What is ASC 606?

 

ASC 606 has had a major accounting impact for any entity which receives contingent commissions or “Retros”. In general, you are required to recognize any estimated future commissions or retrospective payments as revenue at contract inception.

 

It may also apply if you have an excess contractual liability policy and place the funds in a trust account in which the trust account is not part of the assets of an insurance company.

 

The Financial Accounting Standards Board (FASB) released Accounting Standards Update 2014-09: Revenue from Contracts with Customers and created Accounting Standards Codification (ASC) Section 606.

 

For example, suppose you have a retroactive commission for a block of service contracts. The commission is defined as 100% – Loss Ratio – 10%.

 

Therefore, the insurance company is allowed a 10% margin before paying commissions. Typically, deals such as these have formulas for paying these commissions, such as the book must be 50% earned.

 

The actual accounting standard relates to a 5-part accounting test:

 

1. Identify the

 

This part is easy, it is just the service contract.

 

2. Identify the separate performance obligation(s) within a

 

Typically, the performance obligations would be paying claims, issuing refunds and perhaps claim adjustment expenses. When these occur will generally NOT be uniform over the life of the contract.

 

 

3. Determine the transaction

 

4. Allocate the transaction price to the performance

 

5. Recognize revenue as each performance obligation is

 

 

This is typically done using an earnings curve to recognize revenue in proportion to losses.

 

However, if the beneficiary of any trust does not perform any obligations (such as all claims and related services are performed by independent third parties) then generally the transaction will be recognized at contract inception.

 

 

Who does this impact?

 

It impacts any entity reporting under GAAP accounting standards which is not an insurance company. For example, if you are an administrator and have a contractual liability reimbursement policy, the underlying loss experience might be reinsured into a controlled reinsurance company. This business is exempt. However, if you receive a retrospective commission or hold the funds under an excess contractual liability policy, you would likely be subject to this guidance.

 

When is this effective and what about my existing contracts?

 

Under US GAAP accounting standards, revenue recognition was often complex and there were different rules for different industries. ASC 606 is more “in-line” with international standards and provides a principles-based approach for revenue recognition across various industries.

 

In general, most companies simply recognized this type of revenue when received prior to the adoption of this standard.

 

Special transition rules apply for contracts prior to the effective date which was December 31, 2019 for annual reporting.

 

 

An example

 

The following table is a hypothetical example of revenue recognition under ASC 606 compared to actual received payments. In this example, there are no performance obligations, so all revenue is recognized at the beginning of the contract and loss estimates are updated to “true up” the retro commission estimate.

 

 

Service Contracts
Policy Year 2019 Service Contracts
Premium	1,000,000
Margin	10.0%
Retro:	100% – Loss Ratio – Margin. paid when 50% is earned

 

 

Initial Expected Loss Ratio		60%
	(1)	(2)	(3)	(4)	(5)	(6)
		Expected	Actual
	Percent	Loss	Loss	Retro	Expected	Revenue
Year	Earned	Ratio	Ratio	Received	Retro	Reported
1	5%	61%	70%	–	290,000	290,000
2	35%	60%	60%	–	300,000	10,000
3	45%	58%	55%	–	320,000	20,000
4	65%	55%	52%	247,000	350,000	30,000
5	85%	56%	55%	50,500	340,000	(10,000)
6	98%	57%	57%	25,900	330,000	(10,000)
7	100%	54%	54%	36,600	360,000	30,000
				360,000		360,000
(1)	Percent earned as determined by formula
(2)	Estimate of the ultimate loss ratio for this policy year, as of the year-end
(3)	Actual loss ratio of policy year
(4)	Retro Formula: If percent earned is less than 50%, then 0 else (100% – Actual Loss Ratio – Margin) x Premium x Percent Earned. Result is not less than zero and less any prior amounts paid
(5)	(100% – Loss Ratio – Margin) x Premium
(6)	Difference in (5) for current year

 

In this example, most of the revenue is received in year 4, but the entire estimated retro is recognized in year 1. The revenue in future years simply reflects a “true-up” between the initial estimate and the revised estimate and actual results. Actual receipt of contingent

 

revenue does not impact the revenue reported. After all contracts have expired, the total revenue recognized and received is the same.

 

Conclusions

 

Audited GAAP financial statements need support on assumptions regarding retrospective revenue. As a practical matter, revenue will increase for the first few years until prior contracts have expired.

 

Since insurance entities are exempt from these requirements, it may make reinsurance or other risk transfer mechanisms more favorable.

 

And, of course, any individual situation will be fact dependent, and you should rely on your accountant and actuary for appropriate advice on your situation.

 

Kerper and Bowron can assist you and your auditors with analyzing your business to make appropriate ASC 606 assumptions for your financial statements.

 

 

References:

 

Ernst and Young, How the new revenue standard affects the insurance industry (https://www.ey.com/publication/vwluassetsdld/technicalline_05263- 181us_insurancerevenue_19december2018/$file/technicalline_05263- 181us_insurancerevenue_19december2018.pdf?OpenElement)

 

 

Baker Tilly ASC 606 update: Insurance revenue streams affected (https://www.bakertilly.com/insights/asc-606-update-insurance-revenue-streams- affected)

 

Time to Revisit Revenue Recognition

ASC 606 considerations for insurance organizations New York Insurance Association, Inc. Fall 2017