The FASB and the AICPA have issued numerous pronouncements as guidance for revenue recognition and general accounting matters concerning insurers:
FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises (discusses the specialized accounting of insurers and is based on principles and practices in AICPA Guides and Statements of Position for the insurance industry);
FASB Statement No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments (analyzes various insurance contracts exhibiting long pay or investment features and amends Statement 60; see also AICPA Practice Bulletin No. 8, Application of FASB Statement No. 97 … to Insurance Enterprises);
FASB Statement No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts (sets reinsurance accounting standards);
AICPA Statement of Position (SOP) No. 78-6, Accounting for Property and Liability Insurance Companies; and
AICPA Statement of Position (SOP) No. 79-3, Accounting for Investments of Stock Life Insurance Companies.
Under Statement 60, insurers’ contracts are designated as either short- or long-term duration. Short-term duration contracts are for a fixed period, allowing the insurer cancellation or adjustment at the end of the term. Long-term duration contracts are noncancellable contracts that place on the insurer a specific duty of renewal for an extended period of time.
For short-term duration contracts premiums must be recognized as revenue on a proportional basis; that is, over the period of the contract for the insurance protection. Therefore, straight-line revenue recognition normally occurs.
While the preceding is the GAAP rule for short-term duration contracts, the SAP rule requires that premiums be subject to certain experience-type adjustments post-contract period. For instance, premium revenues in health insurance contracts would be adjusted to reflect experiential (exposure) under the actual contract. See, for example Statement of Statutory Accounting Principle (SSAP) No. 51, Life Contracts.
For long-term duration contracts, recognition of revenue occurs when premiums are due from the policyholder. It follows the Statement 60 definition of gross premium as the measure for revenue recognition, and the concept of “loading” (the difference between the gross and net premium) is ignored. So, for investment-type contracts, revenue is recognized even if no premium is paid by the policyholder, as in the case of universal life contracts. Revenue in such contracts represents the premiums assessed.
Jones owns a universal life contract of $1.0 million on his life. The feature of a universal life contract is its premium payment flexibility; that is, Jones can pay the billed premium of $12,000 per year or pay nothing. Regardless of the decision by Jones, the insurer, under Statement 60, has $12,000 per year of recognized revenue. Note that under SAP, unlike GAAP, adjustments to the $12,000 gross revenue may be required for loading.
Finally, for reinsurance contracts, revenue recognition is controlled by Statement 113. The premium paid (reduced by reinsurer premiums retained) is reported as a ceding insurer’s deposit. Adjustments to net revenue recognized from reinsurance transactions reflect acquisition costs.
Reinsurance contract accounting, as set forth in Statement 113, does present a problem. This problem is in the accounting method allowed the seller of the insurance contract versus the buyer of the contract. Perhaps an example will help.
Life Insurance Company transferred its risk of loss on contracts to Ace Indemnity Company, a reinsurance company. Under Statement 113, Ace Indemnity Company should have reflected this transaction as a liability that could grow over time; that is, most reinsurance agreements set a payment amount such as $500 million with a maximum risk limit or cap at $1.5 billion over time. But Statement 113 also permits Ace Indemnity Company to treat the transaction as a mere deposit or “reserve credit” used to pay claims arising from the Life Insurance Company contracts.
So Ace Indemnity Company writes up this reserve credit on its books for the $500 million and doesn’t reflect the maximum risk limit or any other liability. Naturally, Ace Indemnity Company looks much better on paper than it is in substance. The $500 million is a mere deposit with Ace Indemnity Company from Life Insurance Company, albeit the latter treats the transaction as a reinsurance transfer of risk. If true reinsurance accounting were to prevail, Ace Indemnity Company would be required to book the estimated cost of claims as a liability, not as a reserve. Unfortunately, under Statement 113, such is not the case.
The FASB has initiated a technical application and implementation project on insurance risk transfer. This will lead to issuance of an exposure draft in early 2006 and, ideally, a final standard later that same year to amend Statement 113. The amendment should clarify the definition of a true reinsurance transaction and thereby require liability recognition as described above.
Branch offices or agents’ offices, as the case may be, will recognize revenue on insurance applications submitted to the insurer’s underwriting department. This department sets guidelines as to the insurer’s risk level. It is of little financial reward to the agency when the underwriting department rejects an application; for example, a long-term care contract may be rejected due to a pre-existing condition.
Once the underwriting department accepts the risk (the applicant generally pays a premium with the application to “bind” the contract), then the agency can recognize revenue. Note that the mere payment of a premium by an applicant does not result in revenue recognition until the insurer decides to accept the applicant’s offer and payment.
Agencies also recognize, as do respective agents, recurrent premium commissions. Indeed, on variable insurance annuity products such commissions may be for the life of the product. Agencies and insurers handle these in one of two ways.
The agency can receive the overrides for distribution to the agent, or the agent, as is generally the case. Revenue is recognized on a cash basis by the agent. Once the agent leaves, assuming no vested right to the future commissions, most insurers record the revenue as described above, with no payment to the agency (other than possible overrides to the agency employee managers).
Excerpted by permission. Copyright 2007, Specialty Technical Publishers.