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10/10 Rule

The issue of analyzing and demonstrating risk transfer as a prerequisite for using reinsurance accounting was codified in the early 1990s with the adoption of Financial Accounting Standard (FAS) 113 (and its statutory counterpart, SSAP 62). FAS 113 was, itself, a response to perceived abuses and set the standard for testing whether something should be called a contract of insurance. FAS 113 required that risk transfer be demonstrated by comparing the present value of the cash flows associated with a contract and in particular by passing certain thresholds of "significance" of risk. The thresholds, often termed the 9a and 9b tests, are:

9a. The reinsurer assumes significant insurance risk under the reinsured portions of the underlying insurance contracts.

9b. It is reasonably possible that the reinsurer may realize a significant loss from the transaction.

Although neither "significance" nor "reasonably possible" were defined in this context, standard rules of thumb quickly arose in the implementation of FAS 113. The most commonly cited is the "10/10 Rule." This rule states that a contract passes the threshold if there is at least a 10 percent probability of sustaining a 10 percent or greater present value loss (expressed as a percentage of the ceded premium for the contract).


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