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
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.
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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 |
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Receivable for insurance recoverable as of December 31, 20X5 |
$1,000,000 |
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Insurance premium - paid at inception |
$1,800,000 |
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Estimated IBNR liability at December 31, 20X6 |
$2,400,000 |
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Estimated receivable for insurance recoverable at December 31, 20X6 |
$1,300,000 |
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Amount of claim for an unusual incident reported in the 1st quarter not included in the projected IBNR |
$250,000 |
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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 |
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To record the purchase of the claims-made insurance at policy inception
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Dr. Insurance premium expense |
$450,000 |
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Cr. Prepaid insurance asset |
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$450,000 |
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To record the quarterly amortization of the prepaid insurance asset ($1,800,000/4)
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Dr. Loss expense |
$100,000 |
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Cr. IBNR liability |
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$100,000 |
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To record the first quarter impact of the $400,000 expected increase in the IBNR liability ($400,000/4)
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Dr. Insurance recoverable |
$75,000 |
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To record the quarterly increase in the $300,000 expected insurance recoveries ($300,000/4)
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Dr. Loss expense |
$250,000 |
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Cr. Claim payable |
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$250,000 |
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To record the unusual claim reported in the first quarter
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Dr. Insurance recoverable |
$250,000 |
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Cr. Loss expense |
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$250,000 |
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To record the expected insurance recoveries for the unusual claim reported in the first quarter |
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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 |
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Receivable for insurance recoverable as of December 31, 20X5 |
$1,000,000 |
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Estimated premium for the renewal policy commencing July 1, 20X6 |
$2,200,000 |
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Insurance premium - paid at inception (current policy) |
$1,800,000 |
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Estimated IBNR liability at December 31, 20X6 |
$2,400,000 |
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Estimated receivable for insurance recoverable at December 31, 20X6 |
$1,300,000 |
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Amount of claim for an unusual incident reported in the 1st quarter not included in the projected IBNR |
$250,000 |
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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 8-4); less
- The expected increase in the receivable for insurance recoverable of $300,000 (as calculated in Example PPE 8-4)