risk by the insurer structured as a loss corridor, loss cap or an aggregate limit of liability. Adjustable commissions, like sliding scale or profit commissions, or experience refunds in case of a positive or negative performance are also often used for aligning the interests of insurers and reinsurers. Financial reinsurance contracts are also often set up for multiple years and/or multiple lines of business to reduce volatility and aggregate risk. Although the IAIS [9] lists these and some other characteristics of finite reinsurance contracts<sup>9</sup> , it also points out that these could be also present in traditional reinsurance, thus rendering this guidance impractical in some cases.

Under the EU directive 2005/68/EC Art. 2, paragraph 1/q financial reinsurance is defined as follows: “‘finite reinsurance’ means reinsurance under which the explicit maximum loss potential, expressed as the maximum economic risk transferred, arising both from a significant underwriting risk and timing risk transfer, exceeds the premium over the lifetime of the contract by a limited but significant amount, together with at least one of the following two features: (i) explicit and material consideration of the time value of money, (ii) contractual provisions to moderate the balance of economic experience between the parties over time to achieve the target risk transfer” [21].

As there can never be an exclusive list which defines the contract’s categorization, risk transfer assessments should always be conducted on a case by case basis. In the absence of a standardized approach there is ample room for misinterpretations, misrepresentations, and abuses (e.g. avoiding ratings downgrades by employing financial smoothing instruments, saving taxes, circumventing creditor lending conditions by disguising new borrowings as reinsurance, or avoiding or delaying supervisory intervention to prevent breaches of solvency) [9]. As a result, there is an urgent need for a standardized practical approach to a robust regulatory classification of risk transfer contracts.

# **Section II. How to Categorize Contracts as Reinsurance?**

As a first step it has to be analyzed if the reinsurance contract transfers insurance risk (e.g. a book of motor or liability insurance policies is reinsured) or if it transfers financial risks.<sup>10</sup> If under the relevant local statutory and accounting provisions, a contract can be seen as transferring financial risk only, no further categorization is required. Such a contract cannot be considered as reinsurance and has to be accounted for under the investment result.

If the contract transfers insurance risk it has to be determined if the risks transferred are sufficient to allow for reinsurance accounting. However, not every reinsurance contract

> 9 The IAIS list of most common features of risk financing instruments vs. reinsurance contains the following characteristics: a) insurance risk transfer and financing are combined, b) assumption of limited risk by the reinsurer (e.g., aggregate limit of liability, blended cover, sliding scale and other adjustable commissions, loss corridors and limits or caps), c) transfer of volatility (e.g., multiple lines of business, multiple years of account and multiple year contract terms), d) inclusion of future investment income in price of contract (recognition of time value of money with funds withheld), e) potential profit sharing between parties (e.g. profit-sharing formulas, experience accounts), f) pricing determined by ceding insurers’ results and not reinsurance pricing cycle, g) terms and pricing are typically determined in advance for the whole a block of new or in-force business (i.e. administration of reinsurance is done on a bulk basis rather than on a traditional seriatim policy-by-policy basis).[9]

> 10 For example IFRS 4 Appendix A defines financial risks as: “The risk of a possible future change in one or more of a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract.” [3]

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