{Extract from recommended study schedule for SFAS 5}
(The attached PDF file has better formatting.)
SFAS 5: Accounting for Contingencies
Two FASB statements are on the accounting section of the Exam 6 syllabus, and one is on the reinsurance section.
The FASB statements are difficult: you can spend hours on accounting jargon with little benefit. The paragraph by paragraph commentary here lets you master the SFAS material as efficiently as possible.
The FASB statements are guides for practitioners (professionals), not educational texts meant for students. The accounting language is geared to accountants, not actuaries.
SFAS 5 is not insurance specific, but it has relevance for insurance financial statements. Paragraphs 40-45 are about property-casualty insurance catastrophe coverage, with comments on case reserves, IBNR reserves, and premium deferrals.
SFAS 60 is concise, even laconic at times. Read it paragraph by paragraph with the NEAS commentary, or you will miss many GAAP topics, such as deferred policy acquisition costs and premium deficiency reserves. The study schedule background on contract duration, income recognition for life vs property-casualty insurance, GAAP matching procedures, and the rules for gain vs loss deferrals optimize your study of SFAS 60, SFAS 113, Blanchard on accounting concepts, and IASA on reinsurance accounting.
SFAS 113 (reinsurance) is essential for exam preparation. It is also summarized in the IASA textbook chapter on reinsurance. The CAS Guidance Note on the syllabus assumes you understand the risk transfer sections of SFAS 113. Study SFAS 113 after SFAS 60, since the GAAP matching and deferrals rules apply to reinsurance accounting as well.
This study session covers SFAS 5. Spend 2 to 3 hours on the text, the commentary here, and the NEAS illustrative test questions and past exam problems. Focus on the rules and the decision tree here. The seminar presentation of 20 to 25 minutes puts the pieces together so that you can identify the scenario and decide the accounting treatment. Spend another 1 - 2 hours after the seminar memorizing the essential phrases and reviewing the illustrative test questions and past exam questions. You can expect 1 to 2 points from this reading. With proper focus on the likely exam questions, the cost-efficiency is excellent.
Use the following sequence:
(1) Read the paragraphs on the syllabus (§§ 1-4, 8-11, 15, 40-45). This is an overview to see what the statement deals with. Do this in ten minutes to get a sense of the subject matter, not to master the material. Don’t try to understand paragraph 41 about insurance loss contingencies, or the accrual and disclosure rules in paragraphs 8 and 9. The study sequence below is optimal for exam preparation; it does not follow the paragraph order.
(2) The Statement deals with two items: the accrual and disclosure of loss contingencies. We have not yet said what a loss contingency is. For now, know two things:
Loss means an accounting loss, not an insurance loss. This statement is critical, since an insurance loss is an accounting expense, not an accounting loss, and does not quality as a loss contingency.
Loss contingency means the realization of the loss is contingent on a future event, even though the even creating the loss contingency already happened.
We explain both these items as we go though the statement.
Read paragraph 8. Memorize this paragraph for the exam; read it a dozen times by the end of October. Paragraph 8 gives two conditions for the accrual of loss contingencies: (i) the loss contingency is probable and (ii) it can be reasonably estimated.
SFAS 5, ¶8: An estimated loss from a loss contingency (as defined in paragraph 1) shall be accrued by a charge to income if both of the following conditions are met:
Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
The amount of loss can be reasonably estimated.
Accrual means that the event causes a liability on the GAAP balance sheet and a charge on the income statement. Recognition of the loss contingency has the same meaning. The exam tests the accrual and disclosure of loss contingencies, so we being our study by focusing on accrual and disclosure rules.
(3) Read paragraph 3, which gives the meaning of probable. The vague language in these accounting statements can be irritating: Probable means likely; remote means slight chance; reasonably possible is in the middle. Actuaries are criticized for being too technical, but these vague terms are worse. The same definitions, with a reference to SFAS 5, may be found in SFAS 113. Memorize the three types of loss contingencies.
SFAS 5, ¶3: When a loss contingency exists, the likelihood that the future event or events will confirm the loss or impairment of an asset or the incurrence of a liability can range from probable to remote. This Statement uses the terms probable, reasonably possible, and remote to identify three areas within that range, as follows:
Probable.
The future event or events are likely to occur.Reasonably possible. The chance of the future event or events occurring is more than remote but less than likely.
Remote. The chance of the future event or events occurring is slight.
The CAS Guidance note on SFAS 113 discusses these terms and the 10% rule used by some auditors. SFAS 5 and SFAS 113 have no prescribed numbers. Memorize these definitions, since they occur frequently on Exam 6.
(4) Read paragraph 9, which deals with two types of disclosure of contingencies: (i) disclosure when an accrual is made and (ii) disclosure when no accrual is made.
The last clause says: "disclosure may be necessary" (not: "is necessary") "for the financial statements not to be misleading."
Focus on what we disclose and when we disclose, not how we disclose. We disclose by notes to the financial statements; this is not tested on the exam.
If we accrue the loss contingency, we disclose two things: (i) the nature of the accrual and (ii) sometimes, the amount accrued. This is paragraph 9.
SFAS 5, ¶9: Disclosure of the nature of an accrual made pursuant to … paragraph 8, and in some circumstances the amount accrued, may be necessary for the financial statements not to be misleading.
We give a decision tree for accrual and disclosure of loss contingencies. As you read SFAS 5, focus on the items emphasized here and understand the rules. At the end, memorize the flow of the decision tree.
(5) Paragraph 10 deals with disclosure when we don’t accrue the loss contingency or the amount accrued is less than the full contingency.
If the contingency is possible but not probable, or if it probable but not reasonably estimable, we do not accrue the loss contingency but we disclose the loss contingency.
If the loss contingency is probable and reasonably estimable for a range of $100,000 to $250,000, we accrue $100,000. Since the contingency may be as high as $250,000, though the last $150,000 is less likely, we disclose the last $150,000.
Disclosure is needed only when the contingency is possible, not if it is remote. We explain each line of paragraph 10 of SFAS 5:
SFAS 5, ¶10: If no accrual is made for a loss contingency because one or both of the conditions in paragraph 8 are not met, or if an exposure to loss exists in excess of the amount accrued pursuant to the provisions of paragraph 8, disclosure of the contingency shall be made when there is at least a reasonable possibility that a loss or an additional loss may have been incurred.
Explanation: There are two scenarios for disclosure; in both scenarios, the contingency must be possible. If the loss contingency is remote, no disclosure is needed.
SFAS 5, ¶10, continued: The disclosure shall indicate the nature of the contingency and shall give an estimate of the possible loss or range of loss or state that such an estimate cannot be made.
Explanation: The disclosure has two parts: the type of contingency and a dollar amount. The dollar amount may be
a specific figure, if the contingency is estimable but not probable;
a range, if no more specific estimate can be made;
a statement that no estimate is possible.
SFAS 5, ¶10, continued: Disclosure is not required of a loss contingency involving an unasserted claim or assessment when there has been no manifestation by a potential claimant of an awareness of a possible claim or assessment unless it is considered probable that a claim will be asserted and there is a reasonable possibility that the outcome will be unfavorable.
Explanation: Suppose an actuary interviews an actuarial applicant but tells him that at age 58 he is too old for the job. The applicant may sue for age discrimination, but until the applicant makes a claim, the insurer need not disclose the potential contingency. If the insurer believes it is probable that the applicant will sue and win a court decision, the insurer must disclose.
Paragraph 11 is complex. Save it for the end. If a section of a reading is self-contained, difficult, and unlikely to be tested, we review it at the end of the study session. Our objective is to first cover the 80% of the syllabus that is likely to be tested. The remaining 20% of complex or untestable material distracts from efficient study.
(6) We have reviewed the accrual and disclosure of loss contingencies. But what exactly is a loss contingency? Know the definition (theory) and the SFAS 5 of ten examples.
Read paragraph 1, which defines loss contingencies and gain contingencies.
Accounting revenue and expense are income from the normal operations of a firm. Accounting gains and losses are income from other sources. The normal operations of a firm are not loss contingencies or gain contingencies.
The firm’s actions that generate the loss contingency have already occurred, but the liability "will ultimately be resolved when one or more events occur or fail to occur."
SFAS 5, ¶1: For the purpose of this Statement, a contingency is defined as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (hereinafter a "gain contingency") or loss (hereinafter a "loss contingency") to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. Resolution of the uncertainty may confirm the acquisition of an asset or the reduction of a liability or the loss or impairment of an asset or the incurrence of a liability.
A contingency has two parts:
The condition already exists which makes the firm liable.
An uncertainty exists, and the firm’s liability depends on resolution of the uncertainty.
Read paragraph 2. The gist of this paragraph is that "The fact that an estimate is being used does not necessarily make something a contingency."
The study aid has examples. Know the study aid illustrations of pending law-suits and affiliates’ liabilities. The seminar changes dates, amounts, and probabilities and analyzes the effect on existence, accrual, and disclosure of the loss contingency.
Capital gains on common stocks are the normal operations of a brokerage firm which trades stocks, so they are revenue (or expenses). They are not the normal operations of other firms, so they are gains (or losses).
Liability suits are the normal operations of insurers, so they are an accounting expense. They are not the normal operation of other firms, so they are accounting losses.
Many accounting entries are estimates. At year-end, we know the phone bills for January through November, but we estimate the bill for December. The December phone bill is not a loss contingency, since it does not depend on a future event.
SFAS 5, ¶2: Not all uncertainties … give rise to contingencies … Estimates are required … for many on-going … activities … The mere fact that an estimate is involved does not of itself constitute [a contingency]. For example, … estimates are used to allocate the known cost of a depreciable asset … Also, amounts owed for services received, such as advertising and utilities, are not contingencies even though the accrued amounts may have been estimated; there is nothing uncertain … that those obligations have been incurred.
Illustration: A firm depreciates the cost of its mainframe computer over 10 years. It might be that the computer will not last all 10 years; it might become obsolescent before then. Estimates must be made for many accounting entries; an estimate is not a contingency. The firm accrues the full amount of depreciation.
(7) Paragraph 4 gives 10 examples of loss contingencies. Memorize this list; no much else from SFAS 5 is testable, so this list gets asked. Example #g, catastrophes, is explained in paragraphs 40 through 43. The other examples are explained in other paragraphs, which are not on the exam syllabus.
SFAS 5, ¶4: Examples of loss contingencies include:
Collectibility of receivables.
Obligations related to product warranties and product defects.
Risk of loss or damage of enterprise property by fire, explosion, or other hazards.
Threat of expropriation of assets.
Pending or threatened litigation.
Actual or possible claims and assessments.
Risk of loss from catastrophes assumed by property and casualty insurance companies including reinsurance companies.
Guarantees of indebtedness of others.
Obligations of commercial banks under "standby letters of credit."
Agreements to repurchase receivables (or to repurchase the related property) that have been sold.
Memorize this list. It is accounting trivia, but it is tested on the exam. Question 28 from the Fall 1998 Part 7 exam asked:
Question 4 from the Fall 2005 Exam 6 asked:
(8) We have covered the accounting theory in SFAS 5. We are still missing paragraphs 11 and 15. We cover these at the end.
Go to paragraphs 40 through 43. Before you read them, know the four types of insurance losses. Paragraphs 40-43 discuss the four types in accounting jargon. We translate the accounting concepts to actuarial terms.
Case reserves:
A loss occurs and is reported, and a case reserve is set up by the loss adjuster. This is not a contingency, since the loss has already occurred. The case reserve flows through the income statement, even if you have trouble estimating the amount of the loss. Paying for insured losses is the normal operations of the insurer. This is an expense, not a loss, and the loss contingency issues do not arise.A non-insurance firm faced with an uninsured lawsuit that has a high chance of being dismissed and a low chance of being paid an uncertain amount of damages discloses the loss contingency but does not accrue anything. Being sued is not the firm’s normal operations, and this is a loss contingency. Even if the firm has a hundred such lawsuits a year, being sued is not its normal operations. If the suit is covered by a general liability policy, the insurance loss is an accounting expense for the insurer, not an accounting loss. The insurer estimates and accrues for the expected loss.
IBNR reserves: A loss occurs but is not reported, and a bulk reserve is set up by the reserving actuaries. This is an accounting expense, not a loss contingency, since the loss has already occurred and paying losses is the normal operations of the insurer. The fact that the loss is unreported simply makes the bulk reserve more difficult to estimate. The bulk reserve also flows through the income statement.
Catastrophe reserves (beyond policy term): A reinsurer writes property catastrophe covers on January 1, 20XX. On December 31, these treaties expire, though most of them will renew. No catastrophes occur in 20XX, so the reinsurer has a large profit. It expects catastrophes in future years, and it wants to use some of this profit to set up a catastrophe reserve to cover the future catastrophes.
Paragraph 40 prohibits this. "The insurance company has not assumed risk of loss for catastrophes that may occur beyond the term of the policy. No asset has been impaired or liability incurred with respect to catastrophes that may occur beyond the term of the policies in force." It doesn’t matter if a catastrophe loss is an accounting expense or an accounting loss. If the policy has expired and no catastrophe has occurred, the insurer or reinsurer may not accrue a reserve.
Some insurers said: "Instead of setting up a catastrophe reserve, we will defer the recognition of some premium income." Paragraph 42 prohibits this. Deferring the recognition of premium income is the same as setting up a catastrophe reserve.
Contingencies (insurance catastrophes): An insurer issues a block of Homeowners policies in New England on April 1, 20XX. On December 31, it prepares GAAP statements. During January, February, and March of the coming calendar year, there may be a New England snowstorm. To price the policies, the insurer used a catastrophe factor based on the experience of the past 20 years. The insurer does not know whether a serious snowstorm will occur or which policies will be affected. It wants to set up a reserve to cover the potential losses.
The potential catastrophe loss is a loss contingency. When the insurer issued the policy, it accepted the obligation to pay for any insured losses which may occur during the policy term. At policy issuance, it accepted this contingency.
To accrue the loss contingency, it must be probable and reasonably estimable. Forty years ago, actuaries priced catastrophe coverages by using long experience periods, which allow us to estimate the average number and magnitude of snowstorms. Actuaries now use catastrophe models instead of long experience periods; this does not affect the reasoning.
Over a short time span, such as the next three months, the occurrence of such snowstorms is not probable. Even if it were probable, the number and magnitude of such snowstorms is not estimable. We do not accrue for this liability. Similarly, we may not defer any premium that has already been earned to cover future losses.
The GAAP rules for loss contingencies must be read in combination with the rules for premium earning and premium deficiency reserves.
If the premium is earned pro-rata
, we hold one quarter of the premium as an unearned premium reserve on December 31, and we hold one quarter of the acquisition and underwriting costs as a deferred policy acquisition cost asset. If the business is priced adequately, we hold a reserve for future losses.If we expect half the losses on the book of business to stem from snowstorms in the first quarter of the year, we earn the premium as the protection is provided. We hold half the premium as an unearned premium reserve on December 31, and we hold half the acquisition and underwriting costs as a deferred policy acquisition cost asset. If the business is priced adequately, we hold a reserve for future losses.
If the business is not priced adequately, we reduce the deferred policy acquisition cost asset so that the net reserve is adequate to cover future losses. If reducing the DPAC to zero is not sufficient, we hold a premium deficiency reserve.
In all three scenarios, we may not defer an expected future loss. SFAS 5 says that
We may not hold a loss reserve for the future catastrophe losses.
We may not defer premium that has already been earned (unless justified by a premium deficiency reserve).
The intended scenario is the following:
The insurer issues policies covering New England properties. The insurer expects a severe storm every ten years, with expected losses of $100 million. It collects net premium of $10 million a year (after expenses and profit margin) to cover these storms.
From 20X0 through 20X8, the insurer has not had a severe storm, and it has earned extra profits of $10 million a year. The insurer wants to accrue the past profits as a contingency reserve for the years that it has storms. SFAS 5 does not allow this.
The insurer reasons: We expect a severe storm every ten years. For the past nine years, we have had no severe storms. We haven’t really earned the premium from these years, since we are due for a severe storm soon.
Actuarial science, like GAAP, says this reasoning is wrong. The lack of severe storms in past years has no effect on the likelihood of severe storms in the future.
Many readers of SFAS 5 have two questions:
What is wrong with accruing a liability? Isn’t this conservative?
Why does the insurer want to accrue an extra liability? Doesn’t this reduce its surplus?
(1) The goal of GAAP is to provide investors and creditors with accurate estimates of the firm’s financial strength and earnings, not with conservative estimates.
(2) Tax accounting follows statutory accounting, which often follows GAAP. insurers want to reduce taxable income by accruing catastrophe reserves.
As you read SFAS 5, differentiate between the existence of a loss contingency and the accrual for a loss contingency. An insurance contract covering natural catastrophes is a loss contingency, but we do not accrue for this loss contingency in GAAP statements.
Paragraphs 40 - 43 are concise. Find the accounting reference to each type of reserve.
(9) Paragraphs 44 and 45 say: "Compensation for an insurance contract is accounted for as premium only if there is risk to the insurer or reinsurer; otherwise it is accounted for as a deposit." These are the SFAS 113 rules; SSAP 62 is the same. In SFAS 113 (and SSAP 62), the rules applies to reinsurance contracts only; primary insurance contracts don’t need substantial risk to be considered reinsurance. In fact, SFAS 1113 (and SSAP 62) say that if the reinsurance contract has no risk but it transfers the entire insurance business covered by the primary policy, it is reinsurance; this implies that the primary contract need not involve risk transfer.
(10) Read paragraph 11. The paragraph says the following in accounting jargon: Suppose that the GAAP statements for calendar year ending December 31, 20X6 are drawn up in February 20X7. On January 5, 20X7, the company fires one of its managers. On January 25, 20X7, this manager files a suit for age discrimination seeking $1 million in redress. It is probable that this manager will win the suit for the claimed amount.
This is a loss contingency for which the company would accrue a liability for its 20X7 financial statements. No loss contingency existed on December 31, 20X6, so no liability is accrued.
(11) Paragraph 15 builds on paragraph 14; read them together. In lay terms, it says: Suppose you want a reserve for general contingencies, or unspecified business risks. You can’t hold a liability for unspecified risks; this is a component of stockholders’ equity.
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