Risk Management

How Risk-Shifting Affects Earnings

Is your corporate insurance policy really insurance — or is it a loan? The answer could make a difference on your income statement.
David KatzDecember 22, 2006

With the Financial Accounting Standards Board looking to tighten risk-transfer rules, risk managers need to be on the alert for how their companies are accounting for insurance policies that may have significant loan provisions.

Up until now, FASB zeroed in on insurers and had little to say about corporate buyers and their use of so-called finite insurance. At a recent FASB meeting, however, the board voted to work on a plan to make it clear that corporate policyholders “must evaluate whether the insurance contracts they hold transfer significant insurance risk” in order to qualify as insurance rather than as loans or financings.

That means companies that have bought certain nonstandard insurance policies might one day have to shave the proceeds of those policies from their earnings. Typically, such policies include high amounts of self-insurance and little risk for insurance companies.

To be sure, the board shelved a more radical notion it had been circulating for comment. The idea involved splitting — or “bifurcating” — finite-insurance financial reporting into separate insurance and loan parts. But FASB did choose to move ahead with an effort to pin down the wording of existing rules and spell out more what it means by “significant” risk transfer.

At the December 6 meeting, the board voted to improve existing risk-transfer rules. For one thing, FASB wants to propose edits to Statement No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts, that would make clear what the minimum level of risk transfer should be for an insurance company to be able to report a contract as reinsurance. Corporate insurance buyers could then use similar criteria to gauge whether the policies they hold transfer enough liability to be considered insurance rather than a loan.

The standards board also intends to ramp up disclosure rules so that corporations report how and why they use insurance, how the policies are accounted for, whether the policies include any risk-limiting features, and the effect of the policies on the financial statements.

A corporation that transfers a set amount of risk to an insurance company along with money to cover the bulk of that risk could well find itself restating its financials if the risks or the money are material. If FASB has its way, companies won’t be able to gussy up such contracts as “insurance” policies and would have to account for them as loans or financings.

The contrast between reporting an arrangement as insurance and reporting it as a loan can be stark. If the contract has enough risk transfer in it to qualify as insurance, for instance, the company could expense the premiums it paid during the policy period. Better yet, the corporation could report the money it collects on insurance claims as income-statement gains.

But if the policy — or part of the policy — is considered a loan, the policyholder would have to account for it as a “deposit.” The corporation would then treat the insurance premiums it paid as a deposit asset and the money it gets from the insurer if a loss occurs as a reduction of that asset, much like a loan repayment. In that case, the insurance company is the “borrower.” In accounting for the deposit, the corporate buyer would record the insurance premiums as an asset on its balance sheet. The bad part is that the corporation wouldn’t be able to report the money it gets paid on an insurance claim as a gain on its income statement.

In the wake of insurance scandals involving arrangements between AIG and its clients Brightpoint Inc. and General Reinsurance Corp., the board has been mulling the matter of finite insurance policies. Such contracts tend to transfer a clearly defined, restricted piece of an insurance risk from the policyholder to the insurance company, with the policyholder self-insuring a hefty chunk of the risk.

To be sure, under certain finite contracts there may be a good chance that the insurer will be hit with a substantial loss on the contract — meaning that a significant amount of risk had been transferred. But under many such contracts, the difference between depositing cash in a secure account with an insurer and paying an insurance premium can get pretty vague.

The issue of how to apply the accounting rules on risk transfer to corporate policyholders, rather than just insurance companies, has been on the board’s mind for some time now. That’s because the only guidance provided by FASB up until now has been Statement No. 5, which says only that the policy must “indemnify” the policyholder against loss in order to qualify as a risk transfer.

A later guidance, Statement No. 113, applies only to reinsurance, which is bought mainly by insurance companies. (It does, however, touch on captive insurance companies — insurance subsidiaries owned by corporate insurance buyers — which do buy reinsurance.)

In the coming months, the accounting board might find itself wrangling over words with its constituents. Among the changes proposed by the FASB staff is to remove the terms “remote” and “insignificant” from the definitions of risk-transfer limits under Statement No. 113 and replace them with terms “that indicate a more robust requirement for determining risk transfer,” according to a staff handout. The staff also wants to provide added guidance about the meaning of “significant”: they say the word “means more than simply ‘greater than trivial’ and ‘greater than remote.’”

Clarity on such matters, however, may be a long time coming. “The issue of finite risk is something we’re going to have to live with for many years,” Jeffrey Cropsey, the board’s manager for the project, said at the FASB meeting. “Accounting for insurance and reinsurance contracts with significant risk-limiting features is one [issue] that will remain for quite a while.”

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