Www.marsh.com / Accounting & Audit IMAC Captives Course November 9, 2011 Presented By: Alissa Matthews,

www.marsh.com / www.pkfcayman.com

Accounting & AuditIMAC Captives Course

November 9, 2011

Presented By: Alissa Matthews, CA Ben Leung, ACA Senior Vice President, Marsh Managing Partner, PKF [email protected] [email protected]

2

The objective of this course is to understand the process specific to insurance captives, for the following topics:

Accounting & Financial Reporting

Auditing

Overview & Objective

3

Accounting & Financial ReportingOverview

Accounting Oversight & Governance

Accounting for Premiums & Losses Example 1a: Premiums/Losses Example 1b: Reinsurance

Accounting for Retrospectively Rated Programs Example 2a: Retrospectively Rated Program Example 2b: Deposit Accounting

Other Accounting Considerations: Premiums & Losses

Accounting for Investments Example 3: Investment Classifications

4

Accounting & Financial ReportingOversight & Guidance

US Generally Accepted Accounting Principles (US GAAP)– AICPA – American Institute of Certified Public Accountants www.aicpa.org– FASB – Financial Accounting Standards Board www.fasb.org – SEC – Securities Exchange Commission www.sec.gov– Vast majority of Cayman captives follow US GAAP

International Financial Reporting Standards (IFRS)– IASB – International Accounting Standards Board and IFRS Foundation

www.ifrs.org – European Union, Canada, Australia, Asia

US GAAP vs IFRS:– Differences– Global harmonization and convergence– Majority of Cayman Captives use US GAAP– Presentation will focus on US GAAP treatment

5

Accounting & Financial ReportingAccounting for Premiums & Acquisition Costs

Accounting for the insurance program follows the insurance contracts. Under insurance accounting all contract amounts are set-up on day one:

– Premiums recognized as revenue over term of the contract in proportion to the insurance protection provided (typically evenly) (ASC944-605).

– Acquisition costs are related to acquiring the insurance contract and are set up on the balance sheet and expensed over term of contract. Acquisition Costs vary with the contract, ie. commissions, fronting fees, taxes, etc. (ASC944-30-25-1)

– General & Administrative Costs do not vary with contract & are not primarily related to the acquisition of the contract, ie. management fees, audit fees, etc. These costs are expensed as incurred. (ASC944-30-25-2)

– Reinsurance premiums assumed & ceded are accounted for on a gross basis

6

Accounting & Financial ReportingAccounting for Losses & Loss Reserves

Paid Losses & Case/Reported Reserves are based on Loss Runs– Claims Handler estimates reserve for known reported claims

Incurred But Not Reported (IBNR) must be recorded (ASC944-40-30)

– Adverse development on case reserves– Claims not yet reported– Actuary projects ultimate losses then deduct paid losses and case

reserves to obtain the IBNR figure.

Losses related to reinsurance contracts must be recorded gross

Loss & Reserves Note Disclosures:– Narrative on how losses are derived– Break-down components of reserves between case & IBNR– Break-down of movement in loss reserves between incurred and

paid and between current and prior years

7

Accounting & Financial ReportingAccounting for Losses & Loss Reserves

Reserves may be booked at a different confidence level and/or discount rate than that used for funding. – Confidence level or risk margin: higher = more conservative– Discount rate: comparable to risk free rate– Reserving Trends

Expected/Undiscounted 75% confidence level/Discounted

Reserving methodology should be reviewed annually:– Changing confidence level = change in accounting estimate– Changing discount rate = change in accounting estimate– Changing from discounted to undiscounted

Differing treatments: accounting policy vs accounting estimate Check with company’s auditors

8

Accounting & Financial ReportingExample 1 – Accounting for Premiums & Losses

AM Insurance Company (AMIC) has a December 31st year end and their financial statements follow US GAAP.

On October 1st AMIC entered into a year long reinsurance contract with the following terms and conditions: – Premiums $100,000 – Fronting & Acquisition Costs $5,000 – Net premiums ceded quarterly– Administrative expenses were $30,000 for the year – During the year claims were reported of $15,000 of which $5,000

was paid and $10,000 reserved.– Actuary projected ultimate losses of $25,000 as at year-end.

9


Fronting Company

AMIC

Insured

$100,000 in premiums

$95,000 ($23,750 per quarter sent to the captive)

$5,000 deducted for Fronting Fees

10

Accounting & Financial ReportingExample 1a - Accounting for Premiums & Losses

.

Day 1 – Entries (in blue throughout) Debit Credit

Reinsurance Balances Receivable (B/S) $71,250

Acquisition Costs (I/S) $5,000

Cash (B/S) $23,750

Premiums Written (I/S) $100,000

Movement in UPR (I/S) $100,000

Unearned Premium Reserve (UPR) (B/S) $100,000

Deferred Acquisition Costs (DAC) (B/S) $5,000

Movement in DAC (I/S) $5,000

To record premiums written &

costs

To record unearned & deferred amounts

11


Fronting Company

AMIC

Insured

$100,000 in premiums ($25,000 earned per quarter)

$95,000 ($23,750 per quarter sent to the captive)

Loss Runs / Cession Statement:

$5,000 Paid + $10,000 Reserved =

$15,000 Incurred

Invoices:

$30,000 Expenses

Actuarial Report:

$25,000 Ultimate Losses - $15,000 Reported =

$10,000 IBNR (Incurred But Not Reported)

$5,000 for Fronting Fees ($1,250 expensed per quarter)

12


Year-End – Entries (in green throughout) Debit Credit



Movement in DAC (I/S) $1,250

Deferred Acquisition Costs (DAC) (B/S) $1,250

Administrative Expenses (I/S) $30,000

Accounts Payable (B/S) $30,000

Losses Paid (I/S) $5,000

Losses Payable (B/S) $5,000

Movement in Loss Reserves (I/S) $20,000

Loss Reserves (B/S) $20,000

To Record Transfer to Incurred/ Earned

To Record Losses &

Loss Reserves

To Record Expenses

13


Balance Sheet Opening Day 1 Entry Y/E Adj Total

Cash $1,500,000 $23,750 $0 $1,523,750

Insurance Balances Rec 0 71,250 0 71,250

Deferred Acquisition Costs 0 5,000 (1,250) 3,750

Total Assets $1,500,000 $100,000 ($1,250) $1,598,750

Accounts Payable 0 0 30,000 30,000

Losses Payable 0 0 5,000 5,000

Unearned Premium Reserve 0 100,000 (25,000) 75,000

Loss Reserves 0 0 20,000 20,000

Share Capital & APIC 1,500,000 0 0 1,500,000

Retained Earnings 0 0 (31,250) (31,250)

Total Liabilities & Equity $1,500,000 $100,000 ($1,250) $1,598,750

14


Income Statement Opening Day 1 Entry Y/E Adj Total

Premiums Written $0 $100,000 $0 $100,000

Movement in UPR 0 (100,000) 25,000 (75,000)

Acquisition Costs 0 (5,000) 0 (5,000)

Movement in DAC 0 5,000 (1,250) 3,750

Underwriting Income $0 $0 $23,750 $23,750

Losses Paid 0 0 (5,000) (5,000)

Movement in Loss Reserves 0 0 (20,000) (20,000)

Net Underwriting Income $0 $0 ($1,250) ($1,250)

Administrative Expenses 0 0 (30,000) (30,000)

Net Income $0 $0 ($31,250) ($31,250)

15

Accounting & Financial ReportingExample 1b – Accounting for Reinsurance

Example 1b: AMIC decided on October 1st to cede 100% of the premiums to an excess reinsurer for an amount of $85,000 plus $10,000 in commission costs, due to the reinsurers on Day 1 of the policy.

Day 1 – Additional Entries Debit Credit

Reinsurance Premiums Ceded (I/S) $85,000

Commissions (I/S) $10,000

Cash (B/S) $95,000

Deferred Reinsurance Ceded (B/S) $85,000

Movement in Def’d Reins Ceded (I/S) $85,000

Deferred Commissions (B/S) $10,000

Movement in Deferred Commissions (I/S) $10,000


costs


16

Accounting & Financial ReportingExample 1b - Accounting for Reinsurance

Example 1b: AMIC decided on October 1st to cede 100% of the premiums to an excess reinsurer for an amount of $85,000 plus $10,000 in commission costs, due to the reinsurers on Day 1 of the policy.

Year-End – Additional Entries Debit Credit

Movement in Def’d Reins Ceded (I/S) $21,250

Deferred Reinsurance Ceded (B/S) $21,250

Movement in Deferred Commissions (I/S) $2,500

Deferred Commissions (B/S) $2,500

Losses Recoverable (B/S) 25,000

Movement Losses Recoverable (I/S) 25,000

To Record Tsf to

Incurred/ Earned

To Record Recoverable

from Reinsurers

17

Accounting & Financial ReportingExample 1b – Reinsurance Accounting

Balance Sheet Prior Total Day 1 Entry Y/E Adj Total

Cash $1,523,750 ($95,000) $0 $1,452,500

Insurance Balances Rec 71,250 0 0 71,250

Losses Recoverable 25,000 25,000

Deferred Reinsurance Ceded 0 85,000 (21,250) 63,750

Deferred Acquisition Costs 3,750 10,000 (2,500) 11,250

Total Assets $1,598,750 $0 $1,250 $1,600,000

Accounts Payable 30,000 0 0 30,000

Losses Payable 5,000 0 0 5,000

Unearned Premium Reserve 75,000 0 0 75,000

Loss Reserves 20,000 0 0 20,000


Retained Earnings (31,250) 0 1,250 (30,000)

Total Liabilities & Equity $1,598,750 $0 $1,250 $1,600,000

18

Accounting & Financial ReportingExample 1b – Reinsurance Accounting

Income Statement Prior Total Day 1 Entry Y/E Adj Total

Premiums Written $100,000 $0 $0 $100,000

Movement in UPR (75,000) 0 0 (75,000)

Reins Premiums Ceded 0 (85,000) 0 (85,000)

Deferred Reins Prem Ceded 0 85,000 (21,250) 63,750

Acquisition Costs (5,000) (10,000) 0 (15,000)

Movement in DAC 3,750 10,000 (2,500) 11,250

Underwriting Income $23,750 $0 ($23,750) $0

Losses Paid (5,000) 0 0 (5,000)

Movement in Loss Reserves (20,000) 0 0 (20,000)

Mvmt in Losses Recoverable 0 0 25,000 25,000

Net Underwriting Income ($1,250) 0 $1,250 $0

Administrative Expenses (30,000) 0 0 (30,000)

Net Income ($31,250) $0 $1,250 ($30,000)

19

Accounting & Financial ReportingAccounting for Retrospectively Rated Programs

Premiums may be subject to adjustment under retrospectively rated or other experience rated contracts.– If the premium is reasonably estimable, then that amount is

recognized as revenue over the course of the contract and revised to reflect current experience.

– If the premium is not reasonably estimable, then the cost recovery method or deposit method until it is estimable.

Retrospectively-Rated, ‘Zero-Bottom Line’, or ‘Harvard Model’ captives– Premiums typically initially based on the 75% confidence level in the

actuarial funding report plus operating expenses.– Policy notes premiums will be adjusted based on actual loss

experience.– May be subject to a maximum & minimum premium.– May include operating expenses and investment income.– Return excess funding through premium adjustments.

20


Contracts must transfer risk in order to be accounted for on the insurance accounting basis.

ASC 944-20 (FAS113 (9)) states that both the following must be met in order for the transaction to be a risk transfer arrangement:

(a) The reinsurer assumes significant insurance risk under the reinsured portions of the underlying contracts.

(b) It is reasonably possible that that reinsurer may realize a significant loss from the transaction.

In general this clause has been interpreted as:

10% risk of a 10% loss = 90% confidence level x 90%

Evidence of risk transfer must be present at policy inception.

Cap maximum premiums at or below the risk transfer amount for the policy to qualify for insurance accounting treatment.

21


22

Accounting & Financial ReportingExample 2 – Retrospectively Rated Programs

On January 1st, AMIC issued a policy directly to its Parent with the following terms and conditions:– Premiums of $200,000 based on the 75% confidence level funding report of $165,000 plus $35,000 funding for admin expenses. – The policy includes a retrospective premium clause that meets the requirements for risk transfer – Premiums paid quarterly in advance – At year-end claims paid were $10,000

and case reserves $40,000.– The actuary adjusted their ultimate

losses to $130,000 at year-end. – Administrative expenses were $30,000 – Interest earned was $5,000.

Parent Insured

AMIC

$200,000

23

Accounting & Financial ReportingExample 2a – Retrospectively Rated Programs

Day 1 - Entries Debit Credit

Insurance Balances Receivable (B/S) $150,000

Cash (B/S) $50,000





costs


Year-End - Entries Debit Credit

Cash (B/S) $155,000

Insurance Balances Receivable (B/S) $150,000

Interest Income (I/S) $5,000

To Record Premiums &

Interest received

24


Year-End – Entries Continued Debit Credit



Administrative Expenses (I/S) $30,000

Accounts Payable (B/S) $30,000

Losses Paid (I/S) $10,000

Losses Payable (B/S) $10,000


Loss Reserves (B/S) [$130k - $10k] $120,000

Movement in RPA (I/S) $45,000

Retrospective Premium Adj (RPA) Reserve (B/S)

$45,000

To Record Earned

Premiums

To Record Losses &

Loss Reserves

To Record RPA

Movement

To Record Expenses

25


Balance Sheet Opening Day 1 Entry Y/E Adj Total

Cash $1,500,000 $50,000 $155,000 $1,705,000

Insurance Balances Rec 0 150,000 (150,000) 0

Total Assets $1,500,000 $200,000 $5,000 $1,705,000

Accounts Payable 0 0 30,000 30,000

Losses Payable 0 0 10,000 10,000

Unearned Premium Reserve 0 200,000 (200,000) 0

Loss Reserves 0 0 120,000 120,000

Retro Prem Adj Reserve 0 0 45,000 45,000


Retained Earnings 0 0 0 0

Total Liabilities & Equity $1,500,000 $200,000 $5,000 $1,705,000

26


Income Statement Opening Day 1 Entry Y/E Adj Total

Premiums Written $0 $200,000 $0 $200,000

Movement in UPR 0 (200,000) 200,000 0

Underwriting Income $0 $0 $200,000 $200,000

Losses Paid 0 0 (10,000) (10,000)

Movement in Loss Reserves 0 0 (120,000) (120,000)

Movement in RPA 0 0 (45,000) (45,000)

Net Underwriting Income $0 $0 $25,000 $25,000

Investment Income 0 0 5,000 5,000

Administrative Expenses 0 0 (30,000) (30,000)

Net Income $0 $0 $0 $0

27

Accounting & Financial ReportingExample 2b – Retrospectively Rated Programs

Example 2b: All other contract terms remain the same, but the 90% confidence level discounted in the funding report was $230,000.

90% Confidence Level Discounted $230,000Multiply by 90% 90%

Maximum Premiums for Risk Transfer $207,000

Actual Premiums $200,000

Actual Premiums < Max Premiums YES

Retrospectively Rated Policy Cap $250,000

Retro Cap < Max Premiums NO

This example policy DOES NOT PASS the risk transfer test since the retro policy has a cap that is higher than the 90% confidence level discounted x 90%.

28


Day 1 – Entries to record as Deposit Liab Debit Credit


Deposit Liability (B/S) $200,000


Movement in UPR (UPR) (I/S) $200,000

To set up deposit liability

To reverse UPR entries

Accounted for using Deposit Accounting– Premiums received are recorded as additions – Losses paid as deductions to the deposit liability– Includes retrospective premium adjustments as part of policy

The amount of deposit liability should be adjusted to reflect future estimated payments (ASC 340-30-35)

29


Year-End – Entries to Record as Deposit Liab Debit Credit

Deposit Liability (B/S) $35,000

Interest Income Allocated to Deposit Liab (I/S) $5,000

Admin Exp Allocated to Deposit Liab (I/S) $30,000

Losses Paid Allocated to Deposit Liab (I/S) $10,000

Loss Reserves (B/S) $120,000


Retro Premium Adj Reserve (RPA) (B/S) $45,000

Movement in RPA (I/S) $45,000


Unearned Premium Reserve (B/S) $200,000

To Allocate Income

Statement Amounts to

Deposit Liability

To Reverse Reserve Entries

30


DEPOSIT LIABILITY ACCOUNT

Premiums $200,000

Losses Paid (10,000)

Investment Income 5,000

Admin Expenses (30,000)

Balance $165,000

31


Balance Sheet Insurance Day 1 Entry Y/E Adj Deposit

Cash $1,705,000 $0 $0 $1,705,000

Insurance Balances Rec 0 0 0 0

Total Assets $1,705,000 $0 $0 $1,705,000

Accounts Payable 30,000 0 0 30,000

Losses Payable 10,000 0 0 10,000

Deposit Liability 0 200,000 (35,000) 165,000

Unearned Premium Reserve 0 (200,000) 200,000 0

Loss Reserves 120,000 0 (120,000) 0

Retro Premium Reserve 45,000 0 (45,000) 0


Retained Earnings 0 0 0 0

Total Liabilities & Equity $1,705,000 $0 $0 $1,705,000

32


Income Statement Insurance Day 1 Entry Y/E Adj Deposit

Premiums Written $200,000 ($200,000) $0 $0

Movement in UPR 0 200,000 (200,000) 0

Underwriting Income $200,000 $0 ($200,000) $0

Losses Paid (10,000) 0 0 (10,000)

Losses Alloc to Deposit Liab 0 0 10,000 10,000

Movement in Loss Reserves (120,000) 0 120,000 0

Movement in RPA (45,000) 0 45,000 0

Net Underwriting Income $25,000 $0 ($25,000) $0

Investment Income 5,000 0 0 5,000

Administrative Expenses (30,000) 0 0 (30,000)

Inv/Admin Alloc to Deposit 0 0 25,000 25,000

Net Income $0 $0 $0 $0

33

Accounting & Financial ReportingOther Premium/Loss Considerations

Loss Portfolio Transfers/Retroactive Contracts– Retroactive contracts occur when liabilities are transferred after the

end of the policy year ie. contract effective Jan 1, 2010 covering losses reported after

Jan 1, 2010 but occurring prior to Jan 1, 2010. Popular for new captives to cover tail liabilities.

– Initial Treatment: Consideration credited to reserves rather than income statement. Gain on transfer is deferred and recognized over the payout

period of the losses. Loss on transfer is recognized in the current period.

– Future movements in reserves go through income statement.

34

Accounting & Financial ReportingAccounting for Investments

Types of Captive Investments– Liquid: Cash, Money Market Funds, CD’s– US Treasuries, Bonds, Government-Backed Securities– Equities– Managed Funds (private & exchange traded), fund of funds

Custodian Reports vs Investment Reports

Investment Note Disclosures: – Maturity tables– Gross up unrealized & realized gains/losses – ASC820 level disclosures

35

Accounting & Financial ReportingAccounting for Investments

Methods of Recording:– Held to Maturity:

amortized cost– Available for Sale:

Stated at fair value Changes reported in equity (other comprehensive income) Other Than Temporary Impairments (OTTI) ASC 825-10 Election to record at fair value

– Trading: Stated at fair value changes reported in income statement

36

Accounting & Financial ReportingExample 3 – Investment Classifications

AM Insurance Company (AMIC) has a December 31st year end and their financial statements follow US GAAP.– On January 1st, AMIC purchases investments for $700,000. – During the year AMIC sold $100,000 for a profit of $20,000.– During the year the portfolio earned $10,000 of interest income– At year-end there were $20,000 in unrealized losses and $50,000 in

unrealized gains. – Of the unrealized losses at year-end $15,000 have been deemed to

be Other Than Temporary Impairments (OTTI) in the investment value

37

Accounting & Financial ReportingExample 3 – Investment Classifications

Balance Sheet Maturity Avail for Sale Trading

Cash (1) 930,000 930,000 930,000

Investments (2) 600,000 630,000 630,000

Total Assets $1,530,000 $1,560,000 $1,560,000

Share Capital & APIC 1,500,000 1,500,000 1,500,000

Unrealized Gains/Losses (3) 0 45,000 0

Retained Earnings 30,000 15,000 60,000

Total Liabilities & Equity $1,530,000 $1,560,000 $1,560,000

1. Cash value: 1,500,000 – 700,000 + 120,000 + 10,000 = 930,000

2. Investment value: 700,000 – 100,000 = 600,000 cost + unrealized 30,000 = 630,000

3. Unrealized Gains (Other Comprehensive Income): 50,000 - 20,000 + 15,000 = 45,000

38

Accounting & Financial ReportingExample 3 –Investment Classifications

Income Statement Maturity Avail for Sale Trading

Investment Income

Interest Income (1) 10,000 10,000 10,000

Unrealized Gains/Losses (2) 0 0 30,000

Other Than Temporary Impairment (3) 0 (15,000) 0

Realized Gains (4) 20,000 20,000 20,000

Net Income $30,000 $15,000 $60,000

1. Interest Income: 10,000

2. Unrealized Gains/Losses: 50,000 – 20,000 = 30,000

3. Other Than Temporary Impairment (OTTI): 15,000

4. Realized Gains: 20,000

39

AuditingOverview

Audit Purpose & Responsibilities

Audit Process

Audit Planning Timeline

Standard Audit Procedures

Audit Completion

40

AuditingAudit Purpose & Responsibilities

Purpose & Scope– Enhance degree of confidence in the financial statements through

expression of an opinion on those financial statements– Requirement under Insurance Law to be filed 6 months after year-

end

Responsibilities of the Auditor– Conduct audit in accordance with appropriate standard (ISA/GAAS)– Obtain reasonable assurance financials are free from material

misstatement– Obtain evidence on amounts & disclosures– Evaluate appropriateness of accounting policies & reasonableness of

estimates, and overall presentation– Auditors judgement

41

AuditingAudit Overview

Responsibilities of Management– Management is any person(s) with executive responsibility for the

conduct of the entity’s operations – Financial statements are the responsibility of management– Properly recording transactions in the accounting records – Maintaining internal controls sufficient to permit reliable financial

statements– Adjusting the financial statements to correct material misstatements– Ensuring access to all company records and personnel– Ensure sufficient controls & programs to prevent & detect fraud– Ensure compliance with laws & regulations

42

AuditingAudit Process

Timetable & Scope Agreed

Confirmation

Planning & Review

ProceduresFieldwork & Testing

Meetings & Discussion

Completion

Delivery

Annual Audit Cycle

43

AuditingAudit Planning Timeline

Best practice is to get an audit timeline agreed with all parties prior to fieldwork:

Days after Y/E Who

Audit Planning Meeting > 2 weeks Prior Auditor

Actuarial Report Received (2 wks p/t drafts) + 2 weeks Actuary

Management Financials Completed + 3 weeks Manager

Confirmations Sent Out +4 weeks Auditor

Audit Fieldwork Start +4 weeks Auditor

Draft Audited Financials Received +9 weeks Auditor

Meeting to Approve Audited Financials +10 weeks Manager

Final Audited Financials Issued +11 weeks Auditor

44

AuditingStandard Audit Procedures

Investments/Investment Income– Confirm investment holdings with Custodian – Test market valuation of investments to third party pricing sources– Analytically review investment income– Review portfolio for Other Than Temporary Impairments, if applicable– Ensure disclosures have been made

Underwriting Income (Participant Contributions)– Confirm participant contributions assumed– Review policies and assess risk transfer– Agree policy contract terms and amounts– Confirm reinsurance & premiums written and related balances

Cash– Confirm cash balances for all accounts– Review cash reconciliations with bank statements

45

AuditingStandard Audit Procedures

Claim & Claim Expense Reserves– Review of current reserving policy– Test claims handling and/or obtain SAS 70 report from TPA– Obtain actuarial estimates for claim liability and IBNR claims– Review estimates used by actuary for reasonableness

Other Expenses & Procedures– Perform analytical procedures on operating expenses by comparing

previous year, budget, and expected changes– Agree expenses to service provider agreements– Based on the results of analytical review, additional procedures will

be performed, including review of detailed activity and testing of third-party documentation.

46

AuditingAudit Completion

Letter of Representations to Auditors– Sets out responsibilities of Management– Auditors are required to obtain written representations to support audit

evidence (ISA 580)

Management Letters & Control Letters– Proactive approach during the audit

Audit Report– Sets out responsibilities– Auditors Opinion

Clean/Unqualified Emphasis of Matter Qualified Adverse Disclaimer

47

Questions?

48

www.marsh.com / www.pkfcayman.com

Alissa Matthews, CA Ben Leung, ACA Senior Vice President, Marsh Managing Partner, PKF [email protected] [email protected]

Documents

Www.marsh.com / Accounting & Audit IMAC Captives Course November 9, 2011 Presented By: Alissa Matthews,