1. 1 Casualty Actuarial Society Annual Meeting FASB Invitation to Comment Bifurcation of Insurance and Reinsurance Contracts November 14, 2006 Joseph B. Sieverling Reinsurance Association of America

2. 2 FASB Insurance Risk Transfer Project  First discussed at FASB meeting in April 2005  Initially focused on risk transfer in SFAS No. 113  Decided to expand project to insurance and reinsurance contracts  Was initially intended to be a limited scope project  FASB Issued Invitation to Comment (ITC) on Bifurcation of Insurance And Reinsurance Contracts in May 2006

3. 3 FASB Bifurcation ITC  Scope  Affects insurers, reinsurers and policyholders  Applies to P&C, Life and A&H Insurance Contracts  Purpose  Gather input from buyers and sellers about possible bifurcation  Intended as a Neutral document  Will bifurcation result in financial reporting that is more representationally faithful (i.e. Accounting = Economic Substance)

4. 4 FASB Bifurcation ITC  Threshold questions  Is GAAP Definition of insurance and ins. risk adequate?  Whether insurance and reinsurance contracts should be bifurcated  Which contract should be bifurcated  How they should be bifurcated  Little discussion of whether insurance contract should be bifurcated – (i.e is current GAAP broken?)

5. 5 FASB Bifurcation ITC  Two Approaches to determine which contracts to Bifurcate (Both rules-based):  Based on existence or certain contract features  Bifurcate all contracts not identified as exclusively insurance reinsurance or exclusively identified as a financing transaction  Establishes concept of contracts that unequivocally transfer insurance risk.

6. 6 FASB Bifurcation ITC Unequivocal Insurance Risk - Idea is these have negligible non- insurance features – Examples :  Single personal insurance contract for a single risk (whole or term life)  Group of similar coverages on a single asset (Home / Auto)  Single risk reinsurance contract (i.e. Cat cover) Characteristics of Unequivocal Insurance Risk  Market equivalent premiums  prem. not a large portion of coverage  Deductibles and coverage limits are fixed  No risk limiting features that adjust profit or loss (sliding scale commissions, caps, corridors, etc.)  Contract is not likely to result in any claims

7. 7 FASB Bifurcation ITC Not Unequivocal  Group contracts with one policyholder and multiple insureds (Group Health/Group Life)  Similar contracts that compensate for likely payment of expected losses  Portfolios or contracts that qualify individually b/c have an expected level of claim activity (most reinsurance)

8. 8 FASB Bifurcation ITC Methods for Bifurcation (3 proposed)  Expected payout method – (Dollar trading)  Focused on component or contract where there is an expected loss  Proportional Method  Measures degree of variability or cash flows with and without the contract.  Where result is the same - account for as a financing  Cash flow yield method  Uses an implied (market) interest rate to isolate the financing component from the insurance component  Excess cash flow over that needed for a market yield is considered insurance

9. 9 FASB Bifurcation ITC Industry Comments  63 comment letters were submitted from all segments of the industry  Vast majority were critical of the ITC - General comments:  The approaches described in the ITC would not provide users with more decision useful and understandable information  Instead, the FASB should develop improved practical guidance for evaluating risk transfer and the FASB should improve and expand GAAP disclosures, especially for insurance and reinsurance contracts that transfer limited amounts of insurance risk  Many believed the problem was one of compliance with existing standards rather than a flaw in the existing standards  The ITC fundamentally changes insurance and reinsurance accounting – not necessary given the narrow scope of problems  Timing wrong – Consider IASB Convergence

10. 10 FASB Bifurcation ITC Industry Comments – Approach & Methods  Neither Approach A or Approach B is appropriate for identifying which contracts should be bifurcated. Both are rules-based. Approach B is a fundamental and comprehensive change to US GAAP since it would require bifurcation of anything not specifically meeting unequivocal criteria  The criteria for unequivocally transferring insurance risk are flawed. Few contracts would meet this standard. Most contracts have an expected loss. Characteristics are too rules-based and limiting  Bifurcation methods proposed are unclear and likely too subjective to produce reliable, comparable financial information  Data limitations would have a significant affect on the accounting selected and it would be especially difficult for small insurers and corporate insurance buyers to implement the proposals

11. 11 FASB Bifurcation ITC Industry Comments – Approach & Methods  Disagree with the ITC assumption that no single individual risk contains an expected loss component  Aggregating and reinsuring such risks would result in a different accounting treatment under the ITC, even if all such risk was transferred  Any aggregation of single risks would result in different accounting than if the risks had been separately insured – form over substance  If the proposals contained in the ITC were implemented, reliability and comparability would suffer, as entities with similar aggregate risk profiles would report substantially different financial information solely dependent on how their portfolio of risks was assembled

12. 12 FASB Bifurcation ITC Industry Comments – Actuarial Profession  ITC expanded scope incorrect. Concentrate on “problematic contracts”  Bifurcation unlikely to result in more decision useful information. For problematic contracts, consider instead deposit accounting in entirety, more disclosure and other risk transfer approaches  Bifurcation inappropriate for insurance contracts, may be possible for some reinsurance contracts  Don’t endorse any bifurcation method. Contract s/b bifurcated where possible using one of potentially many different methods consistent with the way in which the risks were assembled  Reference work of AAA and NAIC (reasonably self evident, risk transfer methods, disclosure)

13. 13 FASB Bifurcation ITC Industry Comments – Public Accounting Profession  Concerned the FASB ITC approach is too broad – it is more change than is necessary  Prefer the FASB address divergence in practice concerns outlined in AICPA Expert Panel letter of November 2003  Para 9a test – clarify when significant risk has been assumed under the reinsured portions of a contract  What constitutes the reinsured portions of the contract  What type of qualitative or quantitative analysis is required to evaluate risk transfer  Guidance on requirement that reinsurer’s payments vary directly with amount and timing of cedant’s cash flows  Clarification of the limited nature of the paragraph 11 exception

14. 14 FASB Bifurcation ITC FASB Education Session – November 8,  Essentially abandoning the ITC & Bifurcation – “trial balloon was burst”  Way forward is not yet clear, but FASB won’t spend much time on this. Some sentiment that 113 not broken / a compliance issue. Focus on IASB convergence  Initially looking at 3 elements:  Remove SFAS No 113 footnote regarding “remote” Will make 113 more principles based & solve low frequency/high severity  Consider new disclosures – Possibly start with NAIC disclosures  FAS 5 will govern Insurance contracts and FAS 113 will govern reinsurance contracts (tentative understanding – could change)  Monitor discussion at Nov. 21 or Nov 29 Board meetings

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