Nicola Angstadt, senior manager at EY, sheds light on how accounting changes may impact a captive insurance company’s financial statement and gives steps to take now to prepare for those changes

In the ever-evolving landscape of accounting standards, the introduction of two US generally accepted accounting principles (US GAAP) accounting standard updates – current expected credit loss (CECL) and long duration targeted improvements (LDTI) – will significantly impact how insurers, including captive insurance companies, report their financial performance.

Captive insurance companies have long operated as an alternative risk management solution for organisations, and as they navigate the complex terrain of accounting standards, understanding the implications of CECL and LDTI is critical.

Which captives are impacted?

Considering the unique characteristics of captive insurance companies, accounting framework options available in the Cayman Islands and different structures in place, it is important to note these new standards will impact captive insurance companies who apply US GAAP.

As it relates to CECL, the impact of the new standard should be evaluated for all captives, but its effect may be less significant for certain classes of financial assets held by captives wholly owned by its parent. For instance, receivables between entities under common control are exempt from CECL considerations. Conversely, LDTI focuses exclusively on long-duration insurance contracts. Accordingly, captives involved in underwriting or reinsuring such long-duration insurance contracts will be impacted.

CECL: The shift in credit loss accounting

CECL represents a new approach to accounting for credit losses, with a focus on estimating future losses upfront rather than waiting for them to occur.

While CECL was primarily designed for financial institutions, it has a ripple effect on entities with investments and other financial assets, including captive insurance entities.

The Financial Accounting Standards Board (FASB) proposed a staggered implementation timeline, giving private entities more time to prepare for adoption. Accordingly, for private companies, CECL is effective for 2023, whereas for public companies CECL was adopted in 2020.

Impact on captive insurance companies

1. Increased complexity: CECL imposes a more complex and data-intensive process for estimating expected credit losses. Captive insurers must consider not only their outstanding insurance policies and reinsurance contracts, but also on the potential credit losses on other financial assets measured at amortised cost, making the scope broad and requiring different modeling techniques for each financial asset class and potentially within each class, depending on risk characteristics. In addition, the impairment model for available-for-sale debt securities is adjusted to recognise an allowance for expected credit losses when a security is in an unrealised loss position. This allowance can be reversed if conditions change.
2. Historical data: CECL necessitates a greater reliance on historical data to forecast expected credit losses. Captive insurance companies must assess their loss experience over a longer time horizon and consider macroeconomic factors to estimate potential losses.
3. Income statement impact and increased capital reserves: CECL often requires entities to record higher losses during the year of adoption and going forward, thus impacting the profitability of the captive insurance company. This in turn may require entities to set aside higher allowances to cover expected credit losses and may tie up capital that could otherwise be used for risk management, other strategic initiatives, as well as regulatory requirements.
4. Disclosures: CECL demands greater transparency in financial reporting. Captive companies must provide detailed information about their credit loss estimation process, including key assumptions and modeling techniques.
5. Alignment with parent company: Where applicable, captive insurers should consider alignment of their CECL approach with their parent company’s methodology. However, captive insurance companies may need to ‘right-size’ and tailor their application, assumptions and methodology based on investment strategies, liquidity needs, risk tolerances and insurance-specific accounting and regulatory requirements.

LDTI: Transforming the accounting for long duration contracts

LDTI represents a significant change in the accounting standards for long duration insurance contracts under US GAAP.

It was introduced by the FASB to improve and simplify accounting and financial reporting and provide more timely recognition of changes in insurers’ obligations under such long-duration contracts.

The standard, which affects life insurers primarily, introduces new accounting and financial reporting requirements.

While LDTI is mainly designed for traditional life and annuity insurers, captive insurance companies that underwrite or reinsure long-duration insurance contracts are also affected.

Given the surge of reinsurers, particularly in the life and annuity space, establishing a presence in the Cayman Islands, understanding the impact of LDTI and options available, is becoming more relevant for such Cayman entities.

Key changes of long duration contracts

1. Liability for future policy benefits updates: Under the legacy standard, insurers are required to base insurance liabilities for future policyholder benefits on assumptions that are ‘locked in’ at contract inception, unless the portfolio is determined to be in a loss position. Under the new standard, insurers will be required to periodically review and, if needed, update the assumptions used to forecast future cash flows for measuring liabilities associated with future policyholder benefits. Contracts are generally grouped by issue year for measurement. Additionally, the new standard requires the discount rate assumption used to discount the liabilities for future policyholder benefits to be updated using the upper-medium-grade fixed income instrument yield.
2. Market risk benefits: The guidance creates a new category of benefit features called market risk benefits, which is relevant for deposit products with certain benefit features. Market risk benefits provide protection to the contract holder from capital market risk and expose the insurer to other-than-nominal capital market risk. Insurers will now measure market risk benefits at fair value and present them separately in the balance sheet with changes recognised in income.
3. Simplification of deferred acquisition costs (DAC): One aspect the new standard has aimed to simplify is the methods used to amortise deferred acquisition costs. Under LDTI, insurers will now have to amortise on a constant-level basis over the expected life of the contract. The amortisation basis cannot be a function of revenue or profit emergence. Additionally, impairment testing is eliminated; however, adjustments are required for unexpected terminations. Changes in expected life are adjusted for prospectively over the remaining life of the contract.
4. Disclosures: Like most new standards, LDTI will expand the disclosure requirements of long-duration contracts. New requirements include prescribed levels of disaggregation by balance type, disaggregated tabular reserve roll forwards, and qualitative discussion of significant inputs, judgements and assumptions, among others.
5. Transition options: LDTI will come into effect for private insurers in the calendar year 2025, while for public companies it will be effective for 2023, including interim periods within that timeframe. Early adoption continues to be permitted for all insurers, so new startup (re) insurers should carefully weigh whether this choice offers the most efficient approach or if an alternative accounting treatment, such as the ‘fair value’ option, is more appropriate. The LDTI transition guidance prescribes measurement of the liability for future policy benefits and DAC to be applied on a modified retrospective basis, with the option to elect a company-wide retrospective application for each contract issue year. The measurement of market risk benefits is to be applied retrospectively.

Adapting to the changes: A roadmap for captive insurance companies

To successfully navigate the impact of CECL and LDTI on their financial reporting, captive insurance companies should consider the following steps:

1. Assess the impact: Captive insurers should conduct a thorough assessment of how CECL and LDTI will affect their financial statements, profitability and capital requirements. Understanding the magnitude of the changes is essential.
2. Consider options and alternatives: Explore other potential accounting policy options and consult with advisors to determine the best path forward for the entity. Particularly for new life reinsurers starting up and/or acquiring new blocks of business, different accounting policy options may be available in lieu of LDTI, such as the fair value option. Such accounting policy options come with their own set of requirements, challenges and cost/benefits, so it is vital to carefully evaluate which policy is most appropriate for the entity holistically.
3. Invest in data and technology: Both CECL and LDTI require enhanced data capabilities and modeling. Captive companies may need to invest in technology and data analytics to meet the new accounting standards’ requirements.
4. Engage with auditors, advisors and actuaries: Collaborate closely with auditors, advisors and actuaries so the assumptions and models used for estimating credit losses and liabilities align with the new standards. It is essential to maintain an open line of communication and engage in periodic, upfront reviews to help mitigate any late-stage implementation issues.
5. Educate stakeholders: The enhanced disclosure requirements under both CECL and LDTI necessitate improved communication with stakeholders. Captive insurers should plan to educate key stakeholders on the expected changes to financial results, key metrics and disclosures so expectations around earnings and GAAP volatility can be managed.

The views expressed are those of the authors and do not necessarily reflect the views of Ernst & Young Ltd. or any other member firm of the global EY organisation.