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
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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
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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
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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
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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
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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
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Accounting Treatment -
Recognition and Presentation
Divergence in Practice
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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
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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 $16.4 million
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Gross Presentation – Example
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A reconcilation of premiums written and earned is as follows:
2012 2011
Gross written premium 2,249,713$ 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
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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 $680,864
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Net Presentation – Example
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Loss and loss adjustment expense activity is as follows:
2012 2011
Liability, net of reinsurance at January 1 8,667,822$ 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 . . . . . .
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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
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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 $3,000,000
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Ceding Entity Novation – Example
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Loss and loss adjustment expense activity is as follows:
2012 2011
Liability, net of reinsurance at January 1 9,142,436$ 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 . . . . .
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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
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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
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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
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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
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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
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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
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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
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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
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