United States: NAIC Adopts Enhanced Disclosure and Attestation Requirements for Finite Reinsurance Contracts

The National Association of Insurance Commissioners (NAIC) recently approved enhanced disclosure and attestation requirements obligating property and casualty (P&C) insurers to regularly disclose and attest to their use of nontraditional reinsurance contracts generally known as "finite reinsurance."

Finite reinsurance is not easily susceptible to a single definition or description. Overly simplified, the defining characteristic of finite reinsurance is that — unlike traditional reinsurance — it involves little or no actual risk transfer from ceding company to assuming company; rather, the parties generally know at the outset what the financial outcome of their reinsurance transaction will be, or have created mechanisms within or outside the contract that ensure the financial outcome will not exceed certain parameters.

The relative lack of risk transfer often leaves finite reinsurance transactions open to the charge that they should be accounted for as loan facilities using deposit accounting rather than reinsurance transactions using reinsurance accounting, in accordance with Statutory Statement of Accounting Principle (SSAP) No. 62 -— Property and Casualty Reinsurance. Under reinsurance accounting, the ceding company effectively removes the "ceded" liabilities from its balance sheet on the premise that these risks have been transferred to the assuming reinsurer; under deposit accounting, there is no recognition of risks being transferred between the parties and the ceding company effectively retains the "ceded" liabilities on its balance sheet.¹ Thus, when accounted for as a reinsurance transaction, finite reinsurance can have the effect of boosting the ceding company’s balance sheet and the calculation of its statutory capital, with the corresponding risk that the insurer appears more financially sound than it truly is.

The use of "finite reinsurance" products has attracted increased regulatory scrutiny as a result of New York Attorney General Eliot Spitzer’s high-profile investigations into the use of such products by American International Group, Inc. (AIG) and other industry heavyweights. These investigations pursued suspicions that AIG and others engaged in finite reinsurance transactions as a means to inflate their balance sheets or smooth out their income statements, with little intended or actual risk transfer taking place. To the extent AIG and others utilized reinsurance accounting for such transactions, Spitzer claimed they misrepresented their financial condition in their publicly filed and/or available financial statements. In the case of AIG, these claims led to, among other things, the abrupt retirement of AIG’s Chairman Maurice "Hank" Greenberg and multiple restatements of AIG’s 2004 financials involving hundreds of millions of dollars in reserve increases.²

Following Spitzer’s lead, many states issued subpoenas or other formal information requests to their domestic insurers seeking information regarding their use of finite reinsurance products. Generally speaking, these requests were not coordinated and each state’s approach was unique to some degree. Recognizing the need for a more regular and uniform approach, the NAIC recently adopted amendments to its Property and Casualty Annual Statement Blank and Annual Statement Instructions that will take the place of independent inquiries by the various states. These amendments are effective for the upcoming 2005 annual statements of all P&C insurers.

As they pertain to finite reinsurance, the amendments adopted by the NAIC impose three new requirements on P&C insurers:

• P&C insurers must answer several new General Interrogatories in their annual statements related to the use of finite reinsurance

• To the extent a P&C insurer answers any of these new interrogatories in the affirmative, the insurer must submit a new Reinsurance Summary Supplemental Filing form along with its annual statement

• All P&C insurers must include with their annual statements a Reinsurance Attestation Supplement regarding their active reinsurance agreements, signed by their active chief executive officer (CEO) and chief financial officer (CFO)

There are several new interrogatories in the P&C Annual Statement Blank addressing finite reinsurance issues. For example, P&C insurers previously had to answer an interrogatory asking if they reinsure any risk under a quota share contract that effectively reduces or limits the reinsurer’s losses below the stated quota share percentage (e.g., through features such as deductibles, loss ratio corridors, loss caps, aggregate limits, and so forth).³ Under the revised interrogatories, if an insurer answers that question in the affirmative, it must further disclose whether the amount of reinsurance credit it takes with respect to that contract reflects the reduction in quota share coverage driven by these contractual features.⁴

P&C insurers must answer a new Interrogatory 9.1 asking whether they cede risk under any reinsurance contract (or under multiple contracts with the same reinsurer or its affiliates) for which during the period covered by the statement: (i) the insurer recorded a positive or negative underwriting result greater than three percent of its prior year-end surplus, or reported calendar year written premium ceded or year-end loss and loss expense reserves ceded greater than three percent of its prior year-end surplus, (ii) the insurer accounted for the contract under reinsurance accounting rather than deposit accounting, and (iii) the contract contains one or more of the following features or other features with similar results:

• A noncancellable contract term longer than two years

• A limited or conditional cancellation provision requiring the reporting entity to enter into a new reinsurance contract with the reinsurer in the event of cancellation

• Aggregate stop loss reinsurance coverage

• An unconditional or unilateral right by either party to commute the reinsurance contract (except where the same is triggered by a decline in the credit status of either party)

• A provision permitting the reporting or payment of losses less frequently than on a quarterly basis (except where there is no activity during the period)

• A payment schedule, accumulating retentions from multiple years or any features inherently designed to delay the timing of reimbursement to the ceding company⁵

P&C insurers also must answer a new Interrogatory 9.2 asking whether they cede risk under any reinsurance contract (or under multiple contracts with the same reinsurer or its affiliates) during the period covered by the statement where either (i) the written premium ceded to the reinsurer by the reporting entity or its affiliates represents 50 percent or more of the entire direct and assumed premium written by the reinsurer or (ii) 25 percent or more of the written premium ceded to the reinsurer has been retroceded back to the reporting entity or its affiliates.⁶

Finally, P&C insurers must answer a new Interrogatory 9.4 asking whether they ceded any risk under any reinsurance contract (or under multiple contracts with the same reinsurer or its affiliates) during the period covered by the statement and accounted for the transaction one way for purposes of generally accepted accounting principles (GAAP) and another way for purposes of statutory accounting principles (SAP).⁷

A copy of the pertinent sections of the P&C Annual Statement Blank showing these latest revisions to the General Interrogatories can be downloaded at http://www.naic.org/frs/financial_statement_reporting /docs/Property_complete_GenInterr_part2_08_22_05.pdf.

If a P&C insurer answers any of new Interrogatories 9.1, 9.2, or 9.4 in the affirmative, it must file the new Reinsurance Summary Supplemental Filing for General Interrogatory 9 (Part 2) (Reinsurance Supplemental Filing) along with its annual statement.⁸

In the case of affirmative answers to Interrogatories 9.1 or 9.2, the insurer must include the following information in the Reinsurance Supplemental Filing: (i) the aggregate financial statement impact of the suspect reinsurance contract(s) on the balance sheet and statement of income; (ii) a summary of the terms of the suspect reinsurance contract(s), and (iii) a brief discussion of management’s principal objectives in entering into the suspect reinsurance contract(s), including the economic purpose to be achieved.⁹

In the case of an affirmative answer to Interrogatory 9.4, the insurer must include in the Reinsurance Supplemental Filing an explanation as to why the suspect reinsurance contract(s) are treated differently for GAAP and SAP purposes.¹⁰

The Reinsurance Supplemental Filing can be downloaded at http://www.naic.org/frs/financial_statement_reporting/docs/Property_Annual_Reinsurance_SummSuppFiling_08_22_05.pdf.

The New Reinsurance Attestation Supplement

In conjunction with the filing of their annual statements, all P&C insurers are now required to file an annual Reinsurance Attestation Supplement (Attestation) signed by its CEO and CFO. By signing and filing this Attestation, the CEO and CFO are attesting, under penalty of perjury, with respect to all reinsurance contracts for which the insurer is taking credit on its current financial statement, that to the best of their knowledge and belief after diligent inquiry:

• Consistent with SSAP No. 62, there are no separate written or oral agreements between the insurer (or its affiliates) and the assuming reinsurer that would under any circumstances reduce, limit, mitigate, or otherwise affect any actual or potential loss to the parties under the reinsurance contract, other than inuring contracts that are explicitly defined in the reinsurance contract (except as disclosed in the Attestation)

• For each reinsurance contract entered into, renewed, or amended on or after January 1, 1994, for which risk transfer is not reasonably considered to be self-evident, documentation is available for review concerning the economic intent of the transaction and the risk transfer analysis evidencing the proper accounting treatment, as required by SSAP No. 62

• The insurer complies with all requirements of SSAP No. 62

• The insurer has appropriate controls in place to monitor the use of reinsurance and adhere to the provisions of SSAP No. 62 ¹¹

Note that the Attestation only applies to a P&C insurer’s ceded reinsurance program and not to any assumed reinsurance. Note also that the terms of the Attestation effectively create "safe harbors" within which some reinsurance contracts are excluded from the Attestation. For example: (i) the Attestation only applies to contracts "for which the reporting entity is taking credit on its current financial statement;" (ii) the component of the Attestation requiring documentation of a contract’s risk transfer analysis only applies to contracts "entered into, renewed or amended on or after January 1, 1994;" and (iii) the component of the Attestation requiring documentation of a contract’s risk transfer analysis only applies to post-1/1/94 contracts for which risk transfer is not "reasonably considered to be self-evident." ¹²

The Reinsurance Attestation Supplement can be downloaded at http://www.naic.org/frs/financial_statement_reporting/docs/complete_property_09_05.pdf.

For many P&C insurers, compliance with these enhanced disclosure and attestation requirements will be a complex task requiring a great deal of time and effort, both internally and in connection with the insurers’ professional advisors and consultants. This is particularly the case with respect to the initial round of disclosures and attestations for the 2005 annual statement, as many insurers will likely be conducting a comprehensive review of their ceded reinsurance activities for the first time. This review must be completed and the enhanced disclosures and attestations submitted to each insurer’s domestic regulator by March 1, 2006.

Insurers should begin their compliance effort now in order to ensure they are able to comply with this initial deadline. Typical tasks may include, among others:

• A broad internal review of the insurer’s operations to identify and produce documentation for all of the insurer’s active ceded reinsurance contracts, including any side agreements

• The preparation of contract summaries for all of the foregoing reinsurance arrangements

• The identification of contracts (if any) within the foregoing reinsurance arrangements which require disclosure in connection with the insurer’s answers to Interrogatories 9.1, 9.2, or 9.4, and/or for which risk transfer is not reasonably self-evident and which have been accounted for under reinsurance accounting
• For those contracts for which risk transfer is not reasonably self-evident and that have been accounted for under reinsurance accounting, the preservation or creation of documents concerning the economic intent of the transaction and the risk transfer analysis supporting such accounting (as of the contract’s inception)

• The preparation and execution of appropriate sub-certifications from relevant staff members in support of the Reinsurance Attestation Supplement and, if necessary, the Reinsurance Supplemental Filing

• The preparation and execution of the Reinsurance Attestation Supplement and, if necessary, the Reinsurance Supplemental Filing

• The development of formal procedures to facilitate and ensure continued compliance with SSAP No. 62 and the enhanced disclosure and attestation requirements

1. See SSAP No. 62 - Property and Casualty Reinsurance at 17-34.

2. See generally, Finite Reinsurance: Is It Finished?, Captive and ART Review (posted 1/8/2005); see also, Gilbert, Spitzer Crusade Grabs Greenberg, Bypasses Buffet, Bloomberg.com (posted 4/13/05).

3. See Property and Casualty Annual Statement Blank for the Year 2005, General Interrogatories, Part 2, #7.1 (NAIC 2005).

4. See id. at #7.3.

5. See id. at #9.1.

6. See id. at #9.2. This disclosure excludes cessions to approved pooling arrangements or captive insurance companies that are affiliated with (i) unaffiliated policyholders of the reporting entity, or (ii) an association of which one or more unaffiliated policyholders of the reporting entity is a member. See id.

7. See id. at #9.4. This disclosure excludes transaction meeting the requirements of paragraph 30 of SSAP No. 62 - Property and Casualty Reinsurance. See id.

8. See id. at #9.3 and 9.5.

9. See id. at #9.3.

10. See id. at #9.5.

11. See 2005 NAIC Annual Statement Instructions – Property/Casualty, Supp 20-1. Any exceptions to the Attestation statements must be disclosed in the Attestation and an explanation of the exceptions must be attached thereto. See id.

12. See, American Academy of Actuaries — Committee on Property and Liability Financial Reporting, Reinsurance Attestation Supplement 20-1: Risk Transfer Testing Practice Note at 9-10 (Nov. 2005). Unfortunately, the NAIC does not provide further guidance as to when risk transfer is "reasonably…self-evident." The same is a principlesbased standard, however, requiring application of the P&C insurer’s judgment. See id.

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