Types of Insurance Coverage

22.02 Insurance activities of finance companies often involve insuring risks related to loan transactions. Following are the three general types of insurance coverage associated with those transactions:

Credit Life

22.03 Credit life insurance is a form of term insurance that provides for loan repayment if the debtor dies before the loan is fully paid. It ordinarily is written on a single-premium basis, with the amount of the premium added to the loan balance and paid as part of the scheduled installments on the loan.

22.04 Credit life insurance includes level term insurance and decreasing term insurance. Level term insurance provides a fixed amount of coverage, generally the original amount of the loan. Decreasing term insurance, the more common type, insures the debtor's life to the extent of the unpaid balance of the loan, sometimes less any delinquent payments, at the date of death. However, decreasing term insurance usually is based on the contractual loan period. Therefore, the insurer may not pay off the entire uncollected balance on the loan if it is in delinquency status at the time of the debtor's death. The extent to which delinquent installments are covered generally depends on the insurance contract and on applicable state insurance rules and regulations.

22.05 The insurer's risk exposure on a policy at a given point in time under level term insurance differs from that under decreasing term credit life insurance. Because level term insurance provides coverage equal to the original amount of the loan, the insurer's risk exposure is constant throughout the term of the loan. In contrast, the insurer's exposure under decreasing term insurance decreases as scheduled loan repayments become due, usually in direct proportion to the regular monthly reductions of the loan balance.

Credit Accident and Health

22.06 Credit accident and health insurance requires the insurer to make the debtor's monthly loan payments during extended periods of illness or disability. Ordinarily it is written on a single-premium basis, with the premium added to the loan amount and, hence, paid as part of the periodic installments. Under an accident and health policy, the insurer's total risk exposure decreases—as in a decreasing term credit life insurance policy—as loan repayments are made. However, the size of potential claims and the related risk exposure do not decrease in direct proportion to the reduction in the unpaid loan balance, because most credit accident and health insurance claims are for short-duration disabilities that are cured in a period shorter than the remaining loan term.

Property and Liability

22.07 Ordinarily, a finance company requires that the collateral pledged as security to a loan be protected by property insurance. Such coverage may be obtained from the lender's insurance subsidiary or from an unaffiliated insurer. The amount of coverage is usually based on the value of the collateral and does not necessarily bear a relationship to the unpaid balance of the loan. Property insurance policies issued in connection with finance transactions can be written either on a single-premium basis for the loan term or for an annual or other period of less than the remaining loan term, and the policy renewed as desired. Premiums charged by lenders' insurance affiliates for property insurance coverage related to finance transactions frequently are added to the loan amount and paid as part of the regular installment payments on the loan.

Writing Policies

22.08 An insurance subsidiary of a finance company may be a direct writing or a reinsurance company. A direct writing company writes the insurance policies in its name. A reinsurance company insures policies written by direct writing companies.

22.09 The insurance can be issued on either a group or an individual policy basis. For group coverage, the insurer issues the policy to the finance company, which in turn issues individual certificates to its debtor-customers. Group policies may be subject to experience-rated premium adjustments based on experience and profitability of the group being covered.

Commissions

22.10 Insurers, both insurance subsidiaries and independent companies, may pay commissions to companies. Those payments may be in the form of advance commissions computed as a percentage of premiums, retrospective or experience-rated commissions, or combinations of advance commissions and retrospective commissions.

Premium Income

22.13 FASB ASC 944-605 provides guidance to insurance entities on accounting for and financial reporting of revenue from insurance contracts. As discussed in FASB ASC 944-20-15-2, insurance contracts should be classified as short or long-duration contracts, depending on whether the contracts are expected to remain in force for an extended period.

22.14 FASB ASC 944-20-15 provides the following guidance on factors to consider in determining whether a contract is of short or long duration:

22.15 Paragraphs 1 and 5 of FASB ASC 944-20-55 state that examples of short duration contracts include most property and liability insurance contracts and certain term life insurance contracts, such as credit life insurance. Accident and health insurance contracts may be of short duration or long duration, depending on whether the contracts are expected to remain in force for an extended period. For example, individual and group insurance contracts that are noncancelable or guaranteed renewable (renewable at the option of the insured), or collectively renewable (individual contracts within a group are not cancelable), ordinarily are long-duration contracts.

22.16 Insurance policies issued in connection with consumer lending generally are considered to represent short-duration contracts.

22.17 FASB ASC 944-605-25-1 states that premiums from short duration contracts should be recognized as revenue over the period of the contract in proportion to the amount of insurance protection provided. For those few types of contracts for which the period of risk differs significantly from the contract period, premiums should be recognized as revenue over the period of risk in proportion to the amount of insurance protection provided. That generally results in premiums being recognized as revenue evenly over the contract period (or the period of risk, if different), except for those few cases in which the amount of insurance protection declines according to a predetermined schedule.

Acquisition Costs

22.18 Under U.S. generally accepted accounting principles (GAAP), FASB Accounting Standards Update (ASU) No. 2010-26, Financial Services—Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (a consensus of the FASB Emerging Issues Task Force), that was codified into FASB ASC 944-30 states that only acquisition costs that are directly related to the successful acquisition of a contract can be capitalized as deferred acquisition costs (DAC). As noted in FASB ASU No. 2010-26, if the initial application of the amendments in FASB ASU No. 2010-26 results in the capitalization of acquisition costs that had not been capitalized previously by an entity, the entity may elect not to capitalize those types of costs. These deferred amounts are recorded as an asset on the balance sheet and amortized to income in a systematic manner based on related contract revenues or gross profits (or gross margins), as appropriate. Previously, the guidance of FASB ASC 944-30 did not address successful versus unsuccessful efforts.²

22.19 Determination of deferrable costs. The FASB ASC glossary defines acquisition costs as costs that are related directly to the successful acquisition of new or renewal insurance contracts.

22.20 As stated in FASB ASC 944-30-25-1A, an insurance entity should capitalize only the following as acquisition costs related directly to the successful acquisition of new or renewal insurance contracts:

i.  Underwriting

ii.  Policy issuance and processing

iii.  Medical and inspection

iv.  Sales force contract selling

22.21 Incremental direct costs of contract acquisition. The FASB ASC glossary defines incremental direct costs of contract acquisition as a cost to acquire an insurance contract that has both of the following characteristics:

22.22 FASB ASC 944-30-55-1 discusses the types of incremental direct cost of contract acquisition to be capitalized under item (a) in FASB ASC 944-30-25-1A. Such costs include the following:

22.23 Total compensation, benefits, and other costs directly related to acquisition activities. Items (a)–(c) in FASB ASC 944-30-25-1A require that only the portion of costs related directly to time spent performing specified acquisition activities for a contract that actually has been acquired (that is, successful efforts) may be deferred.

22.24 FASB ASC 944-30-55-1C discusses that payroll-related fringe benefits include any costs incurred for employees as part of the total compensation and benefits program. Examples of such benefits include all of the following:

22.25 FASB ASC 944-30-55-1G discusses that the portion of total compensation of executive employees that relates directly to the time spent approving successful contracts may be deferred as acquisition costs. For example, the amount of compensation allocable to time spent by members of a contract approval committee is a component of acquisition costs.

22.26 FASB ASC 944-30-55-1A discusses that examples of other costs related directly to the insurer’s acquisition activities in item (b) in FASB ASC 944-30-25-1A that would not have been incurred by the insurance entity had the acquisition contract transaction(s) not occurred include all of the following:

22.27 Direct-response advertising. FASB ASC 340-20-25-4 notes that the costs of direct-response advertising should be capitalized if both of the following conditions are met:

22.28 FASB ASC 340-20-25-6 specifies that in order to conclude that advertising elicits sales to customers who could be shown to have responded specifically to the advertising, there must be a means of documenting that response, including a record that can identify the name of the customer and the advertising that elicited the direct response. Examples of such documentation include the following:

22.29 Additional guidance for issuers to consider can be found in section 1(B), "Accounting for Advertising Costs," of the SEC’s Division of Corporation Finance: Frequently Requested Accounting and Financial Reporting Interpretations and Guidance:

1. a. A direct relationship between a sale and the specific advertising activity for which cost is deferred must be demonstrated clearly. More than trivial marketing effort after customer response to the advertising and before the sale is consummated (such as customer contact with a sales person or furnishing of additional product or financing information) will disqualify the sale as being deemed a direct result of the advertising. A significant lapse of time between the advertising activity and the ultimate sale in an environment of broad general advertising may disqualify the sale as being deemed a direct result of the advertising.
2. b. The advertisement’s purpose must be one of eliciting a direct response in the form of a sale. For example, if the primary purpose (based on either intent or most frequent actual outcome) is identification of customers to which additional marketing efforts will be targeted, the advertising costs do not qualify.
3. c. Deferrable costs do not include administrative costs, occupancy costs, or depreciation of assets other than those used directly in advertising activities. Payroll related costs that are deferrable include only that portion of employees’ total compensation and payroll-related fringe benefits that can be shown to relate directly relate to time spent performing the qualifying activities. Costs of prizes, gifts, membership kits and similar items are not deferrable under [FASB ASC 340-20-25], but are accounted for as inventory in most circumstances.
4. d. The costs must be probable of recovery from future benefits. Objective historical evidence directly relevant to the particular advertising activity is necessary to demonstrate probability of recoverability. Ancillary income from sources other than the responding customer may not be included in the calculation of future benefits for the test. Future benefits to be included in the calculation are limited to revenues derived from the customer which are the direct result of the advertising activity alone, without significant additional marketing effort. Revenues from subsequent sales and renewals may be included only if insignificant market effort is required to obtain those revenues.

22.30 If the capitalization criteria in FASB ASC 340-20-25-4 are met, the direct-response advertising costs should be included as DAC for classification, subsequent measurement, and premium deficiency test purposes, in accordance with FASB ASC 944 applicable to insurance industry DAC.

22.31 As noted in FASB ASC 340-20-25-12, the cost of the direct-response advertising directed to all prospective customers, not only the cost related to the portion of the potential customers that is expected to respond to the advertising, should be used to measure the amounts of such reported assets.

22.32 As noted in FASB ASC 340-20-25-8, the probable future benefits of direct-response advertising activities are probable future revenues arising from that advertising in excess of future costs to be incurred in realizing those revenues. FASB ASC 340-20-25-9 discusses that demonstrating that direct-response advertising will result in future benefits requires persuasive evidence that its effects will be similar to the effects of responses to past direct-response advertising activities of the entity that resulted in future benefits. Such evidence should include verifiable historical patterns of results for the entity. Attributes to consider in determining whether the responses will be similar include the following:

22.33 Nondeferrable expenses. As stated in FASB ASC 944-720-25-2, an insurance entity should charge to expense as incurred any of the following costs:

22.34 FASB ASC 944-720-55-1 includes examples of acquisition-related costs that cannot be capitalized in accordance with FASB ASC 944-30-25-1A:

22.35 As discussed in FASB ASC 944-30-55-1F, employees’ compensation and fringe benefits related to the activities described in chapter 9, “Commissions, General Expenses, and Deferred Acquisition Costs,” of the AICPA Audit and Accounting Guide Life and Health Insurance Entities, unsuccessful contract acquisition efforts, and idle time should be charged to expense as incurred.

22.36 FASB ASC 944-720-55-2 includes examples of indirect costs, per item (b) in FASB ASC 944-720-25-2, that should be expensed as incurred:

22.37 FASB ASC 944-30-55-1B discusses that costs for software dedicated to contract acquisition are not eligible for deferral as DAC under the definition of that term. Such costs are not other costs directly related to the insurer’s acquisition activities that would not have been incurred but for that contract under the definition of that term. Notwithstanding that the guidance, as described in chapter 9 of the AICPA Audit and Accounting Guide Life and Health Insurance Entities, indicates that equipment costs are expensed as incurred, insurance entities should consider the criteria in FASB ASC 350-40 to determine whether the costs qualify for capitalization as internal-use software.

22.38 As is the case with other business entities, expenses that do not qualify to be capitalized are charged to expense or operating expenses in the period incurred.

22.39 Cost determination. The identification of acquisition costs requires considerable judgment, such as how to determine successful versus unsuccessful efforts and how to determine what types of activities performed by employees are considered to be directly related to sales. The determination of the costs to be deferred can often be determined separately or via a standard costing technique or through a combination of both. Paragraphs 1D–1E of FASB ASC 944-30-55 provide additional discussion.

22.40 Allocation of DAC. FASB ASC 944-30-25-1B requires the following:

22.41 Determining deferrable acquisition costs. FASB ASC 944-30-25-1A discusses what types of costs an insurance entity should capitalize as acquisition costs. An insurance entity should evaluate whether employee compensation and payroll-related fringe benefits are related directly to time spent performing acquisition activities for contracts that actually have been acquired. This determination may be accomplished by a two-step process:

22.42 Both of the following examples are meant to be illustrative, and the actual determination of deferrable acquisition costs under FASB ASC 944 should be based on the facts and circumstances of an entity’s specific situation.

22.43 In situations when an employee is compensated by both commission and salary, judgment will be needed to determine what costs can be capitalized as acquisition costs, based on the facts and circumstances of each specific situation.

22.44 Estimated gross profit. FASB ASC 944-30-35-5 notes that estimated gross profits should include estimates of amounts expected to be assessed for contract administration less costs incurred for contract administration, including acquisition costs not included in capitalized acquisition costs. The guidance in FASB ASC 944-30-35-5 also specifies that those acquisition costs to be included in estimated gross profits that are not included in capitalized acquisition costs consist of policy-related acquisition costs that are not capitalized under paragraphs 3–4 of FASB ASC 944-30-25, such as ultimate renewal commission and recurring premium taxes. Also, as stated in FASB ASC 944-30-35-5, nonpolicy-related expenses, such as certain overhead costs, and costs that are related to the acquisition of business that are not capitalized under FASB ASC 944-30-25, such as certain advertising costs, should not be included in estimated gross profit.

22.45 It should be noted that FASB ASU No. 2010-26 does not change the guidance related to the components or calculation of estimated gross profits. Costs that no longer qualify for deferral under FASB ASU No. 2010-26 do not meet the criteria for inclusion in estimated gross profits.

22.46 Commissions paid to affiliated companies and premium taxes normally are the most significant elements of acquisition costs for captive insurance companies. Deferred costs associated with payment of such commissions and other intercompany items should be eliminated in consolidation.

22.47 Technical Questions and Answers (Q&A) section 6300.40, “Deferrable Commissions and Bonuses Under ASU No. 2010-26” (AICPA, Technical Questions and Answers), states that commissions and bonuses are not deferrable solely due to an insurance entity having a sales transaction. To be deferrable as an incremental direct acquisition cost, the costs must result directly from, and be essential to, the sales transaction(s) and would not have been incurred by the insurance entity had the sales transaction(s) not occurred. Entities will need to use judgment to determine whether acquisition costs related to commissions and bonuses for employees or nonemployees meet the criterion to be deferrable under FASB ASU No. 2010-26 of resulting directly from and being essential to, the sale transaction. Paragraphs 1F–1G of FASB ASC 944-30-55 provide examples of some of the types of activities for which related costs are deferrable and those that are not. Chapter 9 of the AICPA Audit and Accounting Guide Life and Health Insurance Entities contains discussion of the guidance in FASB ASU No. 2010-26.

22.48 The “Internal Replacement Transactions” subsections in FASB ASC 944-30 provide guidance to insurance entities on accounting for and financial reporting of unamortized acquisition costs in the event of an internal replacement transaction. This guidance is applicable to modifications and replacements made to short-duration and long-duration contracts (including those contracts defined as investment contracts per the FASB ASC glossary), according to FASB ASC 944-30-15-8.

22.49 The FASB ASC glossary defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by a contract exchange, by amendment, endorsement, or rider to a contract; or by the election of a benefit, feature, right, or coverage within a contract. The FASB ASC glossary defines a contract exchange as the legal extinguishment of one contract and the issuance of another contract.

22.50 The AICPA also issued a series of Q&A sections on accounting and financial reporting issues related to the “Internal Replacement Transactions” subsections in FASB ASC 944-30 (see Q&A sections 6300.25–.34 [AICPA, Technical Questions and Answers]).

Investment Portfolios

22.51 Insurance subsidiaries maintain investment portfolios usually composed of the same types of securities found in the portfolios of independent insurance companies. State regulations restrict the types of investments that insurance companies may make.

22.52 FASB ASC 320-10-15-2 states that the guidance in FASB ASC 320, Investments—Debt and Equity Securities, applies to all entities including cooperatives and mutual entities (such as credit unions and mutual insurance entities) and trusts that do not report substantially all of their securities at fair value. FASB ASC 320 establishes standards of financial accounting and reporting for both investments in equity securities that have readily determinable fair values and all investments in debt securities, including debt instruments that have been securitized.

22.53 FASB ASC 825, Financial Instruments, allows entities to choose, at specified election dates, to measure eligible items at fair value (the fair value option) with gains and losses recorded in earnings at each subsequent reporting date.

22.54 FASB ASC 944-320-50-1 states that an entity should disclose the carrying amount of securities deposited by insurance subsidiaries with state regulatory authorities.

State Laws

22.55 Insurance companies are regulated by state insurance laws, which require maintenance of accounting records and adoption of accounting practices. The insurance laws and regulations of the states require insurance companies domiciled in those states to comply with the guidance provided in the National Association of Insurance Commissioners Accounting Practices and Procedures Manual except as otherwise prescribed or permitted by state law. Some prescribed or permitted statutory accounting practices differ from GAAP. Accordingly, the financial statements of insurance subsidiaries prepared for submission to regulatory authorities must be adjusted to conform to GAAP before they can be consolidated with the financial statements of the parent companies.

Commissions

22.56 A finance company may receive commissions from an independent insurer for policies issued to finance customers, according to FASB ASC 942-605-05-2.

22.57 According to FASB ASC 942-605-25-1, insurance commissions received from an independent insurer should be deferred and systematically amortized to income over the life of the related insurance contracts because the insurance and lending activities are integral parts of the same transactions. The method of commission amortization should be consistent with the method of premium income recognition for that type of policy as set forth in FASB ASC 944.

22.58 FASB ASC 605-20-25-7 states that income from experience-rated or retrospective commission arrangements should be recognized over the applicable insurance risk period.

22.59 Commissions paid to the parent company by an insurance subsidiary are eliminated in consolidation.

Consolidation Policy

22.60 Consolidation is appropriate if a reporting entity has a controlling financial interest in another entity and a specific scope exception does not apply, as stated in FASB ASC 810-10-25-1. The usual condition for a controlling financial interest is ownership of a majority voting interest, but in some circumstances control does not rest with the majority owner. See FASB ASC 810-10-15 for entities that are subject to consolidation.

22.61 The “Variable Interest Entities” subsections of FASB ASC 810-10 clarify the application of the “General” subsections to certain legal entities in which equity investors do not have sufficient equity at risk for the legal entity to finance its activities without additional subordinated financial support, or, as a group, according to “Pending Content” in FASB ASC 810-10-05-8, the holders of the equity investment at risk lack any one of the following three characteristics:

If the activities of the legal entity, according to “Pending Content” in item (d) in FASB ASC 810-10-15-17, are primarily related to securitizations or other forms of asset-backed financings or single-lessee leasing arrangements, then the legal entity should be evaluated by a reporting entity to determine if the legal entity is a variable interest entity (VIE) under the requirements of the “Variable Interest Entities” subsections of FASB ASC 810-10.⁶

22.62 Insurance subsidiaries of financial institutions may also participate in VIEs through investing in other structured investments, such as synthetic asset-backed securities and catastrophe bonds, certain structured reinsurance transactions, joint ventures without substantive operations, financial guarantees, debt issuance vehicles, synthetic leases, collateralized bond obligation issuances, or limited partnerships.

22.63 Per “Pending Content” in FASB ASC 810-10-15-17, separate accounts of life insurance entities as described in FASB ASC 944 are not subject to consolidation according to the requirements of the “Variable Interest Entities” subsections.⁷ FASB ASC 944-80 provides insurance entities guidance on accounting for and financial reporting of separate accounts, including an insurance entity's accounting for separate account assets and liabilities related to contracts for which all or a portion of the investment risk is borne by the insurer.

22.64 Separate accounts of life insurance entities are described in more detail in the AICPA Audit and Accounting Guide Life and Health Insurance Entities.

Financial Statement Presentation

22.65 FASB ASC 942-210-45-1 states that, unearned premiums and unpaid claims on certain insurance coverage issued to finance customers by a subsidiary may represent intra-entity items because premiums are added to the consumer loan account, which is in turn classified as a receivable until paid, and most or all of the payments on claims are applied to reduce the related finance receivables. Therefore, unearned premiums and unpaid claims on certain credit life and credit accident and health insurance policies issued to finance customers should be deducted from finance receivables in the consolidated balance sheet.

22.66 The following illustrates that type of presentation:

22.67 Alternatively, the balance sheet may present only the net finance receivables if the notes to the financial statements contain sufficient disclosure of unearned premiums and unpaid claims and the allowance for losses. Unearned premiums and unpaid claims for credit life and accident and health coverage should not be applied in consolidation against related finance receivables for which the related receivables are assets of unrelated entities as stated in FASB ASC 942-210-45-1.

22.68 FASB ASC 942-210-45-2 states that, in the consolidated financial statements, unpaid claims for property insurance and level term life insurance should not be offset against related finance receivables because finance companies generally do not receive substantially all proceeds of such claims. That prohibition also applies to credit life and accident and health coverage written on policies for which the related receivables are assets of unrelated entities. In those circumstances, such amounts should be presented as liabilities.