October 2009

Greetings!

This edition of Insurance Perspectives addresses changes on the horizon that may affect many insurers. From statutory accounting treatment of deferred tax assets to proposed changes that may impact the NAIC’s new internal control reporting standard to recent developments in IFRS, insurers and regulators will want to pay close attention.

As always, we welcome your feedback and invite you to share Insurance Perspectives with your colleagues and business acquaintances. If you do not currently receive our newsletter via e-mail, please subscribe at the left.

Tom Finnell
Managing Director

Jim Stangroom
Managing Director

In this Issue

1. What Goes Around Comes Around: Income Tax Accounting for Insurers Again in the Spotlight
2. Last-Minute Proposed Change Throws a Wrinkle into Insurers’ Efforts to Comply with New Internal Control Reporting Standard
3. IFRS: Detours Along the Roadmap
4. Junjie Pan Joins Firm as a Senior Consultant
5. Upcoming Speaking Engagements

What Goes Around Comes Around: Income Tax Accounting for Insurers Again in the Spotlight
by Tom Finnell

The arcane topic of statutory accounting for income taxes generated much heat at the NAIC’s Fall National Meeting in September at National Harbor, MD. Since the financial crisis tumbled markets a year ago, the ACLI has advocated adoption of a wish list of items that would assuage to some degree the impact that the crisis has wrought upon the reported surplus of insurers. One such item, a proposal to ease restrictions on the admissibility of deferred tax assets, narrowly squeaked through with approval but only after an extensive and somewhat acrimonious debate.

It was not that long ago that deferred tax assets simply did not exist in statutory accounting. However, when the NAIC embarked on an ambitious effort in the late 1990s to codify statutory accounting, an industry survey showed that the impact of all of the proposed changes, if adopted as initially drafted, would make a sizeable dent in industry-wide surplus. So, after more negotiation with the industry, deferred tax assets became the “fix.” With the turn of a dial, the NAIC calibrated the codification proposal to be surplus neutral for the industry by allowing deferred tax assets to be reported as admitted assets, subject to limitations of the amount that could be recovered within one year and of 10% of surplus.

As a result, some regulators might say they never quite bought in to the concept of permitting DTAs as a valid statutory accounting concept; rather, admitting some DTAs was simply a negotiated means to plug the difference between the aggregate impact of statutory accounting pre- and post-codification so as to maintain overall surplus neutrality. The debate that began a decade ago over the logic of admitting DTAs as assets was reincarnated at the National Harbor meeting, perhaps with even more rancor because more is now at stake – an ever larger amount of surplus would wind up being backed by DTAs.

While the exact verbiage remains subject to final approval, the proposal adopted in September has the following key components:

• The existing DTA limits of recoverability within 1 year and 10% of surplus are maintained.
• However, insurers with RBC above certain levels – the RBC trend test if applicable, otherwise above 250% for life insurers and fraternals and above 300% for property/casualty companies – may admit greater amounts of DTAs, generally limited to amounts recoverable within 3 years and 15% of surplus.
• Explicit disclosure of such amounts as aggregate write-in items in the financial statements.

There are some interesting peculiarities about the proposal. For example, the RBC test results in an insurer being able to report a greater amount of DTAs and, hence, surplus as long as the “sun shines.” If cloudy weather arises and the company’s RBC triggers the trend test or the other aforementioned thresholds, then the benefit of higher DTAs would be eliminated; surplus that already is being eroded would then have the added detriment from the sudden disallowance of DTAs. Critics of the proposal latched on to this anomaly, noting that if DTAs are not a basis for sound accounting for troubled companies, then neither should there be a double standard that would permit healthier companies to report them.

In addition, regulators may impose on a state-by-state basis additional measures that would prevent the inclusion of the increased amount of DTAs from impacting regulatory triggers that may exist, e.g., for determining compliance with extraordinary dividend provisions.

A sunset clause was also included providing that these new provisions would apply only for financial statement filings through year-end 2010. A subgroup has been formed to recommend admissibility criteria for periods thereafter.

The NAIC’s codification project in the late 1990s was an industry-wide effort to create uniformity in statutory accounting and to reduce if not eliminate permitted accounting practices. The recent crisis has shown how hard it may be to keep to that goal. For example, the Insurance Underwriter recently reported that the number of life insurers using permitted practices increased from 25 companies in 2007 to 80 in 2008, and that the combined effect on surplus for those companies went from a reduction in surplus of $313 million in 2007 to an increase in surplus of $8 billion in 2008. Much of this increase we believe is attributable to permitted practices relating to DTAs. Many insurers who apparently needed the resulting statutory surplus relief the most have therefore already received it. It remains unclear as to how many more insurers may take advantage of the eased limitations on DTAs resulting from the NAIC’s recent actions.

For more information, contact Tom Finnell .

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Last-Minute Proposed Change Throws a Wrinkle into Insurers’ Efforts to Comply with New Internal Control Reporting Standard
by Tom Finnell

The NAIC’s new Annual Financial Reporting Model Regulation (AFRMR) appears to be headed for adoption in the vast majority of states to be effective in 2010. Inasmuch as the upcoming effective date has been known for some time most insurers are, hopefully, well on their way to implementing plans to comply with the AFRMR’s new internal control reporting requirements. However, a proposal under consideration by the NAIC at this late juncture could throw a wrench in the works, and may cause insurers to perform more work than they had initially planned in order to comply.

What started as an effort by the NAIC to take key provisions of the Sarbanes Oxley Act of 2002 (SOX) applicable to public companies and adopt them for application to all insurers, including non-public companies such as mutuals, ultimately took on a more lenient tone when the NAIC incorporated these changes in the final version of the AFRMR:

• The exemption threshold applicable to the internal control reporting provisions was raised from $25 million to $500 million of direct and assumed premiums.
• The requirement for an independent auditor’s attestation on management’s report on internal controls was dropped.
• Insurers were given discretion as to their use of pre-existing documentation and in their choice of an internal control framework.

The AFRMR effort also resulted in the development of an Implementation Guide, which gave insurers certain flexibility given their organizational structure and the degree of integration among affiliated companies. The guide currently states, in part, as follows:

Companies within a holding company structure, or other set of insurers identified by management, may often share common management, systems or processes. Consequently, when management asserts to the effectiveness of their internal controls, it is appropriate to make such an assertion for those companies based upon the organization management determines to be most relevant to meet the reporting requirements. Because holding company structures, and other groups of insurers, can be complex and organized to meet corporate objectives, that structure may not align with the organizations that are responsible for managing and preparing the financial statements of the insurer. The Model provides flexibility to insurers to identify a “Group of insurers” for purposes of evaluating the effectiveness of their internal control over financial reporting.

However, the NAIC/AICPA Working Group of the NAIC now has a proposal outstanding for public comment that would appear to negate some of the intended flexibility that was an explicit part of the initial AFRMR effort. Specifically, the proposal would tack on to the implementation guide’s language cited above the following (emphasis added):

Regardless of the structure deemed most appropriate for the evaluation and reporting of controls, management is required to issue an assertion regarding the effectiveness of internal control over statutory financial reporting. As statutory reporting requires presentation at a legal-entity level, management’s assertion must apply at this level. Therefore, when determining the scope of controls subject to review for the “Group of insurers”, all controls deemed significant to each individual legal entity within the group should be included within the scope of management’s review.

The proposal has been exposed for public comment until October 23, 2009. Interested parties can submit comments to Bruce Jensen of the NAIC at BJenson@naic.org.

For more information, contact Tom Finnell.

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IFRS: Detours Along the Roadmap
by Tim Foley

It has been nearly a year since the SEC released its long-awaited “Roadmap” that would guide U.S. SEC registrants towards adoption of International Financial Reporting Standards, or IFRS. Yet as the end of the 2009 calendar year draws near, confusion and uncertainty as to where we are heading seem to be growing.

Industry within the U.S. has been largely supportive of the SEC’s plan. The FASB and IASB continue to make progress towards convergence on many key standards. The consensus at the recent G-20 Summit, held in Pittsburgh, Pennsylvania, was that a single set of high quality global standards would represent a key element in economic recovery and financial market stability. President Obama’s proposed regulatory reforms called for substantial progress by December of 2009. And most important for the insurance industry, key elements of IFRS 4 Phase 2 have been discussed and debated at nearly every IASB monthly meeting held this year.

Yet despite some progress in key areas, and an environment seemingly well-suited to support such a significant change, accounting practitioners and industry alike are left to wonder where this effort is heading, and how much time and money should be invested in preparing for IFRS.

Respondents to the SEC’s request for comment on the proposed IFRS Roadmap clearly expressed a number of concerns. Some of the most frequently expressed concerns included the following: 

• the requirement for two years comparative information
• the perceived need for more substantial progress in key areas of convergence
• the independence of the IASB
• the lack of industry-specific guidance
• conversion costs

However, despite the concerns expressed and the recommendations made, support for the concept and the timeline was generally strong. A September 2009 survey of more than 150 finance professionals conducted by Deloitte seems to confirm that sentiment. The majority of those polled feel the SEC should move forward with the proposed Roadmap. The survey also indicated that 45% of companies had put their IFRS assessment plans on hold, due mainly to “delays” with the Roadmap. In fairness to the SEC, the Roadmap itself does not call for a decision until 2011. It seems a perceived lack of progress is largely to blame for the heightened level of concern. And while many still prefer a timeline that allows more time for convergence or more time generally, the need for decisiveness on the part of the SEC has been loudly voiced.

In recent weeks, the momentum that seemed largely lost since the start of the financial crisis appeared to emerge once again. On September 18, SEC Chair Mary Schapiro revisited the IFRS issue when she commented publicly, “I expect we will speak a little later this fall about what our expectations are with respect to IFRS,” according to Dow Jones News Wires. She also said “it would be ideal if we can have a single set of high-quality accounting standards that worked globally.”

In an agreement reached on September 25, 2009, to make dozens of changes to the regulation of financial markets, systems and institutions, the leaders of the G-20 called on “international accounting bodies to redouble their efforts to achieve a single set of high quality, global accounting standards within the context of their independent standard setting process and complete their convergence project by June 2011.”  The G-20 leaders also suggested increasing the level of involvement in various stakeholders in the effort to achieve this goal.

Evidence of the ongoing collaboration between the FASB and IASB include the following joint projects:

• Reporting on Discontinued Operations
• Consolidations
• Insurance Contracts
• Accounting for Financial Instruments
• Financial Instruments with Characteristics of Equity
• Financial Statement Presentation
• Leases
• Revenue Recognition
• Earnings per Share
• Income Taxes

But does all of this “convergence” activity really mean we are getting closer to a single set of standards?  Maybe. However, it is clear that the global financial crisis served to widen some of the gaps that already existed. Fair value accounting is a prime example of a situation where accounting standard setters cut short the due diligence deliberations and the exposure draft comment periods under pressure from legislators. This example highlighted issues of independence and governmental influence over standard-setters on both sides of the Atlantic.

Measuring progress on the Insurance Contracts Standard has been difficult. The IFRS 4 Phase 2 Discussion Paper, issued in late 2007, initially endorsed the Current Exit Value (CEV) approach towards the valuation of insurance contracts. This discounted cash flow approach, with explicit margins for risk and service costs, would employ market inputs and equate fair value with the amount that would change hands if the contracts were to be transferred to a third party as of the reporting date. This, of course, is premised on a non-existing, theoretical market.

Support for the CEV approach seemed to wane earlier this year as proponents of the Current Fulfillment Value approach (CFV) expressed concerns about practical application of CEV. While the FASB has voted unanimously in support of CFV, the IASB voting initially yielded no consensus. At its meeting on July 24, 2009, the IASB continued consideration of both measurement approaches. This appeared to be good news for insurance industry and accounting practitioners who strongly support the CFV approach. However, this notion was short-lived as the IASB staff voted, by a narrow 8 – 7 margin, in support of the CEV approach during its September 18, 2009 Board meeting.

The two approaches are similar. Both are discounted cash flow based models utilizing current market inputs. It is in situations where observable market values are not available that the approaches differ. Fulfillment value, predicated upon the assumption that liabilities will ultimately be settled with policyholders rather than a third party, reverts to the use of company-specific assumptions when market inputs are not available. Further, the CFV approach does not take into account the credit standing of the liability. But under the CEV approach changes in the credit ratings of the issuing company would result in changes in the liability value, an outcome that is hard for U.S. insurance regulators to swallow. After more than two years of effort, decisions on basic underlying concepts continue to be debated. The exposure draft scheduled for release in December of this year will include a thorough discussion on both measurement models, and interested parties will be given the opportunity to comment on their relative merits.

The SEC last week issued for comment a draft of its Strategic Plan for Fiscal Years 2010 – 2015. One might have expected to see IFRS initiatives highlighted as a prominent part of this plan. But with support for IFRS convergence initiatives mentioned in just a single sentence of the 55 page document, it is not surprising that interested parties are doing more waiting than preparing.

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Junjie Pan Joins Firm as a Senior Consultant

Invotex Group is pleased to announced that Junjie “JJ” Pan, CPA, CFE, CPCU, FLMI, has joined the firm as a Senior Consultant in the firm’s insurance practice.

Pan has more than eight years insurance industry experience comprising seven years experience with the Illinois Department of Insurance conducting financial examination of property, life and health companies in addition to internal audit experience at a large property and casualty company.

“JJ’s experience within the Illinois DOI in addition to his internal audit experience will enhance Invotex’s service offerings,” said Tom Finnell, Managing Director of the Insurance practice.

Pan has a bachelors degree in Accountancy from the University of Illinois. In addition, he is a Certified Public Accountant, Certified Financial Examiner, Chartered Property and Casualty Underwriter, and a Fellow of the Life Management Institute. He is based in Chicago.

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Upcoming Speaking Engagements

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