It Looks Like It Smells Like It Tastes Like It. What Happens If I Step In It? Accounting For Risk

Transcription

1 It Looks Like It Smells Like It Tastes Like It What Happens If I Step In It? Accounting For Risk Charlie Woodman, CPA Managing Director Risk Finance Advisory Willis National Construction RIMS 2008 San Diego April 29, 2008

2 I Have 90 Minutes To Holy $%#%! Introduce Financial Reporting and its Role Discuss the Components and Relevance of the Financial Statements Discuss the Accounting Concepts and Principles relevant to Risk Finance and Insurance Answer Any Questions Pack Up and Vacate 2

3 Objectives of Financial Reporting Provide information useful to economic decision makers Allow decision makers to predict the organization s future cash flows (and cash flows they will receive from direct operations) Provide information concerning the organization s assets and liabilities and related transactions and events 3

4 Financial Reporting Constituency Information used by Shareholders Financial Partners / Lenders / Creditors Suppliers and Users Peers & Competitors Government To collect taxes To regulate Now what s going on? Our concerns for today Accounting impact on my organization Impact on my risk finance programs 4

5 Accountant s Rules To Live By Never deal in absolutes generally speaking When in doubt all things being equal choose the position that produces the least beneficial result (conservatism) No hard rules to materiality may be a judgment call Accounting needs to be consistent, comparable and verifiable but only if it s understandable, relevant and reliable The Matching Principle know it and be prepared to argue it. Accrual Economic timing Recognition is realization that s reported 5 Substance over Form

6 Reporting Platform: The Annual Report The Financial Statements The Numbers The Disclosures Managements Discussion & Analysis Other Required Discussions / SEC Filings (10K, Certifications, etc.) Contact Info Fluff Letters from the Chairman and CEO Glossy pictures showing shiny, happy people holding hands. Only the Financial Statements are opined upon, but the rest of the stuff must be consistent. 6

7 The Financial Statements: Booking and Disclosing The Required Recognition or "Booked" Financial position at the end of the period Earnings for the period Cash flows during the period Changes in Ownership Financial Statement that Satisfies Requirement Balance Sheet (Primary) Income Statements (Primary) Statement of Cash Flows (Schedule) Statement of Shareholders' Equity (Schedule) Disclosure: In addition, the Annual Report will include Notes To Financial Statements which explain the accounting policies, provide detailed information or breakdown of accounts, and disclose relevant information about many of the amounts and captions shown on the financial statements. 7

8 The Numbers In Motion: Booking 12/31/07 12/31/08 Balance Sheet A = L + S/H Eq Fiscal 2008 Income Statement for the Year Revenue - Expenses Surplus / Deficit Balance Sheet A = L + S/H Eq 8 Statement of Changes in Shareholders Equity Beginning Balances Paid-in Capital Changes Asset changes + Surplus / Deficit - Dividends Ending Balances Statement of Cash Flows Cash Provide d (Used) by: Operating Activities Investing Activities Financining Activities + Beginning Cash Balance Ending Cash Balance

9 Conflict and Turmoil In Accounting 4 years of college, 3 years grad school, four exams for this?! Accounting principles vs. codification of acceptable practices Disclosure especially risks to the concern Control and Attestation (SOX 404) True hedge / true risk transfer Consolidation and true economic beneficiary Valuation Contingencies Cost / Amortization Mark to Market / Mark to Model Reconciliation of Book to Tax 9

10 Accounting Applied Losses Loss Contingencies / Reserves / Provisions for Development Premiums Earned and Expensed Risk Transfer Insurance vs. Deposit Accounting Impact of Taxes (new) Other Relevant Accounting Issues 10

11 Recognition of Losses A loss is recorded only when (FAS 5): 11 The likelihood of actual loss is probable, AND The amount of the loss is reasonably subject to estimation. If reasonable estimates of loss or losses produces a range of equally likely outcomes (FIN 14) book the minimum. Treat the tail of claims-made expected losses as unlimited loss(es) regardless if a new policy will likely be purchased. Importance A company cannot set aside reserves for a loss it believes might occur before it actually happens. If a loss occurs, a company must recognize the full value of the loss as an expense on its financials in the accounting period in which it knows of the event Actual payment reduces a reserve; should not effect earnings.

12 Probability Remote the chance of the future event or events occurring is slight Reporting Action: Do nothing or ID as a Risk of Business, if large, in MD&A Reasonably Possible the chance of the event or events occurring is more that remote but less than likely Reporting Action: Disclose in Notes Probable the future event or events are likely to occur Reporting Action: If Measurable: Book to Financials: Disclose in Notes If Immeasurable: Disclose in Notes under Claims, Lawsuits and Other Contingencies Probability 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Probability Distributions - All Lines 15,000,000 16,500,000 18,000,000 19,500,000 21,000,000 22,500,000 24,000,000 25,500,000 27,000,000 28,500,000 30,000,000 31,500,000 33,000,000 All Lines- Treated as Combined Retained 85th Percentile - Losses / (Gains) Risks Treated In Combination Retained 85th Percentile - Risks Treated In Isolation 34,500,000 36,000,000 37,500,000 39,000,000 40,500,000 42,000,000 43,500,000 45,000,000 46,500,000 48,000,000 49,500,000 All Lines- Treated as Separate 12

13 Measurability Reasonable Reserves Range of Estimates Reasonable Sets of Assumptions Evaluate Uncertainty, Risk of Material Adverse Deviation Identify Sources of Uncertainty Book Management s Best Estimate 13

14 Recognition of Losses - Other Loss Reserves may be discounted, but the effects must be disclosed (in footnotes), if material. Beware of auditor push-back Some accounting practices limit this Confidence level analysis may establish premiums in certain circumstances (think captives, forecasting and marketing), but may not be the basis of the loss contingencies except at expected loss levels. 14

15 Recognition for Premiums Affects Insureds and Insurers (Captives) Premiums paid: Capitalized at policy inception and expensed over term of contract Some policies earn at inception ex: loss portfolio transfers Cancellation penalties should be applied If the transaction is not insurance then deposit accounting (balance sheet to balance sheet) is used FAS 60 Accounting and Reporting by Insurance Enterprises. What about Multi-year? How about when the contract has been satisfied? 15

16 Accounting for Insurance Why Do We Care? The "Insurance Transaction" Insurance Accounting Treatment DR Liabilities / CR Cash Remove the volatility from insured s future financial performance for the covered exposure. But, "Insurance" isn't that clear cut. If it isn't an insurance transaction, then DEPOSIT ACCOUNTING must be used or If ineffective against the direct risk, the MARK TO MARKET / Derivative Accounting is used Under both of these, the insured s balance sheets and income statements are exposed to volatility. 16

17 FASB Statement No. 113 et. al. Affects Insureds and Insurers (including Captives) MAJOR PROVISIONS Applicable for financial statements prepared under Generally Accepted Accounting Principles in the U.S. Defines Risk Transfer Segregates Retroactive and Prospective Contracts Grossed-up balance sheet No longer Net Losses May be applied to test for tax premium deductibility 17

18 FASB Statement No. 113 Risk Transfer Rules for treating a transaction or contract as bona fide (re)insurance and avoiding deposit accounting (bad) Risk transfer requires both of the following: Paragraph 9a - The insurer assumes insurance risk under the insured portion of the underlying contracts 18 Requires both underwriting and timing risk Amount and / or timing of losses and loss payments may not be known at inception No delayed payment clauses allowed Adjustable feature must be considered Paragraph 9b - It is reasonably possible that the insurer may realized a significant loss from the transaction Defined present value test Did not define significant

19 Transfer of Insurance Risk Significance of a loss is evaluated by: Comparing the present value of all cash inflows with the present value of all cash outflows or amounts deemed to have been paid to the reinsurer under reasonably possible outcomes. But 19

20 The Unanswered Questions What constitutes significant insurance risk? What is the definition of reasonably possible? What constitutes a significant loss? 20

21 The 10 / 10 Rule The Old 10 / 10 Rule - Auditors interpreted it to mean the (re)insurer must have at least a 10% chance (actuarially determined) of sustaining at least a 10% present value loss Now: New emphasis of credible assessment of both loss probability and loss severities. (low probability doesn t necessarily exclude realistic exposure to exposure) 21

22 Contractual Provisions That Limit Risk Transfer: Experience refunds Cancellation provisions Profit commissions Retrospective premiums Reinstatement premiums Reductions or changes in coverage Additions of profitable lines of business to the reinsurance contract Although Finite Contracts are less common, captives can be hit hard with this. 22

23 Prospective vs. Retroactive Contracts Prospective insurance contracts cover losses incurred as a result of future insurable events Retroactive insurance contracts cover losses incurred as a result of past insurable events An insurance contract may be both 23

24 FASB Interpretation No. 48 (FIN 48) FIN 48- FASB s latest pronouncement in accounting for income taxes. Released July 13, 2006 / Effective Date for Years Beginning on or After December 15, 2006 FIN 48 interprets FAS 109 Intent is to decrease the diversity in accounting for uncertainty in income tax financial statement positions. Prior to recognizing the benefit of a tax position for financial reporting purposes, the tax position must be more-likelythan-not (MLTN) of being sustained solely on its technical merits (excluding detection risk) Tax positions recognized are reported at the largest amount that is MLTN to be sustained 24 24

25 FIN 48 FIN 48 applies to all tax positions within SFAS 109 Does not apply to non-income taxes Federal insurance excise tax??? Tax position examples: Deductions taken (or expect to be taken) Taxable income excluded Conclusions not to file an income tax return State and Local Taxes Conclusions that an entity or transaction is tax-free May Not Take Into Account Audit Risk or The Likelihood of Being Audited 25 25

26 FIN 48: Generally Applied Oh yeah. I love tax accounting ZZZZ Evaluate each position for recognition. In order to recognize any amount of the benefit, the position must be MLTN of being sustained assuming: The position will be examined The examiner will have full knowledge of all relevant info Evaluation based solely on technical merits No offset or aggregation of positions Should assume resolution in the court of last resort 26 26

27 Recognition Highly certain tax positions Clear tax law Will prevail opinion Extent of evidence and documentation requires judgment Now where s that $#%& opinion letter Evidence & Documentation of Uncertain tax positions: Depends on the nature of the position Legislation, statutes, legislative intent, regulations, rulings & case law Third party experts Tax Opinions Other oral or written advice Role of the auditor 27 27

28 Common Problems for Us Qualifications of Insurance Qualifying as a Reciprocal for IRS purposes Loss Reserve Discounting Correct Lines of Business Correct IRS Factors Advanced Premium Controlled Group Elections Tax Advantaged or Exempt Status 831(b) Small Insurer 501(c)(15) Tax Exempt Insurer State Income Taxes (including unitary) 28 Good News: IRS has stated FIN 48 work papers will be viewed as audit work papers. As such, the IRS will not ask for FIN 48 work papers upon IRS audit. What me worry? 28

29 Other Accounting Issues Consolidation Hard to go off-balance sheet - FIN 46R (Variable Interest Entities) Letters of Credit: Not A Numbers Item (off-balance sheet) Material amounts and effects on bank / borrowing lines should be disclosed Compensating balances are restricted cash Tyranny of the Stacking Evergreens Trusts may be treated as On-balance sheet via restricted cash as funded / liabilities remain Off-balance sheet if fully irrevocable, with reasonably known pool of claimants without termination residual value Off-balance sheet if qualified contested liability trust / fund not an easy thing. 29

30 Warranty (and CYA Statement) These discussions were meant to be general in nature. We at Willis, as risk management professionals, do have a layman s working knowledge of the tax and accounting issues associated with many risk financing arrangements. However, we do not provide legal, tax or financial reporting advice. Therefore, none of our comments in this area may be relied upon to be either accurate or indicative of probable outcomes when applied to specific facts and circumstances. Hear no evil, see no evil, do no evil. I Am Not Here. 30

31 The Accounting for Risk Needs To Be Taken Seriously 31

32 If You re Not Informed and Careful 32

33 Questions and Thank-You Charlie Woodman, CPA Managing Director Risk Finance Advisory Willis National Construction RIMS 2008 San Diego April 29, 2008