In June 2016, the Financial Accounting Standards Board (FASB) approved a new accounting standard, the Current Expected Credit Loss (CECL) model, to replace the former incurred loss model for measuring credit risk on financial instruments. This change will accelerate the financial reporting of credit losses on loans and other financial instruments, including reinsurance recoverables. Much of the CECL model’s focus is on banks and other lenders, but it also will affect ceding insurers required to file with the U.S. Securities and Exchange Commission (US SEC).
The new guidance goes into effect for fiscal years beginning December 15, 2019 (including interim periods), but early adoption is permitted up to one year prior. In preparation for the new standard, affected companies should gain an understanding of the new approach and considerations relevant to the requisite changes in current models and possible implications for reinsurance contract language.
Insurance companies use multiple approaches to evaluate and estimate credit risk. Perhaps the most common approach is the incurred loss model, which recognizes an allowance against its reinsurance recoverable assets for uncollectible reinsurance related to probable and estimable credit losses that are known against its reinsurance recoverable assets as of the financial statement date. Under this approach, the insurer establishes a liability for uncollectible reinsurance related only to known disputes and/or insolvencies. To estimate a provision for uncollectible reinsurance, some insurers consider not only known events but also incorporate a provision for expected amounts that may become uncollectible in the future. This expected loss approach is particularly useful for complex reinsurance situations (e.g., related to asbestos claims) in which the expected allowance can be significant due to a greater risk of dispute resulting from the significant judgment used to determine ceded amounts.
Future uncertain events impact a reinsurer’s ability to fulfill its obligations under a reinsurance contract. As such, uncollectible amounts may not be known until some point in the future. The applicability of the new CECL standard to all reinsurance recoverables will require ceding companies to recognize expected reinsurance recoverable amounts whether or not there is awareness of a current collection issue. The expected loss approach will provide for earlier recognition of uncollectible amounts over the lifetime of a reinsurance agreement.
Estimating uncollectible reinsurance under CELC
Under CECL, the first step to estimating the liability is to separate the known uncollectible risks from the unknown. Insurers should have an existing approach for estimating known uncollectible liabilities; this is typically an incurred loss approach, but there may not be an existing expected loss approach to measure uncollectible reinsurance. Under an expected loss approach, an insurer must make assumptions regarding the likelihood that reinsurance liabilities ultimately will become uncollectible. To establish these assumptions, an insurer may assess reinsurer quality by considering historical reinsurance collection success, as well as current and reasonable future forecasts of economic and market conditions that may impact future collection rates. A ceding insurer’s approach also may consider the nature of the collectible amounts, which can impact dispute risk.
For the full article, refer to page 14 in the Winter 2018-2019 issue.https://www.airroc.org/assets/docs/matters/AIRROC_Matters_Winter_2018-2019_vol_14%20_No_3.pdf