|RAZA HASNANI, CPA, CA, practices with Deloitte & Touche LLP in Philadelphia. He is a member of the AICPA, the Canadian Institute of Chartered Accountants and the Institute of Chartered Accountants in Pakistan.|
The accounting consequences of transferring insurance or reinsurance risk have posed a dilemma to both companies and their CPAs for many years. While previous guidance said an entity should use deposit accounting when it entered into a contract that did not transfer a sufficient amount of risk, the guidance did not define deposit accounting or indicate how to implement it. Companies that enter into insurance and reinsurance contracts need to know precisely how such arrangements will affect their financial statements. Because there was no guidance on the methodology of deposit accounting, this was not always possible. To address the problem, AcSEC issued a position statement.
In October 1998 AcSEC issued SOP 98-7, Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk . However, the SOP solves only part of the problem. While it offers guidance to entities that have determined that deposit accounting is warranted, it unfortunately does not provide guidance on when an entity should account for an insurance or reinsurance contract using the deposit method.
SOP 98-7 applies to contracts that appear to be insurance or reinsurance arrangements but that may not meet the transfer-of-risk requirements in FASB Statement no. 5, Accounting for Contingencies , and Statement no. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts . Previous pronouncements about the accounting treatments for such situations were not definitive. Statement no. 5 requires that if an insurance or reinsurance contract does not indemnify the insured or reinsured company, the entity should use the deposit method. No authoritative guidance on risk transfer rules for insurance contracts is provided in this or any subsequent standard. Statement no. 113 says that because reinsurance contracts do not transfer insurance risk , the entity should use deposit accounting if the probability of significant changes in the amount or timing of payments is remote.
Insurance risk has two aspects: underwriting risk and timing risk. For example, a medical practitioner has two motives when she purchases insurance(1) to transfer the risk that she will have to pay a malpractice claim (underwriting risk) and (2) to remove the risk that she will have to pay claims at a time when she does not have sufficient liquidity (timing risk).
SOP 98-7 addresses insurance and reinsurance contracts that transfer significant underwriting or timing risk, contracts that transfer neither of these risks and contracts with indeterminate risk. It applies to all insurance and noninsurance entities and to both the insured and the insurer. The SOP does not provide entities with guidance on the risk transfer rules for insurance contracts. Authoritative accounting literature does not yet address this issue.
A MATTER OF TIMING
If an insurance company covering workers compensation risks wants to eliminate the uncertainty of when it will need cash to pay claims, it can enter into a contract whereby it pays a deposit to a reinsurance company that will then reimburse the insurance company when it pays a claim. At an agreed-upon date, the insurance company will pay the reinsurer a sum equal to total claims paid less the deposit. If the claims paid are less than the deposit, the reinsurer will return the excess. This arrangement does not affect the total workers compensation claims the insurance company must pay. The following example illustrates the resulting accounting for such contracts.
Example. Atom Insurance Co. (AIC) expects to incur $12 million in environmental cleanup claims in the future. Although the exact timing of these payments is uncertain, AIC expects to pay the claims in equal amounts over a 10-year period. To mitigate its timing risk, AIC enters into a 10-year reinsurance contract with Environmental Reinsurance Co. (ERC). Under the terms of the contract, AIC will pay $10 million to ERC at inception. ERC will reimburse AIC for all environmental cleanup claims as it incurs them and charge a $266,925 premium for this service. After 10 years, ERC will repay AIC for any portion of the initial deposit that it has not already reimbursed (less the premium).
AIC expects receipts from ERC to be $1,200,000, received at the end of every year, for an undiscounted total of $12 million. The implicit discount rate for these cash flows is 4%, which is the calculated discount rate for an annuity with a present value of $9,733,075 (original deposit less retained premium) with 10 annual payments of $1,200,000. This rate usually will be less than the prevailing risk-free rate because of the uncertain timing of the cash flows.
|Exhibit 1: Atom Insurance Co.|
Interest Income and Deposit Asset
|Interest Income (4%)||Recoveries||Deposit Asset|
|Net initial payment||$9,733,075|
At the contracts inception, AIC will record a deposit asset on its balance sheet of $9,733,075. AIC also will record a $266,925 prepaid asset related to the premium. ERC will record a corresponding liability on its books for the same amount (along with deferred income for the premium to be retained).
If the timing of the payments is as originally expected, the interest income and deposit asset appearing on AIC's financial statements at the end of each year will look like exhibit 1.
If, however, the timing of the reimbursement changes because of a change in the timing of the claims payments, both companies will have to recalculate the asset (or liability). Exhibit 2 projects a schedule change at the end of year three so the payments at the end of years four through six are expected to be $2,800,000 each, with no further payments expected after year six. According to SOP 98-7, the effective yield should use the actual or estimated cash flows under the interest method detailed in APB Opinion no. 21, Interest on Receivables and Payables , and FASB Statement no. 91, Accounting for Nonrefundable Fees and Costs Associated With Originating or Acquiring Loans and Initial Direct Costs of Leases . The new implicit rate will be 5.33%, which is the rate of return of these cash flows: $9,733,075 initial outflow, $1,200,000 received at the end of each of the first three years and $2,800,000 each received at the end of the years four through six.
Under the new scenario, AIC will record income every year as shown in the interest income column. For example, in the first year, it would record interest income of $389,323. Since the company received $1,200,000 in reimbursements from the insurance company, the deposit asset of $8,922,398 will be recorded on the first year balance sheet.
At the end of the year three, when the new future cash flows become known, the deposit asset on AIC’s books will be adjusted to $7,578,302the present value of the future cash flows ($2,800,000 annually for three years) discounted at the new implicit rate of 5.33%. The increase in the assets value is reasonable, because receipts have accelerated, increasing the assets present value. The $375,836 increase in the deposit asset due to the reevaluated yield will be recorded as additional interest income.
At the end of year four, AIC will put the following disclosure in the notes to its financial statements:
The company has entered into a contract whereby Environmental Reinsurance Co. will reimburse it for future environmental cleanup claims totaling $12 million at the time such costs are incurred. The timing of the costs and the corresponding reimbursements are uncertain. The contract will not have an impact on the total claims to be paid by the company; it merely will change the timing of such payments. The total deposit asset amounts related to this contract at the end of years four and three were $5,182,225 and $7,578,302, respectively.
The accounting treatment for the insurance company will parallel that shown in exhibit 2.
|Exhibit 2: Atom Insurance Co.|
Interest Income and Deposit Asset
(Timing of Payments Changed)
|Interest Income||Recoveries||Deposit Asset|
|Year 1 (4%)||$389,323||$1,200,000||8,922,398|
|Year 2 (4%)||356,896||1,200,000||8,079,294|
|Year 3unadjusted (4%)||323,172||1,200,000||7,202,466|
|Year 4 (5.33%)||403,923||2,800,000||5,182,225|
|Year 5 (5.33%)||276,213||2,800,000||2,658,438|
|Year 6 (5.33%)||141,562||2,800,000||0|
|Note: The implicit interest rate was rounded to 5.33%. The year six interest income amount was reduced by $133 to adjust for the rounding difference.|
GETTING OUT FROM UNDER UNDERWRITING RISK
To get insurance at a lower cost, an entity may enter into a contract that transfers only underwriting risk. If the company is confident it has sufficient liquidity to pay all claims as they arise, it may retain the timing risk to lower its premiums.
A malpractice claims insurer, for example, may contract with a reinsurance company to reinsure future malpractice claims. The policy might specify that at the end of the contract the reinsurer will pay a lump-sum reimbursement to the malpractice insurer for all claims incurred. This is a delayed reimbursement clause. The primary insurer’s significant timing risk is not transferred; it is still responsible for paying claims when they are incurred. The insurer will, however, recover its losses at the specified date.
The valuation of the asset or liability in such contracts has two components. For the company purchasing the insurance (or reinsurance), part of the asset consists of the unexpired portion of the coverage. The other component is the present value of the expected recoveries related to the actual losses incurred to date.
Example. Marine Insurance Partners (MIP) insures marine vessels. The company wants to purchase reinsurance to cover catastrophic losses, but it also wants to reduce the cost of the coverage. MIP's strategy is to retain the first $7 million of each claim and purchase reinsurance for the excess. MIP has a large amount of cash and is confident it can pay claims as they occur without facing liquidity problems. To mitigate its underwriting risk, MIP enters into a three-year contract with Ocean Reinsurance. Under the terms of the contract, MIP will pay a $12 million premium at inception and fund its own losses as they are incurred. At the end of the third year, Ocean will reimburse MIP for the portion of each loss that exceeds $7 million. If, for example, MIP had had three $9 million claims, Ocean would pay $6 million. If throughout the life of the three-year contract, MIP incurs and pays only one claim exceeding $7 million, a $15 million claim incurred and paid at the end of year two, the company will calculate its deposit asset balance as shown in exhibit 3.
At inception, MIP records the asset on its books at $12 million. During each year, one-third of the coverage expires; therefore, MIP records a $4 million adjustment to incurred losses and reduces the asset by the same amount. At the end of year two, MIP records an additional $7,547,170 asset, the $8 million recoverable from Ocean Reinsurance at the end of year three, discounted at the current rate on U.S. obligations with similar durations (assumed here to be 6%). MIP also reduces recorded losses by the same amount.
In the third year, MIP records a $452,830 offset to recorded losses and increases the deposit asset by the same amount. This is the portion of the asset relating to the recoverable loss at the end of year two ($7,547,170) multiplied by the discount rate. In effect, expense is reduced as a result of the implicit interest income on the recoverable.
At the end of the second year, MIP will put the following disclosure in the notes to its financial statements:
The company reinsures the portion of each individual loss that exceeds $7 million with Ocean Reinsurance. Under the terms of this contract, which spans years one through three, the company pays losses as they are incurred and Ocean Reinsurance is required to reimburse the company for covered losses incurred at the end of year three. In year two, the company incurred a $15 million loss, of which $8 million was recoverable from Ocean Reinsurance. The present value of this amount, $7,547,170, has been recorded as a reduction in year two incurred losses. The insurance premium amortization expense (recorded as an adjustment to incurred losses) for this contract in years two and one was $4 million each. The deposit asset figures related to this contract at the end of years two and one were $11,547,170 and $8 million, respectively.
Timing risk is not transferred in this arrangement (the company still has to pay claims when they are incurred and receives reimbursement at a later date). This contract, therefore, is recorded using the deposit accounting method as described above.
The third-year financial statement will disclose the interest accrual of $452,830 that reduces the recorded loss.
The accounting treatment for Ocean Reinsurance parallels that in exhibit 3, except that changes in the asset other than the unexpired portion of the coverage provided are recorded as an incurred loss.
|Exhibit 3: Marine Insurance Partners|
Deposit Asset Calculation
|Description||Amortization||Offset to Recorded |
at End of Year
|Balance, end of year 1||8,000,000|
|$8 million recoverable||$7,547,170||7,547,170|
|Balance, end of year 2||11,547,170|
|Implicit interest (6%)||452,830|
This example assumes there is negligible risk of nonrecovery from the reinsurer. In case such a risk exists, the discount rate used to calculate the deposit asset should be adjusted to reflect the default risk. The deposit liability on the reinsurers balance sheet should be calculated using the U.S. obligations rate and should not be adjusted for the possibility of default.
OTHER KINDS OF CONTRACTS
Under SOP 98-7, insurance contracts that transfer neither significant timing risk nor significant underwriting risk are expected to be rare. The accounting treatment for such contracts would follow that for contracts that transfer only significant timing risk.
For contracts that transfer indeterminate risk, the prescribed accounting treatment is the open-year method which can be found in SOP 92-5, Accounting for Foreign Property and Liability Reinsurance . Under that method, a company aggregates underwriting results in the balance sheet and does not include them in the income statement until sufficient information becomes available to reasonably estimate and allocate premiums. When this happens, the contract is reclassified as one of the three types of insurance contracts mentioned previously.
SOP 98-7 will standardize financial reporting practices in cases when it is clear that risk has not been transferred in an insurance or reinsurance contract. However, further guidance is needed to answer questions related to circumstances when risk is, or is not, transferred in insurance contracts. The SOP is effective for financial statements for fiscal years beginning after June 15, 1999, with earlier adoption encouraged. Previously issued financial statements should not be restated. Entities should report the effect of the initial adoption as a cumulative effect of a change in accounting principle in accordance with APB Opinion no. 20, Accounting Changes .