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).