The Financial Accounting Standards Board last Thursday issuedfor public comment a controversial proposal that would changefinancial reporting of insurance contracts, fundamentallyreconstructing the measurement of insurance liabilities and incomeas they are reflected in income and earnings statements.

The proposed update would apply to all contracts that meet thedefinition of an insurance contract, not just those written byinsurance companies. It would also apply to ceding insurers inreinsurance contracts.

Basically, it would require accounting to be based on currentassumptions of cash flows to fulfill the coverage on a quarterlybasis, adjusted for the time value of money–even if the claims arenot being paid out for years.

The move, which would not go into effect until 2018, is aneffort to update the U.S. Generally Accepted Accounting Principles(GAAP) and make the accounting standards more comprehensive as wellas forward-looking, or principles-based, and also work toward aconverged international standard, although the new proposal falls abit short on that. The industry is hopeful, however, for moredeliberations — starting in January — to iron out differencesbetween the U.S. and European models.

Currently, as analysts note, GAAP requires insurance premiumsfor long-duration contracts to be recognized when due, notquarterly.

The FASB proposal was developed as part of its broader jointproject with the International Accounting Standards Board (IASB),which released its own proposal June 20. Both proposals containsimilar fundamentals — most notably the use of current estimates —but differences exist, FASB noted in a statement.

The proposed changes to insurance contract accounting willintroduce volatility into financial statements, according toratings agencies and analysts. However, some in the industry do notmind, as long as there is one global standard.

“The proposed standard is intended to bring greater consistencyand relevance to the accounting for contracts that transfersignificant risk between parties,” stated FASB Chairman Leslie F.Seidman in a statement. “Current U.S. standards on insurance haveevolved over the years as new products have been introduced,leading to some inconsistencies in GAAP. The proposed standardwould require a current measure of insurance contracts, includingthe use of updated assumptions and discounting.”

The proposed update would require contracts that transfersignificant insurance risk to be accounted for in a similar manner,regardless of the type of institution issuing the contract. Thus,it would apply to banks, guarantors, service providers and othertypes of insurers, in addition to traditional insurers.

An insurer would recognize revenue in net income in proportionto the value of coverage or services provided. Claims andcontract-related expenses would be recognized when incurred. Thisis a bit like marking to market, although there is no “market,” forlong-tail insurance claims, as one analyst noted.

Any amounts received that are expected to be returned to thepolicyholder or the policyholder's beneficiary, regardless ofwhether an insured event occurs, would be excluded from revenue andexpenses.

The contracts most used by life, annuity and long-term healthinsurers would use one approach, the so-called “building block”approach, and the contracts most used by property casualty insurersand short-term health writers would use another approach, the“premium allocation” approach.

The building block approach would be measured each reportingperiod based on the current present value of the fulfillment cashflows. This would be based on the expected value that incorporatesall relevant information and considers all features of thecontract, including guarantees and options. The measurement wouldalso include a margin that initially reflects the expectedprofitability of the contract.

The premium allocation approach would include a liability forremaining coverage that represents the gross cash inflows not yetearned and is released in subsequent periods on the basis of theexpected timing of incurred claims and benefits. A separateliability would be recorded when the claim is incurred and bemeasured based on the expected present value of future cashflows.

“In general, it will introduce volatilityacross all lines of business, and not just because of quarterlyupdates or the quarterly reset,” said J. Paul Newsome, managingdirector and the senior insurance analyst in the ResearchDepartment of Sandler O'Neill + Partners in Chicago. “There is morevolatility in the building block accounting method because you areintroducing more assumptions into the insurance,” Newsome said.

A lot of this is driven out of Europe and not the UnitedStates. The Europeans do not have a standard, therefore theyare creating one. The U.S. and much of North American and theoffshore communities, which have half the world's insurance, already have a standard (GAAP) but it is incompatible with IASBstandards. “It is a little like the tail wagging the dog,” Newsomesaid.

Under both FASB and IASB proposed approaches, an insurer wouldrecognize revenue in net income in proportion to the value ofcoverage or services provided. Claims and contract related expenseswould be recognized when incurred. Any amounts received that areexpected to be returned to the policyholder or the policyholder'sbeneficiary regardless of whether an insured event occurs would beexcluded from revenue and expenses.

Comments for both the FASB proposed update and the IASBexposure draft are due at the end of October. The FASB websiteoffers a general overview of the proposal and one that focuses onthe types of companies and contracts that would be affected byit.