Is there a brightline test?

Is there a brightline test?

Neither FAS 113 nor SAP 62 defines the terms "reasonable" or "significant." Ideally, one would like to be able to substitute values for both terms. It would be much simpler if one could apply a test of an X percent chance of a loss of Y percent or greater. Such tests have been proposed, including one famously attributed to an SEC official who is said to have opined in an after lunch talk that a 10 chance of a 10 loss was sufficient to establish both reasonableness and significance. Indeed, many insurers and reinsurers still apply this "10/10" test as a benchmark for risk transfer testing.

It should be obvious that an attempt to use any numerical rule such as the 10/10 test will quickly run into problems. Suppose a contract has a 1 chance of a 10,000 loss? It should be reasonably self-evident that such a contract is insurance, but it fails one half of the 10/10 test. It does not appear that any "brightline" test of reasonableness nor significance can be constructed.

Excess of loss contracts, like those commonly used for umbrella and general liability insurance, or to insure against property losses, will typically have a low ratio of premium paid to maximum loss recoverable. This ratio (expressed as a percentage), commonly called the "rate on line" for historical reasons related to underwriting practices at Lloyd's of London, will typically be low for contracts that contain reasonably self-evident risk transfer. As the ratio increases to approximate the present value of the limit of coverage, self-evidence decreases and disappears.

Contracts with low rates on line may survive modest features that limit the amount of risk transferred. As rates on line increase, such risk limiting features become increasingly important.

[edit] "Safe Harbor" exemptions

The analysis of reasonableness and significance is an estimate of the probability of different gain or loss outcomes under different loss scenarios. It takes time and resources to perform the analysis, which constitutes a burden without value where risk transfer is reasonably self-evident.

Guidance exists for insurers and reinsurers, whose CEO's and CFO's attest annually as to the reinsurance agreements their firms undertake. The American Academy of Actuaries, for instance, identifies three categories of contract as outside the requirement of attestation:

• Inactive contracts. If there are no premiums due nor losses payable, and the insurer is not taking any credit for the reinsurance, determining risk transfer is irrelevant.
• Pre-1994 contracts. The attestation requirement only applies to contracts that were entered into, renewed or amended on or after 1 January 1994. Prior contracts need not be analyzed.
• Where risk transfer is "reasonably self-evident."

"Risk transfer is reasonably self-evident in most traditional per-risk or per-occurrence excess of loss reinsurance contracts. For these contracts, a predetermined amount of premium is paid and the reinsurer assumes nearly all or all of the potential variability in the underlying losses, and it is evident from reading the basic terms of the contract that the reinsurer can incur a significant loss. In many cases, there is no aggregate limit on the reinsurer's loss. The existence of certain experience-based contract terms, such as experience accounts, profit commissions, and additional premiums, generally reduce the amount of risk transfer and make it less likely that risk transfer is reasonably self-evident."

- "Reinsurance Attestation Supplement 20-1: Risk Transfer Testing Practice Note," American Academy of Actuaries, November 2005. ...