Accounting & Audit IMAC Captives Course

November 9, 2011 Accounting & AuditIMAC Captives Course Presented By:Alissa Matthews, CABen Leung, ACA Senior Vice President, Marsh Managing Partner, PKF alissa.matthews@marsh.com bleung@pkfcayman.com

Overview & Objective The objective of this course is to understand the process specific to insurance captives, for the following topics: • Accounting & Financial Reporting • Auditing

Accounting & Financial ReportingOverview • Accounting Oversight & Governance • Accounting for Premiums & Losses • Example 1a: Premiums/Losses • Example 1b: Reinsurance • Accounting for Retrospectively Rated Programs • Example 2a: Retrospectively Rated Program • Example 2b: Deposit Accounting • Other Accounting Considerations: Premiums & Losses • Accounting for Investments • Example 3: Investment Classifications

Accounting & Financial ReportingOversight & Guidance • US Generally Accepted Accounting Principles (US GAAP) • AICPA – American Institute of Certified Public Accountants www.aicpa.org • FASB – Financial Accounting Standards Board www.fasb.org • SEC – Securities Exchange Commission www.sec.gov • Vast majority of Cayman captives follow US GAAP • International Financial Reporting Standards (IFRS) • IASB – International Accounting Standards Board and IFRS Foundation www.ifrs.org • European Union, Canada, Australia, Asia • US GAAP vs IFRS: • Differences • Global harmonization and convergence • Majority of Cayman Captives use US GAAP • Presentation will focus on US GAAP treatment

Accounting & Financial ReportingAccounting for Premiums & Acquisition Costs • Accounting for the insurance program follows the insurance contracts. Under insurance accounting all contract amounts are set-up on day one: • Premiums recognized as revenue over term of the contract in proportion to the insurance protection provided (typically evenly) (ASC944-605). • Acquisition costs are related to acquiring the insurance contract and are set up on the balance sheet and expensed over term of contract. Acquisition Costs vary with the contract, ie. commissions, fronting fees, taxes, etc. (ASC944-30-25-1) • General & Administrative Costs do not vary with contract & are not primarily related to the acquisition of the contract, ie. management fees, audit fees, etc. These costs are expensed as incurred. (ASC944-30-25-2) • Reinsurance premiums assumed & ceded are accounted for on a gross basis

Accounting & Financial ReportingAccounting for Losses & Loss Reserves • Paid Losses & Case/Reported Reserves are based on Loss Runs • Claims Handler estimates reserve for known reported claims • Incurred But Not Reported (IBNR) must be recorded (ASC944-40-30) • Adverse development on case reserves • Claims not yet reported • Actuary projects ultimate losses then deduct paid losses and case reserves to obtain the IBNR figure. • Losses related to reinsurance contracts must be recorded gross • Loss & Reserves Note Disclosures: • Narrative on how losses are derived • Break-down components of reserves between case & IBNR • Break-down of movement in loss reserves between incurred and paid and between current and prior years

Accounting & Financial ReportingAccounting for Losses & Loss Reserves • Reserves may be booked at a different confidence level and/or discount rate than that used for funding. • Confidence level or risk margin: higher = more conservative • Discount rate: comparable to risk free rate • Reserving Trends • Expected/Undiscounted • 75% confidence level/Discounted • Reserving methodology should be reviewed annually: • Changing confidence level = change in accounting estimate • Changing discount rate = change in accounting estimate • Changing from discounted to undiscounted • Differing treatments: accounting policy vs accounting estimate • Check with company’s auditors

Accounting & Financial ReportingExample 1 – Accounting for Premiums & Losses • AM Insurance Company (AMIC) has a December 31st year end and their financial statements follow US GAAP. • On October 1st AMIC entered into a year long reinsurance contract with the following terms and conditions: • Premiums $100,000 • Fronting & Acquisition Costs $5,000 • Net premiums ceded quarterly • Administrative expenses were $30,000 for the year • During the year claims were reported of $15,000 of which $5,000 was paid and $10,000 reserved. • Actuary projected ultimate losses of $25,000 as at year-end.

Accounting & Financial ReportingExample 1 – Accounting for Premiums & Losses Insured $100,000 in premiums Fronting Company $5,000 deducted for Fronting Fees $95,000 ($23,750 per quarter sent to the captive) AMIC

Accounting & Financial ReportingExample 1a - Accounting for Premiums & Losses . To record premiums written & costs To record unearned & deferred amounts

Accounting & Financial ReportingExample 1 – Accounting for Premiums & Losses Insured Loss Runs / Cession Statement: $5,000 Paid + $10,000 Reserved = $15,000 Incurred $100,000 in premiums ($25,000 earned per quarter) Fronting Company $5,000 for Fronting Fees ($1,250 expensed per quarter) $95,000 ($23,750 per quarter sent to the captive) Actuarial Report: $25,000 Ultimate Losses - $15,000 Reported = $10,000 IBNR (Incurred But Not Reported) Invoices: $30,000 Expenses AMIC

Accounting & Financial ReportingExample 1a - Accounting for Premiums & Losses To Record Transfer to Incurred/ Earned To Record Expenses To Record Losses & Loss Reserves

Accounting & Financial ReportingExample 1a - Accounting for Premiums & Losses

Accounting & Financial ReportingExample 1b – Accounting for Reinsurance Example 1b: AMIC decided on October 1st to cede 100% of the premiums to an excess reinsurer for an amount of $85,000 plus $10,000 in commission costs, due to the reinsurers on Day 1 of the policy. To record premiums written & costs To record unearned & deferred amounts

Accounting & Financial ReportingExample 1b - Accounting for Reinsurance Example 1b: AMIC decided on October 1st to cede 100% of the premiums to an excess reinsurer for an amount of $85,000 plus $10,000 in commission costs, due to the reinsurers on Day 1 of the policy. To Record Tsf to Incurred/ Earned To Record Recoverable from Reinsurers

Accounting & Financial ReportingExample 1b – Reinsurance Accounting

Accounting & Financial ReportingAccounting for Retrospectively Rated Programs • Premiums may be subject to adjustment under retrospectively rated or other experience rated contracts. • If the premium is reasonably estimable, then that amount is recognized as revenue over the course of the contract and revised to reflect current experience. • If the premium is not reasonably estimable, then the cost recovery method or deposit method until it is estimable. • Retrospectively-Rated, ‘Zero-Bottom Line’, or ‘Harvard Model’ captives • Premiums typically initially based on the 75% confidence level in the actuarial funding report plus operating expenses. • Policy notes premiums will be adjusted based on actual loss experience. • May be subject to a maximum & minimum premium. • May include operating expenses and investment income. • Return excess funding through premium adjustments.

Accounting & Financial ReportingAccounting for Retrospectively Rated Programs • Contracts must transfer risk in order to be accounted for on the insurance accounting basis. ASC 944-20 (FAS113 (9)) states that both the following must be met in order for the transaction to be a risk transfer arrangement: • The reinsurer assumes significant insurance risk under the reinsured portions of the underlying contracts. • It is reasonably possible that that reinsurer may realize a significant loss from the transaction. • In general this clause has been interpreted as: 10% risk of a 10% loss = 90% confidence level x 90% • Evidence of risk transfer must be present at policy inception. • Cap maximum premiums at or below the risk transfer amount for the policy to qualify for insurance accounting treatment.

Accounting & Financial ReportingAccounting for Retrospectively Rated Programs

Accounting & Financial ReportingExample 2 – Retrospectively Rated Programs • On January 1st, AMIC issued a policy directly to its Parent with the following terms and conditions: • Premiums of $200,000 based on the 75% confidence level funding report of $165,000 plus $35,000 funding for admin expenses. • The policy includes a retrospective premium clause that meets the requirements for risk transfer • Premiums paid quarterly in advance • At year-end claims paid were $10,000 and case reserves $40,000. • The actuary adjusted their ultimate losses to $130,000 at year-end. • Administrative expenses were $30,000 • Interest earned was $5,000. Parent Insured $200,000 AMIC

Accounting & Financial ReportingExample 2a – Retrospectively Rated Programs To record premiums written & costs To record unearned & deferred amounts To Record Premiums & Interest received

Accounting & Financial ReportingExample 2a – Retrospectively Rated Programs To Record Earned Premiums To Record Expenses To Record Losses & Loss Reserves To Record RPA Movement

Accounting & Financial ReportingExample 2a – Retrospectively Rated Programs

Accounting & Financial ReportingExample 2b – Retrospectively Rated Programs Example 2b: All other contract terms remain the same, but the 90% confidence level discounted in the funding report was $230,000. 90% Confidence Level Discounted $230,000 Multiply by 90% 90% Maximum Premiums for Risk Transfer $207,000 Actual Premiums $200,000 Actual Premiums < Max Premiums YES Retrospectively Rated Policy Cap $250,000 Retro Cap < Max Premiums NO This example policy DOES NOT PASS the risk transfer test since the retro policy has a cap that is higher than the 90% confidence level discounted x 90%.

Accounting & Financial ReportingExample 2b – Retrospectively Rated Programs • Accounted for using Deposit Accounting • Premiums received are recorded as additions • Losses paid as deductions to the deposit liability • Includes retrospective premium adjustments as part of policy • The amount of deposit liability should be adjusted to reflect future estimated payments (ASC 340-30-35) To set up deposit liability To reverse UPR entries

Accounting & Financial ReportingExample 2b – Retrospectively Rated Programs To Allocate Income Statement Amounts to Deposit Liability To Reverse Reserve Entries

Accounting & Financial ReportingExample 2b – Retrospectively Rated Programs Premiums $200,000 Losses Paid (10,000) Investment Income 5,000 Admin Expenses (30,000) Balance $165,000 DEPOSIT LIABILITY ACCOUNT

Accounting & Financial ReportingExample 2b – Retrospectively Rated Programs

Accounting & Financial ReportingOther Premium/Loss Considerations • Loss Portfolio Transfers/Retroactive Contracts • Retroactive contracts occur when liabilities are transferred after the end of the policy year • ie. contract effective Jan 1, 2010 covering losses reported after Jan 1, 2010 but occurring prior to Jan 1, 2010. • Popular for new captives to cover tail liabilities. • Initial Treatment: • Consideration credited to reserves rather than income statement. • Gain on transfer is deferred and recognized over the payout period of the losses. • Loss on transfer is recognized in the current period. • Future movements in reserves go through income statement.

Accounting & Financial ReportingAccounting for Investments • Types of Captive Investments • Liquid: Cash, Money Market Funds, CD’s • US Treasuries, Bonds, Government-Backed Securities • Equities • Managed Funds (private & exchange traded), fund of funds • Custodian Reports vs Investment Reports • Investment Note Disclosures: • Maturity tables • Gross up unrealized & realized gains/losses • ASC820 level disclosures

Accounting & Financial ReportingAccounting for Investments • Methods of Recording: • Held to Maturity: • amortized cost • Available for Sale: • Stated at fair value • Changes reported in equity (other comprehensive income) • Other Than Temporary Impairments (OTTI) • ASC 825-10 Election to record at fair value • Trading: • Stated at fair value • changes reported in income statement

Accounting & Financial ReportingExample 3 – Investment Classifications • AM Insurance Company (AMIC) has a December 31st year end and their financial statements follow US GAAP. • On January 1st, AMIC purchases investments for $700,000. • During the year AMIC sold $100,000 for a profit of $20,000. • During the year the portfolio earned $10,000 of interest income • At year-end there were $20,000 in unrealized losses and $50,000 in unrealized gains. • Of the unrealized losses at year-end $15,000 have been deemed to be Other Than Temporary Impairments (OTTI) in the investment value

Accounting & Financial ReportingExample 3 – Investment Classifications • Cash value: 1,500,000 – 700,000 + 120,000 + 10,000 = 930,000 • Investment value: 700,000 – 100,000 = 600,000 cost + unrealized 30,000 = 630,000 • Unrealized Gains (Other Comprehensive Income): 50,000 - 20,000 + 15,000 = 45,000

Accounting & Financial ReportingExample 3 –Investment Classifications • Interest Income: 10,000 • Unrealized Gains/Losses: 50,000 – 20,000 = 30,000 • Other Than Temporary Impairment (OTTI): 15,000 • Realized Gains: 20,000

AuditingOverview • Audit Purpose & Responsibilities • Audit Process • Audit Planning Timeline • Standard Audit Procedures • Audit Completion

AuditingAudit Purpose & Responsibilities • Purpose & Scope • Enhance degree of confidence in the financial statements through expression of an opinion on those financial statements • Requirement under Insurance Law to be filed 6 months after year-end • Responsibilities of the Auditor • Conduct audit in accordance with appropriate standard (ISA/GAAS) • Obtain reasonable assurance financials are free from material misstatement • Obtain evidence on amounts & disclosures • Evaluate appropriateness of accounting policies & reasonableness of estimates, and overall presentation • Auditors judgement

AuditingAudit Overview • Responsibilities of Management • Management is any person(s) with executive responsibility for the conduct of the entity’s operations • Financial statements are the responsibility of management • Properly recording transactions in the accounting records • Maintaining internal controls sufficient to permit reliable financial statements • Adjusting the financial statements to correct material misstatements • Ensuring access to all company records and personnel • Ensure sufficient controls & programs to prevent & detect fraud • Ensure compliance with laws & regulations

AuditingAudit Process Timetable & Scope Agreed Delivery Completion Annual Audit Cycle Confirmation Meetings & Discussion Planning & Review Procedures Fieldwork & Testing

AuditingAudit Planning Timeline • Best practice is to get an audit timeline agreed with all parties prior to fieldwork:

AuditingStandard Audit Procedures • Investments/Investment Income • Confirm investment holdings with Custodian • Test market valuation of investments to third party pricing sources • Analytically review investment income • Review portfolio for Other Than Temporary Impairments, if applicable • Ensure disclosures have been made • Underwriting Income (Participant Contributions) • Confirm participant contributions assumed • Review policies and assess risk transfer • Agree policy contract terms and amounts • Confirm reinsurance & premiums written and related balances • Cash • Confirm cash balances for all accounts • Review cash reconciliations with bank statements

AuditingStandard Audit Procedures • Claim & Claim Expense Reserves • Review of current reserving policy • Test claims handling and/or obtain SAS 70 report from TPA • Obtain actuarial estimates for claim liability and IBNR claims • Review estimates used by actuary for reasonableness • Other Expenses & Procedures • Perform analytical procedures on operating expenses by comparing previous year, budget, and expected changes • Agree expenses to service provider agreements • Based on the results of analytical review, additional procedures will be performed, including review of detailed activity and testing of third-party documentation.

AuditingAudit Completion • Letter of Representations to Auditors • Sets out responsibilities of Management • Auditors are required to obtain written representations to support audit evidence (ISA 580) • Management Letters & Control Letters • Proactive approach during the audit • Audit Report • Sets out responsibilities • Auditors Opinion • Clean/Unqualified • Emphasis of Matter • Qualified • Adverse • Disclaimer

Questions?

Alissa Matthews, CABen Leung, ACA Senior Vice President, Marsh Managing Partner, PKF alissa.matthews@marsh.com bleung@pkfcayman.com www.marsh.com / www.pkfcayman.com

Accounting & Audit IMAC Captives Course