Weather Watch Insurance Accounting and Tax Developments

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Weather Watch Insurance Accounting and Tax
Developments

• Jim Murphy, Partner
• Josh Keene, Principal

September 18, 2006
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What will 2006 be like?
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Or
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Presentation Summary

• FASB
• NAIC
• AICPA
• Recent federal income tax developments affecting
  captives

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FASB Update Developments in GAAP Accounting
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Summary

• Bifurcation project
• Accounting for uncertain tax positions
• Taxes collected from customers
• Other current projects
• Lease accounting
• Derivatives
• Defined benefit pensions
• Financial guarantee insurance

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Bifurcation Where accounting meets politics

• Background
• Risk transfer described as a requirement for
  reinsurance contracts in SFAS Nos. 5, 60 and 113.
• What to do with contracts that do not transfer
  risk not defined before SOP 97-1 (effective for
  2000)

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Reinsurance Bifurcation

• Clearly not reinsurance
• Contracts structured so that ceding company
  recognizes an underwriting gain on Dec 31, and
  then reverses transaction on Jan 1.
• Contracts that allow ceding company to write more
  than its surplus can support, while guarantying
  profit to the reinsurer

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Enter Politics

• AIG/Gen Re transaction (known)
• Analysts concerned that AIG reserves too low
• Gen Re cedes 500 million of reserves to AIG for
  500 million in reinsurance premium
• AIG pays Gen Re 5 million commission
• AIG at risk to pay losses up to 600 million
  (adverse development)

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AIG / Gen RE

• AIG/Gen Re transaction (known)
• AIG recorded as reinsurance
• Premiums assumed 500
• Losses incurred (500)
• Commission expense (5)
• Income statement effect (5)

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AIG / Gen RE

• AIG/Gen Re transaction (unknown)
• Did Gen Re pick claims that had little risk of
  adverse deviation?
• Was there a side agreement that promised that Gen
  Re would pay extra if claims developed adversely?
• Did AIG show the incurred loss as a strengthening
  of old, existing reserves to placate analysts?

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AIG / Gen RE

• AIG subsequently admits that the contract should
  not have been accounted for as reinsurance
  (deposit)
• NAIC (NY regulators) rush to propose changes to
  current accounting

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Bifurcation of Insurance and Reinsurance
Contracts

• Current accounting
• Reinsurance contracts that transfer significant
  insurance risk accounted for as ceded/assumed
  premium
• Reinsurance contracts that do not transfer
  significant risk accounted for as deposits

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Bifurcation of Insurance and Reinsurance
Contracts

• FASBs Invitation to Comment
• Bifurcate (separate) contracts into insurance and
  deposit components
• Applicable to corporate policyholders as well as
  insurers/reinsurers
• Policyholder premium reported as deposit (asset)
  and insurance recoveries amortized to expense
  over time

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Group Health Premium
Expected claim payments
Administration, profit and risk
Record deposit and amortize to expense as claims
are paid by insurance company
Expense as incurred
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Bifurcation

• FASB is asking whether this alternative will
  provide more useful information to users of
  financial statements
• Comments received have been strongly against the
  proposal

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Bifurcation You be the judge
or
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FIN No. 48 Uncertain tax positions

• Accounting for tax positions likely to be
  challenged by the IRS
• Step 1 Determine whether it is more likely
  than not that a tax position will be sustained
  upon examination

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FIN No. 48 Uncertain tax positions

• Accounting for tax positions likely to be
  challenged by the IRS
• Step 2 Determine the largest amount of the
  benefit to be recognized in the financial
  statements and record it
• The amount recorded in the financial statements
  may be different than the amount of benefit
  claimed in the tax return, which will create a
  deferred tax liability which should be recorded

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FIN 48 Uncertain Tax Positions

• An enterprise must disclose the following items
  related to FIN 48
• Tabular reconciliation of the total unrecognized
  benefits and the changes form one reporting
  period to the next
• Total unrecognized tax benefits that, if
  recognized, would affect the tax rate
• Total amount of any interest and penalties
  recognized in the financial statements

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FIN 48 Uncertain Tax Positions

• Disclosures (continued)
• Any uncertainties that could cause the amount of
  the benefit to change from one reporting period
  to the next
• A description of the tax years that remin subject
  the examination.

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EITF 06-03 Taxes collected from customers

• Question Should a company report taxes collected
  from its customers as revenue and equal expense
  (gross method) or excluded from revenues and
  expenses (net method)?

Answer Either is acceptable, as long as
consistently applied and accounting policy is
disclosed (GAAP)
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NAIC Update Statutory Accounting and Reporting
Changes
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Summary

• NAICs attempts to regulate RRGs
• Statutory accounting changes
• Collateral securing reinsurance balances

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NAIC Activities Related to RRGs

• Failure of National Warranty RRG
• August 2005 GAO report
• Lack of uniform regulation across domiciles
• Capitalization (race to the bottom)
• Few concrete recommendations
• NAIC threatens to use accreditation to force
  states to apply NAIC standards

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NAIC Activities Related to RRGs

• Use of SAP versus GAAP
• Letters of credit and surplus notes as capital
• Risk-based capital as a solvency monitor

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NAIC Activities Related to RRGs

• Corporate governance
• Majority of the board should be independent
• Board must be able to cancel service provider
  contracts
• Approved governance guidelines annual
  certification of compliance
• Standing audit committee of independent directors

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NAIC Activities Related to RRGs

• Editorial comments
• NAIC will likely continue deliberations into 2007
• May signal first battle in state-versus-federal
  regulation

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Statutory accounting changes

• Disclosure of supplemental information in the
  audited financial statements
• Supplemental investment schedules
• Supplemental reinsurance attestation
• Accounting for certain mutual fund investments
• ETF
• Class 1 bond funds

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Statutory accounting changes

• Disclosure of investments with unrealized losses
  deemed temporary
• Securities in unrealized loss position by
  duration (ltgt 12 months) by type (bonds, common
  and preferred stock)

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Reinsurance collateral

• Current SAP requires unauthorized reinsurers to
  collateralize 100 of their balances due to
  ceding companies
• Trust accounts
• LOC
• Funds withheld

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Reinsurance collateral

• NAIC Reinsurance Task Force appears close to
  reducing collateral requirement based on
  reinsurers capital and solvency rating (RNRO)
• RR1 - 0
• RR2 - 25
• RR3 - 50
• RR4 - 75

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AICPA Update
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Eight new auditing standards

• Requires more in-depth understanding of the
  entity and its environment
• Documentation and testing of internal control
  required for all audits
• More documentation of inherent risks
• More testing to mitigate the risk of material
  misstatement in the financial statements

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Eight new auditing standards

• Certain standards applicable to 2006 audits
• More significant changes coming in 2007

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Federal Income Taxation of Captives
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Overview

• Revenue Ruling 2005-40
• Notice 2005-49

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Update on Single Owner Captive Insurance Taxation

• In 2005, the IRS issued Revenue Ruling
• 2005-40 and a Notice 2005-49 evidencing an
  increased scrutiny of captive arrangements

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Revenue Ruling 2005-40

• In Ruling 2005-40, the IRS gave four situations
  showing specific examples of what did or did not
  represent insurance
• In situation 1, the IRS said there was no
  insurance if there is only one insured

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Revenue Ruling 2005-40

• The same is true if there are two insureds - -
  one of which has at least 90 of the insurance
• This was true for Situations 1 and 2 even if the
  parties were completely unrelated and all
  formalities were otherwise met

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Revenue Ruling 2005-40

• The IRS ruled that single member LLCs that are
  disregarded for all other tax purposes are not
  counted as insureds
• Showed that single member LLCs that elect to be
  treated as corporations are counted as insureds

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Revenue Ruling 2005-40

• Are S corporations and multi-member LLCs taxed as
  partnerships treated as insureds? Limited
  partnerships? General partnerships?

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Tax Update

• How do you count the percentage insurance?
• If the insurance is all the same type, then it is
  presumably the percentage of net premium (the
  Revenue Rulings assumed that the percentage of
  gross and net premiums was identical)

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Tax Update

• The IRS has asked taxpayers to comment on the
  significance of having the captive issue more
  than one type of insurance (what if the risks are
  not homogeneous?)
• The VCIA and CICA each commented that having
  diverse risks often helps an insurance company
  accordingly, they believe homogeneity is not
  required

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Notice 2005-49

• In Notice 200549, the IRS asked for public
  comment on
• the circumstances under which
• qualification of an arrangement
• between related parties as insurance
• may be affected by a loan back of
• the amounts paid as premiums.

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Notice 2005-49

• The comments state that if each of these four
  factors are present in a loan back, there is
  insurance (if insurance otherwise exists)
• Bona fide indebtedness (enforceable reasonable
  terms and rates appropriate security)
• Permitted or approved by the regulators
• Sufficient liquidity of the insurance company
• Sufficient liquidity of the borrower

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Notice 2005-49

• If less than all four factors are present, the
  comments state that the facts and circumstances
  must be reviewed to determine if the investment
  function undermines the essence of insurance

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Notice 2005-49

• In Notice 2005-49, the IRS also asked for
  comments on (1) cell captives and related
  elections and (2) finite insurance

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Notice 2005-49

• CICA and VCIA submitted similar responses to this
  request
• The same principles currently used in determining
  the insurance tax status of non-cell captive
  arrangements should be applied in analyzing cell
  captive structures

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Notice 2005-49

• Since taxpayers have chosen a structure designed
  to legally segregate assets and liabilities
  within a particular cell, the form of this
  segregation should be respected for tax purposes
  as well
• Testing for the presence or absence of
  insurance should be conducted on a cell by cell
  basis employing the traditional body of law

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New IRS Releases Misc.

• New IRC 409A Deferred Compensation
• FASB Interpretation No. 48

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Questions / Comments

• Thank You