Odomirok - GAAP

Question 1

Which came first SAP or GAAP?

Answer 1

GAAP came first and SAP evolved from it over time on a state by state basis

Question 2

What is the fundamental difference between GAAP and SAP

Answer 2

• It is driven by the intended user
• GAAP is primarily used by investors who are focussed on earnings
• SAP is used by regulators and is thus focused on solvency
• SAP is focussed on insurance companies ability to pay claims while GAAP is focussed on earnings.
• SAP is thus more conservative

All companies use GAAP, but only insurance companies use SAP

Question 3

What are the key areas of difference between GAAP and SAP?

BASIC D³ING + PDF

Answer 3

• Balance sheet presentation of reinsurance
• Anticipated Salvage/subrogation
• Structured settlements
• Invested Assets
• Ceded Reinsurance
• -
• DAC
• DTA
• Discounting Loss Reserves
• Non-admitted assets
• Goodwill
• +
• PDR (Premium Deficiency Reserve)

Question 4

What is the difference between SAP and GAAP regarding balance sheet presentation of prospective reinsurance?

Answer 4

• SAP liabilities are shown NET of reinsurance on the balance sheet. No separate asset shown for ceded reinsurance recoveries since liabilities are net.
• GAAP liabilities are shown GROSS of reinsurance on the balance sheet
  
  • G = GROSS
  • GAAP needs a separate asset with “anticipated ceded reinsurance recoveries” so that everything balances.
• Similar Concept for UPR as GAAP UPR is Gross.

SAP Net L&ALAE Rsv = GAAP Grs L&ALAE Rsv - GAAP Reins Recov (Asset)

SAP no seperate ASSET becuse reserves NET, GAAP seperate ASSET as reserves Gross.

Question 5

What is the difference between SAP and GAAP regarding balance sheet presentation of retroactive reinsurance?

Answer 5

• GAAP Treatment
  
  • a separate asset is established for ceded reserves. Any gain (if ceded rsv > than amt paid) is deferred and amortized over time
  • No Immediate Impact on income or surplus as amortized over time (ie matching)
• SAP Treatment
  
  • undiscounted ceded reinsurance reserves are recorded as a negative write-in liability (or contra-liability).
  • The gain is recorded as a write-in gain and goes to other income
  • Gain = (negative write-in liability) – (cost of reinsurance) ]
  • Stays in special surplus until actual paid recovery exceeds amt paid for reinsurance

Question 6

What is the difference between SAP and GAAP regarding DAC?

Answer 6

• GAAP defers acquisitions because this more accurately reflects the matching of expenses over the policy period.
  
  • Remember GAAP is focussed on profitability over time (going concern)
• SAP recognizes these costs up front as these expenses are not available to meet obligations in event of liquidation.
  
  • SAP focussed on solvency and these expenses are not available to pay claims

No DAC in SAP. If you think there is DAC, then you are a SAP :)

The difference here is really due to the fundamental diff between GAAP and SAP.

Question 7

What is a Premium Deficiency Reserve (PDR)

Answer 7

A PDR exists when the unearned premium reserve (UPR) is insufficient to cover the anticipated costs.

Must be calculate by policy grouping, can’t offset the PDR of one grouping with profits of another grouping.

PDR must be recognized with a charge to current operations

Question 8

How do you calculate the PDR under SAP?

Answer 8

• For each Policy Group determine SAP Profit (UPR - PV Loss + Inv Inc)
• SAP PDR is the max(-SAP Profit, 0) for each group
  
  • Basically this means the SAP PDR = SAP Loss, but not offset by profit in other groups.

Note we don’t account for DAC here since already expensed.

Question 9

How do you calculate the PDR under GAAP?

Answer 9

• For each Policy Group determine GAAP Profit (UPR - PV Loss + Inv Inc - DAC)
  
  • Note for GAAP we calc profit after subtracting out DAC
• Initial Premium Deficiency equals max(-GAAP Profit, 0) for each policy group
• Final PDR = MAX(0, Premium Deficiency - Orig. DAC)
  
  • Reduce DAC to offset Premium Deficency, but can’t go below 0
  • DAC can reduce to 0 to lower PDR.
  • Can not use DAC from profitable premium groups to offset, so can have both PDF and DAC.

Final DAC = Max(Original DAC - Intial Premium Deficieny,0)

Question 10

How are bonds (invested assets) treated differently between SAP and GAAP?

A GAAP vs. SAP Difference (Invested Assets)

Answer 10

**SAP: Based on Quality of Bond
* NAIC 1-2 (Investment Grade) are held at amortized cost
* NAIC 3-6 (Below Investment Grade) are held at the lower of amortized cost or fair value.

GAAP: Based on Intent of Investment
* HFT (Held for Trading / Intent to Sell within hours/days): Fair Value
* HTM (Held to Maturity / Intent to keep) - Amortized Cost
* AFS (Available for Sale / after 1 year before maturity) - Fair Value

GAAP = What’s the value as ongoing concern, SAP = Value at liquidation.

Question 11

How are stocks/equity (invested assets) treated differently between SAP and GAAP?

A GAAP vs. SAP Difference (Invested Assets)

Answer 11

SAP: Based on Quality of Equity
* Common Stock are held at fair value
* Non-Redeemable Preferred Stock
* NAIC 1-2 held at fair value
* NAIC 3-6 held at lower of fair value or cost
* Redeemable Preferred Stock
* NAIC 1-2 held at lower of fair value or amortized cost
* NAIC 3-6 held at lower of fair value, cost, or amortized cost

GAAP: Based on Intent of Investment
* HFT (Held for Trading / Intent to Sell within hours/days): Fair Value
* AFS (Available for Sale / after 1 year before maturity) - Fair Value
* Thus Stock Always held at fair value

Note Stock can’t be held to maturity so no HTM category

GAAP = What’s the value as ongoing concern, SAP = Value at liquidation.

Question 12

How are structured settlements handled differently between GAAP and SAP?

Answer 12

• On certain liability claims an insurance company may purchase from a life insurance company with the beneficiary being the original claimant.
• When full release is given (ie agree to settle for future annuity payments then SAP and GAAP are the same:
  
  • The cost of the annuity is recorded as a paid loss
• When full release is not given then
  
  • GAAP treats the annuity as a reinsurance recoverable, where it maintains the reserve, but sets up a reinsurance recoverable asset.
  • SAP treats the same as if there is full release (paid loss), but requires the company disclose the amount of these contingent liabilities in Notes to Financial Statements

Question 13

What is the treatment of ANTICIPATED SALVAGE AND SUBROGATION in GAAP vs. SAP?

Answer 13

SAP:
* Either Unpaid Loss is stated either gross or net of salvage, but if net of salvage then the amount must be stated in Schedule P

GAAP:
* Unpaid loss amounts are stated net of salvage.

Question 14

How is loss reserve discounting handled between SAP and GAP

Answer 14

• In both cases, very limited discounting is allowed.
  
  • Only on WC and other long term disability claims may use discounting
• In the case of tabular reserves, SAP and most states are silent but typically 3.5% is used.
• For non-tabular reserves, should be in accordance with ASOP 20, but capped at:
  
  • The company’s net rate of return on statutory invested assets minus 1.5%
  • The current yield to maturity on a U.S. Treasury debt instrument with a duration similar to the payment of the claims

GAAP is the same is SAP, but allows for a reasonable alternative.

Question 15

What is the difference between SAP and GAAP regarding non-admitted assets?

Answer 15

• GAAP - All assets are allowed!!!!
  
  • Supports GAAP purpose as all assets are relevant for a company as a going concern
• SAP - disallows certain assets of low liquidity, such as furniture because these are not liquid after an insolvency
  
  • Supports SAP’s purpose of liquidity after insolvency.

Question 16

What is the basic SAP Calculation for Surplus?

Answer 16

SAP Surplus = Admitted Assets - SAP Liabilities

Question 17

How do you go from SAP Surplus to GAAP Surplus

Answer 17

GAAP Surplus = SAP Surplus + Non-Admitted Assets + RP + DAC

These are just some examples, there are others.

Note the change in carrying value of invested assets would impact surplus

Question 18

How does the calculation for Goodwill differ between GAAP and SAP?

Answer 18

SAP: Goodwill = min(P - S, 10% x S)
* Amortize over 10 years (at most)
* 10% x S serves as a Cap….maximum goodwill

GAAP: Goodwill = P - (Net Assets)
* Where Net Assets = FV(Assets) - FV(Liabilities)
* Test regularly for impairment

P = Purchase Price, S = Stat. Surplus of Purchased Comp, FV = Fair Value

Question 19

How is Fair Value determined under US Purchase GAAP

Answer 19

Fair value is the PRICE at which an orderly transaction to sell an asset would take place between market participants at the measurement date under current market conditions.

Question 20

What are the components of FV(liabilities) under GAAP purchase accounting?

Answer 20

• Nominal future cash flows of liability (either given or can calc using LDF’s
• Reduction / Discount to recognize the time value of money and additional load to account illiquid nature of liability - use risk free rate + additional illiquid loading.
• Risk Margin to compensate for risk associated with liabilities - use cost of capital approach or solvency II approach to take 99.5% VaR as required capital.

Question 21

How do you discount the cash flows as part of the FV(Liabilities)?

Answer 21

• The discount rate (i) is the risk free rate + load for illiquidity of liabilties
• Assuming the cash flow in middle of year then discounted losses is equal to summation of Cash Flow / (1+i)^0.5+…..+ Cash Flow / (1+i)^3.5

Question 22

How do you calculate the risk margin component of FV(Liabilities)

Answer 22

• Using the Cost of Capital Approach
• First we need the know the amount of capital required each year, which is average of the capital requirement at beginning and end of year.
  
  • Capital requirement likely stated as % of liability
• Example Year 1 Capital Reqirement = Avg(C₀,C₁) / (1+i)¹
• Follow same calculation for subsequent years
• Sum of pieces and mulitiply total by (R - i), where R is pre-tax cost-of-capital and i is the risk-free rate that includes illiquidity premium

rsk margin=(R - i) x Σ [ avg(C_t, C_t+1) /(1+i)^t+1

Risk Margin is for the uncertainty of liabilities

Question 23

How is SAP’s treatment of bond’s inconsistent with the general philosophy of SAP?

Answer 23

• SAP is conservative and focuses on solvency and thus SAP should use the lowest reasonable estimate of bond value
  
  • In a time of rising interest rates, using the amortized value for investment grade bonds may overstate their value at liquidation.
  • Thus is inconsistent with SAP purpose and focus on solvency

Question 24

Under SAP accounting perspective, why might insurers rent furniture rather than buy?

Answer 24

• If rented, the fees can be expense
• While if purchased, the furniture is a non-admitted asset that reduces surplus

Question 25

What is the purpose of the 10-year loss development table in the insurer’s 10-K?

Answer 25

• Provide information regarding the deficiency (redundancy) of the initial AY reserve using subsequent evaluations. Was it low or high.
• To calculate, assume that paid loss is unchanged. Based on subsequent experience, how would unpaid losses have looked if the initial estimate had been higher or lower.