Two finite products, loss portfolio transfer and per risk excess of loss cover, (see Gregory Peterson, CPCU, "Finite Risk Insurance: Whatizit?" RMQ Volume 10, No. 1, for discussion of these products) have been marketed as financial statement enhancers.

    Specifically, the loss portfolio transfer enables a company to transfer its recorded losses to an underwriter for a premium. The premium typically is a discounted version of these losses. Consequently, to the extent that losses transferred/removed from the balance sheet exceed the premium, a gain is recognized for financial statement purposes in the fiscal year the transfer is executed.

    The per risk excess of loss cover, on the other hand, permits the company to spread and finance the excess losses (the infrequent, moderate to high severity losses) over time. While the plan stabilizes cash flow, stabilization of earnings is questionable at best. The program's architects attempt to sprinkle the scheme with some element of risk transfer typically in the form of charging a premium which is a discounted version of the policy limits and/or minimal aggregate cover.

    The objective is to exhibit "indemnification" of the insured by the insurer/reinsurer. The program then would allegedly satisfy paragraph 44 of FASB 5. This axiom dictates that to the extent the contract does not, despite its form, provide for indemnification of the insured/ceding enterprise by the insurer/reinsurer against loss or liability, the premium paid less the amount of premium to be retained by the insurer or reinsurer would be accounted for as a deposit by the insured. Therefore, should the infrequent loss occur and the contract not exemplify "indemnification," earnings would be charged and a liability would be established to the extent that the two-prong test of FASB 5 is satisfied:

      Consequently, the earnings for the fiscal year in which the loss occurs would be torpedoed by the recording of the uninsured loss. Conversely, should the transaction pass muster as providing "indemnification," the company would merely expense the funds paid to the underwriter, thereby stabilizing earnings as well as cash flow.

    The study of evolution of ideology and social institutions suggests that accounting processes are reactive; that they develop mainly in response to business needs at any given time; and that their growth is relative to economic progress generally.¹

    This evolution is evidenced by the motives for FASB 113's promulgation.  Specifically, these are the issues of:

      These issues have been studied by the insurance, the accounting, and actuarial professions for some time, and interest has grown in recent years. as a result of the widespread public attention focused on failures of insurance enterprises. In fact, risks associated with reinsurance have been cited as a contributing factor in several of those failures. Some have observed that offsetting of reinsurance-related assets and liabilities and inadequate reinsurance disclosure obscure risks associated with reinsurance. Others have observed that the accounting guidance in FASB 60 allows the use of reinsurance to accelerate the recognition of income relating to the reinsured contracts.

    These issues led the Financial Accounting Standards Board to reconsider the accounting for reinsurance required by FASB 60. FASB 113’s ramifications on these two products are discussed below.

Loss Portfolio Transfer

    Heretofore, a company which transferred its liabilities for less than the liabilities recorded value was able to recognize a gain in the year that the transfer was consummated. However, paragraph 22 of FASB 113 now requires that the amounts paid for retroactive reinsurance (loss portfolio transfer) shall be reported as reinsurance receivables to the extent the amounts do not exceed the recorded liabilities relating to the underlying reinsured contracts.

    If the recorded liabilities exceed the amounts paid, reinsurance receivables shall be increased to reflect the difference and the resulting gain deferred. This deferred gain is then to be amortized over the estimated remaining settlement period of the transferred losses. 

    If the amounts and timing of the reinsurance recoveries can be reasonably, estimated, the deferred gain is to be amortized using the effective interest rate inherent in the amounts paid to the reinsurer and the estimated timing and amounts of recoveries from the reinsurer. Otherwise, the proportion of the actual recoveries total estimated recoveries (the recovery method) shall determine the amount of amortization.

    Further. FASB 60 continued the long-established practice that originated in statutory accounting whereby the ceding enterprise reported insurance activities net of the effects of reinsurance -- liabilities were reported net of reinsurance amounts and earned premium and claims cost were reported net of reinsurance in the statement of earnings. Paragraph 14 of FASB 113 requires that reinsurance contracts that are legal replacements of one insurer by another (often referred to as assumption and novation) extinguish the ceding enterprise's liability to the policyholder(s) and result in the removal of related assets and liabilities from the financial statements of the ceding company.

Exhibits I and II contrasts the pre- and post- FASB 113 treatment for a portfolio transfer in which $1,000,000 of liabilities
are transferred for a premium of $800,000 in fiscal year 19X1.
Exhibit II demonstrates the amortization of the gain in year 19X2 through 19X5 based on estimated annual recovery of $250,000 commencing in 19X2.

Per Risk Excess of Loss Cover

   This vehicle is primarily a funding mechanism in which an infrequently expected loss is funded over multiple years.  Consequently, cash flow is stabilized, and should the scheme exhibit indemnification, the annual payment/premium would be expensed, as opposed to expensing/accruing the loss if and when it occurs which would de-stabilize earnings.
   The dilemma to date , however is that determining whether a reinsurance contract indemnifies the ceding enterprise against loss or liability has been controversial and problematic in practice.  For instance, does a program which exacts premiums equal to 70, 80 or 90 percent, etc. of the policy limits constitute indemnification?  Thus, the board concluded that FASB 113 should provide general guidance on the circumstances under which the contract provides indemnification against loss or liability related to insurance risk.
   In paragraph 9, the board established the following criteria to determine if the plan indemnifies the insured:

     The opinion further clarifies this criteria stating that the insurer/reinsurer shall not be considered to have assumed significant variation in either the amount or timing of payments by the insurer/reinsurer is remote.  Contractual provisions that delay timely reimbursements to the insured would prevent this condition from being met.

    To determine if it is reasonably possible for an insurer/reinsurer to realize a significant loss, the evaluation is to be based on the present value of all cash flows between the ceding and assuming enterprises under reasonably possible outcomes.  The same interest rate is to be used to compute present value of cash flows for each reasonably possible outcome tested.

   Paragraph 11 of the opinion, however, provides an exception to this theorem.  This exception is invoked if substantially all of the insurance risk relating to the insurance contract has been assumed by the insurer/reinsurer.  This condition is met only if insignificant insurance risk is retained by the ceding enterprise.  The term insignicant is defined in paragraph 8 of FASB 97 to mean "having little or no importance; trivial" and is used in the same sense in FASB 113.

   Even with the advent of FASB 113, the evaluation still involves subjective thought; albeit a uniform model has been promulgated.  Exhibits III,  IV, and  V  provide and example of the proposed methodology.  Exhibit III, depicts the enterprise's limits hierarchy, and Exhibits IV and V demonstrate the evaluation of a $5 million per risk excess of loss cover layer under two possible outcomes.

Conclusion

   FASB 113, in its focus on substance as opposed to form, requires that any gain realized in a loss portfolio transfer be recognized over the claim settlement period, as opposed to the year in which the transfer is consummated.  Additionally, unless the ceding enterprise/insured is relieved of its liability to the policyholder/claimant, the related assets and liabilities are not removed from its financials.  The net/offset methodology is no longer appropriate in that scenario.

   Regarding per risk excess of loss cover, the opinion sets out the appropriate methodology to evaluate the extent to which, if any, the transaction indemnifies the insured/ceding enterprise.  As promulgated in paragraph 44 of FASB 5 and paragraph 40 of FASB 60, the presence of indemnification is the essential ingredient if the transaction is to accomplish its touted objective of stabilizing earnings.²  Consequently, determining whether the contract provides indemnification and thus will stabilize earnings requires a complete understanding of that contract and other contracts between the ceding enterprise and the assuming entity. This complete understanding includes an evaluation of all contractual features that

A) limit the amount of insurance risk to which the reinsurer is subject (such as experience refunds, cancellation provsions, adjustable features) or

B) delay the timely reimbursement  of claims by the insurer/reinsurer (such as accumulating retentions from multiple years or payment schedules.  In essence, each contract must be judged on its attributes.€

Exhibit III Finite Risk - Indemnification Analysis $44 Million Excess $6 Million per occurrence Finite Risk $5 Million per occurrence Primary $1 Million LIMITS HIERARCHY Premium for Finite Risk $800,000 annually for 5 years

Exhibit IV
Finite Risk-Indemnification Evaluation Cash Flows  Scenario 1- - $5 Million Loss
Occurs mid-year in Year 1
	Yr 1	Yr 2	Yr 3	Yr 4	Yr 5	Yr 6	Yr 7	Total
Premium Payments*	$800,000	$800,000	$800,000	$800,000	$800,000	$200,000		$4,000,000
Interest on Deficit**	96,000	144,000	96,000	48,000				384,000
Total Cash in flows	896,000	944,000	896,000	848,000	800,000			4,384,000
Cash out flows
Defense Cost***	125,000	$125,000	125,000	125,000	125,000	125,000	------------	750,000
Claims Settlement****							4,250,000	4,250,000
Interest on Surplus**	16,000							16,000
Total cash out flows	141,000	125,000	125,000	125,000	125,000	125,000	4,250,000	5,016,000
Net Cash Flows	755,000	819,000	771,000	723,000	675,000	(125,000)	(4,250,000)	(632,000)
NPV Factor @ 8%	.962	.892	.826	.763	.709	.653	.606
Assumptions:
* Funding 80% of policy limits over 5 years - Underwriter's P & A (minimum premium) is $400,000-10% of Funding **Insured pays 6% interest from occurrence of loss on funding deficit.  Underwriter pays 4% interest to insured on Funding Surplus ***Defense costs are projected to be %15 of $5,000,000 loss payable annually and are within limits ****$5 million loss occurs mid-year yr 1 of program and paid out in mid-year 7 *****Underwriter realizes a profit in spite of paying out policy limits - No indemnification

Exhibit V
Finite Risk-Indemnification Evaluation Cash Flows  Scenario 2- - $5 Million Loss
Occurs mid-year in Year 5
	Yr 1	Yr 2	Yr 3	Yr 4	Yr 5	Yr 6	Yr 7	Yr 8	Yr 9	Yr 10	Yr 11	Yr 12	Total
Premium  Payments*	$800,000	$800,000	$800,000	$800,000	$800,000	$	$	$	$	$	$	$	$4,000,000
Interest on Deficit**
Total Cash  in flows	800,000	800,000	800,000	800,000	800,000								4,000,000
Cash out  flows
Defense  Cost***						125,000	125,000	125,000	125,000	125,000	125,000		750,000
Claims  Settlement****												4,250,000	4,250,000
Interest  on Surplus**	32,000	65,280	99,891	135,887	86,662								419,720
Total cash  out flows	32,000	65,280	99,891	135,887	86,662	125,000	125,000	125,000	125,000	125,000	125,000	4,250,000	5,419,720
Net  Cash Flows	768,000	734,720	700,109	664,113	713,338	125,000	125,000	125,000	125,000	125,000	125,000	4,250,000	(1,419,720)
NPV Factor   @ 8%	.962	.892	.826	.763	.709	.653	.606	.562	.521	.481	.446	.413
NPV Cost to U/W	$738,816	$655,370	$578,290	$506,718	$505,756	($81,625)	($75,750)	($70,250)	($65,125)	($60,125)	($55,750)	($1,755,250)	***** $821,075
Assumptions:
* Funding 80% of policy limits over 5 years - Underwriter's P & A (minimum premium) is $400,000-10% of Funding **Insured pays 6% interest from occurrence of loss on funding deficit.  Underwriter pays 4% interest to insured on Funding Surplus ***Defense costs are projected to be %15 of $5,000,000 loss payable annually and are within limits ****$5 million loss occurs mid-year yr 5 of program and paid out in mid-year 12 *****Underwriter realizes a profit in spite of paying out policy limits - No indemnification

 

Footnotes: 1. Michael Chatfield, D.B.A., CPA, A History of Accounting Thought, New York: Robert E. Kreiger Publishing Co., 1977. 2. For a discussion of the economic disadvantages of finite risk products, see Richard M. Duvall, Ph.D., CPCU, "A New Look at Financial Insurance Products."  Risk Management, (November, 1992).
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