Risk Transfer - What Changes Are On The Horizon? 23/07/2018 Risk Transfer - What Changes Are On The Horizon? Panelist: Marc Oberholtzer - PwC CAS Seminar on Reinsurance June 6-7, 2005 Bermuda

23/07/2018 Discussion Topics An Audit Firm Actuary’s Perspective on Evaluating Risk Transfer Relevant Accounting Guidance Role of Audit Firm Actuary Contracts Where Auditors Request Assistance from Audit Firm Actuary Process used to Evaluate Contracts Determine Substance of Arrangement Evaluate Cash Flows/Scenario Testing Thresholds (e.g., 10/10 rule) Terms/Conditions Requiring Special Consideration Possible Changes to Reinsurance Accounting Activity at the NAIC; Possible Changes for US Statutory Accounting: Increased Disclosure Attestations NY Proposal re: Bifurcation Activity at the FASB

Evaluating Risk Transfer – Process 23/07/2018 Evaluating Risk Transfer – Process Current Relevant US Accounting Guidance US GAAP FAS 113 – Primary US GAAP guidance on Reinsurance Accounting. Para 9a – “Transfer of Significant Insurance Risk” Para 9b – “Reasonable Possibility of Significant Loss” EITF 93-6 – Multi-Year RRC Topic D-54 – Reserve Guarantee Accounting US Statutory SSAP 62 – Similar Guidance to US GAAP; no D-54 Retroactive Exception

Evaluating Risk Transfer – Process 23/07/2018 Evaluating Risk Transfer – Process Role of Audit Firm Actuary The Auditor (i.e., an Accountant) Considers Input from The Audit Firm Actuary in his/her Assessment of Risk Transfer Such Input Includes: A View as to the Economic Substance, as Compared to the Contractual Form, of the Arrangement The Evaluation and Conclusion on Reasonableness of Projected Cash Flows under Contract, Ensuring Appropriate Consideration of Historical Losses, Modeling Assumptions and Contractual Terms The Evaluation of Related Disclosures as Applicable

Evaluating Risk Transfer – Process 23/07/2018 Evaluating Risk Transfer – Process Which Contracts Is the Auditor More Likely to Seek the Assistance of the Audit Firm Actuary? Those with Various Risk Limiting Features. Typically, this includes: Quota Share Contracts with Corridors and/or Sliding Scale Commissions and Loss Ratio Caps Aggregate Stop Loss or Loss Ratio Covers with Premium Payments and/or Profit Commissions Contracts with Experience Accounts or Similar Provisions

Evaluating Risk Transfer – Process 23/07/2018 Evaluating Risk Transfer – Process Which Contracts Is the Auditor Less Likely to Seek the Assistance of the Audit Firm Actuary? Those without Significant Various Risk Limiting Features. Typically, this includes: Most Traditional Excess of Loss Arrangements Quota Share without Risk Limiting Features Most Single Year Catastrophe Covers

Evaluating Risk Transfer – Process 23/07/2018 Evaluating Risk Transfer – Process The Substance of Arrangement Identify the Contract or Contracts being evaluated Obtain and Read Entire Contract and Related Contracts, if any Substance does not Always Follow Form Obtain from the Audited Company an Understanding of the Business Purpose and Substance of the Transaction. Obtain and Review as much Background to the Transaction as Possible Obtain and Review Underwriting Memo, Accounting Memo Risk and/or Risk Transfer Memo In unavailable, there might be control implications and an inability for auditor to conclude on risk transfer

Evaluating Risk Transfer – Process 23/07/2018 Evaluating Risk Transfer – Process Evaluate Company’s Analysis of Cash Flows/Scenario Testing – Subject Losses Conclude on Reasonableness of Company’s Estimates of Loss Estimates, Payout Patterns, and their Variability over Reasonably Possible Scenarios Company’s Selected Mean, CV and Distribution of Subject Losses Based on Company History? Industry Data? Judgment? Payout Patterns How Selected? What is the basis and methodology used to vary the Payout Patterns?

Evaluating Risk Transfer – Process 23/07/2018 Evaluating Risk Transfer – Process Evaluate The Audited Company’s Analysis of Cash Flows/Scenario Testing – Contractual Terms Amount and Timing of Additional Premiums, Commissions, or Related Payments Are all contractual terms considered in the risk transfer calculation? Interaction of Loss Payments with Experience Accounts and/or Funds Held Accounts, including Interest Credits and Charges Determine Impact of Commutation Clauses or Related Terms Obtain Management’s Representation as to its Intentions regarding Such Clauses

Evaluating Risk Transfer – Process 23/07/2018 Evaluating Risk Transfer – Process Evaluate The Audited Company’s Analysis of Cash Flows/Scenario Testing – Interest Rate used to Calculate Present Value Conclude on Reasonableness of Company’s Selected Interest Rate Used to Present Value Cash Flows Ensure that All Cash Flows are Being Present Valued, and at the same Interest Rate Determine the Expected Timing and Duration of Payments based on Cash Flow Analysis Compare Risk-Free Rates at Expected Duration with those used in the Risk Transfer Calculation – modify Calculation as needed to reflect a Risk-Free Rate

Evaluating Risk Transfer – Process 23/07/2018 Evaluating Risk Transfer – Process Common Rule of Thumb – 10/10 Rule 10% chance of a 10% loss (in present value terms) Calculated from the Assuming Company’s perspective The present value of net of cash flows for losses and commissions, divided by The present value of net cash flows for premiums Appears to be the Industry Standard Regarding the Minimum Threshold for Risk Transfer A higher standard may be appropriate There are other considerations What happens at other scenarios? What is the maximum loss to the Company? Does the Company’s suggested accounting reasonably match the substance of the agreement?

Evaluating Risk Transfer – Process 23/07/2018 Evaluating Risk Transfer – Process Some Terms, Conditions or Circumstances that Require Close Scrutiny Multi-Year Arrangements Does Loss Experience under the Contract create Rights for the Assuming Company that need to be considered? Different Interest Rates; For example, Interest Credit on Funds Held Accounts exceeding the Rate used to Present Value Cash Flows The Amount that the Interest Credit Exceeds the Rate used to Present Value Cash Flows is Considered Additional Consideration in the Risk Transfer Analysis Ceding Commission Paid in the Future The Time Value Benefit to the Ceding Company is Considered to be Additional Consideration in the Risk Transfer Analysis Maintenance Fees Expected Amounts Are Present Valued and Considered Additional Consideration in the Risk Transfer Analysis Commutation Accounts Can the Assuming Company Reduce its Losses by Exercising a Right to Commute, and is such Right Considered in the Evaluation?

Industry Update – Possible Changes 23/07/2018 Industry Update – Possible Changes May 10, 2005 NAIC Meeting – Possible Changes to SSAP 62 for Year-end 2005: Increased Disclosure for certain reinsurance contracts Aggregate Stop Loss Quota Share with Limiting Features Many others with Certain Terms/Conditions Attestation from CEO and CFO No Side deals Documentation exists Supporting Risk Transfer and the Economic Intent of All Reinsurance contracts Bifurcation of Certain Contracts Portions of Certain Contracts where there is more than a 90% Probability that Premiums would be Recovered would be Accounted for as a Deposit

Industry Update – Possible Changes 23/07/2018 Industry Update – Possible Changes May 10, 2005 NAIC Meeting – Possible Changes to SSAP 62 for Year-end 2005: A Significant Expectation of Documentation within the CEO, CFO Attestations Expectation by Regulators that Documentation Exists Supporting Risk Transfer and the Economic Intent of All Reinsurance Contracts – Regulators View Lack of Such Documentation as Lack of Compliance with SSAP 62 and the corporate recordkeeping requirements of Foreign Corrupt Practices Act of 1977 (as Amended) . Compliance Would Effectively Require Documentation Contemporaneous with Entering into Transactions

Industry Update – Possible Changes 23/07/2018 Industry Update – Possible Changes May 10, 2005 NAIC Meeting – Possible Changes to SSAP 62 for Year-end 2005: A Significant Proposal – Bifurcation Certain contracts, including quota share with limits, aggregate stop-loss and retroactive potentially subject to bifurcation Bifurcation is the separation of a contract into financing and risk transfer components for accounting purposes Would require actuarial evaluation to estimate/allocate premium and related consideration between the risk transfer and deposit components

Industry Update – Possible Changes 23/07/2018 Industry Update – Possible Changes May 10, 2005 NAIC Meeting – Proposed Bifurcation Possible Benefits An Ability to Better Match The Accounting with a Contract’s Economics Would Likely Eliminate the Benefit, and then eventually the Existence, of Those Contracts Viewed as Problematic by Regulators, Rating Agencies and Investors

Industry Update – Possible Changes 23/07/2018 Industry Update – Possible Changes May 10, 2005 NAIC Meeting – Proposed Bifurcation Possible Concerns Complexity – Bifurcation Could be Very Complicated, in particular for Certain Quota Share Arrangements with Risk Limiting Features Potential Unintended Consequences Change in Structure, Pricing of Traditional Market Bifurcation of Contracts that are not viewed as Problematic or Viewed to have Significant Risk Limiting Features Differences in Accounting between US SAP, US GAAP and other Accounting Bases

Industry Update – Possible Changes 23/07/2018 Industry Update – Possible Changes Other Recent Regulatory Activity New York – Effective March 2005 For Reinsurance Cessions, NY Insurance Department will Require the CEO of companies to attest that: There are No Side Agreements For each Contract, a File exists that Documents the Economic Intent of the Transaction and the Risk Transfer Analysis Evidencing the Proper Accounting Treatment, which is Available for Review. Massachusetts – Effective May 2005 Insurer's Audit Committee Chair will be Required to: Sign Off on any Finite Reinsurance Contracts Certify that there are no Informal or Side Agreements that might affect Transactions

Industry Update – Possible Changes 23/07/2018 Industry Update – Possible Changes Activity at the FASB – Insurance-Risk Transfer Project (April 6, 2005 meeting) Underlying Purpose - to Improve the Accounting for Insurance and Reinsurance Contracts by More Clearly Defining which Contracts or Portions thereof should be Accounted for as Insurance and which Should be Accounted for as Deposits (financings). Objectives: Clarify Transfer of Significant Insurance Risk; Define Insurance Contracts and Codifying related Guidance in current FASB and AICPA literature. Explore Simple Approaches to Bifurcation