Risk Transfer Testing of Reinsurance Contracts: Analysis and Recommendations

This paper was prepared in response to a call from the American Academy of Actuaries Committee on Property and Liability Financial Reporting (COPLFR). The call requested ideas about how to define and test for risk transfer in short duration reinsurance contracts as required by FAS 113 and SSAP 62. These accounting standards require that a reinsurance contract must satisfy one of two conditions in order to qualify for reinsurance accounting treatment: 1) the contract must transfer "substantially all" of the underlying insurance risk, or failing that, 2) it must at least transfer "significant" insurance risk. The paper presents methods to test for both conditions, but the main focus is on testing for "significant" risk transfer. The shortcomings of the commonly used "10-10" test are discussed and two alternative testing frameworks are presented as significant improvements over "10-10". The first of these, which is presented in detail, is based on the expected reinsurer deficit (ERD). Conceptually, that approach is a refinement and generalization of "10-10" that addresses its major shortcomings. The second framework, based on the right tail deviation (RTD), is presented more briefly. It has certain desirable properties but at the cost of greater complexity.

Keywords: risk transfer testing, FAS 113, "10-10" test, downside risk, expected reinsurer deficit (ERD), right tail deviation (RTD), tail value at risk (TVaR), parameter uncertainty