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Reporting entities often manage risk by purchasing insurance. Common types of purchased insurance arrangements include property loss, business interruption, and claims-made insurance policies. However, purchasing insurance rarely changes the primary obligation of the reporting entity in the event of a loss. The reporting entity is required to reflect the impact of a loss event even when insurance is available to cover the loss and separately account for the impact of the insurance policy. Generally, offsetting insurance receivables for expected recoveries against liabilities recognized for a loss contingency would not be appropriate.
While this chapter discusses the accounting for purchased insurance arrangements in the event of a loss, there may be additional accounting and reporting implications companies should consider when a loss event (e.g., natural disaster) occurs. Examples of additional accounting and reporting guidance to consider in these scenarios may include:
  • Long-lived asset impairment under ASC 360, Property, Plant, and Equipment (PPE 5)
  • Indefinite-lived intangibles and goodwill impairment under ASC 350, Intangibles – Goodwill and Other (BCG 8 and BCG 9)
  • Environmental obligations under ASC 410-30, Asset Retirement and Environmental Obligations, Environmental Obligations (PPE 9)
  • Asset retirement obligations under ASC 410-20, Asset Retirement and Environmental Obligations, Asset Retirement Obligations (PPE 3)
  • Exit and disposal cost obligations, including contract termination costs under ASC 420, Exit or Disposal Cost Obligations (PPE 6.5)
  • Debt and liquidity issues, including debt covenant compliance under ASC 470, Debt (PwC’s Financing Transactions guide)
  • Derivative and hedging considerations under ASC 815, Derivatives and Hedging (PwC’s Derivatives and Hedging guide)
  • Going concern considerations under ASC 205-40, Presentation of Financial Statements, Going Concern (FSP 24.5)
  • Subsequent event considerations under ASC 855, Subsequent Events (FSP 28)

8.2.1 Recognition of insurance recoveries

An insurance recoverable asset can be recorded when there is an enforceable insurance contract in place that covers the event causing the loss. The timing of the initial recognition of an insurance recovery asset depends on assessing the enforceability of the claim being covered by the insurance policy and whether the expected proceeds would result in a recovery of a recognized loss or represent a gain contingency. No recoverable can be recorded if coverage is in dispute or if the policy is unclear as to the calculation of the reimbursable amount.
A gain contingency exists when the insured entity expects recovery of a loss not yet recognized in the financial statements (e.g., a business interruption policy that covers margin expected to be lost) or when the insured entity expects to recover an amount in excess of a loss recognized in the financial statements (e.g., replacement cost of a damaged fixed asset that exceeds the carrying value). Conversely, the recovery of a recognized loss is not a gain contingency.
Unless the conditions in ASC 210-20, Balance Sheet, Offsetting, are met, offsetting prepaid insurance and receivables for expected recoveries from insurers against a recognized liability or the liability incurred as a result of a past insurable event would not be appropriate. ASC 210-20 allows the offsetting of assets and liabilities only when the right of setoff exists. The right of setoff exists when (1) each of the two parties owes a determinable amount, (2) the setoff is enforceable at law, and (3) the reporting entity has the ability and intent to set off. Generally, the loss accrual resulting from an insurable event and any related insurance receivable under an insurance contract are with different parties; therefore, the requirements for the right of offsetting the balances are not met. See FSP 2.4 for additional information on requirements for balance sheet offsetting.
In the event of an insured loss, the amount of the recorded recoverable will depend on the assumptions used in recording the underlying covered loss and the realization of any proceeds in excess of recognized losses from the event. When a loss is covered by insurance and the amount and timing of the reimbursement from the insurance company depends on the amount and timing of the related loss event payments, a reporting entity should measure the insurance receivable using the same assumptions used to measure the associated recognized loss. An example of a reimbursement that depends on timing would be when claims are paid when submitted to the insurance company (vs. a policy that pays claims on a specific, pre-determined date).

8.2.1.1 Recovery of recognized losses versus gain contingencies

A gain contingency should not be recognized prior to being realized, nor should a minimum amount of gain be recognized based on a probability assessment. A gain is realized when cash (or other assets, such as claims to cash) has been received, or is contractually due, without expectation of repayment. A single expected insurance recovery may represent both a recovery of a loss and a gain contingency. Each component should be analyzed separately for recognition purposes.
A gain related to an insurance recovery is not realized until all contingencies relating to the insurance claim have been resolved. For example, a gain could be recorded at the balance sheet date if (1) it is acknowledged that the loss event is covered, (2) information is received prior to the release of the financial statements that will confirm the amount to be received, and (3) collection is probable. However, if the existence of the claim or the applicability of coverage is being disputed by the insurance company or the amount of the claim has not been finalized, the gain would not be considered realized and should not be recognized until final settlement.
Recovery of a recognized loss is not a gain contingency. If there is (1) a legally enforceable contract that stipulates the terms of the insurance coverage, (2) the terms are not in dispute and there is no reason to believe they would be disputed, and (3) there is reason to believe recovery is collectible, a receivable for the recovery of a recognized loss should be recorded, even if final settlement amounts are not yet determined.

8.2.1.2 Gain or loss on involuntary conversions

When an insurance receivable is recorded as a result of theft or damage to a nonmonetary asset (e.g., a building), it is considered to be an involuntary conversion of the nonmonetary asset (i.e., the building) to a monetary asset (i.e., the receivable for insurance proceeds). Such events are considered monetary transactions and should be measured at the value of the monetary consideration received and not considered an exchange of nonmonetary assets, even if the proceeds from the insurance policy will be used to construct a replacement asset (e.g., to construct a new building).
Recognition of a gain or loss on an involuntary conversion is measured as the difference between the carrying amount of the nonmonetary asset and the amount of monetary assets received. See FSP 3.6.10 for discussion of the income statement classification of gains or losses resulting from an involuntary conversion and FSP 6.9.22 for discussion of the cash flow presentation of insurance proceeds.
Example PPE 8-1 illustrates the recognition and measurement of an equipment casualty loss and the related potential insurance recovery from an insurance policy with no deductible. Example PPE 8-2 illustrates the recognition and measurement of an equipment casualty loss and the related potential insurance recovery from an insurance policy with a deductible. Note that although Example PPE 8-1 and Example PPE 8-2 assume the complete destruction of the insured property, the same concepts would apply to a partial destruction of the insured property.
EXAMPLE PPE 8-1
Accounting for casualty loss with an insurance recovery – no deductible
On June 1, 20X4, PPE Corp’s equipment is heavily damaged while being transported from its manufacturing facility to its retail facility. Due to the nature of the damage, PPE Corp determines that there is a total loss. The equipment had a net book value of $7 million and an estimated replacement value of $6 million as of the date of loss. PPE Corp files a property and casualty claim with its insurer for recovery of the $6 million replacement value. Based on its discussions with the insurer and review of the policy by in-house experts, PPE Corp concludes that it has a covered loss under the policy and that it is probable the insurer will settle the claim for at least $5 million. There is no deductible under the insurance policy. The insurer has communicated to PPE Corp that the amount of final settlement is only subject to verification of the identity of the equipment damaged and the receipt of additional market data regarding its replacement value.
How should PPE Corp recognize and measure the loss of the equipment and the potential insurance recovery?
Analysis
PPE Corp would write-off the net book value of the equipment of $7 million and recognize an insurance recoverable asset of $5 million for the probable recovery of its loss. PPE Corp would recognize any remaining recovery (i.e., any excess over the initial $5 million recoverable recognized) when recovery of an additional amount is probable (e.g., when the identity of the damaged equipment has been established and additional market data confirm its value).
If it were probable PPE Corp would receive $8 million to settle the claim (rather than $5 million), PPE Corp would record an insurance recoverable asset of $7 million, equal to the amount of the recognized loss. The excess insurance proceeds of $1 million ($8 million settlement compared to the $7 million recognized loss) would be recognized as a gain when all contingencies related to receiving the $1 million are resolved. The $1 million of insurance proceeds in excess of the recognized loss should not be deferred and amortized over the future periods nor applied to the cost basis of the new asset.
EXAMPLE PPE 8-2
Accounting for casualty loss with an insurance recovery – with deductible
On November 1, 20X4, PPE Corp’s warehouse is heavily damaged by a tornado. Due to the nature of the damage, PPE Corp determines that there is a total loss. The warehouse had a net book value of $100 million and an estimated replacement value of $105 million as of the date of loss. PPE Corp files a property and casualty claim with its insurer for recovery of $105 million, as the insurance policy is for replacement cost. Based on its discussions with the insurer and review of the policy by in-house experts, PPE Corp concludes that it has a covered loss under the policy and that it is probable the insurer will settle the claim for the replacement cost of $105 million. There is a $2 million deductible under the insurance policy. The insurer has communicated to PPE Corp that the amount of final settlement is only subject to verification of the identity of the warehouse damaged and the receipt of additional market data regarding its value. The insurance proceeds are received on April 1, 20X5.
How should PPE Corp recognize and measure the loss of the equipment and the potential insurance recovery?
Analysis
PPE Corp should write-off the net book value of the warehouse of $100 million and recognize an insurance recoverable asset of $100 million for the probable recovery of its loss on November 1, 20X4. Upon receipt of the insurance proceeds of $103 million on April 1, 20X5 ($105 million gross receipts, less $2 million deductible), PPE Corp would record an additional gain of $3 million, representing the excess of the replacement cost proceeds received over the net book value of the warehouse, less the $2 million deductible. The gain should not be deferred and amortized over the future periods nor applied to the cost basis of the new asset.
Alternatively, PPE Corp could write-off the net book value of the warehouse of $100 million and recognize an insurance recoverable asset of $98 million (representing the proceeds to be received up to the net book value of the warehouse of $100 million, less the $2 million deductible) on November 1, 20X4. Upon receipt of the insurance proceeds of $103 million ($105 million gross receipts, less $2 million deductible) on April 1, 20X5, PPE Corp could then record an additional gain of $5 million, representing the excess of the replacement cost proceeds received over the net book value of the warehouse. The gain should not be deferred and amortized over the future periods nor applied to the cost basis of the new asset.

8.2.1.3 Discounting insurance recoverables

Whether the time value of money should be considered in the determination of the recorded amount of a potential recovery is addressed in ASC 410-30-35-11.

Excerpt from ASC 410-30-35-11

[T]he time value of money should not be considered in the determination of the timing of the recorded amount of a potential recovery if the liability is not discounted and the timing of the recovery is dependent on the timing of the payment of the liability.

Often a contingent liability for litigation exposure is not discounted because the timing of the settlement of the liability is uncertain. If the related insurance reimbursement for the liability will be paid only when the covered liability is settled, then the insurance recoverable asset should not be discounted (as the timing of settlement and thus reimbursement is uncertain).
Conversely, if the insurance policy pays all covered claims at the end of a defined time period (e.g., a five-year policy period, with insurance settlement occurring at the end of the policy period), the expected future payment would need to be a discounted, even if the underlying litigation liability is not discounted. This is because the timing of the insurance reimbursement is known and is not dependent on the timing of liability settlement.

8.2.2 Retroactive and prospective insurance policies

An insurance policy can be retroactive, prospective, or both. A retroactive contract covers past insurable events and a prospective contract covers future insurable events. Some contracts may contain both retroactive and prospective provisions.
Under a retroactive insurance policy, a reporting entity may purchase insurance to cover a loss after it has occurred to protect against the possibility that the estimates of loss could increase or mitigate the uncertainty of when the needed payouts will be made in the future. For example, a company may purchase insurance to cover the liabilities associated with a chemical spill that has already occurred.
Premiums paid for retroactive insurance should be expensed immediately and a receivable should be recorded for expected recoveries based on the amount of the recorded obligation that is covered by the insurance. If the receivable established exceeds the amounts paid for the insurance, the gain from the excess proceeds should be deferred and amortized either (1) using the interest method over the estimated period over which the entity expects to recover substantially all amounts due under the terms of the insurance contract, or (2) following the proportion of actual recoveries to total estimated recoveries. See ASC 720-20-35-2 for considerations when determining how such a gain should amortized. Immediate gain recognition and liability derecognition would not be appropriate as the liability has not been extinguished and the reporting entity has not been fully relieved of its obligation. If the retroactive insurance policy includes coverage for legal and other costs, the accounting for those costs should be consistent. See ASC 720-20-25-3 through ASC 720-20-25-5 for further information.
Example PPE 8-3 illustrates the recognition of gains on retroactive insurance.
EXAMPLE PPE 8-3
Recognizing gains on retroactive insurance
PPE Corp records a liability of $120 million for a loss incurred from a past event and buys an insurance policy for a $90 million premium with a $20 million deductible to cover that loss. It is probable the company will receive $100 million, net of the deductible from the insurance company.
How should the gain on the retroactive insurance policy be recorded?
Analysis
The $10 million excess of the $100 million expected recovery over the $90 million premium is a gain. The gain would be deferred and recognized over the expected settlement period of the direct obligation. See ASC 720-20-35-2 for information on the method for amortizing the deferred gain.

Often the gain, if any, from purchasing insurance is the result of the recorded liability not being discounted while the pricing of the insurance is based on discounted cash flows, because the insurance payments will be paid over time. Subsequent increases in the estimate of the recoverable amount would also be deferred and recognized over the settlement period.
If the policy contains no retroactive provision, then it should be accounted for as a prospective policy. Premiums paid for prospective policies should be expensed over the policy coverage period in proportion to the amount of insurance protection provided, generally on a straight-line basis. Losses are recorded as incurred and changes in estimates are recorded when facts and circumstances change. As discussed in PPE 8.2.1, insurance recoverables are recorded based on the estimated covered loss amount related to the insured event.

8.2.3 Representations and warranties insurance policies

Representations and warranties (R&W) insurance is an insurance policy used in acquisition transactions to protect the acquirer against losses arising due to the seller’s breach of certain of its representations and warranties in the acquisition agreement. Examples of covered representations under R&W insurance policies may include the completeness and accuracy of financial statement representations, disclosure of material contracts, and the seller’s compliance with laws and regulations, including tax compliance. The acquirer typically pays a one-time, upfront premium to the insurance carrier for a policy covering a period of time (i.e., multiple years). As R&W insurance policies typically only cover losses from matters existing prior to or as of the acquisition date, premiums paid for retroactive insurance should generally be expensed immediately following the retroactive insurance policy guidance of ASC 720-20-25-3. However, reporting entities should consider the coverage under R&W insurance policies to determine whether any prospective insurance provisions exist within the policy.

8.2.4 Claims-made insurance policies

Most insurance is occurrence-based, which means the policy covers claims resulting from events occurring during the policy coverage period, regardless of when the claims are reported to the insurance carrier. In contrast, under claims-made insurance, an entity is covered for any claims reported during the policy period, including events that occurred prior to the policy effective date (but after a specified retroactive date). Reporting entities may purchase claims-made insurance for certain exposures when the occurrence date is difficult to determine, or the occurrence may span over a long period of time. For example, claims-made insurance is typically purchased for directors and officers (D&O), product, and malpractice liabilities. This type of insurance can mitigate coverage disputes between policies because the occurrence date of the event is generally not relevant in determining the coverage.

8.2.4.1 Retroactive date for claims-made insurance policies

The retroactive date is the earliest date an incident could have occurred to be covered by a claims-made policy. The policy covers claims reported to the insurance company during the policy period for an incident that occurred after the policy's retroactive date. For example, if the retroactive date were January 1, 20X6, the claims-made policy would not cover any occurrences prior to January 1, 20X6, even if the claim were reported during the policy period. Instead, the reporting entity’s prior occurrence-based policy would cover that loss. To prevent any gaps in coverage or overlapping coverage with previous insurance, the retroactive date is generally the last date covered under a previous occurrence-date policy.
Upon renewal, whether the retroactive date is updated or remains the inception date of the initial claims-made policy will impact whether there are any gaps in coverage. The renewal policy would cover claims reported for incidents that occurred during the policy period and since the retroactive date. If the retroactive date is changed to the inception date of the renewal policy, coverage would only apply for incidents occurring after the new retroactive date. Claims reported for prior occurrences would not be covered and a gap in coverage would result.
For example, assume an initial claims-made policy period of January 1, 20X5 to December 31, 20X5 with a retroactive date of January 1, 20X5. The renewal policy period is January 1, 20X6 to December 31, 20X6 and the retroactive date is unchanged. If an incident occurred on October 1, 20X5 and was reported on February 2, 20X6, the claim would be covered as the incident occurred after the retroactive date and was reported during the policy period. However, if upon the renewal, the retroactive date was changed to January 1, 20X6, the October 1, 20X5 incident would not be covered.

8.2.4.2 Tail coverage for claims-made insurance policies

Claims-made policies may contain an extended reporting period or tail coverage provision. If an incident occurs before the end of the policy period, this type of provision extends the claims reporting period for a specific time beyond the policy expiration date. The effect of purchasing tail coverage is to convert the previous claims-made policies to occurrence-based coverage. Some typical forms of extended reporting period or tail coverage include:
  • Mini-tail: automatic noncancelable 60-day coverage, which begins at the end of the policy period if new coverage is not obtained
  • Five-year tail: noncancelable coverage, which covers claims reported within five years after the end of the policy period resulting from events that occurred during the policy period
  • Full tail: unlimited time coverage, which allows claims incurred during the claim-made policy period to be reported at any time

8.2.4.3 Accounting for claims-made insurance policies

Having insurance does not relieve the requirement to account for any direct contingent liabilities. As claims-made policies with no tail coverage do not cover losses incurred in the current policy period if they are reported in a future policy period, any portion of recognized losses that represents incurred but not reported (IBNR) losses will not be covered by the current insurance policy.
By its nature, claims-made insurance is a combination of retroactive and prospective insurance coverage. If at inception of the claims-made contract, no known asserted or unasserted claims for events that might result in a specific claim exist, prospective insurance accounting is appropriate. If there are known claims that will be covered, or the pricing has other indications of considering more than historical normal claims, retroactive insurance accounting will be required. See PPE 8.2.2 for the accounting for retroactive and prospective insurance.
As described in ASC 720-20-05-6, if the reporting entity can renew the claims-made policy and can purchase tail coverage if desired, such a strategy will effectively convert the coverage to occurrence-based. As a result, the reporting entity could record a receivable for expected insurance recoveries for the portion of the IBNR liability that is insured under the renewal policy. In some cases, the reporting entity would also need to record the cost of the expected premium for the coverage (see ASC 720-20-30-2).
A reporting entity would be eligible to purchase tail coverage when the claims-made coverage ends (e.g., due to cancellation, nonrenewal, advancement of the retroactive date, a gap in coverage, or replacement by an occurrence-based policy). If the reporting entity decides to change its program in a way that will create a gap in coverage and expects to purchase tail coverage (at a premium not to exceed the maximum specified in the claims-made policy), the reporting entity would record an expected insurance recoverable for the portion of the IBNR liability that is insured under the tail coverage. The expected premium would need to be expensed, as described in ASC 720-20-30-2.

ASC 720-20-30-2

The estimated cost of purchasing tail coverage is not relevant in determining the loss to be accrued because paragraph 210-20-45-1 prohibits netting the insurance receivable against the claim liability. However, if the insured entity had the unilateral option to purchase tail coverage at a premium not to exceed a specified fixed maximum, then the insured entity could record a receivable for expected insurance recoveries (after considering deductibles and policy limits) for the portion of the incurred but not reported liability that is insurable under the tail coverage. In that case, the entity would need to record as a cost the expected premium for the tail coverage. The purchase of tail coverage does not eliminate the need to determine if an additional liability should be accrued because of policy limits or other factors.

Prospective insurance accounting when the fiscal year and policy year coincide
When the reporting entity’s fiscal year and the claims-made policy year coincide, the year-end IBNR liability relates to obligations for claims and incidents incurred prior to year-end that will be reported after year-end. The annual expense for the current year will be comprised of the claims-made insurance premium for the year, the change in IBNR from the previous year-end, and any change in the insurance recoverable related to the IBNR liability.
ASC 720-20-35-4 allows the estimated annual expense that is not related to specific losses to be recognized over the fiscal year. Any material, unusual losses and related insurance recoverable should be recorded in the quarter in which they occur. Figure PPE 8-1 summarizes an appropriate method to estimate and record each of the components of the annual expense.
Figure PPE 8-1
Methods of estimating and recording components of annual expense
Expense
Description
Premium paid for the claims-made policy
The premium paid at the beginning of the fiscal year for the new claims-made insurance policy should be recognized as a prepaid expense and amortized to expense over the policy year.
Change in estimated IBNR liability
At the beginning of the fiscal year, the reporting entity should project its IBNR liability for the end of the fiscal year, which involves estimating the claims and incidents that are expected to be incurred prior to fiscal year-end but reportable after fiscal year-end.
The projected year-end IBNR liability would be adjusted for relevant historical patterns such as changes in products, manufacturing processes, or risk management systems. The change in projected IBNR liability from the previous year-end would be expensed during the year.
Change in estimated insurance recoverable related to the IBNR liability
The reporting entity should determine the insurance recoverable under the insurance policy related to the claims projected. The recoverable should be adjusted each period based on changes in circumstances, changes in estimates of liabilities, and amounts that will be received.
The estimated annual expense is recognized during interim periods based on a methodology that best reflects how the benefits of the insurance coverage are consumed and the IBNR liability is incurred.
The estimate for the year-end IBNR liability should be reviewed whenever interim financial statements are prepared. If events and circumstances in the interim period indicate that unusual claims and incidents have been incurred prior to the end of the interim period, the entity should recognize any related significant adjustments of the estimated year-end IBNR liability in that interim period. Any routine adjustments to the estimated liability should continue to be recognized ratably in each of the remaining interim periods. Claims incurred during the year that are not specifically included in the IBNR estimate should be recognized as an expense in the interim period in which they are incurred.
The reporting entity should adjust any insurance recoverable recognized, either related to the IBNR or to a specific incurred claim, based on changes in circumstances.
Example PPE 8-4 illustrates prospective insurance accounting when the fiscal year and policy year coincide.
EXAMPLE PPE 8-4
Prospective insurance accounting when the fiscal year and policy year coincide
In prior years, PPE Corp had occurrence-based coverage. On January 1, 20X6, it purchased its first D&O claims-made policy for the policy year January 1, 20X6 to December 31, 20X6. PPE Corp follows a calendar year-end, and therefore, the fiscal year and policy year coincide.
The following table summarizes relevant information at the end of the first quarter of fiscal year 20X6.
IBNR liability as of December 31, 20X5
$2,000,000
Receivable for insurance recoverable as of December 31, 20X5
$1,000,000
Insurance premium - paid at inception
$1,800,000
Estimated IBNR liability at December 31, 20X6
$2,400,000
Estimated receivable for insurance recoverable at December 31, 20X6
$1,300,000
Amount of claim for an unusual incident reported in the 1st quarter not included in the projected IBNR
$250,000
Assume there is no deductible per incident, no policy limits, and amortization of the premium and IBNR liability are on a straight-line basis. Also assume PPE Corp expects to renew the claims-made coverage in the future.
What is the estimated annual and quarterly expense for PPE Corp in 20X6 and what are the journal entries to be recorded for the claims-made expense in the first quarter of 20X6?
Analysis
The annual estimated expense is $1,900,000, consisting of:
  • The annual premium cost of $1,800,000; plus
  • The expected increase in the IBNR liability of $400,000 ($2,400,000 updated estimate less $2,000,000 estimate at December 31, 20X5); less
  • The expected increase in the receivable for insurance recoverable of $300,000 ($1,300,000 updated estimate less $1,000,000 estimate at December 31, 20X5)

The expected quarterly expense is $475,000 ($1,900,000/4).
The following journal entries would be recorded in the first quarter of 20X6.
Dr. Prepaid insurance asset
$1,800,000
Cr. Cash
$1,800,000
To record the purchase of the claims-made insurance at policy inception

Dr. Insurance premium expense
$450,000
Cr. Prepaid insurance asset
$450,000
To record the quarterly amortization of the prepaid insurance asset ($1,800,000/4)

Dr. Loss expense
$100,000
Cr. IBNR liability
$100,000
To record the first quarter impact of the $400,000 expected increase in the IBNR liability ($400,000/4)

Dr. Insurance recoverable
$75,000
Cr. Loss expense
$75,000
To record the quarterly increase in the $300,000 expected insurance recoveries ($300,000/4)

Dr. Loss expense
$250,000
Cr. Claim payable
$250,000
To record the expected insurance recoveries for the unusual claim reported in the first quarter

Prospective insurance accounting when policy year and fiscal year do not coincide
As discussed in ASC 720-20-35-08, when the policy year and fiscal year do not coincide, the only difference in prospective insurance accounting is that the premium cost for the year should include a portion of next year’s renewal claims-made policy if one is expected to be purchased. At the beginning of the fiscal year, the reporting entity should estimate its future premium costs of the new claims-made policy it expects to purchase during the fiscal year. The reporting entity should also estimate the portion of the future premium cost related to claims and incidents that will be incurred after the end of the fiscal year. That portion represents the estimated prepaid asset at the end of the fiscal year. The future premium cost involves estimating the effect of past claims and incidents, historical patterns, and any new factors.
Example PPE 8-5 illustrates prospective insurance accounting when the fiscal year and policy year do not coincide.
EXAMPLE PPE 8-5
Prospective insurance accounting when the fiscal year and policy year do not coincide
In prior years, PPE Corp had occurrence-based coverage. On January 1, 20X6, it purchased its first directors and officers (D&O) claims-made policy for the policy year June 30, 20X5 to July 31, 20X6. PPE Corp follows a calendar year end, and therefore, the fiscal year and policy year do not coincide.
The following table summarizes relevant information at the end of the first quarter of fiscal year 20X6.
IBNR liability as of December 31, 20X5
$2,000,000
Receivable for insurance recoverable as of December 31, 20X5
$1,000,000
Estimated premium for the renewal policy commencing July 1, 20X6
$2,200,000
Insurance premium - paid at inception (current policy)
$1,800,000
Estimated IBNR liability at December 31, 20X6
$2,400,000
Estimated receivable for insurance recoverable at December 31, 20X6
$1,300,000
Amount of claim for an unusual incident reported in the 1st quarter not included in the projected IBNR
$250,000
Assume there is no deductible per incident, no policy limits, and amortization of the premium and IBNR liability are on a straight-line basis. Also assume PPE Corp expects to renew the claims-made coverage in the future.
What is the estimated annual expense for PPE Corp in 20X6?
Analysis
The annual estimated is expense is $2,100,000, comprised of:
  • Six months of the current policy premium of $900,000 ($1,800,000 × (6/12)); plus
  • Six months of the estimated premium of the new policy of $1,100,000 ($2,200,000 × (6/12)); plus
  • The increase in the IBNR liability of $400,000 (as calculated in Example PPE 8-3); less
  • The expected increase in the receivable for insurance recoverable of $300,000 (as calculated in Example PPE 8-3)

8.2.5 Business interruption insurance policies

Business interruption insurance may provide coverage if business operations are suspended due to the loss of use of property or equipment, cybersecurity attacks, events damaging brands or tradenames, or other covered losses that result in the suspension of business. This type of insurance generally covers loss of gross profit or reimbursement of certain expenses while a reporting entity is unable to conduct its business. Some business interruption coverage may also extend coverage to include damage at the location of customers or suppliers. Due to the varying nature of business interruption policy terms and coverages, these policies should be carefully analyzed to determine covered events.
When a business interruption event occurs, the absence of expected revenue or income is not a loss recognized in the financial statements. As a result, recoveries of lost profits or revenue under business interruption policies are considered to be a gain contingency and should not be recognized until the gain contingency is resolved. Typically, a business interruption recovery gain should not be recognized prior to the insurance carrier acknowledging that the claim is covered and communicating the amount to be paid to the company. Any stipulation from the carrier (e.g., "pending final review") should be reviewed to determine whether it is an indication the claim may not be realizable. The reporting entity’s history in collecting such claims should also be considered. When the insured has received payment without the expectation of repayment or refund, the contingency is considered resolved and the gain should be recognized immediately. Business interruption recovery gains should not be deferred and amortized over the future periods of expected lost revenues or profit margins, including in scenarios when a reporting entity receives an up-front, nonrefundable settlement payment for estimated future losses.
Unlike lost profits or revenues, the impairment of an asset or other directly-related fixed costs incurred while the business is interrupted (e.g., salaries paid to idle workers, relocation costs incurred) are considered a loss recognized in the financial statements. As discussed in PPE 8.2.2, an insurance recovery should be recorded for such losses when realization of the claim for recovery is probable.
For guidance on the classification of insurance proceeds in the income statement and cash flow statement, see FSP 3.6.10 and FSP 6.9.22, respectively.

8.2.6 Residual value insurance contracts

Residual value insurance contracts guarantee that a properly maintained asset will not be worth less than a specified amount on a specified date (e.g., on the termination date of a lease agreement). The insurance protects the insured (i.e., the lessor) from losses due to greater than expected declines in the market value of an asset. Premiums are typically paid by the lessor to an insurance carrier at the inception of the insurance policy. Settlement is usually based on comparing the insured value agreed upon at the inception of the policy to the amount determined by one of the following common settlement provisions:
  • Specific asset appraisals or actual proceeds from the sale of the asset;
  • The higher of the specific asset appraisal, actual proceeds from a sale, or value established by reference to an asset valuation guide (such as Blue Book); and/or
  • The asset value as indicated by an agreed-upon asset valuation guide (such as Blue Book)
Residual value guarantees between a lessor and a lessee in a lease arrangement are not residual value insurance contracts and instead should be accounted for under the guidance of ASC 842, Leases (or ASC 840, Leases, prior to the effective date of ASC 842). See LG 3.3.4.4 for information on the accounting for residual value guarantees in a lease arrangement.
Residual value insurance contracts between a lessor and an insurance carrier (i.e., when a lessor independently purchases residual value insurance) are accounted for as either purchased insurance contracts or derivatives under ASC 815, Derivatives and Hedging, depending on the contract’s characteristics. Residual value insurance guarantee contracts are generally accounted for as derivatives unless they qualify for the scope exception in ASC 815-10-15-59.

Excerpt from ASC 815-10-15-59

Contracts that are not exchange-traded are not subject to the requirements of this Subtopic if the underlying on which the settlement is based is any one of the following:
[ … ]
b. The price or value of a nonfinancial asset of one of the parties to the contract provided that the asset is not readily convertible to cash. This scope exception applies only if both of the following are true:
1. The nonfinancial assets are unique.
2. The nonfinancial asset related to the underlying is owned by the party that would not benefit under the contract from an increase in the fair value of the nonfinancial asset. (If the contract is a call option, the scope exception applies only if that nonfinancial asset is owned by the party that would not benefit under the contract from an increase in the fair value of the nonfinancial asset above the option’s strike price.)

When payment under the residual value insurance contract is not based on the value of a specific nonfinancial asset, but instead based on an index (e.g., the Blue Book value for automobiles), the contract would not qualify for the scope exception under ASC 815-10-15-59 and would be accounted for as a derivative. However, settlement based on using the appraisal value or the sales proceeds of the specified asset owned by the party would meet the scope exception in ASC 815-10-15-59 and the contract would be accounted for as purchased insurance.
In instances when settlement is based on the higher of multiple amounts (e.g., the higher of the specific asset appraisal, actual proceeds from a sale, or value established by reference to an asset valuation guide), the contract is considered to have multiple underlyings. The contract is subject to ASC 815 if all of the underlyings behave in a manner that is highly correlated with any of the underlyings that do not qualify for the scope exception. For example, a Blue Book value for automobiles and actual sales proceeds are deemed to be highly correlated as the Blue Book values are based on actual sales and transactions or new manufacturer price information. If a contract settles based on a comparison of the insured value with the higher of sales proceeds or asset valuation guide, the reporting entity would compare the results under the contract using the combined underlyings with the result using only the asset valuation guide. If the two underlyings are highly correlated, the contracts would not meet the ASC 815-10-15-59 scope exception and would be accounted for as a derivative.
Example PPE 8-6 illustrates the accounting for a residual value insurance contract.
EXAMPLE PPE 8-6
Accounting for a residual value insurance contract
Lessor Corp purchased residual value insurance to protect against greater than expected declines in the market values of their trucks, trailers, and construction equipment that are leased to local construction companies. The policy terms of the insurance contract state that settlement is based on the higher of specific asset appraisal, actual proceeds from a sale, or the value established by reference to Blue Book value.
Should Lessor Corp account for the residual value insurance contract as purchased insurance or as a derivative under ASC 815?
Analysis
Lessor Corp should account for the contract as a derivative under ASC 815. Settlement is based on the higher of actual proceeds from sales, appraisals of the Lessor’s trucks, trailers, and construction equipment, or reference to Blue Book value for similar assets. The contract has multiple underlyings, which are all considered highly correlated to the Blue Book value since Blue Book value is based on actual sales and transactions of similar assets in the region. As the underlyings are highly correlated to the index value, the contract does not qualify for the ASC 815-10-15-59 scope exception.
If settlement was based solely on actual sales or specific appraisal values, the contract would qualify for the ASC 815-10-15-59 scope exception and would be accounted for as a purchased insurance contract. See DH 3.2.14 for further discussion of residual value guarantees.

8.2.7 Retrospectively-rated insurance contracts

Retrospectively-rated insurance contracts, commonly referred to as “loss sensitive contracts,” are policies when the insurance premiums adjust according to covered loss experience, rather than being a fixed amount set at the inception of the insurance contract. Retrospectively rated insurance is used when the insured and the insurer cannot agree on a fixed price for the risk or the insured wants to participate in the benefits of controlling its claims. Based on the contract's loss experience, the insurance contract will provide for changes in the amount or timing of future contractual cash flows, including adjusting the original premium or changing the amount of covered claims.
The initial premium is paid at the beginning of the coverage period, which consists of a minimum premium plus an additional amount subject to experience adjustment. The claim experience portion may be based on the loss history of the insured or on the collective claim experience of a group of insureds.

8.2.7.1 Accounting for retrospectively rated insurance contracts

The portion of the premium that is subject to adjustment based on actual claims essentially is a funding mechanism for self-insurance. The money will be returned to the insured as either as a claim reimbursement or premium adjustment and therefore is treated as a deposit asset. The minimum premium portion of the initial premium is the price of the insurance risk purchased and should be expensed ratably over the policy term.
As insured losses are incurred and recognized in the income statement, the amount recoverable from the insurer is recorded as a reduction to the deposit asset instead of as an insurance reimbursement in the income statement. The result is that until the deposit asset is exhausted, the income statement will not reflect an insurance coverage offset to the loss expense incurred. There are additional complexities in accounting for retrospectively rated insurance contracts. See ASC 720-20-25-15 and ASC 720-20-30-3 through ASC 720-20-30-4 for further information.

8.2.8 Changing insurers and insurance settlements

An insurer and insured may negotiate an early payment of a claim in return for ending an insurance contract. This could be due to many reasons, such as concerns about the insurer’s credit or to limit ongoing legal or administrative costs. Such a settlement would be treated as a termination of the insurance contract and all balances related to the contract would be written-off. Any difference between those balances and the proceeds received would be recognized immediately in the income statement without regard to the intended use of the proceeds.
When a reporting entity uses the proceeds for the purchase of retroactive insurance coverage (i.e., replacing one insurer for another), the reporting entity has settled an insurance contract with the original insurance company, and the insurance receivable would be relieved. The settlement gain or a loss would be recognized immediately and should not be deferred over the settlement period of the underlying accrued liabilities. The purchase of new insurance coverage is a separate transaction and would not result in an immediate gain or loss upon purchase. Instead, retroactive insurance accounting would be followed for the new insurance contract.

8.2.9 Changing an insurance program

Changing an insurance program can result in modifications to coverage for certain risks and events that can lead to noninsured or underinsured risks. It is appropriate to consider disclosures in circumstances when the insurance coverage is significantly less than prior years or the type of policy is changed from occurrence to a claims-made policy. However, ASC 450-20-50-7 indicates that disclosures are not required for noninsured or underinsured risks that have not changed.
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