Transferring Risk: A Look Into Loss Portfolio Transfer s, Novations and Commutation Agreements. Joshua Partlow, CPA Partner

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1 Transferring Risk: A Look Into Loss Portfolio Transfer s, Novations and Commutation Agreements Joshua Partlow, CPA Partner

2 Learning Objectives Clarify terms LPT s, Novations, Commutations Highlight differences Uses for each in practice Accounting Treatment -Recognition and Presentation Divergence in practice Gross vs. net presentation Recognition of gains on transaction Premium tax considerations Business combination red flags 2

3 Why Do We Care? Given the economic environment the ART Insurance Space is ripe for LPTs, Novations and Commutation agreements Parent Companies are looking for ways to place old risks into pure captives RRGs are looking to expand and may target volume found in RRG s looking to exit Captives and RRGs looking to exit may look to transfer risk to affiliates or commercial market 3

4 Clarify Terms -LPT Loss Portfolio Transfer (LPT) A reinsurance transaction in which loss obligations that are already incurred are ceded to a reinsurer Two party agreement does not require policyholder consent May include known and unknown claims (IBNR) The original policy issuer continues to be responsible to policyholders should the reinsurer fail to honor its obligations Business Uses of LPT s Exit a line of business Transfer historical losses of a Parent to a Captive i.e., deductible reimbursement programs or self-insured retentions 4

5 Clarify Terms Novation Novation Agreement An agreement to replace one party to an insurance policy or reinsurance agreement with another company from inception of the coverage period. The novatedcontract replaces the original policy or agreement i.e., a cancel and rewrite Three party agreement requires consent of original policyholder Novatedparty s legal obligation to original insurance company / reinsurer is extinguished Business Uses of Novation Transfer of risk between affiliates Transfer of a departing Member s risk from an RRG to their newly created RRG 5

6 Clarify Terms Commutation Commutation Agreement An agreement between insurer and reinsurer that provides for the complete discharge of all obligations under a particular policy or reinsurance contract Cancels future reinsurance obligations under the reinsurance agreement No continued exposure to reinsurer Business Uses of Commutations Exit a line of business Discontinue operations Removal of reinsurer from treaties Close out agreement after volatile years / claims have settled Limit expense and administrative burden of agreement 6

7 Consistent Items In determining the pricing: Liabilities transferred should be actuarially determined The time value of money (discounting) should be considered Interest rate Margin for development Premium paid could be in the form of cash or other assets (investment portfolios, trust accounts) Can result in a gain or loss for either party in the transaction 7

8 Accounting Treatment - Recognition and Presentation Divergence in Practice

9 Limited GAAP and Statutory Guidance Divergence in Practice 9

10 Gross vs. Net Presentation Gross Presentation Assuming Entity Compensation received = Premium Losses transferred = Incurred losses More likely for most LPT s and Novations Net Presentation Assuming Entity Compensation received netted against losses transferred Net loss recorded as incurred loss More to come on gains More likely for commutation agreements 10

11 Gross Presentation Example Gross Presentation Assuming Entity On May 1, 2011, Captive enters into an LPT to assume selfinsured retention of Parent for GL exposures from March 1, 2004 February 28, 2011 Cash consideration of $14.7 million Assumed losses of $16.4 million 11

12 Gross Presentation Example A reconcilation of premiums written and earned is as follows: Gross written premium $ 2,249,713 $ 3,324,000 LPT premiums assumed - 14,736,677 Change in unearned premium 206,964 (190,666) Premiums earned $ 2,456,677 $ 17,870,011 Loss and loss adjustment expense activity is as follows: Liability at January 1 $ 33,125,380 $ 21,141,054 Incurred related to: Current year 4,501,608 4,416,671 LPT Assumption - 16,435,564 Subsequent development of LPT 295,350 1,295,895 Prior years (1,426,406) (3,372,989) Total incurred during the year 3,370,552 18,775,141 Paid related to: Current year (138,930) (29,179) LPT (2,726,131) (3,735,157) Prior years (2,872,010) (3,026,479) Total paid during the year (5,737,071) (6,790,815) Example to show recognition of gross presentation Other presentation options for LPT development Liability as of December 31 $ 30,758,861 $ 33,125,380 12

13 Gross Presentation Example Alternative presentation approaches Present amount assumed and subsequent development of LPT in 1 line item Group LPT development in current or prior year development With narrative disclosure Without narrative disclosure Materiality of transaction and preference of management plays a significant part in determining appropriate presentation 13

14 Net Presentation Example Net Presentation Assuming Entity On June 13, 2011, RRG enters into a commutation and release agreement with one of its reinsurers Consideration received from reinsurer of $1,692,191 Loss reserves previously recoverable (including paid losses recoverable, case reserves and IBNR) of $2,373,055 Net loss on commutation of $680,864 14

15 Net Presentation Example No impact on Premium Loss and loss adjustment expense activity is as follows: Liability, net of reinsurance at January 1 $ 8,667,822 $ 7,307,995 Incurred related to: Current year 4,955,417 4,146,708 Prior years (304,070) (1,999,744) Loss on commutation (100,419) 680,864 Total incurred during the year 4,550,928 2,827,828 Paid related to: Current year (524,418) (578,599) Prior years (3,681,558) (889,402) Total paid during the year (4,205,976) (1,468,001) Effectively treats cash received as a reinsurance recovery with any resulting loss increasing the net reserves Liability, net of reinsurance as of December 31 $ 9,012,774 $ 8,667,822 15

16 Net Presentation Example Alternative presentation approaches Group commutation gain / loss in prior year incurred and disclose Show gain / loss on commutation separately on the face of the statement of operations Net presentation may also be appropriate for LPTs and Novation agreements as long as properly disclosed Materiality of transaction and preference of management

17 Ceding Entity Presentation Loss Portfolio Transfer Reflected as a reinsurance transaction as the LPT does not relieve the insurer of its primary obligation to policyholder Commutation or Novation Reflected in loss roll forward as a reduction of liability either within paid loss section or as a separate line item Resulting gain or loss is reflected as incurred loss development See example 17

18 Ceding Entity Novation Example Ceding Entity Example On June 15, 2011, RRG enters into an novationand release agreement with New RRG which is owned by a former member Per the agreement all liabilities associated with policies previously issued to the former member were transferred to New RRG Consideration paid to New RRG of $2,667,600 Losses and LAE (case and IBNR) prior to the agreement totaled $3,000,000 18

19 Ceding Entity Novation Example No impact on Premium Loss and loss adjustment expense activity is as follows: Liability, net of reinsurance at January 1 $ 9,142,436 $ 8,559,632 Incurred related to: Current year 4,165,663 4,456,761 Prior years (457,804) (200,000) Total incurred during the year 3,707,859 4,256,761 Gain of $332,400 is reflected as a component of PY favorable development. Paid related to: Current year (150,507) (250,000) Novation and release agreement - (2,667,600) Prior years (1,500,788) (756,357) Total paid during the year (1,651,295) (3,673,957) Liability, net of reinsurance as of December 31 $ 11,199,000 $ 9,142,436 19

20 Ceded Novation Example Alternative presentation approaches Break out or disclose impact of novation on losses incurred Show consideration paid as separate line item and not a component of paid losses Include everything in prior year numbers and Include a narrative disclosure Exclude a narrative disclosure Materiality of transaction and preference of management

21 Recognition of Gains Generally under GAAP guidance, gains on transactions are deferred and recognized into income as related obligations are met Although limited guidance is available it follows that: For LPT s, novationsand commutations assumed -obligation is fulfilled over the anticipated payout period and thus any gain would be deferred and amortized to income For novationsand commutations ceded no further obligation exists for the ceding entity thus a gain can be fully recognized when executed For LPT s ceded further obligation could exists depending upon credit worthiness of the reinsurer continue to report as reinsurance 21

22 Recognition of Gains Under Statutory guidance, gains on transactions are treated as retrospective reinsurance Any gain would be recorded through a special surplus account and amortized into surplus over anticipated payout period 22

23 Limited Guidance There is limited guidance under both GAAP and Statutory principles, thus: Treatment for gains is often varies in practice Dependent upon materiality of gain to the entity, continuing obligation and type of contract Recognition of gain up front is clearly an aggressive position Not consistent with numerous GAAP Guidance Check with Firm and Regulators and proceed with caution 23

24 Premium Taxes Certain LPT S, novationsand commutations may be exempt from state premium taxes Treatment varies by domicile When taxed would be so at the lower assumed tax rate Good practice to check with domicile regulators prior to executing transaction 24

25 Business Combinations GAAP Guidance on business combinations FASB ASC 805 (formerly FAS 141(r)), may come into play for certain transactions Not applicable to entities under common control If deemed a business combination a transaction would need be subject to purchase price accounting and treated as a purchase pursuant to ASC Assets and liabilities would be fair valued Intangible assets would be identified and valued Goodwill would be recorded for any additional balances 25

26 Business Combinations Red Flags Indicators that a business has been acquired rather than assumed regardless of legal structure of transaction Non insurance / policy related liabilities and assets are transferred as part of the transaction Especially when substantially all of the ceding entities assets and liabilities are transferred Equity and membership interest are transferred as part of the transaction, especially if: Equity agreements for new acquired members are not reissued or significantly equivalent to the acquiring entities other membership agreements Substantially all of the ceding entities members or a specific class of members have been transferred 26

27 Business Combinations Treatment as a business combination is much different than traditional insurance assumption arrangements May not be the economic reality of the transaction that was intended 27

28 Thoughts For the Road Given subjectivity and divergence in practice in many areas, companies should look to their consultants, accountants, lawyers and regulators prior to executing transactions. Minor revisions to form of agreements may help to avoid unintended consequences and save headaches and fire drills With a little research your auditors may be ok with presentation preference items 28

29 Josh Partlow, CPA Partner Thank You for Joining Us!