United States: The Financial Accounting Standards Board Proposes Bifurcation of Insurance Contracts

The Financial Standards Accounting Board (FASB) recently invited public comments on a proposal to bifurcate many insurance and reinsurance contracts for financial reporting purposes.¹ Under the FASB proposal, certain insurance and reinsurance contracts would be divided into an "insurance" component and a financing component called a "deposit."

While the FASB says it has not reached even a tentative conclusion on this proposal, it has solicited comments because some have suggested that bifurcation would provide users of financial statements with better information about the economic substance of insurance arrangements.

Under current accounting practice, a contract is treated as a whole either as insurance or as a deposit depending on whether the contract transfers a significant insurance risk. Under the bifurcation proposal, a contract would be bifurcated where the contract may be divided into a component reflecting claims payments that are likely to occur and a component reflecting claims payments that are possible but not likely to occur. The former component would be treated as a deposit made to fund the expected claims payments, and the latter would be treated as insurance.

Under the FASB proposal, several kinds of contracts would be excluded from bifurcation. These would include contracts such as loans that do not meet a specific definition of "insurance contract." Generally Accepted Accounting Principles (GAAP) currently do not define an insurance contract, and part of the current FASB project is to collect comments on a proper definition.

A second kind of excluded contract would be the "unequivocal insurance contract," one that has "negligible noninsurance features." A typical contract of this kind would be a single-risk contract (e.g., single life, single asset or single event), where the premium is appropriately low, the contract has no risk-limiting features and the contract is not likely to produce in any claims during its term. This type of contract would be treated entirely as insurance.

A third kind of excluded contract would be the contract that does not transfer "significant insurance risk." A contract that did not transfer significant risk would be treated entirely as a deposit. For identifying such a contract, the FASB proposes to incorporate the guidance provided by GAAP (Statement 113) to determine whether a reinsurance contract transfers significant insurance risk. The FASB has invited comments specifically on whether it would be appropriate to apply the Statement 113 guidance to insurance contracts as well as reinsurance contracts.

The FASB has suggested that bifurcation might be limited to those kinds of insurance contracts that have been described as "finite risk arrangements." Under this approach, a fourth exclusion would preserve for bifurcation only contracts that meet tests designed to identify these specific arrangements. The tests would look for risk-limiting terms or features in a contract, such as a matching of anticipated income and disbursements or provisions for profit or loss sharing between insurer and insured, that produce "a significant financing component or an insignificant insurance component."

Alternatively, the FASB has suggested that bifurcation might be employed for all contracts remaining after the first three exclusions have been applied. This approach would be designed to provide "consistent accounting across all remaining insurance and reinsurance contracts regardless of the form, products, or features included in the contract."

The FASB has described three possible methods for bifurcating contracts. One, called the "expected payout method," would identify a level of likely claims payments for a contract andwould treat a portion of the premiums paid under the contract as a financing of these expected payments. This approach has also been described as a "dollar-trading method" of identifying the deposit component of insurance and reinsurance contracts.

A second method, the "proportional method," would determine what portion of the entire risk addressed by a contract has been retained by the policyholder. The ratio of the retained risk to the entire risk would then be applied to the contract’s cash flows to determine the deposit component of the contract.

A third method, the "cash flow yield method," would undertake to identify a portion of an insurance contract’s cash flows that provides a return equivalent to the interest rate on a loan. This portion would be treated as financing, while cash flows in excess of the interest rate would be treated as insurance. The FASB has specifically noted that more research is necessary to determine the feasibility of this approach.

The FASB has acknowledged that there is a wide divergence of opinion on many aspects of the bifurcation proposal. While advocates of bifurcation believe that the user of a financial statement "would be able to determine better the risk that a company bears and its strategy to limit that risk," some opponents believe that insurance contracts are "essentially indivisible," and some believe that bifurcation would not permit readers of financial statements to evaluate "what the bifurcated components imply about future cash flows."

The FASB proposal leaves many questions unanswered. For example, the proposal suggests that group contracts, such as group health or life insurance, would be bifurcated because a portion of the premium for such contracts compensates the insurer for the likely payment of expected claim losses. A portfolio of "unequivocal insurance contracts," on the other hand, would be treated entirely as insurance even though a portion of the premium received on the portfolio as a whole similarly compensates the insurer for the payment of expected claim losses. For the purpose of evaluating the financial condition of the insurer as a whole, it is not clear why a group contract and a portfolio of individual contracts should produce such disparate accounting results.

The FASB has noted that the International Accounting Standards Board (IASB) is planning in the near future to solicit comments on a paper containing its own tentative decisions on the accounting treatment of insurance contracts. The FASB has stated that it will decide whether to join the IASB in a project to develop a comprehensive standard for such accounting after receiving comments from its own constituents on the IASB paper. The IASB has reported that its paper will likely be published near the end of 2006.

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