On May 26, The Financial Accounting Standards Board sent out anInvitation to Comment (ITC) on a proposal regarding BifurcatingInsurance and Reinsurance Contracts--the implications of whichcould be far reaching, in my view.

Especially under the most severe scenario contemplated by theFASB, there are potentially significant ramifications not only forinsurers and reinsurers, but also for buyers of insurance andreinsurance.

Bifurcation refers to the intention to separate the financingcomponent of insurance and reinsurance contracts from the insurancerisk portion of the contracts. This is not a new idea, and is evenincluded in SFAS 113, the accounting standard on reporting cededreinsurance.

It has gained momentum in the past three years as several publiccompanies have had to restate their financial statements toreflect, among other issues, inappropriate treatment of insuranceand reinsurance contracts.

Briefly, under the ITC if an insurance or reinsurance contractdoes not "unequivocally transfer insurance risk," its financingelement may be separated from the rest of the contract forfinancial reporting purposes. (Some of the elements of the FASB ITCare discussed in greater detail in the accompanying sidebar,"Bifurcation Defined.")

There are several significant open questions, including:

o Should bifurcation be considered for all contracts that arenot "unequivocally insurance" contracts?

o Should bifurcation only be considered for some smallersubgroup of contracts with significant adjustable features based onloss experience--sometimes considered finite risk contracts?

Contract types that might be considered unequivocally insuranceinclude individual accident and health, homeowners insurance,personal auto insurance, and professional liability for a solepractitioner. Others may also meet that standard.

On the other hand, group A&H, fleet auto covers andprofessional liability for multiple practitioners are not exemptfrom further testing under the ITC. Further, all reinsurance--otherthan facultative reinsurance of a single risk--would not be exemptfrom bifurcation analysis.

So the implications of the ITC may be widely felt. Even withthese uncertainties, however, it is still possible to think aboutwhat might happen.

o A Most Severe Scenario--All contracts that are not"unequivocally insurance" are subject to bifurcation (ITC OptionB).

Let's consider a corporate insured with a basket programprotecting all its locations and all its vehicles against bothfirst-party and third-party exposures. If the premium for thisprotection is $1 million, using the language of the ITC, some levelof "expected losses" may be presumed to be part of thatpremium.

For the purchaser, therefore, that $1 million premium may needto be split into an expense portion (for the insurance risk) and adeposit component (for the financing or dollar-tradingcomponent).

The insurer would similarly not record the full $1 million asrevenue--the dollar trading deposit would not be premium income tothe insurer.

We must remember that one of the unanswered questions in the ITCis precisely how to compute the deposit portion of this premium.Three methods are proposed, and the FASB has asked for additionalproposals. So it is difficult to assess how the deposit amountwould compare to the expected loss cost underlying the $1 millionpremium. It likely would be less than 100 percent of the expectedloss cost.

o A More Moderate Scenario--Only contracts with significantadjustable features based on loss experience are subject tobifurcation (ITC Option A).

The contract above would probably not be subject to reviewunless it contained a premium adjustment provision based on lossexperience. Large retro-rated contracts might be reasonably thoughtto fall into this category.

The analysis of such a contract for purposes of this articlewould be highly conjectural, but some portion of a retro ratedcontract might be considered financing--possibly the ultimateamount in excess of the minimum premium.

Under either scenario, a reduction in the total volume ofreinsurance transactions--or at least in the amount reported asceded and assumed premium--is likely because many quota-share orstructured quota-share contracts may be deemed to be subject tobifurcation.

Simply put, the potential impact of the ITC on bifurcation ofinsurance and reinsurance contracts includes a reduction inreported premium by insurers and reinsurers, a reduction ininsurance expense by corporate insureds and a reduction in cededpremium by insurers and reinsurers (ceding business underretrocessional contracts).

It could also increase the workload on all parties as newanalyses will be required for contracts. The importance of thislatter point should not be ignored in considering what the futurelandscape may be.

These changes will also affect the traditional leverage ratios,such as premiums-to-surplus and reserves-to-surplus, that have longstood as well understood benchmarks of the risk profile of aninsurance company.

In short, there is potential for significant dislocations,particularly among larger buyers of insurance and many buyers ofreinsurance. There may be significant additional work required bythese parties, and their financial statements may look differentthan they otherwise would.

The financial statement changes may be felt most significantlyin the reinsurance sector, where top-line revenues may be impactedthe most. There may be a period of adjustment while all parties getused to the new landscape and accustom themselves to smaller toplines and smaller insurance expenses or ceded reinsurancecosts.

For insurers, the impact on small insurers, who are now heavilyreliant on reinsurance protections, may be most severe.

There are many uncertainties. When the FASB sent out this ITC,it included remarks to the effect that: FASB has not reached anytentative conclusions on the issues; the ITC is a neutraldiscussion document; and alternatives identified in the ITC areillustrative and presented to facilitate discussion rather than tostate a conclusion on FASB's final position.

As already mentioned, the discussion document has areas where noanswer is proposed, such as the question of whether all contractsor only some contracts will be subject to bifurcation and how toidentify contracts subject to bifurcation if aless-than-all-contracts approach is eventually adopted.

We'll have to wait and see what comments the FASB receives inresponse to its ITC, and how the FASB decides to proceed afterthat.

The views expressed in this article are those of the author anddo not necessarily represent those of his firm.