Loss Portfolio Transfers: Accounting Considerations

1. Loss Portfolio Transfers: Accounting Considerations Charles Woodman, CPA 2001 Casualty Loss Reserve Seminar New Orleans / September 12

2. Discussion Flow • General Comments: LPT and Accounting Issues • Relevant Accounting Fundamentals: Discussion Definitions • Financial Accounting and Reporting • Generally Accepted Accounting Principles • Statutory Accounting Principles • Tax • US Federal Income • Other Relevant Tax Issues

3. General Comments: LPT and Accounting Issues • Extensive topic / Limited time: Each transaction must be weighed on its individual facts and circumstances. • For our purposes, Accounting is defined as the formal reporting of a transaction to interested third parties. • Shareholders, SEC, Financial Institutions, etc. • Insurance Departments, NAIC • Internal Revenue Service

4. Relevant Accounting Fundamentals: Discussion Definitions • LPT is a broad term. • Most LPT transactions will have accounting & tax implications. • Distinctions: Financial Accounting vs. Tax Accounting • Financial Reporting: • GAAP, FASB, SEC • Fair representation of going concern • SAP (Stat), Individual States, NAIC • Financial condition • Tax Reporting • Congress, Internal Revenue Code, IRS, • Tax Minimization

5. Financial Reporting of LPTs: Relevant GAAP • Financial / Transactional Impact: • Positive Earnings • Balance Sheet Clean-up • Disclosure Relief • FAS 5 & FAS 60: Loss Contingencies and Reporting of Insurance Transactions • FAS 113: (Re)insurance Transaction Defined • EITF 93-6: Retrospectively Rated Contracts / Transfers • Other • FAS 125: Extinguishment of Liabilities • FAS 133: Accounting for Derivatives and Hedging Activities • FAS 141: Business Combinations • FAS 142: Purchase Goodwill

6. FAS 113: Accounting and Reporting for Reinsurance of Short-term and Long-term Contracts • Imposes conditions on the accounting by insurance enterprises for (re)insurance contracts; failure to pass FAS 113 requires deposit accounting • Creates hoops for us to get a transaction classified as a (re)insurance. • To qualify for insurance accounting three criteria must be met: ("risk transfer tests") • 1. The contract must transfer U/W risk. • Interest rate risk and Timing risk are not insurance risks by themselves. • 2. Cash flow timing to cedant from rein'r uncertain @ inception. • 3. The rein'r must have reasonable possibility of significant loss on the contract.

7. FAS 113 (cont’d) • Technically, FAS 113 only applies to reinsurance contracts. Nonetheless, many auditors will apply it to direct insurance transactions as well (EITF 93-14). • "Reasonable possibility" and "significant loss" are not specifically quantified. • Many interpret them to mean the (re)insurer must have at least a 10% chance (actuarially determined) of sustaining at least a 10% present value loss (calculated by taking the present value of all premiums and dividing it by the present value of the projected loss payouts, using current market interest rates).

8. FAS 113 (cont’d) • Importance • Bona fide insurance contract • If FAS113 not met, "insured" must treat "premium" as deposit. • If FAS113 met, insured may be able to expense premium. • IRS will apply FAS 113 to determine whether premiums are deductible.

9. EITF 93-6: Accounting for Multi-year Retrospectively Rated Contracts by Ceding and Assuming Enterprises • Effects Loss Portfolio Transfers and Multi-year contracts • Governs whether premiums should be expensed when paid or treated as deposit. • Must be fixed term. • Contract must be able to have FAS 113 applied to it. • Premiums must be reasonable to the risks covered.

10. FAS 113 & EITF 93-6 • Red Flags • Multiple-year contracts • Terms not finalized or final performance not determinable at inception • High profit commissions or "adjustments" • Early cancellation or generous commutation provisions • Experience accounts • Insured control • What Does This Mean... • Analysis on all material (re)insurance contracts • Quantitative precision must overlay qualitative process • Closer Accountant / Actuary participation

11. Other Relevant GAAP Issues • FAS 125: Extinguishment of Liabilities • Technical interpretation has been known to hinder full LPTs. • Requires OK of all concerns. • FAS 133: Accounting for Derivatives and Hedging Activities • May become an issue with contracts which combine insurance and “other risks.” • Risk of policy bifurcation. • “Derivative element” may be capitalized and subject to mark-to-market accounting.

12. Financial Reporting: STAT • Reporting Strategy: • Capital Structure / Surplus Enhancement. • Common transaction between (re)insurers • “Old” Chapter 22 • “New” SSAP 62: Adopts FAS 113 & EITF 93-6 w/ modifications: • Gains are “write-in gains” in other income. • Surplus created restricted to special surplus account until reinsurance recovered exceeds consideration / premiums paid. • Adjustments (commission, premiums or coverage) recognized based on experience to date, including early termination / commutation clauses. • Reinsurance recoverables on unpaids presented as a contra-liability.

13. Tax Reporting: Basics • Corporations • May take deductions for business expenses which are ordinary and necessary, generally on an accrual basis. • Business purpose other than tax avoidance. (see UPS) • Insurance premiums are business expenses. • For “insurance companies,” losses are deductible on an incurred basis (discounted) including IBNR. • For non-insurers, property and casualty losses are deductible as business losses; HOWEVER MAY ONLY BE DEDUCTED ON AN "AS PAID" BASIS. (an inconsistency with accrual accounting) • Self-funding mechanisms do not constitute an insurance transaction • Substance over Form (don’t blow the form.)

14. Tax Reporting • The P&C Insurance Transaction is not defined by the Internal Revenue Code • Insurance has been defined to have three elements • Insurance Risk • Risk Transfer and Risk Distribution • Nuances and Common Notions of Insurance • Where risk transfer is the most problematic issue regarding prospective alternative risk financing, LPTs also involve insurance risk as major issue. • If not: • For ceding party: premiums would be treated as deposit. • For assuming party: losses not recognized as incurred.

15. The Tax Law • Rev Rul 89-96: The “MGM Grand” Ruling • The event has occurred. • GCM 39795 & GCM 39796. • International Life Ins. Co. v. Comm • IRS has taken the position that premiums associated with liability transfers, especially Adverse Development must be capitalized over coverage life. Stegler v. Comm. • FAS 113 will be applied. • IRS has shown reluctance to provide advance determination. • For Insurers / Reinsurers: The Annual Statement drives, therefore Statutory Accounting is the basis, however, the IRS can propose “adjustment” on substance issues.

16. Other Issues • IRC Section 845: Authority to make “adjustments” where tax benefit exceeds reinsurance benefit or where there is a “significant tax avoidance effect”. • IRS does not need to reverse transaction on both sides. • Issues: • Age and character of business reinsured • Profit structure • Duration of agreement • Termination / Commutation • Tax positions of parties • Statute of Limitations for raising issue: • Generally 3 years from return filing • 6 years if liability is significant.

17. Other Relevant Tax Issues • State Premium Taxes • On direct transactions with admitted carrier • Self-procurement or Direct Placement Taxes • On direct transfers to non-admitted or offshore insurers • Federal Excise Taxes • 4% on direct • 1% on reinsurance • If not insurance, no tax.