Accounting for Reinsurance Contracts

Reinsurance contracts tend to be very complicated. As we have already studied in the previous articles, a wide variety of complicated structures with various cash flow probabilities are associated with reinsurance contracts. Hence, it needs to be understood that the complicated nature of these reinsurance contracts sometimes ends up creating complicated accounting policies as well.

The accounting policies which are relevant to reinsurance companies vary widely across the world. This is because the different accounting standards treat the same contracts in a very different manner. There have been a lot of changes in the same accounting standards as well.

For example, the accounting policies related to reinsurance accounting in the IFRS have markedly changed after the introduction of IFRS 17. The constantly evolving policies make reinsurance accounting an even more complicated affair.

In this article, we will have a look at some of the facts related to the fundamentals of accounting for reinsurance contracts.

When are Reinsurance Contracts Recognized?

The matching principle is one of the fundamentals of accounting. The idea is to match the revenues directly to the expenses. However, this can be difficult in the case of reinsurance. This is because reinsurance contracts are higher-level contracts that provide coverage to several lower-level individual insurance policy contracts.

Now, it is possible that each of these individual contracts may have different start dates.

It is therefore also possible that some of the end dates for the contract may fall out of the accounting period. This makes it difficult for the reinsurance company to prorate and recognize revenues. Hence, when a reinsurance contract provides coverage to all these contracts, calculating which contacts need to be recognized in which given period can become an extremely challenging task.

Allocation of Revenues and Costs in Reinsurance

As mentioned in the previous point, reinsurance is an aggregation of several contracts. It is possible for these contracts to have different start and end dates which may even spill onto different fiscal years. Hence, the allocation of revenues and costs can become problematic.

Different accounting standards have created very detailed rules about the manner in which revenues, as well as expenses, should be allocated. This is because of the fact that different types of allocations could lead to different revenue and expense recognition which could completely change the profitability in a given period.

Cash Flows Are Very Different from Book Profits

The cash flows of any business generally tend to be different as compared to the book profits of the firm. However, in the case of the reinsurance business, this difference can be very huge. This is because of the fact that reinsurance contracts are about the transfer of risk.

Hence, even if there is no loss in a given year, reinsurance companies are expected to set aside certain sums of money as reserves to cover any losses if they arise at a later date. Now, reserves are not an actual cash outflow. It is just money that is kept in a separate account or invested in different asset classes.

Hence, the book profits of the reinsurance company vary widely from the reserves. Most accounting standards have special prescribed procedures that reinsurance companies need to follow in order to derive cash flows.

Presentation of Cash Flows: Different accounting standards have different rules which govern the presentation of reinsurance contracts. Some accounting standards allow the clubbing of several reinsurance contracts for accounting purposes. On the other hand, some other accounting standards require the individual presentation of such contracts.

Now, reinsurance companies also need to make a payout related to reinsurance contracts. Once again, they may have more than one option to present this in their accounting statements. Some accounting standards allow the gross presentation of payouts. However, in other cases, the reinsurance company is expected to link the cash outflow to the particular reinsurance policy. Hence, the allocation of premiums to particular policies can become a complicated affair in such cases.

Reinsurance Contracts Are Held Separately From Underlying Insurance

In many cases, captive reinsurance companies issue insurance contracts as well as some reinsurance contracts. Now, it needs to be understood that almost all accounting standards prohibit the combined presentation of these cash flows.

Insurance contracts are to be considered separate from reinsurance contracts even if they are within the same group. This is because of the fact that the liability of the insurance company is not contingent upon receiving cash flows from the reinsurer.

It is quite possible that even though both companies are within the same group, the company providing reinsurance has gone bankrupt and as a result, the onus of paying primary policyholders is still with the insurance company. Netting these two cash flows would give the false impression that one is contingent on the other even though this is not the case.

Contractual Service Margin: Contractual service margin is another important concept related to reinsurance accounting. The contractual service margin represents the unearned profit that lies on the books of the reinsurance companies. These profits will get accrued as and when services are provided.

It is important to realize that there is a significant judgment that needs to be exercised while calculating contractual service margins. Hence, it is important for accounting boards to provide clear-cut instructions about these calculations.

Disclosures: Reinsurance firms are required to follow high standards regarding disclosures. Firstly, they are expected to disclose all related party transactions. Subsequently, they are also required to disclose information related to the losses which they have already realized as well as the losses which they are expecting to be realized in the near future.

The fact of the matter is that reinsurance accounting is quite different from regular accounting. It is therefore important for students of reinsurance to be aware of these differences.