Accounting for Financial Guarantee Insurance Contracts—an interpretation of FASB Statement
Why Is the FASB Issuing This Statement and When Is It Effective?
Diversity exists in practice in accounting for financial guarantee insurance contracts by insurance enterprises under FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises. That diversity results in inconsistencies in the recognition and measurement of claim liabilities because of differing views about when a loss has been incurred under FASB Statement No. 5, Accounting for Contingencies. This Statement requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation. This Statement also clarifies how Statement 60 applies to financial guarantee insurance contracts, including the recognition and measurement to be used to account for premium revenue and claim liabilities. Those clarifications will increase comparability in financial reporting of financial guarantee insurance contracts by insurance enterprises. This Statement requires expanded disclosures about financial guarantee insurance contracts. The accounting and disclosure requirements of the Statement will improve the quality of information provided to users of financial statements.
This Statement is effective for financial statements issued for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years, except for some disclosures about the insurance enterprise’s risk-management activities. This Statement requires that disclosures about the risk-management activities of the insurance enterprise be effective for the first period (including interim periods) beginning after issuance of this Statement. Except for those disclosures, earlier application is not permitted.
What Is the Scope of This Statement?
The scope of this Statement is limited to financial guarantee insurance (and reinsurance) contracts, as described in this Statement, issued by enterprises included within the scope of Statement 60. Accordingly, this Statement does not apply to financial guarantee contracts issued by enterprises excluded from the scope of Statement 60 or to some insurance contracts that seem similar to financial guarantee insurance contracts issued by insurance enterprises (such as mortgage guaranty insurance or credit insurance on trade receivables). This Statement also does not apply to financial guarantee insurance contracts that are derivative instruments included within the scope of FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities.
How Will This Statement Change Current Practice?
The changes to current practice in accounting for financial guarantee insurance contracts that result from applying this Statement relate to recognition and measurement of premium revenue and claim liabilities and to disclosures.
The premium revenue recognition approach for a financial guarantee insurance contract links premium revenue recognition to the amount of insurance protection and the period in which it is provided. For purposes of this Statement, the amount of insurance protection provided is assumed to be a function of the insured principal amount outstanding, since the premium received requires the insurance enterprise to stand ready to protect holders of an insured financial obligation from loss due to default over the period of the insured financial obligation. That approach is similar to the premium revenue recognition approach for a short-duration insurance contract in Statement 60 (even though the period of the financial guarantee insurance coverage may not be short duration).
The recognition approach for a claim liability relating to a financial guarantee insurance contract requires that an insurance enterprise recognize a claim liability when the insurance enterprise expects, based on the present value of expected net cash outflows to be paid under the insurance contract discounted using a risk-free rate, that a claim loss will exceed the unearned premium revenue. That approach is similar to the recognition approach for some liabilities for future policy benefits relating to a long-duration insurance contract in Statement 60.
An insurance enterprise is required to measure the claim liability equal to the present value of expected net cash outflows. Expected net cash outflows are probability-weighted cash flows that reflect the likelihood of all possible outcomes for payments by the insurance enterprise under the insurance contract. Under this Statement, the expected net cash outflows are developed using the insurance enterprise’s own assumptions about the likelihood of all possible outcomes based on all information available to the insurance enterprise (including relevant market information). This Statement clarifies that those assumptions should be consistent, where applicable, with the information tracked and monitored through the risk-management activities of the insurance enterprise to evaluate credit deterioration in its insured financial obligations. Changes in the expected net cash outflows are reflected as they occur. The expected net cash outflows are discounted using a current risk-free rate at the date the claim liability is initially recognized. That rate is updated each reporting period.
An insurance enterprise is required to provide expanded disclosures about financial guarantee insurance contracts. Those disclosures would focus, in part, on the information included in the risk-management activities used by the insurance enterprise to evaluate credit deterioration in its insured financial obligations, including (1) the groupings or categories used to track insured financial obligations with credit deterioration, (2) the insurance enterprise’s policies for placing an insured financial obligation in and monitoring each grouping or category, and (3) financial information about the insured financial obligations included within those groupings and categories.
What Is the Effect of This Statement on Existing Accounting Pronouncements?
This Statement interprets Statement 60 and amends existing accounting pronouncements to clarify their application to the financial guarantee insurance contracts included within the scope of this Statement. Specifically, this Statement:
- Amends Statement 60 to clarify that financial guarantee insurance contracts issued by insurance enterprises are included within the scope of that Statement as interpreted by this Statement
- Amends FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments (paragraph 8(c)), to clarify that the requirements of that Statement apply to financial guarantee insurance contracts included within the scope of this Statement
- Amends Statement 133 (paragraph 10(c)) to clarify that its scope exception for some insurance contracts does not apply to financial guarantee insurance contracts included within the scope of this Statement
- Amends FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (paragraph 6(d)), to clarify that it does not apply to financial guarantee insurance contracts included within the scope of this Statement
- Nullifies EITF Issue No. 85-20, “Recognition of Fees for Guaranteeing a Loan,” for financial guarantee insurance contracts included within the scope of this Statement.
What Is the Effect of This Statement on Convergence with International Financial Reporting Standards?
The International Accounting Standards Board (IASB) has on its agenda a project to comprehensively address the accounting for insurance contracts. In May 2007, the IASB issued for public comment its Discussion Paper, Preliminary Views on Insurance Contracts, setting out its preliminary views reached on that project to date. In August 2007, the FASB issued for public comment the Invitation to Comment, An FASB Agenda Proposal: Accounting for Insurance Contracts by Insurers and Policyholders Including the IASB Discussion Paper, Preliminary Views on Insurance Contracts. The FASB Invitation to Comment seeks input on whether to add to its agenda a joint FASB/IASB project to comprehensively address the accounting for insurance contracts, which ultimately could result in changes to existing U.S. generally accepted accounting principles (GAAP) for all insurance contracts, including those addressed in this Statement.
While the FASB acknowledges that the issues addressed in this Statement may be addressed by the IASB’s project on the accounting for insurance contracts, the FASB addressed this project at the request of the staff of the Securities and Exchange Commission and identified an approach to address the diversity in practice by building on existing requirements (in Statement 60) without creating a comprehensive new model. Accordingly, the FASB decided to interpret existing U.S. GAAP insurance accounting literature for financial guarantee insurance contracts rather than create a new model. If the FASB subsequently adds a joint project on insurance contracts to its agenda, the accounting guidance in this Statement ultimately may change and be converged with IASB literature.