MILLIMAN
Captive insurers need to prepare for changes to financial reporting standards. Amy Angell of Milliman explores the challenges created by the new accounting principles.
T
he US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are working jointly on changes intended to improve accounting for insurance contracts. The FASB’s objective
is for the generally accepted US accounting principles (GAAP) to converge with International Financial Reporting Standards (IFRS). While the final state of the standards is still unknown, the proposed rules as deliberated thus far have significant implications for the reserving and financial reporting of captives. The adoption of more principles-based accounting standards will require more work on the part of auditors and actuaries and is likely, in many cases, to increase loss reserves and lower surpluses.
Background Reporting and reserving for insurance contracts under the proposed IASB rules is a risk-based approach, and is therefore somewhat more nuanced and complex than under the current GAAP. The IASB approach is based on four building blocks:
1. An estimate of future cash outflows less cash inflows that will arise as the insurer fulfils the insurance contract;
2. A discount rate that adjusts those cash flows for the time value of money;
3. Risk adjustment for the effects of uncertainty about the amount and timing of those future cash flows; and
4. A residual margin to eliminate any gain at inception. (Most captives write short-duration contracts of 12 months or less, and are therefore allowed to use an alternative measurement technique that does not include residual margin, so it is not included in this analysis.)
A graphical comparison of the old way—the current GAAP approach—versus the new way—the proposed IFRS approach—is shown in Figure 1.
Higher reserves and delayed recognition of income Under IFRS rules, reserves are discounted to reflect the time value of money. The discount rate should be consistent with current market prices for instruments with cash flows whose characteristics reflect those of the insurance contract liability, including timing, currency, and liquidity, and should be a current rate that is updated in every reporting period. In practical terms, this means that the discount rate will be recalibrated in every accounting period (rather than remaining fixed for each accident year, as is the case with the discount factors used by the Internal Revenue Service to calculate discounted reserves for income tax purposes), and will probably be higher than a risk-free rate and lower than the expected yield on assets.
If discounting were the only modification, reserve levels would tend to be lower under IFRS, because most captives do not discount their reserves under current GAAP. However, the third building block—the risk adjustment—adds an amount to the reserves to account for the risk that actual cash outflows will be different from expected.
Under IFRS, three methods have been proposed for calculating the risk adjustment. Each method involves a number of subjective input assumptions and there can be a large range of reasonable outcomes. However, several factors will tend to increase the risk adjustment
Figure 1: GAAP versus IFRS
CICA | Forty years of captive leadership
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