Run a risk transfer test to decide between reinsurance accounting and deposit accounting, and trace the consequences through the financial statements.

A cedant buys a contract that looks like reinsurance but shifts almost no real loss to the reinsurer. Book it as reinsurance and surplus jumps for a transaction that transferred nothing. The risk transfer test decides which accounting applies.

Under statutory guidance, a contract earns reinsurance accounting only when both hold.

$$\text{Reinsurance} = (\text{significant insurance risk}) \;\wedge\; (\text{reasonably possible significant loss})$$

KEY: Significant insurance risk means the reinsurer bears both underwriting risk (how much) and timing risk (when). A pure funding arrangement transfers neither.

Compute the reinsurer's present-value loss in each scenario as PV(losses and expenses) minus premium, then as a percent of premium.

HIGH-FREQUENCY: 10-10 rule. At least 10% probability of at least a 10% PV loss passes. When outcomes are skewed, use ERD (probability of an NPV loss times its average severity as a percent of premium). ERD greater than 1% indicates risk transfer, consistent with 10-10 because 10% times 10% equals 1%. Borderline results near 1% require further consideration and documentation, not an automatic pass.

Common mistakes

• Testing only underwriting risk. Timing risk also counts; a contract can transfer amount but fix timing and still fail.
• Reading 10-10 as an "or." You need both a 10% probability and a 10% loss, not either one.
• Ceding reserves after a failed test. Deposit accounting keeps reserves gross; only reinsurance accounting removes them.

Bottom line

• Reinsurance accounting requires BOTH conditions: the reinsurer assumes significant insurance risk, and it is reasonably possible the reinsurer realizes a significant loss.
• Insurance risk has two parts: underwriting risk (amount) and timing risk (when paid).
• Common heuristic is the 10-10 rule: at least a 10% probability of at least a 10% present-value loss to the reinsurer.
• Expected Reinsurer Deficit (ERD) is the probability-weighted alternative when the loss distribution is skewed.

Exam shortcut

Run the test as an AND gate: significant insurance risk AND reasonably possible significant loss. Fail either and it is deposit accounting. For 10-10, compute each scenario's PV loss as a percent of premium, then sum probabilities where that percent is at least 10%. Need at least 10% total. For ERD, multiply the probability of an NPV loss by its average severity as a percent of premium.

The full lesson (about 1,266 words, 8 min read) adds 2 worked examples, all 8 common mistakes, a self-check, free in the app.

Learning objectives

• D2

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