Norwalk, Conn. Insurance and reinsurance have recently made headline news, and it has not been pretty.
The legal tribulations of AIG and half a dozen other insurers have again brought big-ticket fraud to the headlines. Malfeasance most likely played a part, but insufficient accounting standards may have greased the skids.
The Financial Accounting Standards Board was already considering issuing a staff position on risk transfer in insurance and reinsurance contracts when the AIG scandal surfaced late last year. The financial shenanigans apparently grabbed the board's attention, and in early April, FASB added the project to its agenda.
The board isn't setting out to identify and correct the specific problems that allowed the scandals, but, depending on the scope of the project, any new guidance is expected to tighten definitions and give corporate and public accountants something more solid on which to base decisions and analyses.
"This project will examine many issues relating to risk transfer in insurance and reinsurance contracts," said FASB project manager Jeffrey Cropsey, "But it's too early to know what impact, if any, the board's decisions will have."
The board has not yet determined the scope of the project, but it is expected to begin by studying a gaping hole in guidance on risk transfer in insurance contracts.
FASB's Statement 113 deals with reinsurance contracts, but offers little on determining the degree of risk transferred in insurance contracts. Statement 5, on accounting for contingencies, requires that insurance and reinsurance contracts must indemnify the insured against loss or liability, but it fails to define "indemnify."
Neither statement defines "insurance contract" or "insurance risk."
As part of its ongoing effort to pull together and codify all existing pronouncements on accounting issues, the board is expected to compile related guidance from various sources. A staff presentation to the board suggested that a study of existing guidance would help determine what needs to be done.
"The staff believes that such a compilation could provide a useful starting point for defining an insurance contract and an insurance risk," the presentation document stated, "as well as setting a framework for analyzing current risk transfer criteria and reviewing approaches for strengthening those criteria."
To some extent, Statements 5 and 113 exemplify the kind of "principles-based" standard that leaves terms loosely defined, allowing the preparers and auditors of financial reports to use the spirit of generally accepted accounting principles, rather than depending on highly detailed guidance.
The board may have to consider whether the relatively vague definitions of these statements led to misinterpretations that caused problems at AIG and several other companies.
It is unlikely, however, that bona fide misinterpretation led to the scandals.
The deals behind the scandals involved complex contracts that combined recognized concepts to produce agreements with little purpose beyond a company or insurer temporarily using the balance sheet of a reinsurer to hide or postpone losses.
The Reinsurance Association of America advocates the proper use of reinsurance for purposes of managing the volatility of underwriting, credit, investment, timing and other risks, capital financing through surplus relief, reduced volatility of financial results, and increased underwriting capacity. In a recent report, the association saw no need for additional standards, but offered to cooperate if improvements are sought.
"Current GAAP and statutory accounting principles accounting guidance provides an appropriate framework to evaluate the economic substance of reinsurance transactions and the appropriate framework for establishing the proper financial accounting and reporting disclosures to address the needs of a broad user base," the report concluded. "If insurance regulators, FASB or others decide that further prospective evolution of the SAP or GAAP accounting, disclosure or risk transfer rules is necessary, then regulators, insurers and reinsurers should work cooperatively to effect that change."
The risk transfer issues first came to FASB's attention via a paper issued by the American Institute of CPAs' Insurance Experts Panel. The main issues focused on certain contractual risk-limiting features of short-duration reinsurance contracts.
That lack of definition may contribute to the problems behind the recent scandals, which involved contracts being used to transfer a negligible amount of risk but primarily to smooth earnings or enhance the financial condition of a company, at least on paper. FASB's eventual decisions should help clarify how much risk must be transferred to qualify as a true reinsurance transaction.
FASB's first focus is likely to be on definitions. From there, it may move on to look separately at two parts of finite risk contracts: the part that transfers risk, and the part that doesn't. The former may be considered insurance, while the latter is considered a deposit.
The scope of the project has yet to be determined. It may amend or interpret Statements 5 and 113, or it may lead to a whole new standard.
Cropsey said that the board had not yet set a timetable for the release of a document or exposure draft.
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