It Looks Like It…Smells Like It…Tastes Like It…

What Happens If I Step In It?

Accounting For Risk

Charlie Woodman, CPAManaging Director

Risk Finance AdvisoryWillis National Construction

RIMS 2008San Diego

April 29, 2008

2

I Have 90 Minutes To

• Introduce Financial Reporting and its Role

• Discuss the Components and Relevance of the Financial Statements

• Discuss the Accounting Concepts and Principles relevant to Risk Finance and Insurance

• Answer Any Questions

• Pack Up and Vacate

Holy $%#%!

3

Objectives of Financial Reporting

• Provide information useful to economic decision makers

• Allow decision makers to predict the organization’s future cash flows (and cash flows they will receive from direct operations)

• Provide information concerning the organization’s assets and liabilities and related transactions and events

4

Financial Reporting Constituency

• Information used by• Shareholders• Financial Partners / Lenders / Creditors• Suppliers and Users• Peers & Competitors• Government

• To collect taxes• To regulate

• Our concerns for today• Accounting impact on my organization• Impact on my risk finance programs

Now what’s going on?

5

Accountant’s Rules To Live By

• Never deal in absolutes…generally speaking

• When in doubt – all things being equal –choose the position that produces the least beneficial result (conservatism)

• No hard rules to materiality – may be a judgment call

• Accounting needs to be consistent, comparable and verifiable but only if it’s understandable, relevant and reliable

• The ‘Matching Principle’ – know it and be prepared to argue it.

• Accrual

• Economic timing

• ‘Recognition’ is realization that’s reported •Substance over Form

6

Reporting Platform: The Annual Report

• The Financial Statements• The Numbers

• The Disclosures

• Managements Discussion & Analysis

• Other Required Discussions / SEC Filings (10K, Certifications, etc.)

• Contact Info

• Fluff• Letters from the Chairman and CEO

• Glossy pictures showing shiny, happy people holding hands.

• Only the Financial Statements are opined upon, but the rest of the stuff must be consistent.

7

The Financial Statements: Booking and Disclosing

Disclosure: In addition, the Annual Report will include Notes To Financial Statements which explain the accounting policies, provide detailed information or breakdown of accounts, and disclose relevant information about many of the amounts and captions shown on the financial statements.

The Required Recognition or "Booked"

Financial Statement that Satisfies Requirement

Financial position at the end of the period

Balance Sheet (Primary)

Earnings for the period Income Statements (Primary)

Cash flows during the period

Statement of Cash Flows (Schedule)

Changes in Ownership Statement of Shareholders' Equity (Schedule)

8

Balance Sheet

12/31/07

Balance Sheet

12/31/08

Fiscal 2008

A = L + S/H Eq A = L + S/H EqRevenue- Expenses

Surplus / Deficit

Income Statement for the Year

Statement of Changes in Shareholders’ Equity

Beginning BalancesPaid-in Capital ChangesAsset changes+ Surplus / Deficit- DividendsEnding Balances

Statement of Cash FlowsCash Provided (Used) by:

Operating ActivitiesInvesting ActivitiesFinancining Activities

+ Beginning Cash BalanceEnding Cash Balance

The Numbers In Motion: Booking

9

Conflict and Turmoil In Accounting

• Accounting principles vs. codification of acceptable practices

• Disclosure – especially risks to the concern

• Control and Attestation (SOX 404)

• True hedge / true risk transfer• Consolidation and true

economic beneficiary• Valuation

• Contingencies• Cost / Amortization• Mark to Market / Mark to Model• Reconciliation of Book to Tax

4 years of college, 3 years grad school, four exams…for this?!

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Accounting Applied

• Losses – Loss Contingencies / Reserves / Provisions for Development

• Premiums Earned and Expensed

• Risk Transfer• Insurance vs.

• Deposit Accounting

• Impact of Taxes (new)

• Other Relevant Accounting Issues

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Recognition of Losses

• A loss is recorded only when (FAS 5):• The likelihood of actual loss is probable, AND

• The amount of the loss is reasonably subject to estimation.

• If reasonable estimates of loss or losses produces a range of equally likely outcomes – (FIN 14) book the minimum.

• Treat the tail of claims-made expected losses as unlimited loss(es)regardless if a new policy will likely be purchased.

• Importance

• A company cannot set aside reserves for a loss it believes might occur before it actually happens.

• If a loss occurs, a company must recognize the full value of the loss as an expense on its financials in the accounting period in which it knows of the event

• Actual payment reduces a reserve; should not effect earnings.

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Probability

• Remote – the chance of the future event or events occurring is slight

• Reporting Action: Do nothing or ID as a Risk of Business, if large, in MD&A

• Reasonably Possible – the chance of the event or events occurring is more that remote but less than likely

• Reporting Action: Disclose in Notes

• Probable – the future event or events are likely to occur

• Reporting Action: • If Measurable: Book to Financials:

Disclose in Notes• If Immeasurable: Disclose in Notes

under “Claims, Lawsuits and Other Contingencies”

Probability Distributions - All Lines

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

15,000,000

16,500,000

18,000,000

19,500,000

21,000,000

22,500,000

24,000,000

25,500,000

27,000,000

28,500,000

30,000,000

31,500,000

33,000,000

34,500,000

36,000,000

37,500,000

39,000,000

40,500,000

42,000,000

43,500,000

45,000,000

46,500,000

48,000,000

49,500,000

Losses / (Gains)

Prob

abili

ty

All Lines- Treated as Combined All Lines- Treated as Separate

Retained Risk @ 85th Percentile -

Risks Treated In Combination

Retained Risk @ 85th Percentile -

Risks Treated In Isolation

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Reasonable Reserves

Range of Estimates

Reasonable Sets of Assumptions

Evaluate Uncertainty, Risk of Material Adverse Deviation

Identify Sources of Uncertainty

Book Management’s Best Estimate

Measurability

14

Recognition of Losses - Other

• Loss Reserves may be discounted, but the effects must be disclosed (in footnotes), if material.

• Beware of auditor push-back

• Some accounting practices limit this

• Confidence level analysis may establish premiums in certain circumstances (think captives, forecasting and marketing), but may not be the basis of the loss contingencies except at ‘expected loss levels’.

15

Recognition for Premiums

• Affects Insureds and Insurers (Captives)

• Premiums paid:• Capitalized at policy inception and expensed over term of contract

• Some policies earn at inception – ex: loss portfolio transfers

• Cancellation penalties should be applied

• If the transaction is not ‘insurance’ then ‘deposit accounting’ (balance sheet to balance sheet) is used

• FAS 60 – Accounting and Reporting by Insurance Enterprises.

• What about Multi-year? How about when the contract has been satisfied?

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Accounting for Insurance

• Why Do We Care?• The "Insurance Transaction"• Insurance Accounting Treatment• DR Liabilities / CR Cash• Remove the volatility from insured’s future financial performance for the

covered exposure.

• But, "Insurance" isn't that clear cut.

• If it isn't an insurance transaction, then DEPOSIT ACCOUNTING must be used or

• If ineffective against the direct risk, the MARK TO MARKET / Derivative Accounting is used

• Under both of these, the insured’s balance sheets and income statements are exposed to volatility.

17

FASB Statement No. 113 et. al.

Affects Insureds and Insurers (including Captives)

MAJOR PROVISIONS

• Applicable for financial statements prepared under Generally Accepted Accounting Principles in the U.S.

• Defines Risk Transfer

• Segregates Retroactive and Prospective Contracts

• Grossed-up balance sheet – No longer ‘Net Losses’

• May be applied to test for tax premium deductibility

18

FASB Statement No. 113 – Risk Transfer

• Rules for treating a transaction or contract as bona fide (re)insurance and avoiding deposit accounting (bad)

• Risk transfer requires both of the following:• Paragraph 9a - The insurer assumes insurance risk under the

insured portion of the underlying contracts• Requires both underwriting and timing risk• Amount and / or timing of losses and loss payments may not

be known at inception• No delayed payment clauses allowed• Adjustable feature must be considered

• Paragraph 9b - It is reasonably possible that the insurer may realized a significant loss from the transaction

• Defined present value test• Did not define “significant”

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Transfer of Insurance Risk

Significance of a loss is evaluated by:

• Comparing the present value of all cash inflows with the present value of all cash outflows or amounts deemed to have been paid to the reinsurer under reasonably possible outcomes.

• But…

20

The Unanswered Questions

• What constitutes significant insurance risk?

• What is the definition of reasonably possible?

• What constitutes a significant loss?

21

The “10 / 10” Rule

• The “Old 10 / 10 Rule” - Auditors interpreted it to mean the (re)insurer must have at least a 10% chance (actuarially determined) of sustaining at least a 10% present value loss

• Now:

• New emphasis of credible assessment of both loss probability and loss severities. (low probability doesn’t necessarily exclude realistic exposure to exposure)

22

Contractual Provisions That Limit Risk Transfer:

• Experience refunds

• Cancellation provisions

• Profit commissions

• Retrospective premiums

• Reinstatement premiums

• Reductions or changes in coverage

• Additions of profitable lines of businessto the reinsurance contract

• Although Finite Contracts are less common, captives can be hit hard with this.

23

Prospective vs. Retroactive Contracts

Prospective insurance contracts cover losses incurred as a result of future insurable events

Retroactive insurance contracts cover losses incurred as a result of past insurable events

An insurance contract may be both

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FASB Interpretation No. 48 (FIN 48)

• FIN 48- FASB’s latest pronouncement in accounting for income taxes.

• Released July 13, 2006 / Effective Date for Years Beginning on or After December 15, 2006

• FIN 48 interprets FAS 109• Intent is to decrease the diversity in accounting for uncertainty in

income tax financial statement positions.

• Prior to recognizing the benefit of a tax position for financialreporting purposes, the tax position must be more-likely-than-not (MLTN) of being sustained solely on its technical merits (excluding detection risk)

• Tax positions recognized are reported at the largest amount that is MLTN to be sustained

24

25

FIN 48

• FIN 48 applies to all tax positions within SFAS 109• Does not apply to non-income taxes

• Federal insurance excise tax???

• Tax position examples:• Deductions taken (or expect to be taken)

• Taxable income excluded

• Conclusions not to file an income tax return

• State and Local Taxes

• Conclusions that an entity or transaction is tax-free

• May Not Take Into Account Audit Risk or The Likelihood of Being Audited

25

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FIN 48: Generally Applied

Evaluate each position for recognition. In order to recognize any amount of the benefit, the position must be MLTN of being sustained assuming:

• The position will be examined

• The examiner will have full knowledge of all relevant info

• Evaluation based solely on technical merits

• No offset or aggregation of positions

• Should assume resolution in the court of last resort

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Oh yeah. I love tax accounting…ZZZZ

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Recognition

• Highly certain tax positions• Clear tax law

• Will prevail opinion

• Extent of evidence and documentation requires judgment

• Evidence & Documentation of Uncertain tax positions:• Depends on the nature of the position

• Legislation, statutes, legislative intent,

regulations, rulings & case law

• Third party experts • Tax Opinions

• Other oral or written advice

• Role of the auditor

27

Now where’s that $#%& opinion letter

28

Common Problems for Us

• Qualifications of Insurance

• Qualifying as a Reciprocal for IRS purposes

• Loss Reserve Discounting

• Correct Lines of Business

• Correct IRS Factors

• Advanced Premium

• Controlled Group Elections

• Tax Advantaged or Exempt Status

• 831(b) Small Insurer

• 501(c)(15) Tax Exempt Insurer

• State Income Taxes (including unitary)

• Good News:• IRS has stated FIN 48

work papers will be viewed as audit work papers.

• As such, the IRS will not ask for FIN 48 work papers upon IRS audit.

28What me worry?

29

Other Accounting Issues

• Consolidation

• Hard to go “off-balance sheet” - FIN 46R (Variable Interest Entities)

• Letters of Credit: Not A ‘Numbers’ Item (off-balance sheet)

• Material amounts and effects on bank / borrowing lines should bedisclosed

• Compensating balances are “restricted cash”

• Tyranny of the “Stacking Evergreens”

• Trusts may be treated as

• On-balance sheet via “restricted cash” as funded / liabilities remain

• Off-balance sheet if fully irrevocable, with reasonably “known” pool of claimants without “termination residual value”

• Off-balance sheet if qualified “contested liability trust / fund” – not an easy thing.

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Warranty (and CYA Statement)

These discussions were meant to be general in nature. We at Willis, as risk management professionals, do have a layman’s working knowledge of the tax and accounting issues associated with

many risk financing arrangements. However, we do not provide legal, tax

or financial reporting advice. Therefore, none of our comments in this area may be relied upon to be

either accurate or indicative of probable outcomes when applied to

specific facts and circumstances.Hear no evil, see no evil, do no evil.

I Am Not Here.

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The Accounting for Risk Needs To Be Taken Seriously

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If You’re Not Informed and Careful…

Questions and Thank-You

Charlie Woodman, CPAManaging Director

Risk Finance AdvisoryWillis National Construction

RIMS 2008San Diego

April 29, 2008