Insurance Advisor Newsletter - Spring 2015

April 2015

Insurance Advisor Newsletter Spring 2015

SEC Hot Buttons for the Insurance Industry   

By John Green  

At least once every three years, the Securities and Exchange Commission (SEC) is required to review the 10K filings of every publicly traded company. The SEC issues comment letters to the registrant under review and these letters are publicly available. Periodically, we like to review the SEC’s hot topics, as reported in the comment letters, because they are important to publicly traded insurance companies and many of these issues will be incorporated into private company generally accepted accounting principles (GAAP) or statutory reporting in the future.

Overall, for the six months ended June 30, 2014, there was a 25 percent decrease in the number of comment letters as compared to the first six months of 2013. Issues noted in comment letters that apply across all industries include:
  • Management Discussion and Analysis (MD&A)
  • Valuation of investments
  • Fair value measures
  • Business combinations
  • Goodwill/impairment
  • Consolidations
  • Internal Control over Financial Reporting (ICFR)
  • Income taxes
These topics are largely repeats from prior years. The focus on ICFR is an area that the SEC will continue to scrutinize as a result of the new COSO framework that has been adopted by many registrants. For registrants that have retained the old COSO framework, expect comments with future filings. For registrants that file restated or revised financial statements to correct prior errors, the SEC requires a discussion of ICFR with the presumption that the controls were not adequate since an error occurred.

The MD&A comments were by far the largest. In particular, the SEC requested additional disclosures regarding the results of operations. In this area, the SEC wants to see registrants clearly explain the nature of variations from prior reporting periods, changes in key metrics and associated impact to the registrant’s financial statements.

With respect to the insurance industry, there are a number of specific SEC comments including:
  • Statutory disclosures
  • Regulatory capital and regulatory orders
  • Claims/low interest rate environment
  • Captive subsidiaries
  • Reinsurance receivables
  • Reserves and loss adjustment expenses
  • Deferred Acquisition Costs (DAC)
The SEC continues to be concerned about the disclosures surrounding statutory capital, specifically dividend restrictions of subsidiaries, as well as financial statement items that require significant management estimates such as DAC, loss reserves and investment valuations. The SEC would like to see registrants clearly disclose the methods and assumptions used to arrive at estimated amounts as well as the risk factors that impact operations and financial results.

Issues Breakdown on 10-K and 10-Q Comment Letters All Registrants

Statement of Cash Flows

In a December 8, 2014, SEC Staff Speech, T. Kirk Crews of the Office of the Chief Accountant indicated that while the number of restatements over the past five years has remained relatively consistent, restatements due to errors in the statement of cash flows continue to increase annually. The SEC Staff is considering why the statement of cash flows seems to be increasingly prone to error. They suggest that registrants consider the following aspects of their process and controls for the preparation of the statement of cash flows:

Information – How are you collecting the financial data necessary to prepare the statement of cash flows? What processes are in place to ensure this information is complete and accurate, especially to the extent new or nonrecurring transactions have occurred? Are there manual processes that are ad hoc that could be standardized or automated?

People – Do those individuals preparing the statement of cash flows understand the principles in Topic 230? Are there ways you can provide them with better training to perform their job? Do those individuals reviewing the statement of cash flows have enough expertise to identify and prevent misstatements in their review process?

Timing – Are there ways to prepare and review the statement of cash flows earlier in the financial statement closing process?

SEC Specific Requirements for Insurance Companies

Publicly traded insurance companies are required to supplement their financial statement disclosure checklists with insurance industry specific requirements of the SEC and GAAP. The sources of the supplemental disclosures are SEC Industry Guide No. 6 – Disclosures Concerning Unpaid Claims and Claims Adjustment Expenses of Property and Casualty Underwriters, and Regulation S-X Article 7 – Insurance Companies.

Guide 6 requires that information be furnished if reserves for unpaid property & casualty claims and claims adjustment expenses of the registrant and its consolidated subsidiaries, its unconsolidated subsidiaries and its 50 percent-or-less owned equity basis investees (taken in the aggregate after intercompany eliminations) exceed one-half of the common stockholders’ equity of the registrant and its consolidated subsidiaries as of the beginning of the latest fiscal year. Except where noted, the information furnished pursuant to Guide 6 shall be for the latest annual period for which financial statements are required. Article 7 contains specific guidance for the content and format of an insurance company’s balance sheet, income statement and supplementary information.

Looking Forward

A number of regulatory issues will undoubtedly become the source of SEC comments in the near future. Many of the provisions of the Dodd-Frank Act are now being implemented, some of which will affect insurance companies. As the provisions of Solvency II and the National Association of Insurance Commissioners (NAIC) Own Risk and Solvency Assessment (ORSA) are implemented, additional disclosures regarding enterprise risk management (ERM) and capital adequacy will likely become a topic for the SEC. One thing is for sure: like death and taxes, public company disclosures can only increase and never decrease.

For more information, please contact John Green at [email protected].

Eight Questions Your Board and Audit Committee Should Be Asking Management

By Barb Woltjer

Insurance organizations face a dizzying array of risk management, financial reporting and regulatory challenges that have intensified in both frequency and the severity of potential damage in recent years. Cybersecurity is just one of many issues that have grown exceedingly complicated and worrisome. But where do management’s responsibilities in protecting the organization end and a board member’s begin?

It’s a question that many are asking, but there are no clear answers. One thing that is certain is that the board’s role is changing. Board members have greater risk management responsibilities today and are expected to be more proactive, especially in organizations with high public visibility. That requires a bigger time commitment than in the past. Instead of waiting for management to surface issues that the corporate board would advise on, it’s now the board’s job to dig deeply into enterprise-wide risk management at the outset so that they have the understanding and expertise to provide the necessary governance and oversight.

The “Tone at the Top” is vital to achieving a successful enterprise risk management system, according to the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Tone at the Top, established by both executive management and the board, sets the organization’s commitment to integrity and ethical values, the importance of maintaining effective internal control and the expectation that all employees have a responsibility to play a part in maintaining an effective system of internal controls. Boards and executive management are also challenged with how to achieve the corporate strategy they have set out while minimizing risks to the organization. It forces them to consider the appropriate balance of risk versus return. How do organizations manage risk exposures while still effectively achieving their strategic goals?

So what issues are chipping away at board members’ time? A recent study conducted by BDO USA’s Corporate Governance practice found that being educated on the latest regulatory changes, assessing the impact of new financial reporting requirements, addressing the growing risk of cyberattacks and managing executive compensation were a few of the major issues corporate boards were dealing with last year. And board members indicated that risk management and succession planning are areas that ought to have more emphasis.

All of this leaves even the most proactive board members debating where they can have the most impact. In what areas should they be pushing more aggressively and asking questions of management? How can they understand more about the risks facing the organization?

Following is a list of common questions board members should be asking to better understand organizational risk exposure:
  1. What uncertainties exist that require greater board focus? Do we have the appropriate expertise internally, or availability of external resources, to address these uncertainties?
  2. How extensive is our enterprise risk management assessment? To what extent are the individual business units involved in assessing risk in their areas of expertise and familiarity? How often is this assessment updated? What is our process for addressing specific areas of vulnerability?
  3. What are we doing to develop and retain younger managers who have the potential to lead the organization in the future with the requisite knowledge, initiative and shared vision to execute the strategic goals of the organization
  4. How adaptive is our executive management team and overall organization to the required changes needed to respond to market opportunities and/or emerging risks?
  5. Have we sufficiently considered our vulnerability to cyberthreats? How are we leveraging necessary technology advancements to optimize growth while protecting against costly cyberattacks?
  6. How are changes imposed by insurance regulatory authorities and rating agencies impeding our ability to take advantage of market opportunities? How is our management team responding to those challenges?
  7. How are we responding to the potential shift in customer loyalty in an environment of innovation and changing customer preferences?
  8. How do we align our risk exposure with earnings objectives and the overall strategic plan? How do risk and uncertainty factor into our strategic decision process?
According to David Martin, author of Risk and the Smart Investor, “Risk management must be transformed into a cornerstone of effective strategic actions and corporate governance – and fully integrated into executive and investment decisions, organizational structures and corporate cultures. Meanwhile, failure to adapt to the new reality can be lethal.” Executive management teams and boards that take measures to adjust to the new norm of corporate governance can successfully marry opportunities for strategic growth with a culture of responsibility, responsiveness, adaptability and long-term sustainability.

For more information, please contact Barb Woltjer at [email protected].

Deducing the Deduction: Final Regulations Create Compensation Complications

By Sara Hendrix, CPA, BDO USA

On September 23, 2014, the IRS issued final regulations on the $500,000 limit imposed under the Affordable Care Act (ACA), on the deduction for compensation paid by a “covered health insurance provider” (CHIP).  The final regulations provide critical guidance on several issues, including both the application of the controlled group rules for purposes of determining whether an entity is regarded as a CHIP, and rules for allocating compensation to a specific year of service (particularly in the case of compensation payable in a subsequent tax year(s)). Section 162(m)(6) of the Internal Revenue Code was enacted as part of the ACA in order to limit the compensation expense deduction available to certain health insurance providers that are regarded as CHIPs.  For tax years beginning after December 31, 2012, an issuer of health insurance is treated as a CHIP if they receive 25 percent or more of their gross premiums from “minimum essential coverage” (MEC), generally defined as coverage that individuals are required to maintain to avoid incurring ACA penalties. This MEC includes any employer-provided health insurance coverage, individual market coverage, and governmental coverage (such as Medicare or TRICARE).

Adding to the complexity under these rules, the determination of whether a health insurance issuer is a CHIP can vary with each tax year as compensation and revenue streams change. The deduction limitation may apply in one tax period, but the entity may be exempt in subsequent or prior periods. And the exceptions to the rule are complex and cross tax years, applying to both current and deferred compensation. They also apply to tax years beginning January 1, 2013, meaning some insurers will have to revisit past tax years and re-evaluate their liability.

Every entity sharing common control with a CHIP (defined by the Internal Revenue Code as being in the same “aggregate group”) is also, by that association, subject to the compensation deduction limit.  In addition, the $500,000 deduction limitation applies to compensation provided all employees, directors, and (in certain cases) independent contractors within the CHIP aggregate group, and not just the top-four highest compensated employees as under the $1M compensation limit imposed on public companies.

Common types of aggregate groups include parent-subsidiary entities, affiliated service groups or non-corporate entities under common control. As the distinction between healthcare provider and insurer blurs, it stands to reason that more hospitals and long-term care providers could find themselves subject to CHIP tax provisions if they provide insurance themselves or enter a common control arrangement with an insurer.

By understanding the exceptions to Section 162(m)(6) and considering strategic compensation planning, insurers and those under common control can both limit their tax burden and retain more control over cash flow.

Planning Ahead for CHIP Status

Each taxpayer that has the potential to be defined as a CHIP should perform a thorough evaluation of its revenue streams and compensation policies on an annual basis to ensure that they are prepared for the possible limitations that Section 162(m)(6) may provide.

Affected entities may be able to design base compensation, or long-term incentive and deferred compensation arrangements in order to avoid/minimize the deduction limit.  One option includes spreading compensation out over a number of tax years. While deferred compensation is subject to the provision, an organization that knows it will fall under CHIP provisions one year but not the following may opt to defer bonuses or other compensation to limit its tax burden and retain control over cash flow.

Understanding Exceptions to CHIP Status

De Minimis Exception
The IRS provides an exception for de minimis premiums. Under this exception, an aggregate group that would otherwise be a CHIP is not subject to the compensation limitation if the premiums for minimum essential coverage received by all members of the aggregate group are less than 2 percent of the gross revenue of the aggregate group for the tax year. Further, the final regulations provide a “grace period” to permit entities to adjust and adapt to a change in their status as a CHIP, or a member of the aggregate group of a CHIP: The deduction limit will not apply in the first year that premiums exceed 2 percent of the gross revenue if the aggregate group qualified for the de minimis exclusion in the prior tax year.

Revenue Exceptions Not Considered Premiums
A health insurance issuer is defined as a CHIP only if it receives premiums from providing minimum essential coverage. Entities that are concerned about their potential CHIP status should examine all of their revenue streams with someone who understands the revenue exceptions.
  1. Amounts received under an indemnity reinsurance contract and amounts defined to be direct services payments, for example, are not treated as premiums for purposes of Section 162(m)(6). Specifically, health insurance issuers may reinsure a portion of their risks by entering into indemnity reinsurance contracts with various reinsurers. The final regulations affirmed that premiums received under an indemnity reinsurance contract are not treated as premiums from providing health insurance coverage, provided that under the reinsurance contract (1) the reinsuring company agrees to indemnify the health insurance issuer for all or part of the risk of the loss and (2) the health insurance issuer retains its liability to the individual insured.
  2. Some health insurance issuers enter into arrangements with third parties to provide, manage or arrange for the provision of services by physicians, hospitals or other healthcare providers. Under these arrangements, the health insurance issuer may pay compensation to the third party in the form of capitated, prepaid periodic or other payments for these services (referred to as “direct service payments”). The third party may also bear some or all of the risk in the event that the compensation is insufficient to cover the full cost of providing and managing these services.
The final regulations provide that these direct service payments made by a health insurance issuer are not treated as premiums for purposes of Section 162(m)(6), regardless of whether the third party is subject to healthcare provider, health insurance or other regulatory requirements under state law.

Compensation Subject to Limitation – Current and Deferred
The $500,000 compensation limitation applies to both current and deferred compensation paid to applicable individuals. Current compensation generally includes salaries or bonuses paid within 2½ months of year-end. Deferred compensation (referred to as “deferred deduction remuneration,” or “DDR” under Section 162(m)(6)) is compensation that is deductible in a tax year(s) after the year in which the related services were performed, such as non-qualified deferred compensation, stock option compensation, long-term incentive compensation arrangements or severance.

The $500,000 compensation limit applies first to the current compensation received. If this current compensation is less than $500,000 for that tax period, the remaining amount is applied to any deferred compensation earned in that year. The final regulations provide complicated rules for assigning DDR to one or more years of service.  DDR must be allocated to the tax years in which the services were performed, and the $500,000 compensation limit for a particular tax year is applied to the portion of compensation allocated to that year.  In addition, the regulations allocate DDR to years of service differently, depending upon the type of compensation arrangement in issue.  The method for allocating the compensation generally must be applied consistently for each type of compensation arrangement, and/or for each employee.

Sara Hendrix is a tax senior director at BDO. She can be reached at [email protected].

PErspective in Insurance

PErspective in Insurance is a feature examining the role of private equity in the insurance industry

The market for cat bonds and insurance-linked securities (ILS) has revolutionized the reinsurance industry in recent years, with insurers increasingly turning to the capital markets to transfer peak risk, instead of to the traditional reinsurance companies such as Munich Re and Swiss Re. On the other side of the market, alternative investors—private equity, hedge funds and, more recently, pension funds—are increasingly comfortable with cat bonds and ILS, which have produced annualized returns of more than 8 percent over the last 12 years, the Financial Times reports. Since their performance is not linked to that of other assets, they are an attractive option for investors looking to diversify their risks.

Read about PErspective in Insurance

Did you know...

Google launched an auto insurance comparison-shopping site in California in March and hopes to offer the service nationwide by next year, according to The Wall Street Journal.

The Council of Insurance Agents & Brokers’ Commercial P/C Market Index Survey found that premium pricing was slightly lower and demand generally was up for commercial P&C insurance in the fourth quarter of 2014.

Insured losses from severe winter weather in the U.S. this year are projected to exceed $1 billion, according to Impact Forecasting, Aon Benfield’s catastrophe model development team.

Towers Watson’s 2015 Insurance Industry Outlook Survey found that 77 percent of life and P&C insurers around the globe expect market conditions to remain flat or worsen somewhat over the next three years.

A recent report from Standard & Poor’s Ratings Services says it anticipates further mergers and acquisitions in the global reinsurance industry, emphasizing that the future will require greater scale.

For more information on BDO USA’s service offerings to this industry, please contact one of the following regional practice leaders:
Richard Bertuglia
New York
  Brent Horak

Doug Bekker
Grand Rapids
  Timothy Kovel
New York

Phil Forret 
  Albert Lopez

Carla Freeman
Los Angeles
  Imran Makda
New York

Jay Goldman
  Barb Woltjer
Grand Rapids

John Green
New York