Odomirok Ch 22&23: US GAAP & Fair Value Under Purchase GAAP

Question 1

Describe the different intended users of SAP & GAAP:

Answer 1

• SAP: used primarily by regulators, and therefore focuses on the insurers ability to pay claims (surplus adequacy).
• GAAP: used mainly by investors and creditors, and is therefore focuses on the measurement of earnings emergence.

Question 2

Name some things that are treated differently between SAP and GAAP

Answer 2

 Deferred acquisition costs
 Premium deficiency reserves (PDR)
 Nonadmitted assets
 Deferred tax assets (DTAs)
 Invested assets
 Balance sheet presentation of reinsurance
 Ceded reinsurance (prospective & retroactive)
 Structured settlements
 Anticipated salvage & subrogation 
 Discounting of loss reserves
 Goodwill under purchase accounting

Question 3

Compare the GAAP & SAP treatment of Deferred Acquisition Costs (DAC):

Answer 3

• GAAP creates a DAC asset to defer the recognition of acquisition expenses, to match the recognition of earned premium.
• SAP does not allow deferring the expenses. Instead, all costs are expensed as incurred.

Question 4

Compare the GAAP & SAP treatment of Premium Deficiency Reserves (PDR):

*Must be recognized under both frameworks

Answer 4

• SAP: commissions & acquisition costs do not need to be considered to the extent that they have already been expensed

Recognized as either a write in liability, or within the UEPR balance

• GAAP: first netted from the DAC. Any remaining PDR recognized as a liability

Question 5

Compare the GAAP & SAP treatment of nonadmitted assets:

Answer 5

SAP: does not include these assets in surplus.

GAAP: does not have “nonadmitted assets”, so they are included in surplus

Question 6

Compare the GAAP & SAP treatment of DTA:

Answer 6

• GAAP: fully recognizes the DTA, but creates a valuation allowance if it is more likely than not that the DTAs will not be recognized.
• SAP: there is a strict admissibility test to recognize DTA, in addition to the valuation allowance.

Question 7

SAP valuation rules of various types of investment assets:

Answer 7

• Investment grade bonds and higher rated redeemable preferred stocks are valued at amortized cost
• Lower rated bonds & preferred stocks are valued at min(amortized cost, fair value)
• Common stocks & higher rated non redeemable preferred stock are valued at fair value

Question 8

GAAP valuation rules various types of investment assets:

Answer 8

• Available for Sale (AFS): purchased with the intention to sell before maturity, but after a year: fair value
• Held to Maturity (HTM): intent & ability to hold till maturity: amortized cost
• Held for Trading (HFT): purchased with the intention of selling within hours or days: fair value

Question 9

Compare the GAAP & SAP treatment of anticipated prospective reinsurance recoveries:

• This is for losses unpaid by ceding company

Answer 9

• SAP records the reserves net of anticipated reinsurance recoveries
• GAAP establishes an asset to recognize the ceded reinsurance recoverables

Question 10

SAP treatment of retroactive reinsurance:

Answer 10

• undiscounted ceded reserves are recorded as negative write in liabilities
• Schedule P is therefore not impacted
• a gain may be generated if the consideration paid is less than the negative write in liability. This is treated as a write-in gain as part of “other income”; and the surplus benefit is treated as “special surplus” until the paid reinsurance recovery exceeds the consideration paid

Question 11

GAAP treatment of retroactive reinsurance:

Answer 11

• the ceded reserves are treated as a reinsurance recoverable asset
• any gain is deferred, so there is no immediate income or surplus benefit.
• this gain is amortized over time

Question 12

Compare the GAAP & SAP treatment of structured settlements if the claimant signs a release:

Answer 12

GAAP and SAP Treatments are the same.

1. The purchase price of the annuity is recorded as a paid loss
2. The claim is closed

Question 13

Compare the GAAP & SAP treatment of structured settlements if a release is not signed:

Answer 13

• SAP: treatment is the same as the case where there is a release. However, the insurer must also disclose the contingent liability in the Notes to the Financial Statements
• GAAP: the settlement is treated like a reinsurance contract, which involves creating a reinsurance recoverable asset

Question 14

Compare the GAAP & SAP treatment of anticipated salvage & subrogation:

Answer 14

• Under SAP accounting, the insurer has the option about whether to record the reserves in Schedule P gross or net of anticipated salvage and subrogation.
• Under GAAP accounting, the insurer must subtract the anticipated balances.

Question 15

Compare the GAAP & SAP treatment of loss reserve discounting:

Answer 15

SAP: rarely allows discounting. Tabular discounts permitted in some cases

GAAP: Allows SAP discount rate to be used, but also allows for alternative discount rate

Question 16

Describe SAP treatment of goodwill:

Answer 16

• Goodwill equals the difference between the purchase price and the statutory surplus.
• It is capped at 10% of the acquiring firms capital & surplus.
• It is amortized to unrealized capital gains over the period in which the acquiring firm benefits economically (up to 10 years)

Question 17

Describe GAAP treatment of goodwill:

Answer 17

• Assets & liabilities are recorded at fair value.
• Goodwill is the difference between the purchase price and the fair value of net assets.
• It is regularly evaluated for impairment (as opposed to being amortized)

Question 18

Compare the GAAP & SAP treatment of negative goodwill:

Answer 18

• SAP: the negative balance is recorded as a contra asset and amortized to unrealized capital gains over 10 years or less
• GAAP: the negative balance is first used to offset the book value of the acquired non-current assets. Any residual is recorded as a “bargain purchase gain” in the income statement

Question 19

Describe the 10-Q form:

Answer 19

Essentially an abbreviated version of the 10-K.

Question 20

Describe the 8-K form:

Answer 20

Filed to disclose certain material events, including:

• Change in principal officers or directors
• Change in the company’s certified accountant
• Entering/ terminating a material definitive agreement

Question 21

List 2 regulations that outline the SEC reporting requirements:

Answer 21

• Regulation S-X: Form & Content of financial statements

- Regulation S-K: Integrated Disclosure rules

Question 22

3 components of the fair value of reserves, according to the mark-to-model approach:

Answer 22

1. Expected value of nominal future cash flows
2. A reduction to reflect the time value of money at the risk free rate, plus a load to reflect the illiquid nature
3. A risk adjustment to compensate for the risk associated with the liabilities

Question 23

2 methods to estimate the cash flows from the nominal reserves:

Answer 23

1. Use a payout pattern based on the loss reserve development
2. Use the implied pattern based on the ratio of paid losses to ultimate losses by accident year