The Financial Accounting Standard Board will propose new rules for insurance accounting on Thursday that seem likely to increase volatility in reported profits for many insurers and lower reported revenue for rapidly growing companies, as noted by Floyd Norris of The New York Times.

Insurance Accounting

“The proposed standard is intended to bring greater consistency and relevance to the accounting for contracts that transfer significant risk between parties,” said Leslie F. Seidman, FASB chairwoman. “Current U.S. standards on insurance have evolved over the years as new products have been introduced, leading to some inconsistencies” in insurance accounting.

Important Change for Some Life Insurance Companies

One important change for some life insurance companies would be the timing on recognizing revenue. Instead of recognizing premiums when they are received, premiums would be recognized over time, as the insurance is being provided. Expenses would also be delayed, so the effect on net income might not be large, but revenue growth might seem much slower for some companies.

Life insurance companies now set up reserves when a policy is sold, based on estimates of factors like life expectancy and the chance the policy will lapse before the policyholder dies. Under the new rules, those assumptions would have to be revised every three months, leading to changes in the book value of the policies. But many of those changes would go into a category called “other comprehensive income” and thus not affect the net income figures.

Important Change for Property and Casualty Insurers

For property and casualty insurers, an important change would come in how reserves are calculated. Currently, most companies estimate the most likely result. Under the new rules, they would have to average out the possible results, based on probability. So for a company that thought there was a 60 percent chance that it would have to pay $1,000 on a claim, and a 40 percent chance it would have to pay $2,000, its required reserve would rise from $1,000, the most probable number, to $1,400 — the average of the probabilities. That calculation would have to be updated frequently, leading to changes in earnings in one quarter that could be reversed in the next.

A significant change would be that reserves would now be subject to discounting based on time and interest rates. In the example above, the figure now would be $1,000 whether the company expected to pay the claim next year or 10 years from now. Under the proposal, the reserve for the claim that is not expected to be paid for 10 years would be discounted and would then rise every year as the expected payment date neared.

The new rules would affect only companies that issue insurance. Purchasers of insurance — basically every company — would not have to change their current accounting.

Protests Against Proposed New Rules

Some of the largest protests might come from companies that until now have thought insurance accounting rules did not apply to them. The new rules would cover any company that issues contracts that are seen as insurance, or similar to insurance.

Insurance is defined as “accepting significant risk” from another party — the insured policyholder — by agreeing to pay compensation “if a specified uncertain future event adversely affects the policyholder.” That could include product warranties issued by third parties, mortgage guarantees and residual value guarantees. Most banks would have at least some products subject to the insurance rules.

But not all products that seem like insurance would be covered. The accounting for credit default swap, which pay if a borrower like a company or country defaults, would not change. The logic behind that is that such swaps are sold to speculators, who are betting that a default will come, as well as to bondholders who would suffer from a default.