The Financial Accounting Standards Board (FASB) recently issued Proposed Accounting Standards Update - Insurance Contracts (Topic 834) (the update) to improve current US generally accepted accounting principles (GAAP) and to move toward an international standard. Existing GAAP has continually been adjusted to meet the needs of individual contract types, resulting in several different models that vary based on the contract terms. Due to the multiple changes, some of the models are inconsistent with recently issued guidance. FASB worked concurrently with the International Accounting Standards Board (IASB) on the proposed update, as the International Financial Reporting Standards (IFRS) did not sufficiently cover insurance contracts. FASB and IASB believed it was important to work on this project together, as the global insurance industry is significantly dominated by entities preparing their financial statements in accordance with GAAP.
Who is affected by the proposed update
The proposed update will affect any entity that issues an insurance contract, not only insurance companies. Some examples of contracts that are within scope of the update include product warranties issued by third parties, financial guarantees, mortgage guarantees, and standby letters of credit. As defined by the proposed update, "an insurance contract is a contract under which one party (the issuing entity) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder or its designated beneficiary if a specified uncertain future event (the insured event) adversely affects the policyholder." There are some scope exclusions in the update, including product warranties issued by a manufacturer, dealer, or retailer; fixed-fee service contracts that meet specified criteria; and employer-provided benefit plans.
Objective of the proposed update
The main objective for the proposed update is to provide comparability between entities issuing the same types of contracts. Under current GAAP, the guidance regarding insurance contracts only relates to insurance companies. Currently, an entity that issues a contract similar to an insurance contract, and is not an insurance company, is not required to follow the same rules. Under current GAAP for example, if a financial institution sold a financial guarantee to a creditor, either to protect against default or to enhance debt, they would account for this transaction in accordance with Accounting Standards Codification (ASC) Topic 460 – Guarantees even though it has similar characteristics as an insurance contract. Therefore, two separate entities issuing the same contract could be recording the transaction differently. The new update will reduce the number of different models used and will require all entities that issue an insurance contract to record the transaction consistently. The update will only allow the use of two models, the Building Block Approach and the Premium Allocation Approach.
The Building Block Approach
The Building Block Approach would apply to all contracts with a coverage period of more than 12 months. This would include most life, annuity, and long-term health contracts. The update is seeking to propose a single model for these contracts which would replace multiple models today. Under the Building Block Approach, the liability for future claims would be measured each reporting date based on the present value of the expected value. Expected value is defined as the unbiased, probability-weighted estimate of the fulfillment cash flows (future cash outflows – expected claims less the future case inflows – expected premiums). Fulfillment cash flows include all costs directly attributable to, or allocable to, the fulfillment of the contract, plus costs specifically chargeable to the policyholder. According to the update, the types of costs that can be included are similar to current GAAP, plus additional guidance for costs that were not previously defined. The discount rate used in the present value calculation should reflect the characteristics of the liability. There is no prescribed method for measurement; however, there are examples included in the update that could be used. Companies will have to use judgment in determining the best approach for their product. Currently, the liability is measured when the contract is executed and only updated when certain events occur.
Additionally, under the Building Block Approach, entities will be required to record the margin (the expected profitability of the contract) as deferred revenue and recognize the revenue as the uncertainty in the cash flows decreases. Under current GAAP, the margin is recognized as a part of the liability for future claims. The margin would be recorded net of any deferred policy acquisition costs (DAC); currently DAC is recorded as a separate asset.
The update also includes significant changes to revenue and expense recognition for long-term duration contracts. Currently, for traditional long-term contracts, revenue is generally recognized when premium is due and expense is recognized for the change in the liability. Under the update, revenue will be recognized for the fulfillment of cash flows (including accretion of interest) over the coverage period in proportion to the value of coverage plus any other services; and will exclude from revenue the amounts that are estimated to be returned to the policyholder, or its beneficiary, regardless of the occurrence of an insured event. The amendments in the update would require that changes in expected future net cash flows be immediately recognized in net income. The update requires the recognition of claims, benefits, and related expenses when the claims are incurred, of other non-claims fulfillment costs when those costs are incurred, and of reversals of previously recognized amounts.
Changes in the margin are recognized through net income over the coverage and settlement periods as the entity satisfies its performance obligation to the policyholder. The margin should not be adjusted to offset changes in expected cash flows, but in determining its release from risk, an entity should consider changes in actual and expected cash flows.
The change in the revenue recognition was influenced by another joint FASB/IFRS proposed update, Revenue from Contracts with Customers.
The Premium Allocation Approach
The Premium Allocation Approach would apply to all contracts with a coverage period of 12 months or less. This would include most property, liability, and short-term duration health contracts, as well as some guarantees and service contracts. Under current GAAP, the liability for incurred claims is based on the best estimate of the undiscounted claims cost. The term ‘best estimate’ is interpreted differently at each entity, which leads to an inconsistent methodology of determining the liability. Under the Premium Allocation Approach, entities will be required to calculate the probability-weighted expected amount (the mean) of the liability and discount the mean to present value.
Currently, unearned premium reserve is typically reduced and premium revenue is recognized on a straight-line basis over the coverage period of the contract. Under the proposed guidance, the liability for remaining coverage (unearned premium) should be recognized the same way unless the expected timing of incurred claims and benefits is significantly different from the straight-line approach. This will provide for better matching of the premiums with the expenses incurred. For example, if a car manufacturer issues a ten-year extended warranty and historical evidence shows the incurred claims are 50% greater in years 9 and 10 than years 1-8 combined, then 50% of the premium should be recognized in years 9 and 10. Additionally, the update introduces the possibility of having to discount the liability for remaining coverage if the contract has a significant financing component. However, if at contract execution the entity expects that the time period between when the policyholder pays the entire premium (or substantially the entire premium) and when the entity provided the corresponding coverage is one year or less, the time value of money does not have to be considered. For example, if a company issues a three-year surety contract and premiums are due at the beginning of each year, and the premium amount is proportionate to the coverage provided for the upcoming year, then discounting and accreting interest on the liability for the remaining coverage would not be necessary. However, if the company issued the same policy, but the premiums were received in one lump sum at the time of contract execution, then the company would be required to discount and accrete interest on the liability over the remaining coverage period. If the time value of money is necessary, the discount rate used should be based on the discount rate determined at the time of contract execution and not updated.
Under both models, changes in the estimated expected cash flows would be recorded in net income; however, changes in the discount rate would be recorded in other comprehensive income.
The estimated effective date by FASB is January 1, 2018. The comment period is open through October 25, 2013. Included in the proposed update are instructions on how to submit a comment letter. Please see www.fasb.org for more information on the proposed update.
The proposed update is going to cause a significant amount of changes for insurance companies and other entities that issue insurance contracts. There will be a need for significant change in accounting systems to ensure revenue is recognized in accordance with the new standard, especially as it relates to those required to use the Building Block Approach. For companies using that approach, it appears there will be a major modification in how revenue is recognized, which when implemented will cause comparability issues. The update is to be applied retrospectively as of the beginning of the earliest period presented – the transition date. Significant disclosures will also be required during the transition period, including prior period information that has been retrospectively adjusted, the cumulative effect of the change on components of equity, and any indirect effects on the financial statements.