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Weather Watch Insurance Accounting and Tax Developments

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Title: Weather Watch Insurance Accounting and Tax Developments


1
Weather Watch Insurance Accounting and Tax
Developments
  • Jim Murphy, Partner
  • Josh Keene, Principal

September 18, 2006
2
What will 2006 be like?
3
Or
4
Presentation Summary
  • FASB
  • NAIC
  • AICPA
  • Recent federal income tax developments affecting
    captives

5
FASB Update Developments in GAAP Accounting
6
Summary
  • Bifurcation project
  • Accounting for uncertain tax positions
  • Taxes collected from customers
  • Other current projects
  • Lease accounting
  • Derivatives
  • Defined benefit pensions
  • Financial guarantee insurance

7
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)

8
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

9
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)

10
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)

11
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?

12
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

13
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

14
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

15
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
16
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

17
Bifurcation You be the judge
or
18
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

19
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

20
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

21
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.

22
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)
23
NAIC Update Statutory Accounting and Reporting
Changes
24
Summary
  • NAICs attempts to regulate RRGs
  • Statutory accounting changes
  • Collateral securing reinsurance balances

25
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

26
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

27
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

28
NAIC Activities Related to RRGs
  • Editorial comments
  • NAIC will likely continue deliberations into 2007
  • May signal first battle in state-versus-federal
    regulation

29
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

30
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)

31
Reinsurance collateral
  • Current SAP requires unauthorized reinsurers to
    collateralize 100 of their balances due to
    ceding companies
  • Trust accounts
  • LOC
  • Funds withheld

32
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

33
AICPA Update
34
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

35
Eight new auditing standards
  • Certain standards applicable to 2006 audits
  • More significant changes coming in 2007

36
Federal Income Taxation of Captives
37
Overview
  • Revenue Ruling 2005-40
  • Notice 2005-49

38
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

39
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

40
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

41
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

42
Revenue Ruling 2005-40
  • Are S corporations and multi-member LLCs taxed as
    partnerships treated as insureds? Limited
    partnerships? General partnerships?

43
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)

44
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

45
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.

46
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

47
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

48
Notice 2005-49
  • In Notice 2005-49, the IRS also asked for
    comments on (1) cell captives and related
    elections and (2) finite insurance

49
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

50
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

51
New IRS Releases Misc.
  • New IRC 409A Deferred Compensation
  • FASB Interpretation No. 48

52
Questions / Comments
  • Thank You
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