Reinsurance Involving Partial Risk Transfer Addressing the Accounting Difficulties

The paper proposes a measure for risk transfer, the portion or percentage of risk transferred ("PRT") that varies between 0% and 100%. Such measure would provide a superior basis for a binary decision between reinsurance accounting and deposit accounting (with a likely critical value of 50%). A preferred approach would be to use PRT as the basis for continuous accounting. The paper differentiates between "natural" reinsurance contract provisions that do not limit risk transfer and "structural" contract provisions that may limit risk transfer. The PRT measures the risk-limiting impact of the structural provisions by comparing risk distributions before and after the application of structural provisions. PRT is 100% for contracts without structural provisions. The risk to be measured is defined as potential adverse deviation from the amounts reflected in accounting values. Fixed reinsurance contract provisions that are accounted for without uncertainty provide no potential for adverse deviation and do not affect PRT. The paper includes a discussion and critique of the FAS 113 definition of risk transfer, and finds two fundamental flaws: (1) the definition is based on an absolute measure of the riskiness of the ceded cash flows, so that reinsurance of high risk subject portfolios often passes even though the risk transfer is severely limited; and (2) the focus on reinsurer profitability includes fixed amounts that are unrelated to risk, and thereby includes an implicit standard for reinsurance pricing that is an inappropriate role for accounting. The paper includes examples of the application of PRT and several other risk transfer measures to a range of underlying cash flows and reinsurance contract structures.