Accounting Rule Guidance Statement of Financial Accounting Standards No. 113-Considerations in Risk Transfer Testing

Genesis. In an effort to provide some considerations to the CAS membership on risk transfer testing, the CAS Valuation, Finance, and Investment Committee (VFIC) conducted a research project. This paper is the culmination of VFIC's work. The demonstration of risk transfer for a reinsurance contract is required by FAS 113 in order for the contract in question to receive reinsurance accounting treatment for GAAP purposes. However, there is little supporting literature from which to draw guidance on risk transfer testing methodology, risk metrics, or threshold values; hence this paper. Approach After a brief introduction, this paper begins with an overview of FAS 113 (§3) and other related risk transfer statements (§4). VFIC conducted a brief survey of risk transfer practices, which is presented in §5. Next, a series of examples are presented (§6) to illustrate the data requirements, methodology, and considerations involved in approaches commonly used today to demonstrate risk transfer in reinsurance contracts. The remaining sections of the paper (§7-8) are devoted to the discussion of other risk metrics that actuaries could use to characterize the level of risk present in a reinsurance contract. Conclusions. Methodology. FAS 113 states that risk transfer testing of reinsurance contracts must include 1) a thorough understanding of contract provisions, 2) a model of the incidence of cash flows between parties, 3) a single, appropriate discount rate, and 4) insurance risk only. By their absence, these requirements preclude consideration of income taxes, reinsurer expenses, brokerage, or credit risk in the determination of risk transfer. To meet the FAS 113 requirements we recommend that risk transfer analysis include a view of the distribution of expected contract losses, identification of an appropriate risk metric and threshold values, and duration-matched or immunized yields as the appropriate discount rates. Risk Metric. Current practice tends to split risk transfer analysis into separate tests of probability (of an adverse result) and significance (magnitude of the result). A measure of loss at a given probability is called value at risk, or VaR. While FAS 113 couches risk transfer in words like "reasonable possibility" and "significant loss," the broader issue is whether a particular contract transfers risk. In this vein, a variety of other risk metrics were explored. VFIC analyzed expected deficit measures (such as expected policy holder deficit, or EPD), tail value at risk (TVaR), and distributional transforms such as the exponential and Wang transforms. Some of the positive and negative aspects of each of these are discussed in this paper. Threshold or Critical Values. Over time, common practice seems to have concluded that a 10% chance represents a 'reasonable probability,' and a 10% loss represents a 'significant loss.' That is, the critical value for VaR is -10% at a probability of 10%. Thus we have what many term the 10-10 rule. In practice, other critical values are commonly used. R must be stressed that such rules-of-thumb are used in practice, but FAS 113 itself does not dictate critical values. Our analysis of TVaR suggested that critical values in the range of-25% would represent minimal risk transfer. The discussion of distribution transforms proposes a critical value for the Wang transform of-10% that is wholly consistent with the 10-10 rule. Regardless of the model employed or the risk metric used, judgment is still required as to where to establish the threshold or critical values for what constitutes risk transfer and what does not. Intuitively, it seems natural to judge risk transfer for a reinsurance contract by analyzing whether the cedant has transferred (reduced) risk, not, as FAS 113 requires, by whether the reinsurer has assumed risk. While the answers to these two questions may be the same when focusing on a single transaction (as done in FAS113), on an enterprise-wide basis, they can be different. It should be noted that the recommendation on Index Securitization proposed the opposite to FAS 113: analysis is done from the cedant's perspective on an enterprise-wide basis. This could lead to different accounting treatments for reinsurance products and index securitizations, unless both tests are required for securitization and industry loss triggers.