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Transferring Risk:

A Look Into Loss Portfolio

Transfer’s, Novations and

Commutation Agreements

Joshua Partlow, CPA

Partner

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

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

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

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 novated contract replaces the original policy or agreement

– i.e., a cancel and rewrite

– Three party agreement – requires consent of original policyholder

– Novated party’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

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

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

Accounting Treatment -

Recognition and Presentation

Divergence in Practice

9

Limited

GAAP

and

Statutory

Guidance

Divergence in

Practice

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

Gross Presentation – Example

• Gross Presentation – Assuming Entity

– On May 1, 2011, Captive enters into an LPT to assume self-

insured 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

Gross Presentation – Example

12

A reconcilation of premiums written and earned is as follows:

2012 2011

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:

2012 2011

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)

Liability as of December 31 30,758,861$ 33,125,380$

Example to show recognition of gross

presentation …

Other presentation options for LPT development

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

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

Net Presentation – Example

15

Loss and loss adjustment expense activity is as follows:

2012 2011

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)

Liability, net of reinsurance as of December 31 9,012,774$ 8,667,822$

No impact on Premium

Effectively treats cash received as a reinsurance recovery with any resulting loss increasing the net reserves

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 . . . . . .

16

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

Ceding Entity Novation – Example

• Ceding Entity Example

– On June 15, 2011, RRG enters into an novation and 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

Ceding Entity Novation – Example

19

Loss and loss adjustment expense activity is as follows:

2012 2011

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

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$

No impact on Premium

Gain of $332,400 is reflected as a

component of PY favorable

development.

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 . . . . .

20

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, novations and commutations assumed - obligation is fulfilled

over the anticipated payout period and thus any gain would be

deferred and amortized to income

– For novations and 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

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

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

Premium Taxes

• Certain LPT’S, novations and 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

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 805-20-25

– Assets and liabilities would be fair valued

– Intangible assets would be identified and valued

– Goodwill would be recorded for any additional balances

25

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

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

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

Thank You for Joining Us!

Josh Partlow, CPA

Partner

802-383-4819

[email protected]