Reinsurance (Paper 3A/69A)
The FASB and IASB met for more than two and a half hours to discuss the topic of reinsurance which was originally scheduled to be discussed on 16 May. A reinsurance contract is an insurance contract that an insurer purchases to transfer insurance risk to another insurance company. The paper presented eight staff recommendations which were mostly agreed upon by the Boards. The Staff recommendations were developed considering feedback received from constituents that more details are required on the subject of reinsurance than what was included in the Exposure Draft / Discussion Paper (ED/DP).
Definition of significant risk transfer
The first Staff's recommendation was to add new application guidance to the significant risk transfer test. The guidance states that a reinsurance contract is deemed to meet the definition: "If substantially all of the insurance risk relating to the reinsured portions of the underlying insurance contracts has been assumed by the reinsurer".
Board members from both the IASB and FASB were uncomfortable with the words "substantially all" and, although they tentatively agreed with the principle behind the new guidance, they asked the Staff to refine the wording. Some Board members suggested using similar wording to those in paragraph 35 of the paper - "if the economic benefit to the reinsurer for its respective portion of the underlying policies is virtually the same as the ceding company's economic benefit, then the reinsurer has assumed substantially all the insurance risk related to the reinsurer policies". The Staff also explained that the guidance is effectively a short cut, and that if the "substantially all" condition is not met, the reinsurer would have to perform the full significant risk transfer test.
Both Boards tentatively agreed with the Staff's recommendation, assuming the wording is changed in line with that in paragraph 35 of the paper.
The second proposal from the Staff is for the guidance to be clarified such that an "insurer shall assess the significance of insurance risk contract by contract and that, contracts entered into simultaneously with a single counterparty for the same risk, or contracts that are otherwise interdependent, shall be considered a single contract". Both Boards tentatively agreed with the Staff's recommendation without much debate.
Recognition of reinsurance contract
The Staff recommended that "when the amount recoverable from the reinsurer for a loss on an underlying insurance contract is independent of the losses and recoverable on other underlying insurance contracts, the cedant should recognise a reinsurance asset when the underlying contract is recognised, otherwise the cedant should recognise a reinsurance asset when the reinsurance coverage begins". Although the Boards tentatively agreed with the principle proposed, they asked the Staff to clarify the wording as many found it confusing. The Staff clarified that this guidance should deal with non-coterminous contract covers when the reinsurance contract reinsures a class of insurance contract which may include also contracts that will be issued in future. In these cases if the reinsurance policy is on an aggregate loss basis, a reinsurance asset would be recognised at the effective date of the reinsurance policy. The reinsurance asset would be remeasured to take into account the new reinsurance contracts issued when they are initially recognised.
Ceded risk adjustment
The Staff recommendation is for the "ceded portion of the risk adjustment to represent the risk being removed from the use of reinsurance". In the Staff view, an insurer should arrive at the same answer whether it calculates the ceded risk adjustment based on the gross or net basis and it does not propose to specify the method that should be used to calculate it. The IASB tentatively agreed with the recommendation. The FASB did not discuss this topic given their preference for a composite margin.
Treatment of gains and losses
The Staff recommended a significant change from the ED/DP approach proposing that gains on purchase of reinsurance contracts are not recognised on day one. FASB unanimously supported this recommendation whilst a minority of four members of IASB out of the fifteen present voted against it.
The basis for this approach is that the cedant has not been relieved of the obligation it has reinsured (i.e. the reinsurance does not cause derecognition of the insurance liability) and that it could cancel or commute the reinsurance contract at a later stage. For these reasons, the measurement of the reinsurance assets using the building block approach noted above is reduced by any positive difference from that calculation. In other words, the initial recognition of the reinsurance assets is not greater than any upfront premium paid to the reinsurer to purchase the contract. Both Boards approved this change from the ED/DP and asked to include in the final IFRS that an additional reason to not allow the cedant to recognise a gain on reinsurance purchased is the subjectivity in the measure and the ultimate obligation the cedant has reinsured.
The Staff also recommended a change to the ED/DP when reinsurance protection is purchased by the cedant at a loss on day one (i.e. the building block calculation produces a net negative probability weighted present value inclusive of a risk adjustment asset). The Staff proposed that the ED/DP approach that when the reinsurance contract covers pre-claims liabilities a loss should not be taken to profit or loss immediately and it should instead be amortised over the coverage period as a component of the reinsurance asset. However, this treatment would not be permitted for reinsurance of post-claims liabilities (e.g. retrospective reinsurance) where a negative building block net result would have to be recognised immediately through profit or loss.
Although the FASB members found the language used unclear and over-complicated, they generally agreed with the Staff's recommendation. A very large minority of seven out of fifteen IASB members voted against deferring the loss over the coverage period and expressed a preference for immediate loss recognition also for reinsurance purchased to cover pre-claims liabilities.
Cession of residual / composite margin on underlying insurance contracts
The Staff proposal was that on initial recognition of the reinsurance contract the "cedant shall estimate the present value of the fulfilment cash flow for the reinsurance contract, including the ceded premium and without reference to the residual/composite margin on the underlying contracts, in the same manner as the corresponding part of the present value of the fulfilment cash flows for the underlying insurance contracts". Although one IASB member disagreed, both Boards tentatively agreed with this recommendation without much debate.
The Staff recommended that the "ceding commissions and expense allowances from the reinsurance contract be included in the expected cash flows of the measurement of the liability to the extent that the cedant has included their direct costs in the expected cash flows. Any excess amount should be recorded as a reduction in the ceded premium." There was confusion among Board members on this topic as it was not clear to them whether this was a question of measurement or presentation. The Staff clarified this is related to presentation and the Boards asked the Staff to bring back this discussion when they address presentation in a wider context.
Credit risk of reinsurer
The recommendation from the Staff was that "the cedant record an allowance for the risk of non performance by the reinsurer when estimating the present value of the fulfilment cash flows when the current information and events suggest the cedant will be unable to collect all amounts due according to the contractual terms of the reinsurance contract." The FASB were unanimously in favour of the Staff's recommendation. The IASB on the other hand preferred to rely on the general impairment model that is available in the current literature in IAS 39. This will be reviewed in light of the new impairment model for financial assets once it is finalised.