28 November 2013Accounting & tax analysis

Proposed ASU: a broad reach

On June 27, 2013, the Financial Accounting Standards Board (FASB) issued a proposed Accounting Standards Update (ASU), Insurance Contracts (Topic 834), which potentially represents a significant change in the way an insurance contract is viewed and accounted for in financial statements. Here we provide an explanation of the scope of the proposed standard, emphasise how it extends beyond traditional insurance contracts and address how it may therefore apply to entities outside the insurance industry.

Existing US generally accepted accounting principles (GAAP) for insurance contracts have developed over many years as new insurance contract terms and features have been developed by the industry. These product-related changes have resulted in multiple measurement models that vary based on the nature of the insurance contract. However, to date, the existing accounting principles on insurance contracts only apply to insurance entities, which have historically been defined to include only those licensed as insurers and subject to a regulatory regime.

As a result, contracts issued by non-insurance entities that contain identical or similar economic characteristics to insurance contracts issued by regulated insurance carriers may not have been accounted for in the same manner.

One of the major objectives of the proposed guidance is to address synchronising how all contracts that provide an indemnity are measured by those issuing such contracts. This proposed standard clarifies that it applies broadly to all entities, many of whom likely never thought they were issuing an insurance contract.

"While existing us GAAP also requires timing risk for a contract to be considred an insurance contract, this is not an explicit requirement of the proposed ASU."

With limited exceptions, the proposed guidance would be applicable to all contracts that an entity issues, as well as reinsurance contracts that an entity holds, that meet the definition of an insurance contract. An insurance contract is defined in the proposed ASU as “a contract under which one party (the issuing entity) accepts significant insurance risk from another party (the policy holder) by agreeing to compensate the policyholder or its designated beneficiary if a specified uncertain future event (the insured event) adversely affects the policyholder.”

Careful consideration should be given to this definition as contracts that are traditionally labelled as insurance contracts, such as finite reinsurance contracts, may not result in significant insurance risk to the issuer and, therefore, not meet the definition, while other contracts that are not traditionally viewed as insurance contracts could meet the definition.

Insurance risk is defined in the proposed ASU as “the risk arising from uncertainties about underwriting risk as opposed to financial risk. Insurance risk is fortuitous; the possibility of adverse events occurring is outside the control of the insured.”

Other relevant definitions contained in the proposed ASU are helpful in evaluating whether the risk associated with a contract is insurance risk. They include:

•  Timing risk: Risk that arises “from uncertainties about the timing of the receipt and payments of the net cash flows from premiums, commissions, claims, and claim settlement expenses paid under a contract.”

•  Underwriting risk: Risk that arises “from uncertainties about the amount of net cash flows from premiums, commissions, claims, and claim settlement expenses paid under a contract.”

•  Financial risk: The risk of a possible future change in interest rate, price, foreign exchange rate or other variable.

It is important to distinguish between the various types of risks as insurance risk requires underwriting risk and cannot, therefore, be financial risk alone. Additionally, while existing US GAAP also requires timing risk for a contract to be considered an insurance contract, this is not an explicit requirement of the proposed ASU.

What is insurance?

When we think about insurance, we may consider health insurance, homeowner insurance, vehicle insurance and the like. However, there are various types of contracts issued by non-insurance entities that could meet the definition if one party agrees to take on significant insurance risk for the benefit of another. Examples may include:

•  Travel protection;

•  Service contracts such as auto warranty coverage provided by a third party and certain roadside assistance programmes;

•  Life contingent annuities;

•  Guarantees to repurchase certain assets, such as loans sold through a securitisation structure or otherwise, or to reimburse the purchaser against loss, in the event the transferred assets do not conform to specified guidelines;

•  Financial guarantees offered to creditors as protection against default on debt or to the debt issuers as a form of debt enhancement;

•  Private mortgage guarantees in which the guarantor receives a premium that is typically paid by the borrower to protect the lender from the risk of default;

•  Indemnities for contingent exposures related to financial arrangements such as taxes, derivatives, securities transactions and annuities;

•  Debt cancellation coverage whereby certain debt is forgiven upon the occurrence of a specified event such as death or disability;

•  Liquidity facilities designed to provide liquidity to special purpose entities through a commitment to purchase certain bonds or beneficial interests from the holders at specified dates and prices in the event of losses or defaults;

•  Guaranteeing that the acquirer in a merger or acquisition transaction will have sufficient funds to make the acquisition payments;

•  Corporate guarantees that another entity will make certain minimum revenue levels or the guarantor will make payments to the other entity for the shortfall;

•  Performance bonds issued to guarantee another party’s performance on a contractual obligation such as a contractor’s completion of a project;

•  Certain standby letters of credit that oblige the issuer to repay money on behalf of another party according to a pre-defined schedule or in the event of default; and

•  Residual value guarantees that provide for a payment if the value of an asset is less than a guaranteed amount at a specified date.

The above examples are not an all-inclusive list, but they illustrate the broad nature of the proposed ASU. Additionally, while there are various types of contracts that fall within the scope of the proposed standard, several types of contracts have been specifically excluded from its scope, including the following:

•  Product warranties issued by manufacturer, dealer or retailer;

•  Fixed fee service contracts that meet specified criteria;

•  Contingent consideration in a business combination;

•  Contractual rights and obligations based on future use of a non-financial item;

•  Employer-provided insurance;

•  Employers’ assets and liabilities under employee benefit plans and retirement benefit obligations reported by defined benefit retirement plans;

•  Charitable gift annuities;

•  Certain guarantees including those that are both unusual and non-recurring and unrelated to the type of risk that is the subject of other guarantees issued by the entity;

•  Insurance contracts (other than reinsurance contracts) in which the entity is the policyholder; and

•  Contracts within the scope of Topic 815, Derivatives and Hedging, of the FASB’s Accounting Standards Codification.

While on the surface the inclusion of new indemnity contracts within the scope of the proposed ASU may appear to be simple, we expect the analysis involved to be very complicated. We predict that the identification of contracts that are within the proposed standard, and compliance with the new measurement approaches, would touch many people in an organisation—from actuarial to underwriting to finance. The FASB believes this expansion in the scope of what would be deemed an insurance contract will provide comparability in financial statements across entities as well as a consistent, comprehensive framework for the recognition, measurement, presentation and disclosure of insurance contracts.

Since this proposed standard potentially applies to many types of entities and could require recognition of various types of contracts as insurance for the first time, readers are encouraged to evaluate the proposed ASU for its potential impact on their financial statements.

Ian Lomas is a partner at RSM Cayman. He can be contacted at:

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