insurance Commissioners. Life and Health Reinsurance Agreements Model Regulation, MDL 791-1. October 2002. 5 National Association of Insurance Commissioners. Credit for Reinsurance Model Regulation. MDL 786-1, January 2012.

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describes the standards for the security. This regulation also requires that the reinsurance treaty contain an insolvency clause in order for the ceding company to take the ceded reinsurance reserves credit. Mirror Image Reserves Although the NAIC has attempted to create consistency in regulation, reserving requirements may differ. There are instances when a ceding company may be required to hold larger reserves than the reinsurer. Some states have a “mirror image” reserve requirement that does not allow the ceding company to reduce its reserves by an amount greater than the reserves the reinsurer holds. The ceding company may be able to negotiate with the reinsurer to have the reinsurer hold the higher reserves. Even if both companies are using the same reserve basis, there will be differences in reserves because of reporting delays between the companies. In any case, in a mirror image situation, the ceding company must communicate with the reinsurer prior to the end of the reporting period to agree on the amount of the reserve credit. Principle-Based Accounting The NAIC has established the Principle-Based Accounting (PBA) Implementation Task Force.6 The PBA system is still under development and is scheduled for implementation in 2017. It is anticipated that the reserves for reinsurance ceded and assumed will be based on principles similar to those for direct insurance, reflecting the underlying risks actually reinsured. The specifics of special interest for reinsurance, such as reserve ceded credits and handling of rate increase clauses, are still in development.

ACCOUNTING STANDARDS The NAIC’s Accounting Practices and Procedures Manual currently sets out approximately 100 Statements of Statutory Accounting Insurance Principles (SSAP) and the Actuarial Standards Board sets out 47 Actuarial Standards of Practice (ASOP) to provide guidance to actuaries in the performance of their duties. Statement of Statutory Accounting Principles-61R SSAP 61R—Life, Deposit-type and Accident and Health Reinsurance (SSAP-61R) contains the accounting standards used for life and health reinsurance. This SSAP has two appendices: A-785 Credit for Reinsurance and A-791 Life and Health Reinsurance Agreements. These appendices contain the model regulations stated in the same name. An exposure draft of SSAP-61R was sent out in 2012 for comments. New language was inserted to cover reinsurance ceded to certified reinsurers. SSAP 61R requires reinsurance treaties to transfer risk in order to receive reinsurance accounting treatment. If a treaty does not transfer sufficient risk, as defined in the SSAP, the accounting for that treaty must follow deposit accounting guidelines; the ceding company is unable to take full reinsurance reserve credit or more likely no credit at all. Non-proportional reinsurance must be assessed to determine what, if any, risk transfer occurs. Any feature in

6 http://www.naic.org

U.S. STATUTORY ACCOUNTING 367

the agreement that delays the timing of the reimbursement to the ceding company violates the conditions for reinsurance accounting. The ceding company generally has the primary obligation of reporting reinsurance inforce, unpaid premiums, incurred claims, and other reinsurance balances because it has the current status of reinsured policies. There is often a lag in reporting these items to the reinsurer requiring the reinsurer to make estimates. Reinsurance premiums, commissions, allowances, benefits, reserves, and other amounts should be reported separately on the balance sheet. Assets. Reinsurance assets must meet the definition of assets in SSAP 4-Assets and Nonadmitted Assets to be considered to be admitted assets. Companies can follow defined procedures to have the NAIC declare a specific asset to be admitted and give the asset a rating. Premiums. Special rules are set out for premiums collected but not remitted to the reinsurer and advance premiums paid to the reinsurer. If the first year allowance exceeds the first year premium, the allowance is accounted for on a cash basis, but if there is a chargeback based on persistency, the amount subject to potential chargeback must be recorded as a liability. If renewal allowances do not cover renewal expenses, a liability for the present value of the shortfall must be established. Non-proportional Reinsurance. Most non-proportional reinsurance is written on an annual premium basis. If the agreement is for more than one year, the agreement must be reviewed to ascertain if it is proportional or non-proportional reinsurance. In order to get a reserve credit for non-proportional reinsurance, the ceding company must demonstrate that the present value of expected recoveries exceeds the present value of unearned reinsurance premiums. Mod-co. If a treaty provides modified coinsurance, the ceding company retains the assets equal to the modified coinsurance reserves. Both parties report premiums, allowances, and benefit payments normally. The ceding company holds the reserves on its balance sheet and the assuming company reports no reserves. The mod-co adjustment is reported in the summary of operations. Funds Withheld. Any amounts withheld by the ceding company are recorded as a liability on its accounts; the ceding company also records any interest amounts due and payable in the aggregate write-ins for miscellaneous deductions in its annual statement. The reinsurer records funds withheld by the ceding company as an accounts receivable and records any interest earned or receivable in the aggregate write-ins for miscellaneous income on its annual statement. Certified Reinsurers. The reinsurance treaty must contain a clause requiring the certified reinsurer to provide security in the amount necessary based on its rating in order for the ceding company to take reserve credit. The “net obligation” subject to collateral from the certified reinsurer equals the sum of:

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1. The reserve credit taken including the Interest Maintenance Reserve (IMR) adjustment, if any, plus

2. Claim liability credits taken, plus 3. Other asset increases or liability decreases from recoverables, less 4. Amounts due to the reinsurer.

The “net liability” is the “net obligation” less the “net obligation” times the ratio the amount of collateral provided divided by the amount of collateral required based on the reinsurer’s rating. A change in net liability is a charge or a credit directly to surplus. Unauthorized Reinsurers. If the reinsurer is not authorized; the ceding company may take reserve credit if the reinsurer puts up collateral that meets the requirements of Appendix A-785. The ceding company must set up a net liability equal to:

1. The reserve credit taken, including the IRM portion, plus 2. Claim Liabilities taken, plus 3. Other asset increases or liability decreases for amounts recoverable, less 4. Funds withheld or deposits pledged as security in compliance with Appendix A-785,

less 5. Recoverables covered by letters of credit in compliance with Appendix A-785, less 6. Amounts due the reinsurer.

Interest Maintenance Reserve. The IMR is used to accumulate realized capital gains and losses resulting from assets sold. These amounts are amortized into income and shown as an adjustment to the net investment income, essentially placing investment income in the years it would have occurred had the company not sold the assets. Following the guidance of Paragraphs 45 - 47 of SSAP 61, after-tax interest-related gains or losses derived from assets sold or transferred with the sale, transfer, or reinsurance of a block of business is credited or charged to the IMR. In reinsuring inforce blocks of policies or in assumption, it may be appropriate for the existing IMR balance relating to assets backing the inforce policies and the amortization of that IMR balance to be transferred to the new company. Methodology related to the calculations may be found in the Calculation Form, line 3 of the NAIC Annual Statement instructions. Gains and Losses on Indemnity Reinsurance. For indemnity reinsurance of an inforce block (policies issued prior to the effective date of the agreement), the accounting is described in Appendix A-791, paragraph 3. In the first year, any surplus gain is reported as commissions and expense allowances. Any increase in surplus net of federal income taxes should be separately identified as “Change in Surplus as a Result of Reinsurance” in the Capital and Surplus account. The paragraph states, “Recognition of the surplus increase as income shall be reflected on a net of tax basis as earnings emerge from the business reinsured.” This recognition process is relatively straightforward for the party doing the policy administration. It is important that the reinsurance agreement stipulate data information details that will be needed for the other

U.S. STATUTORY ACCOUNTING 369

party to meet its reporting requirements. Any losses on inception of a treaty are to be recognized immediately on the normal itemized lines. Recapture and Terminations. Commuted, recaptured, or terminated amounts are written off in all the accounts, exhibits, and schedules. Reserves, reserve credits, and any receivables or unearned amounts are eliminated; the terms of the cash and entries vary by contract. In essence, all balances are written to zero, any other amounts flow through the gain and loss statement, and any net gain or loss on the recapture is thus fully reflected. Any special adjustments or entries are also zeroed out, except for any net effect on the IRM due to asset sales or transfers related to the recapture, commutation, or termination event. This treatment is true for both ceding companies and reinsurers. Deposit Accounting. Deposit accounting is used for reinsurance when there is no or insufficient risk transfer for the treaty to be accorded reinsurance accounting treatment. The net consideration is recorded as an asset by the payer and a liability by the receiver. All transactions are recorded through the asset/liability accounts. Income and losses are recognized only when both the income or loss has been earned and the other party has no recourse to repayment in the future. At the end of the contract, any difference between the initial consideration and the amounts recovered is recoded as a miscellaneous income or loss. Assumption Transactions. All assets and liabilities associated with the assumed policies are grouped together and the total is called the “net policy liabilities.” In most circumstances, the transferring, or original, company will have a net gain. If the policies are mature with large reserves, the transferring company may have to transfer cash or assets. If the policies have small liabilities, the assuming company may pay some cash amount. Once the policies are transferred to the assuming company, according to the terms approved by state regulators, the transferring company recognizes the gain or loss immediately. The gain or loss is the book value of the difference between the assets and liabilities. The assuming company values the assets at the fair market value as of the date of transfer and the liabilities according to applicable statutory requirements. If liabilities exceed assets, the difference is called “goodwill” and is amortized over the life of the policies, but not exceeding 10 years. Goodwill is initially a non-admitted asset and follows the treatment prescribed in SSAP-68-Business Combinations and Goodwill. Under certain conditions, some or all goodwill can become an admitted asset. If assets exceed liabilities, the assuming company records a deferred liability and amortizes the amount into the operations over 10 years. If assumption or the reinsurance of an inforce block that occurs between affiliated companies is not an economic transaction, neither party recognizes a gain or loss. Statutory liabilities are transferred without adjustment. The assuming company amortizes the transferred IMR at the same rate the ceding company would. If the value of the assets transferred differs from the value of the liabilities, the ceding and assuming companies will defer and amortize the difference as if it were a non-affiliated transaction.

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Actuarial Standard of Practice No. 117 Actuarial Standard of Practice No. 11 (ASOP No. 11), entitled Financial Statement Treatment of Reinsurance Transactions in Life or Health Insurance Company, provides guidance not only for statutory, but also for GAAP and other financial statements. It was originally issued in 1989 and was revised in 2005. The standard defines net statement liabilities to be the reserves, net of reinsurance reserve credits, plus any other liabilities, such as amounts due reinsurers, less any other assets arising from reinsurance transactions, such as amounts receivable from reinsurers. In GAAP accounting, the deferred acquisition cost asset is part of the net liability reviewed by the valuation actuary. ASOP No. 11 holds that it is the responsibility of the ceding company and the reinsurer to establish net statement liabilities for their respective obligations. These net statement liabilities must satisfy all legal, accounting, and valuation requirements for the accounting system under consideration. These liabilities must also make appropriate provision for all unmatured obligations according to the actuary’s best estimate of future experience. The net statement liability of the ceding company plus the net statement liability of the reinsurer may be more or less than that which the ceding company would hold if no reinsurance had taken place. ASOP No. 11 provides that the actuary should perform all of the following tasks regarding the business for which he or she is providing an opinion.

1. Review all the material financial features of the reinsurance agreements and recognize all risks transferred;

2. Consider all of the cash flows that have a material impact, including any non-proportional features or termination provisions;

3. Determine adjustments to reinsurance ceded items that are consistent with the calculation of the corresponding direct items except as dictated by the terms of the treaty;

4. The ceding company actuary should calculate the adjustment for reinsurance ceded. 5. The reinsurance company actuary may use different assumptions for GAAP. 6. Review the termination provision; 7. Consider additional liabilities that need to be established such as in the case where

the reinsurer has the right to raise reinsurance premiums without providing for the ceding company to raise premiums or terminate the agreement;

8. Consider all applicable regulations; 9. Consider if the agreement qualifies as reinsurance under statutory or GAAP

accounting; 10. Refer to ASOP 23 for guidance when relying on data supplied by others; and, 11. Document the methods, assumptions, procedures, and sources of data.

7 Actuarial Standards Board. Actuarial Standard of Practice No. 11 Financial Statement Treatment of Reinsurance Transactions involving Life or Health Insurance. June 2005. Updated for Deviation Language effective May 1, 2011.

U.S. STATUTORY ACCOUNTING 371

The actuary should refer to ASOP No. 23 and ASOP No. 41, summarized as follows, concerning actuarial communications and disclose any unresolved concerns about the information as well as the extent of reliance on data supplied by others. The actuary should disclose information described in ASOP No. 41. Actuarial Standard of Practice No. 238 The purpose of ASOP No. 23 is to provide the actuary with guidance regarding selecting data, relying on data provided by others, reviewing data, using data, and making the appropriate disclosures regarding data quality. It does not require the actuary to audit data. This ASOP went into effect in 2004. The reinsurer is expected to obtain or maintain data in sufficient detail to be able to assure the regulators, as well as other stakeholders, that the financial statements are correct. It is, therefore, important to establish and maintain sufficient administrative standards to satisfy the needs of data quality. Data quality affects the ability of the reinsurer’s valuation actuary to place a reasonable value on the reserves. It also affects the various accounting staff members and senior management as they are required to certify the accuracy and completeness of the reinsurer’s files and records. The need for reliable data of high quality is the joint responsibility of the reinsurer and the ceding company. The ceding company clearly needs this data for its own financial reporting. Most reinsurance treaties provide requirements for ceding company data, but the ceding company also has an ethical obligation to provide timely, complete, and accurate data. The ASOP recognized that available data is rarely perfect and that the limitation of the data should be disclosed. The actuary should consider the scope of the assignment and the intended use of the analysis. In selecting data, the actuary should consider the following points.

1. The appropriateness of the data for the intended purpose, 2. The comprehensiveness and consistency of the data, 3. Any known limitations, 4. The cost, feasibility, and availability of alternative data, 5. The benefits gained by alternative data, and 6. Any sampling methods used to collect data.

If data is supplied by others, this must be disclosed. The validity of the data is the responsibility of the party providing it. The actuary should, however, review the data unless he or she feels it is unnecessary or not practical. If the actuary becomes aware of material errors, the actuary must disclose this. The actuary’s review should include a review of the data definitions, identify questionable or inconsistent values, and review against prior data for consistency, if prior data is available. The actuary is not required to determine if the data is falsified or intentionally misleading or audit the data. 8 Actuarial Standards Board. Actuarial Standard of Practice No. 23 Data Quality. December 2004, updated for deviation language effective May 1, 2011.

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Actuarial Standard of Practice No. 419 This ASOP provides guidance in actuarial communication. The following items should be disclosed in any actuarial communications.

1. The identity of the responsible actuary; 2. The identity of the actuarial documents including the data, subject, and version; 3. Disclosures regarding any of the following:

a. Intended users, b. Scope and purpose of assignment, c. Qualification standards, d. Cautions, e. Limitations or constraints on applicability of the findings; f. Conflicts of Interest, g. Information relied on by the actuary, or h. Other pertinent information;

4. Assumptions or methods prescribed by law; and 5. Responsibility for assumptions and methods.

BALANCE SHEET

Pages 2 and 3 of the Annual Statement Blank summarize the assets, liabilities, and surplus and other funds for life insurance companies. A special provision is made for reporting certain reinsurance items.

ASSETS Invested assets are normally not affected by the presence or absence of reinsurance. Assets held on behalf of a reinsurer are usually reported as part of other assets of that generic type. Coinsurance treaties usually provide that the reinsurer will not participate in policy loans. Should the reinsurer share in policy loans, however, it would include the appropriate amount with its direct policy loans. An interesting question arises concerning the treatment of such policy loans on the ceding company’s statement. There is no specific provision for reduction of this asset even though coinsurance reserves are specifically deducted from the gross reserves in Exhibit 5. The most common treatment for a ceding company in this situation is to show the net policy loan asset; this would be the gross policy loans less those funded by the coinsurer. Any amounts due from reinsurers to a ceding company are summarized on Page 2. The reinsurance-specific items on Page 2 include the following.

1. Amounts recoverable from reinsurers reflects the reinsured portion of benefits which have been paid by the ceding company but have not yet been reimbursed by the

9 Actuarial Standards Board. Actuarial Standards of Practice No. 41 Actuarial Communications. December 2010.

U.S. STATUTORY ACCOUNTING 373

reinsurer or amounts that are a result of a lag in processing. Allowances withheld on certain transactions may also be included here.

2. Funds held by or deposited with reinsured companies represent amounts which are withheld by a ceding company, say in a funds withheld coinsurance or similar treaty, and payable to the reinsurer. It is held as an asset to offset the corresponding reserve liability.

3. Other amounts receivable under reinsurance contracts may include experience refunds which are normally calculated and paid after the end of the year or allowances not yet paid. Detail by reinsurer for these items is given in Schedule S and is repeated in the Exhibit of Non-Admitted Assets.

Assets held in segregated accounts or protected cell accounts are reported separately near the bottom of the assets page. The effects of any reinsurance transactions are included in the net amounts shown. If the ceding company pays premiums to the reinsurer in advance of the due date of the premiums, the ceding company would reflect this amount as a write-in admitted asset and would not recognize the amount on the income statement until the due date. The treatment of assumed reinsurance is usually straightforward, as most items are treated the same as for direct insurance. Any invested assets are reported with other such assets. Any amounts due the reinsurer are reported on the appropriate line.

LIABILITIES In general, liability items are developed on a net basis with reference to reinsurance ceded. Liabilities arising from reinsurance assumed are treated just as though they arose from direct insurance policies, unless otherwise specified. The aggregate reserve for life policies and contracts is shown net of reinsurance ceded, as is the reserve for accident and health policies, and the reserve for deposit type contracts. The amount of Mod-co reserves included in each category is highlighted. The derivation of these amounts is discussed in more detail subsequently in the discussions of Exhibits 5, 6, and 7. The amounts shown for Contract claims on life and accident and health policies are shown net of amounts recoverable from reinsurers. Reinsurers rarely participate in dividends or policy loans, but if they do, the amounts should be shown net of reinsurance. Commissions and expense allowances due on reinsurance assumed are shown on a separate line. If a reinsurer receives premiums in advance of the due date, it would record the amount as a liability in Premiums and annuity considerations for life and accident and health contracts received in advance. This premium is not included in premium income until the due date. Recognition is given in separate lines to Reinsurance in unauthorized and certified companies, Funds held under reinsurance treaties with unauthorized and certified reinsurers, and Funds held under coinsurance.

374 CHAPTER 13

Reinsurance in unauthorized and certified companies is the net amount of reserve credit taken in Exhibit 5 for reinsurance placed with unauthorized companies in excess of the amount of funds withheld, trusteed assets, letters of credit, and other funds held for the benefit of the ceding company. Details are shown in Schedule S. The effect of this liability is to reverse any credit for reinsurance ceded taken in the reserve items above if the reinsurer is unauthorized and no security is provided. The appropriate reserve liability reflects the reinsurance if the treaty offers valid risk transfer, but an additional liability is required due to unauthorized status. In some ways, this liability can be considered to be earmarked surplus. If the reinsurer deposits assets to secure the reserves, an offsetting asset is shown on Page 2, offsetting the decrease in surplus of the same amount of disallowed credit. The treatment of reinsurance ceded to unauthorized companies can be somewhat confusing, so consider an example where coinsurance is ceded to an unauthorized reinsurer. The ceding company takes a reserve ceded credit in its Exhibit 5 net reserve liability calculation. It then establishes a liability for that same amount for Reinsurance in unauthorized companies. If funds are deposited with the ceding company, it establishes an asset for the amount of the deposit, but not exceeding the value of the assets. In this example, the net effect on the ceding company’s surplus is the same as coinsurance with an authorized reinsurer, assuming the value of the deposited funds at least equal the reserve credit taken. The annual statement geography and audit trail are significantly different. Funds held under reinsurance treaties with unauthorized and certified reinsurers is the total amount from Schedule S excluding letters of credit and trust agreements, to the extent that these funds were included as part of total assets on Page 2 or not offset by a directly related credit asset on Page 2. This liability deals with deposits made by reinsurers to provide reserve credit. Reserve credit is taken in the appropriate liability item, but in this instance, assets are also given to the ceding company to secure the credit. Thus, the ceding company has decreased liabilities but also has increased assets due to the deposits. The purpose of this line is to avoid double-counting the effect of the transaction in surplus. Mod-co avoids this need as reserve liabilities are not reduced when the assets are paid to the ceding company. Only deposited assets are included in this account. Letters of credit and trusts are not shown as assets on Page 2 of the ceding company’s annual statement because the ceding company does not establish an additional liability for these amounts.

SUMMARY OF OPERATIONS

The Summary of Operations is shown on Page 4 of the convention blank and the Analysis of Operations by Line of Business is shown on Page 6. The comments which apply to Page 4 also apply to Page 6.

INCOME ITEMS The Premiums and annuity considerations and Considerations for supplementary contracts with life contingencies include premiums on reinsurance assumed and are net of premiums

U.S. STATUTORY ACCOUNTING 375

on reinsurance ceded. Amounts must agree with Exhibit 1, Part 1. Commissions and expense allowances on reinsurance ceded are shown on a separate line as are the Commissions and expense allowances on reinsurance assumed. The Amortization of Interest Maintenance Reserve will include amounts credited, charged, or transferred to the IMR as a result of the sale, transfer, assumption, or reinsurance of a block of business. These amounts are excluded from Net realized capital gains. Reserve adjustments on reinsurance ceded normally reflects the modified coinsurance adjustment due from the reinsurer. One should remember that this item includes the increase in reserve less the appropriate investment income credited to the reinsurer. This may be viewed as balancing other income items; the investment income portion of the modified coinsurance adjustment is included in the ceding company’s net investment income on line 4 and the reserve increase is included in the amount shown on line 17. The aggregate write-ins for miscellaneous income is somewhat flexible in application and may be used for a variety of reinsurance related items such as experience refunds and the interest adjustment in Mod-co assumed. Some companies use this line to include allowances on annuity deposits or for initial allowances when blocks of inforce business are ceded. Experience refunds earned are generally included here.

BENEFIT AND EXPENSE ITEMS All incurred benefit payments and increases in aggregate reserves are reported net of reinsurance ceded, including that ceded in unauthorized companies, and inclusive of reinsurance assumed. Expenses include reinsurance ceded and assumed expenses. Commissions and expense allowances exclude commissions on reinsurance ceded and assumed. Commissions and expense allowances on reinsurance assumed are shown on a separate line.

CAPITAL AND SURPLUS ACCOUNT The Capital and Surplus Account is shown on Page 4 following the Summary of Operations. A reconciliation of the change in capital and surplus funds for the year is provided. The effects of reinsurance, as reflected in the Summary of Operations, are included in the net income. Reinsurance normally does not change surplus directly. Instead, the effect of reinsurance on each of the various liabilities and assets will affect the level of surplus. In the absence of other events, if a reinsurance transaction causes an asset to increase or a liability to decrease, surplus will increase. Likewise, a transaction which causes an asset to decrease or a liability to increase will cause surplus to decrease. There are two exceptions to this treatment. The first is for the Change in liability for reinsurance in unauthorized and certified companies. Recognition is given here to directly reflect this amount in surplus and not the Summary of Operations. The second exception is made in the case of indemnity reinsurance of an inforce block in the first year of the transaction. The portion of the initial gain equal to the pre-tax effect of the

376 CHAPTER 13

gain in surplus is reported as a Commissions and expense allowances on reinsurance ceded line of the Summary of Operations. The tax liability will flow through the Federal income taxes incurred line of the Summary of Operations. Thus, the entire after-tax surplus gain on the effective date of the agreement goes directly to surplus without passing through the Summary of Operations. The increase in surplus net of federal income taxes is recognized in the Change in surplus as a result of reinsurance line. The treatment for renewal periods is to recognize the gains through the Summary of Operations as they would have been without the reinsurance, less any cost of reinsurance accruing in that accounting period and any different tax effects. This amount, roughly, is the sum of the after tax gains on the business, assuming no reinsurance had occurred, less any cost of reinsurance plus any experience refunds credited to the ceding company. This amount is entered as Commission and expense allowance on reinsurance ceded. The experience refund is reported as an Aggregate write-in for miscellaneous income. The negative of the amount entered as an expense allowance is entered in the write-ins line of the Capital and Surplus Account. In effect, the portion of the surplus earned in that year is transferred from surplus and recognized in earnings. There is no similar effect in the reinsurer’s Capital and Surplus Account. All items are reflected in the appropriate line of the Summary of Operations and the net effect enters into the Capital and Surplus as part of the company’s overall gains and losses. The Aggregate write-ins for gains and losses in surplus line may be used for a variety of reinsurance related items. Experience refunds incurred by reinsurers, for example, may be included here, as might amounts incurred under modified coinsurance adjustments. Or ceding companies may use this line to reflect the amount of reserves transferred to reinsurers under an agreement covering an inforce block of insurance for surplus relief, rather than recording this as premiums and considerations.

Reinsurance seldom has a direct influence on the other items of the capital and surplus account, except in special circumstances.

CASH FLOW

The Cash Flow Analysis appears on page 5. All reinsurance items should be reflected on or embedded in the appropriate lines as cash actually received or disbursed, for both ceded and assumed reinsurance transactions. Since incurred and non-cash items are not shown in this analysis, there may be significant differences in the amounts shown relative to the corresponding items in the Summary of Operations. Amounts withheld, for example, are not included in the cash flow reporting.

625

24

MANAGING REINSURANCE Risk management is an important function for all insurance companies and reinsurance plays a significant role in managing risks. The evolution of the reinsurance market has created needs to actively consider, review, manage, and sometimes modify existing agreements for regulatory, financial, administrative, and risk management reasons. Unfortunately, the tendency of both ceding companies and reinsurers is to give treaty maintenance a low priority. Managing reinsurance is a broad topic. This chapter focuses principally on risk management issues such as retention limits, recapture, new business considerations, and evaluating counterparty risk. Administration and treaty management are discussed in separate chapters. In Canada, risk management is part of the formal supervisory framework. OSFI describes its expectations in the Guideline: Corporate Governance: Sound Business and Financial Practices.1 The Guideline includes the establishment of a board approved risk management framework, a risk appetite statement, a board risk committee, and the position of a Chief Risk Officer to oversee all relevant risks. The Canadian model represents good business practice as part of an insurance company’s enterprise risk management framework. The U.S. does not have the same regulatory guidelines. The Risk Management and Own Risk Solvency Assessment Model Act2 went into effect January, 2015, but it only applies to very large companies. Still, all companies should consider the effect of reinsurance on profitability, retained risk, counterparty risk and recoverability considerations, administrative accuracy, and administrative expense. This chapter looks at sound business practices in managing reinsurance from the perspectives of both ceding companies and reinsurers because they share many concerns and issues. Reinsurance is a relationship in which both parties to an agreement have responsibilities. If both parties understand the needs of the other, future misunderstandings can be avoided. It is also not unusual for an insurer to have both ceded and assumed business.

1 Office of the Superintendent of Financial Institutions. Corporate Governance: Sound Business and Financial Practices, January 2013. 2 National Association of Insurance Commissioners. Risk Management and Own Risk Solvency Assessment Model Act, MDL 505-1, September 2012.

In the past, other than changes for retention increases and possible recapture, both of which were relatively rare, few changes were made to existing agreements. Since the 2008 Financial Crisis, regulators and insurance companies are more aware of the need to manage risks. Insurance company administrative and modeling systems are more sophisticated than they were thirty years ago making analysis easier and more reliable.

626 CHAPTER 24

RETENTION LIMITS

A key factor in any automatic reinsurance program is the retention limit schedule adopted by the ceding company. Each product line has its own retention limits: ordinary life, group life, group health, annuity, disability, long term care, and medical. Companies may use different retention limits for different products and for supplemental or ancillary benefits within a product line. Many companies vary retention limits by issue age or underwriting classification, usually with lower retentions for higher and lower age issues or for more substandard risks. The reinsurer is usually relatively indifferent to these variations as long as they do not exhibit significant antiselection. In some companies, each line of business maintains independent retentions, while others establish a combined or company retention. A combined retention may be used when the company limits its total exposure to an amount less than the sum of the limits of all the lines. A company may, for example, have a $500,000 limit each for individual life insurance and group life insurance, but have a company limit of $750,000 per insured life. If the company already had $350,000 of retention on an insured under a group policy, it would retain a maximum of only $400,000 on an individual policy issued on the same life, not $500,000. Retentions on line of business are allocated on a first-in basis. The key purpose of the retention limit is to allow the insurance company to absorb fluctua-tions in earnings caused by fluctuations in claims without overly depleting surplus. Retention limits normally increase as the size of a company increases, because the probability of fluctuation in the expected amount of claims reduces as the amount of inforce increases. Some companies still found it desirable to maintain lower retention limits as they grew, especially if the issue sizes have not increased. The retention limit reflects the insurer’s risk appetite. Most insurance companies wish to maintain retention limits which balance reinsurance costs against the need for protection from adverse claim fluctuations. Most insurance companies periodically review their retention limits in terms of reinsurance costs and claim fluctuation protection. Four basic analytical approaches are used to evaluate a company’s retention limit:

1. Modeling; 2. Ratio method; 3. Rosenthal’s approximation; and, 4. Pentikäinen’s approach.

These methods range from simple to theoretical. In setting a retention limit, there is no single correct answer, prescribed method, or even current scholarly literature on the subject. Before performing any retention study, it is important to determine the insurer’s overall risk appetite which encompasses many factors which will affect the final decision. Two insurers may appear identical on paper, but may have different retention limits because of different risk appetites.

MANAGING REINSURANCE 627

MODELING Perhaps the most common approach to retention limit determination is the development of models including inforce business and anticipated new business. Given a relatively detailed model and recent mortality experience information, various retention limits can be tested to determine the optimum limit for a company or line of business. In addition, the use of differing retention limits by product can be readily analyzed. Such modeling was not feasible until relatively recently. As cash flow testing emerged as a major requirement for testing reserve adequacy, it became feasible to use the models developed, or modifications thereof, for other purposes. These models should include sufficient detail and cell definition to recognize differences in various reinsurance programs and the distribution of business by original policy plan, issue age, gender, underwriting classes, and size of risks. Different assumptions for mortality, persistency, expenses, and reinsurance costs – indeed for any relevant factors – should be developed as appropriate for the various cells. The effects of different proposed retention limits can be analyzed in this manner. A key element of this analysis is the comparison of the cost of reinsurance versus the cost of mortality, after adjusting for the cost of capital. The total capital required and the return on the capital under various alternative retention limits and reinsurance programs can be reviewed and any limitations of the availability of capital taken into consideration. Simpler models based on just the present values of the cost of reinsurance versus the cost of mortality using expected mortality and persistency, are used by many companies, especially in the analysis of a single plan of insurance. While these models are useful, and could be considered sufficient, they do not give much information regarding the risk associated with variance in the assumptions. Some insight into possible variance can be gained from running the model with a series of different deterministic sets of assumptions. The best models include stochastic scenario generators to explore the effect of different probability distributions and develop confidence intervals around sample retention limits. These models must include detail of variations in mortality and persistency by plan, issue age, gender, underwriting classification, and size of risks. Some companies have been able to adjust their cash flow testing models to determine optimal retention limits. Advantages There are several advantages to using models.

1. This method attaches financial values and confidence intervals to possible retention scenarios that can be understood by senior management and the board of directors in making decisions.

2. Testing multiple scenarios increases information and confidence. 3. Modeling allows analysis of capital effects of ceding more or less risk, as well as the

cash costs. 4. Once a model is developed, it is relatively easy to update to reflect emerging views

of the future and of changes in sales or the distribution of the inforce.

628 CHAPTER 24

Disadvantages The primary disadvantage is the expense of developing a model, especially if the net cost of reinsurance is considered minimal. Modification and simplification of cash flow testing models may reduce the cost significantly. On a practical level, testing expected mortality is simple, but the determination of a distribution of mortality around that expected is much more difficult.

RATIO METHOD The ratio method is the easiest and most practical method to use in evaluating a retention limit increase. It is often a two part process. The company begins by examining the changes in the ratios of the retention limit to surplus, the retention limit to the amount of insurance inforce, the retention limit to premiums, the retention limit to assets, and the retention limit to expected claims since the last retention increase. There are no published or accepted standards or guidelines concerning these ratios. A company rarely would make a radical change in the established ratio unless it had reason to believe that the ratio was unrealistic. The company would consider any changes in risk patterns or reinsurance costs in establishing new ratios. A second part of the frequently performed ratio method process is to review these ratios for peer companies with similar amounts of surplus and inforce and with similar growth patterns. Many companies want to be in a range generally comparable with other companies in their peer group. Advantages The advantages of the ratio method include the following:

1. It is quick and easy and does not involve technical resources. 2. The results are easy to communicate. 3. It is likely that senior management and the board members will want to know how

the proposed limits compare to peers no matter what method is used. Disadvantages The disadvantages include the following:

1. There are no set standards for the ratios. 2. It assumes historic ratios are applicable in the present. 3. It assumes the peer group is a good match. 4. It does not reflect the cost of reinsurance. 5. It does not consider the cost of capital. 6. Competitive pressure may result in higher than prudent retention limits. 7. It is not useful in quota share situations.

The ratio method is a “quick and dirty” method for analyzing retention limits. There is no scientific basis for it, but it is still frequently used because it is easy to understand and communicate. As a practical matter, in the end, the decision to raise retention limits is based on the comfort level or risk appetite of the board of directors.

MANAGING REINSURANCE 629

ROSENTHAL’S APPROACH Rosenthal’s Approach has rarely been applied in life insurance practice due to the volume and complexity of the calculations; today’s modeling and computing capacity make the approach feasible if application is desired. A basic concept behind individual risk theory is that, in a group of insured lives, a claim probability can be associated with each life, and the amount of the claim is known in advance. The claim probabilities may change over time, but the probability of a claim for one member of the group is independent of the claim probability for another member. The gain or loss on any given policy in any given period is the basic random variable. The total gain on the portfolio is equal to the sum of the gains of the individual policies. This distribution of gains is assumed to follow the normal curve. Assume there are z

xn policyholders in a group of N insured lives with amount of insurance Z and probability of dying during the year of .xq It follows that 1 .x xp q Ignoring interest and lapses, the net premium for any policyholder is the expected value of a claim, .xZq If the policyholder survives, the gain is ;xZq if he dies, the loss is .x xZ Zq Zp The expected value of the gain for one policyholder is ( ) 0.x x x xE gain Zq p Zp q The variance of the gain for one policyholder is

2 2

2 2

2

2

( ) ( ) ( )

( ) ( )

( )

.

x x x x

x x x x

x x x x

x x

V gain Zq E gain p Zp E gain q

Zq p Zp q

Z p q q p

Z p q

The expected value of the gain for all z

xn members of the cell with amount of insurance Z and probability of dying xq is equal to the summation of all the expected gains for each individual, or zero. The variance of the cell gain is equal to the sum of the variances:

2

( ) ( )

.

zxn

zx x x

V cell gain V gain

Z n p q

The variance of the class gain, where Z is fixed and x varies, is equal to the sum of the variances:

For more information about risk theory, the reader is referred to Bowers, Actuarial Mathematics (Schaumburg: Society of Actuaries, 1997) and Camilli, Duncan, and London, Models for Quantifying Risk (Winsted: ACTEX, 2014).

630 CHAPTER 24

2

( ) ( )

.x

zx x x

x

V classgain V cell gain

Z n p q

The variance for the total portfolio of N lives is equal to the sum of the variations over all amount classes Z:

2

( )( )

.Z

zx x x

Z x

V class gainV total gain

Z n p q

This involves a great many calculations, one for each policyholder. Rosenthal3 developed an approximation for the variance. Let 2

R represent Rosenthal’s approximation, given by

22 ,z zR

Z

Z N qNpq Nq

where ,z

xZ x

N n

,zz x

xN n

q average value of xq over the entire portfolio, and

zq average value of xq over amount class Z. The Rosenthal approach involves estimating the variance in the amount of claims in a portfolio which would be in excess of the retention limit. The variance calculated can be used to determine the size of the risk reserve or claim fund necessary to absorb claims with a certain probability. The Rosenthal approximation states that the approximation is conservative if, as is believed to be the case, there is a positive correlation between the series of Z’s and the associated q’s; that is, if the approximation of the variance tends to be larger than the actual variance. As such, the probability that claims do not exceed a certain value based on the approximation tends to be less than the actual probability. There is no guarantee, however, that this relationship will be true in every case and the results may obviously not be appropriate if a normal approximation is not appropriate. Furthermore, events may not be independent, which also affects the actual results as compared to those modeled. For a given retention limit, the Rosenthal approximation can be used to calculate the probability that actual claims do not exceed those expected by a predetermined amount. This

3 I. Rosenthal. “Limits of Retention for Ordinary Live Insurance.” RAIA, XXXVI. 1947.

MANAGING REINSURANCE 631

predetermined amount is the maximum claim loss4 the company is willing to absorb in any year. When using the Rosenthal approximation, one question that needs to be addressed by management is “What is a suitable level of safety?” Is a 95% level sufficient? Is 99% sufficient or too conservative? Advantages of the Rosenthal Approximation The advantage of the Rosenthal approximation is that it assigns a value to the probability that losses in a year will exceed the fund provided for this loss. Management can use this information in its decision making process. Disadvantages of the Rosenthal Approximation There are three major disadvantages:

1. The calculation is nontrivial. 2. The results may be difficult to interpret. 3. The implications may be difficult to communicate to nontechnical management.

PENTIKÄINEN’S APPROACH As is the case of the Rosenthal approximation, the Pentikäinen approach is seldom used in practice and is provided here to demonstrate the use of ruin theory in risk management. The Theory of Pentikäinen Approach Pentikäinen5 investigated the retention limits of Finnish insurance companies to study the probability of ruin within one year. This approach uses ruin theory to evaluate a retention change. Ruin theory is used to estimate the probability that claims will exceed the claim fluctuation fund or risk reserve. The risk reserve at time t, denoted ( ),U t is defined as

( ) ( ) ( ),U t u K t m X t where

u initial risk reserve at 0,t ( )K t net risk premium expected claim amount, m security loading where m is the expected number of claims and is the

security loading factor (addition to net premiums), and ( )X t aggregate amount of claims, a random variable.

Further, if 1p is the first moment of the claim function, or the average claim amount, then

1mp is the expected amount of aggregate claims, or ( ).K t 4 In this analysis, “loss” can be considered to be any unfavorable claims deviation, or the excess, if any, of actual claims over expected claims. 5 T. Pentikäinen, “On the Net Retention and Solvency of Insurance Companies,” Skand Aktur, J., XXV (1952).

For more information about ruin theory, the reader is referred to Bowers, Actuarial Mathematics (Schaumburg: Society of Actuaries, 1997) and Camilli, Duncan, and London, Models for Quantifying Risk (Winsted: ACTEX, 2014)

632 CHAPTER 24

For the purpose of this illustration, the following definitions will be used:

M retention limit

u initial risk reserve on January 1

(1)K net risk premiums or expected claims

( ,1)U u probability of ruin within one year

For various portfolios of insurance, Pentikäinen plotted the logarithm of the ratio of the retention limit to mean claim amount, 1,M p against the logarithm of j, where

1/21

.(1)

u mjp K

Pentikäinen discovered that for a given value of the probability of ruin, the curves for the various portfolios were fairly close together for values of 1,M p up to 50. Assuming a 1% chance of ruin within one year, he found that the straight line

1 1

1log log log 1.9 log 1.92

uM Mj p p

would give a conservative, or lower, value of M than the actual curves. It then follows that

1/2

1/21

1

log log 1.9 ,1

u + m M pKp

so that

1/ 21/ 2 1.9 ,

(1)u m MK

and 1/ 2

,4 (1)u mM K

or 2 .4 (1)u mM K

If M is at least fifty times the average claim amount, and there are at least 500 expected claims, Pentikäinen estimated the error in his formula to be 10-30% and seldom more than 50%. For any given risk reserve or claim fluctuation fund U, values of M can be developed from the aggregate amount of expected claims and the security loading expressed in terms of the number of expected claims. These values of M can be used in management’s discussions regarding a retention limit increase.