CECL impact on insurance companies

ASC 326, the current expected credit loss (CECL) standard, has substantially changed how entities, including insurers, estimate credit losses on financial assets measured at amortized costs.

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CECL requires shifting from a previously used incurred loss model to a forward-looking approach. It requires an estimate of the expected credit losses on financial assets measured at amortized costs over the contractual life of the asset, even if the risk is remote. The purpose of the standard is to reflect the expected amount of the asset that will be realized/collected based on historical loss experience, current conditions, and reasonable and supportable forecasts.

CECL is effective for private companies’ applications for periods beginning after December 15, 2022 (i.e., January 2023). This includes financial statements issued within the period (e.g., March 2023) and all year-end audits after that.1

CECL for insurance companies

Most insurance companies have different types of financial assets within CECL’s scope (see examples below). CECL effectively revised how to calculate and account for the credit risk related to different types of assets.

The most significant change is that, in addition to past and present information, those calculations now include future information based on reasonable and supportable forecasts.

Important to note is that the estimate for credit risk is calculated even if the risk is remote. The overarching principle of ASC 326-20 is that an entity will recognize an allowance for credit loss (ACL), resulting in the financial statements  reflecting the “net amount expected to be collected” from the financial assets. However, risks other than credit risks, such as policy cancellations, disputes with reinsurers, etc., should not be included in the ACL. 

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Components

Primary components of allowance for credit losses under CECL include:

Insurance graphic CECL components

The above can be summarized by the following questions:

  • What economic factors will affect collections?
  • What are the projected values of those factors?
  • How do those projected values affect the value of the expected collections?

For example, an insurance company that solely offers home insurance in Florida is susceptible to a natural disaster causing bankruptcy; therefore, no cedent can recoup their booked reinsurance receivable.

Under previous guidance, the allowance might have been based on historical loss experience. However, under CECL, the allowance for the current reporting period might increase due to including current and reasonable and supportable forecast conditions in the calculation. 

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Some of the key financial assets that fall under the scope of CECL

  • Premium receivables – The CECL impact on premium receivables tends to be nominal as they are short-term in nature. Estimate the ACL on the earned portion of premiums due and any receivable amounts to be earned during the payment grace period, as outlined in the insurer’s policy, e.g., for premium receivable of $120, unearned premium is $80, and receivable for grace period is $20, net exposure subject to CECL is $60 (i.e., (($120 - $80) + $20).
  • Reinsurance recoverables – Includes all amounts recoverable from reinsurers for settled and unsettled claims, claim settlement expenses (including incurred but not reported claims), and policy benefits. The length of the period to close the unsettled portion of the claim depends on the underlying reinsurance contracts in force, which requires companies’ diligent and thorough analysis and judgment on CECL calculations. Amounts receivable and payable between the ceding entity and reinsurer shall be offset as a common practice, as most reinsurance arrangements have a valid right of setoff.
    • Reinsurance recoverables may comprise a variety of risks that affect collectability including:
      • Credit risk.
      • Other non-contractual, noncoverage issues, including reinsurance billing and others.
      • Contractual coverage disputes.*
      • *Contingent losses relating to disputed amounts should be measured in accordance with ASC 450-20
    • If similar risk characteristics are shared between reinsurance recoverables, companies are required to perform a collective assessment. Similar risk characteristics include, but are not limited to:
      • Credit rating of the reinsurer.
      • Geographic region or concentration of geographic region of the reinsurer.
      • Size of the reinsurer.
      • Type of reinsurance agreements the reinsurer is a party to.
    • Factors to consider when estimating the allowance for credit loss are:
      • Expected term of the exposure under the contract, including termination clauses.
      • Historical losses of similar reinsurers.
      • Funds withheld, trust accounts, letters of credit, and other collateral provisions, as long as they are not freestanding.
      • Geographic and coverage type concentration of the reinsurer.
      • Credit rating, financial health, and regulatory oversight of the reinsurer.
      • Ability and history of government administrator to fund or assess members to keep the program viable and whether there is a political environment for legislative change.
  • Funds withheld assets (arising from a reinsurance contract) – These assets are subject to CECL requiring estimated credit losses over the asset's lifetime.
  • Held-to-maturity (HTM) securities – HTM securities are securities that the enterprise has the positive intent and ability to hold to maturity. These instruments are subject to CECL as they are recorded at amortized costs. Companies need to pool their HTM securities by similar risk characteristics, such as type, term, industry of the borrower, collateral, size, effective interest rate, credit scores, and risk ratings. Also, companies may need to consider collateral and non-freestanding credit enhancements when calculating the allowance for credit loss. 
  • Other financial assets – Insurance companies may have other financial assets measured at amortized costs that  are subject to CECL. For example, financial guarantees purchased, structured settlements purchased, and other receivables (except out-of-scope assets as listed below).

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Financial assets that are not subject to CECL

Some of the financial assets that do not fall under the scope of CECL include:

  • Financial assets measured at fair value through net income.
  • Loans and receivables between entities under common control.
  • Receivables arising from operating leases under Topic 842. 
  • Policy loan receivables of an insurance entity.

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Available-for-sale (AFS) debt securities

AFS securities fall outside the CECL model's scope. However, the new standard offers a modified impairment approach, restricting credit loss to the difference between fair value and amortized cost and eliminating the other-than-temporary impairment concept. If the amortized cost is below fair value, ask the following questions to determine if credit loss needs to be recognized in earnings:

  1. Do you intend to sell the security or is it more likely than not that you will be required to sell the security before recovery? If yes, recognize the difference between fair value and amortized cost in earnings. If no, answer the following question.
  2. Is a portion of unrealized loss related to credit risk (the risk that the security issuer will default or fail to meet obligations) and not market or interest rate risk? If the answer is yes, an entity shall distinguish the credit loss and recognize in earnings, with a maximum credit loss of the difference between the fair value and the amortized cost. 

The portion of unrealized loss related to market risk or interest rate risk should be recognized in OCI. 

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Methodology

Prior to CECL (under the incurred loss model), historical loss experience and current conditions were the common approach to calculating valuation adjustments. Under CECL, forward-looking analysis is a required part of the valuation method, and a pooling approach is required to estimate the credit losses for all assets with similar risk characteristics.

Below are the few methods that can be used to estimate the credit loss under CECL:

  • Discounted cash flow method - Amortized cost is compared with the present value of the estimated principal and interest cash flows.
  • Loss-rate method - Estimated lifetime rate of loss applied to a pool of financial assets.
  • Roll-rate method (or migration analysis) – Historical analysis of credit quality indicators based on the frequency of assets transitioning from one stage to another (delinquency or risk rating).
  • Probability of default method - Expected credit losses are determined by multiplying the probability of default (PD - the probability the asset will default within the given time frame) by the loss given default (LGD - the percentage of the asset not expected to be collected because of default) to the exposure at default (ED - estimate of outstanding balance at the time of default).
  • Methods that utilize the aging schedule - Consider the length of time a receivable has been outstanding.

Methods may vary based on the type of financial asset, the entity’s ability to predict the timing of cash flows, and the information available to the entity. Methods used should be practical, relevant, and consistent given the specific facts and circumstances.

Financial assets subject to CECL are to be reported at the net present value expected to be collected. Therefore, the calculated allowance for credit losses should be deducted from the expected amortized value of the asset. The calculated allowances, factors and pools are required to be reevaluated at each reporting period. 

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Disclosure

The disclosure requirements in ASC 326 are designed to enable users of financial statements to understand the credit risk inherent in the portfolio, how management monitors the related credit quality, management’s estimate of expected credit losses and information about changes in the estimate of expected credit losses occurring during the period.

The following disclosures are required:

  • In the year of adoption, disclose the change in accounting principle in accordance with ASC 250, which includes:
    • Nature of change in accounting principle, including an explanation of newly adopted accounting principle.
    • Method of applying the change.
    • Effect of adoption on any line item in the statement of financial position, if material, as of the beginning of the first period when CECL became effective.
    • Cumulative effect of change on retained earnings or other components of equity in the statement of financial position, as of the beginning of the first period when CECL became effective.
  • Separately report the ACL on the face of the balance sheet.
  • Accounting policy and methodology for developing the ACL.
  • Factors that influenced the current estimate of ACL.
  • Credit quality indicator information.*
  • Risk characteristics and reasons for significant change in write-offs.
  • Significant purchases or sales amount of financial assets during the period.
  • Roll forward of allowance including write-offs, recoveries, and current provision for ACL.
  • The nature and past-due status.*
  • Non-accrual status.*
  • Purchased financial assets with credit deterioration.
  • Collateral dependent financial assets.
  • Off-balance sheet credit exposures.
  • A discussion of the reversion method applied for periods beyond the reasonable and supportable forecast period. 

*The requirement to disclose credit quality indicators and nature, past-due and non-accrual status do not apply to receivables measured at the lower of amortized cost basis or fair value, or trade receivables due in one year or less. 

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Valuable tips

Implementing a new accounting standard can be time-consuming. Entities at each reporting period should update the estimate and adjust the ACL accordingly.

Below is a list of valuable tips that insurance companies can utilize to navigate the transition effectively:

  • Identifying the financial assets within the scope of CECL – As an initial step, performing scoping activities over the business and financial accounting will help in identifying the list of financial assets which are subject to CECL. CECL compliance is an important issue for entities because it includes technical accounting, complex models, calculation of ACL and drafting new and updated disclosures which are imperative for stakeholders and regulators. Some of such financial assets are HTM securities, premium receivables, and reinsurance recoverables, which are discussed above.
  • Data gathering – This includes the need for granular-level detail, better segmentation reflecting creditworthiness, and greater understanding of the dimensions and drivers of repayment and prepayment risk. CECL calculation requires estimating the credit losses over the contractual life of the asset, which means that entities need to review the historical data and assess the complex technical data that may be required to be obtained from third-party service providers like investment managers, credit rating agencies and similar. Some examples of such data gathering include interest rate trends, interest defaults, payment structure, credit score and rating, collateral valuations, unemployment rates, and market sensitivity trends.
  • Model selection and validation – As there is no set roadmap or mandatory approach, there are multiple models that place a lot of emphasis on judgment and decisions and compel the companies to develop both methodologies and supporting rationales. CECL model validation activities include evaluating CECL model methodology (PD, LGD or DCF) and its soundness, assessing the economic indicators’ relevance for the model, data integrity and governance, evaluating the assumption and calculation methodologies, process verification and benchmarking, model documentation and compliance, and analyzing the model output. Periodically, the management of the entities is required to re-evaluate the factors and pools used for reporting.
  • Selection of relevant economic forecast – As a contrast to the legacy model, CECL brings a new layer of challenge requiring companies to build models to generate forward-looking credit loss estimates based on reasonable and supportable economic forecasts.
  • Documentation of the rationale behind selecting and validating the suggested best practices – Companies need to provide continual documentation and reasoning to justify the methodologies implemented, including those methodologies that may vary from year to year based on future market conditions.
    Some examples to consider are:
    • The company accounts for credit losses using the expected credit loss model for receivables. The allowance for credit losses is generally calculated by aging the receivable balances and applying default factors based on its historical collection data. The financial exposure of a credit loss is determined by net of offsets (such as related unearned premium reserves).
    • The company uses the probability of default and loss given default methodology in estimating the allowance, whereby the credit ratings of reinsurers are used in determining the probability of default. Prior to applying default factors, the net exposure to credit risk is reduced for any collateral for which the right of offset exists, such as funds withheld, assets held in trust and letters of credit. The allowance is based upon the company’s ongoing review of amounts outstanding, length of collection periods, changes in reinsurer credit standing and other relevant factors.
  • Implementing internal controls and processes –Companies will see an increased need for implementation and enhancement of the internal control system which links governance, oversight, data modeling, systems, and reporting functions in order to achieve a smooth CECL implementation.

Conclusion

To ensure a smooth transition to CECL compliance, insurance companies must be well-prepared and understand the essential requirements and challenges of the new standard.

For more information contact us.

Authors

Anthony StranixPartner, Insurance Practice Leader
Lankesh Kodandaramu, Senior Manager, Insurance
Roshni Grover, Manager, Quality & Risk Management 
Allie Wanamaker, Manager, Insurance 
Emma Blake, Senior, Insurance 

Footnote 

  1.  CECL will not be reflected in the financial statements for insurance companies prepared in accordance with statutory accounting principles (SAP).

The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.