The Financial Accounting Standards Board (FASB) Thursday issued for public comment a controversial proposal that would change financial reporting of insurance contracts, fundamentally reconstructing the measurement of insurance liabilities and income as they are reflected in income and earnings statements.
The proposed update would apply to all contracts that meet the definition of an insurance contract, not just those written by insurance companies. It would also apply to ceding insurers in reinsurance contracts.
Basically, it would require accounting to be based on current assumptions of cash flows to fulfill the coverage on a quarterly basis, adjusted for the time value of money–even if the claims are not being paid out for years.
Currently, as analysts note, U.S. Generally Accepted Accounting Principles (GAAP), which requires insurance premiums for long-duration contracts to be recognized when due, not quarterly. The proposal would not go into effect until 2018.
The move is an effort to update GAAP and make the accounting standards more comprehensive as well as forward-looking, or principles-based, and also work toward a converged international standard, although the new proposal falls a bit short on that. The industry is hopeful, however, for more deliberations–starting in January–to iron out differences between the U.S. and European models.
The FASB proposal was developed as part of its broader joint project with the International Accounting Standards Board (IASB), which released its own proposal June 20. Both proposals contain similar fundamentals–most notably the use of current estimates–but differences exist, FASB noted in a statement.
The proposed changes to insurance contract accounting will introduce volatility into financial statements, according to rating agencies and analysts. However, some in the industry do not mind, as long as there is one global standard.
The accounting convergence work got underway more than a decade ago, at least, but in the past few years it has taken on a greater urgency as the international community, led by Europe, pressures for commonality and convergence on a great number of financial work streams in the wake of the global economic crisis.
“The proposed standard is intended to bring greater consistency and relevance to the accounting for contracts that transfer significant risk between parties,” stated FASB Chairman Leslie F. Seidman in a statement. “Current U.S. standards on insurance have evolved over the years as new products have been introduced, leading to some inconsistencies in GAAP. The proposed standard would require a current measure of insurance contracts, including the use of updated assumptions and discounting.”
The proposed update would require contracts that transfer significant insurance risk to be accounted for in a similar manner, regardless of the type of institution issuing the contract. Thus, it would apply to banks, guarantors, service providers and other types of insurers, in addition to traditional insurers.
An insurer would recognize revenue in net income in proportion to the value of coverage or services provided. Claims and contract-related expenses would be recognized when incurred. This is a bit like marking to market, although there is no “market,” for long-tail insurance claims, as one analyst noted.
Any amounts received that are expected to be returned to the policyholder or the policyholder’s beneficiary, regardless of whether an insured event occurs, would be excluded from revenue and expenses.
The contracts most used by life, annuity and long-term health insurers would use one approach, the so-called “building block” approach, and the contracts most used by property casualty insurers and short-term health writers would use another approach, the “premium allocation” approach.
The building block approach would be measured each reporting period based on the current present value of the fulfillment cash flows. This would be based on the expected value that incorporates all relevant information and considers all features of the contract, including guarantees and options. The measurement would also include a margin that initially reflects the expected profitability of the contract.
The premium allocation approach would include a liability for remaining coverage that represents the gross cash inflows not yet earned and is released in subsequent periods on the basis of the expected timing of incurred claims and benefits. A separate liability would be recorded when the claim is incurred and be measured based on the expected present value of future cash flows.
“In general, it will introduce volatility across all lines of business, and not just because of quarterly updates or the quarterly reset,” said J. Paul Newsome, managing director and the senior insurance analyst in the Research Department of Sandler O’Neill + Partners in Chicago. “There is more volatility in the building block accounting method because you are introducing more assumptions into the insurance,” Newsome said.
Mike Monahan director of accounting policy at the American Council of Life Insurers (ACLI), said the member companies are “100 percent behind” global accounting convergence and are optimistic that further deliberations will be joint (FASB and IASB) and they would be able to iron out remaining differences.
“We do not want a separate set of books for our multi-nationals. We hope they pick one method and go with it,” Monahan said.
For example, there is the use of a single margin for unearned profit on insurance contracts by FASB and a double margin–a risk margin and a service margin of embedded profit–favored by Europeans and the IASB.
“…These are not big differences. The pain is keeping track of two separate systems,” Monahan said.
As for volatility, Monahan said, “We don’t believe in masking volatility–we believe you should be showing that. Under the current system, the numbers are hidden. Now they will be there for all to see, so there is no black box mentality (as some analysts suggest of insurers’ financials).
The draft accounting methodology “would open the box and show the moving parts,” Monahan said. “There is more transparency, which we think is important.”
“If the IASB and FASB are successful, a version of the building block method will be used by most countries on a global basis and there will be more consistency of accounting possibly globally from a theoretical perspective, but I am not so certain you will have better comparability because so much subjectivity in how the accounting is prepared,” Newsome said.
The purpose behind this standard is more political than anything else, he noted.
“The proposal could significantly change key performance indicators such as net loss and expense ratios for entities with significant reinsurance programs,” stated Ernst & Young accounting in a report on the proposed rules.
A lot of this is driven out of Europe and not the United States. The Europeans do not have a standard, therefore they are creating one. The U.S. and much of North American and the offshore communities, which have half the world’s insurance, already have a standard (GAAP) but it is incompatible with IASB standards. “It is a little like the tail wagging the dog,” Newsome said.
Under both FASB and IASB proposed approaches, an insurer would recognize revenue in net income in proportion to the value of coverage or services provided. Claims and contract related expenses would be recognized when incurred. Any amounts received that are expected to be returned to the policyholder or the policyholder’s beneficiary regardless of whether an insured event occurs would be excluded from revenue and expenses.
Comments for both the FASB proposed update and the IASB exposure draft are due at the end of October. The FASB website offers a general overview of the proposal and one that focuses on the types of companies and contracts that would be affected by it.