On May 26, The Financial Accounting Standards Board sent out an Invitation to Comment (ITC) on a proposal regarding Bifurcating Insurance and Reinsurance Contracts–the implications of which could be far reaching, in my view.

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

Bifurcation refers to the intention to separate the financing component of insurance and reinsurance contracts from the insurance risk portion of the contracts. This is not a new idea, and is even included in SFAS 113, the accounting standard on reporting ceded reinsurance.

It has gained momentum in the past three years as several public companies have had to restate their financial statements to reflect, among other issues, inappropriate treatment of insurance and reinsurance contracts.

Briefly, under the ITC if an insurance or reinsurance contract does not “unequivocally transfer insurance risk,” its financing element may be separated from the rest of the contract for financial reporting purposes. (Some of the elements of the FASB ITC are 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 are not “unequivocally insurance” contracts?

o Should bifurcation only be considered for some smaller subgroup of contracts with significant adjustable features based on loss experience–sometimes considered finite risk contracts?

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

On the other hand, group A&H, fleet auto covers and professional liability for multiple practitioners are not exempt from further testing under the ITC. Further, all reinsurance–other than facultative reinsurance of a single risk–would not be exempt from bifurcation analysis.

So the implications of the ITC may be widely felt. Even with these uncertainties, however, it is still possible to think about what might happen.

o A Most Severe Scenario–All contracts that are not “unequivocally insurance” are subject to bifurcation (ITC Option B).

Let’s consider a corporate insured with a basket program protecting all its locations and all its vehicles against both first-party and third-party exposures. If the premium for this protection is $1 million, using the language of the ITC, some level of “expected losses” may be presumed to be part of that premium.

For the purchaser, therefore, that $1 million premium may need to be split into an expense portion (for the insurance risk) and a deposit component (for the financing or dollar-trading component).

The insurer would similarly not record the full $1 million as revenue–the dollar trading deposit would not be premium income to the insurer.

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

o A More Moderate Scenario–Only contracts with significant adjustable features based on loss experience are subject to bifurcation (ITC Option A).

The contract above would probably not be subject to review unless it contained a premium adjustment provision based on loss experience. Large retro-rated contracts might be reasonably thought to fall into this category.

The analysis of such a contract for purposes of this article would be highly conjectural, but some portion of a retro rated contract might be considered financing–possibly the ultimate amount in excess of the minimum premium.

Under either scenario, a reduction in the total volume of reinsurance transactions–or at least in the amount reported as ceded and assumed premium–is likely because many quota-share or structured quota-share contracts may be deemed to be subject to bifurcation.

Simply put, the potential impact of the ITC on bifurcation of insurance and reinsurance contracts includes a reduction in reported premium by insurers and reinsurers, a reduction in insurance expense by corporate insureds and a reduction in ceded premium by insurers and reinsurers (ceding business under retrocessional contracts).

It could also increase the workload on all parties as new analyses will be required for contracts. The importance of this latter point should not be ignored in considering what the future landscape may be.

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

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

The financial statement changes may be felt most significantly in the reinsurance sector, where top-line revenues may be impacted the most. There may be a period of adjustment while all parties get used to the new landscape and accustom themselves to smaller top lines and smaller insurance expenses or ceded reinsurance costs.

For insurers, the impact on small insurers, who are now heavily reliant 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 any tentative conclusions on the issues; the ITC is a neutral discussion document; and alternatives identified in the ITC are illustrative and presented to facilitate discussion rather than to state a conclusion on FASB’s final position.

As already mentioned, the discussion document has areas where no answer is proposed, such as the question of whether all contracts or only some contracts will be subject to bifurcation and how to identify contracts subject to bifurcation if a less-than-all-contracts approach is eventually adopted.

We’ll have to wait and see what comments the FASB receives in response to its ITC, and how the FASB decides to proceed after that.

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