Last Thursday, the Financial Accounting Standards Board (FASB) issued an exposure draft on a proposed update to accounting standards for insurance contracts. The proposal would significantly change the way that insurance companies measure liabilities in their income and earnings statements, requiring them to value liabilities in each financial reporting period by re-forecasting the liabilities’ impact on cash flow using up-to-date assumptions.
“Today, insurance is typically accounted for using assumptions that were made when a product was sold,” explains Donald Doran, national professional services financial instruments co-leader with PwC. For example, he says, life insurance companies determine the value of their liabilities by assessing issues such as: “‘What do we think lapses will be? What do we think deaths will be? What do we think expenses will be?’ All these assumptions are locked in on day one, so there’s very little volatility in the liabilities on a life insurance company’s financial statements.”
In contrast, under the proposed new rules, insurers would need to re-forecast their cash flows each financial reporting period. “Changes in cash flow projections from period to period would affect the insurer’s income statement,” Doran says. “From a life insurance perspective, financial statements would be much more volatile because you’re doing projections of a long-term liability.” Likewise, property and casualty insurers would have to discount reserves that they were not discounting before.
The move is designed to make insurance-related U.S. GAAP more principles-based. The International Accounting Standards Board (IASB) and FASB worked together closely on this issue, although the IASB released a separate proposal. It’s similar to the FASB proposal in many ways, but the international version would allow insurers to reduce volatility by putting some changes in liabilities’ value against their unearned profit so that financial statements wouldn’t have to reflect the full amount of every swing in value.
For corporate risk managers, the rules in the current FASB proposal might make some types of insurance harder to come by. “To the extent that the types of insurance coverage a company buys are longer-term and have elements in them like interest guarantees, corporate risk managers may find that their insurers are less willing to write those policies,” Doran says. Those that don’t have difficulty finding coverage might pay more. “By forcing insurance companies to put a current value on options and guarantees, these rules might raise the price on products that have options and guarantees,” Doran adds.
The FASB and IASB proposals are both open for public comment until October 25. Doran expects a final rule by early 2015, after which implementation may take three years or more.