Accounting for Risks and Contingencies

During 2004, a number of criticisms and concerns cast a spotlight on the state-regulated insurance industry and related financial reporting practices. As a result, management may be rethinking the relative merits of the various forms of risk management, such as self-insurance, contracts with insurance companies, and captive insurance subsidiaries.

Do the company's risk management practices still meet its objectives?

Questions about risk management strategies can be triggered by any one of a host of recent developments, including the following:

• Well-publicized investigations by state prosecutors into bid-rigging and contingent commissions.
• Reports and remarks by the Public Company Accounting Oversight Board (PCAOB). The Board has cautioned that it expects (a) companies will have adequate processes and controls for underlying claims data, and (b) auditors will perform sufficient tests of the data, processes, controls, and loss accruals.
• Reports of rating agencies. The reports have criticized the financial reporting practices for finite-risk reinsurance on the grounds that these policies do not transfer or manage risk. Instead, the policies may be used to smooth earnings or they may act as disguised loans when the premium paid for the coverage amounts to a deposit or loan.

Is the company properly reporting its risks and contingencies?

In view of the events described above, BDO USA is reminding companies of the accounting guidance for insured and uninsured risks and contingencies:

• A liability should be recorded for any unpaid claims that are probable and reasonably estimable in accordance with FASB Statement No. 5, Accounting for Contingencies. The liability should generally be for the gross amount of the loss, even if the entity has purchased insurance to cover the loss.
• When insurance is purchased to cover risks or contingencies, amounts receivable under the insurance contract should not be offset against the liability for unpaid claims. Further, amounts receivable under an insurance contract should be recorded only if realization is probable.
• Companies that purchase insurance must consider whether the contract transfers risk to the insurance company and whether the contract is retroactive or prospective. Guidance on retroactive contracts is provided by EITF Issue No. 03-8, "Accounting for Claims-Made Insurance and Retroactive Insurance Contracts by the Insured Entity."
• Companies that self-insure must accrue losses for asserted and unasserted claims in accordance with Statement 5. If the liability is significant, the company will likely require the assistance of an actuary to estimate the liability.

Specific guidance applies to companies that buy non-traditional or loss-mitigation insurance policies.

• Statement 5 establishes the accounting for an insurance contract (or reinsurance contract) that does not, despite its form, provide for indemnification of the insured company by the insurer (or re-insurer) against loss or liability. The payment should be accounted for as a deposit.
• FASB Statement No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts, provides guidance for insurance companies on the transfer of risk in reinsurance contracts and may provide guidance by analogy for insurance contracts.

The American Institute of CPAs (AICPA) has summarized the guidance on this subject in a technical practice aid (TPA) entitled "Accounting by Noninsurance Enterprises for Property and Casualty Insurance Arrangements That Limit Insurance Risk." the TPA includes questions and answers about the accounting for and use of finite property and casualty insurance contracts between a policyholder (a noninsurance company) and an insurance enterprise. The TPA can be found on the AICPA's website: http://www.aicpa.org/download/acctstd/Commercial_Insurance_TPA.pdf.

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