F18 Q19d

patbaker12patbaker12
in Odomirok.22-23-GAAP

Could you provide a little color on how differences in SAP & GAAP treatment of DTA's, Invested Asset valuation, Goodwill, & Reinsurance support (or don't support) the philosophical differences between the two frameworks? The CAS conveniently left out explanations for these.

Thanks

Comments

  • grahamgraham

    Yes I see, they chose 2 items from part (c) to explain in part (d) but left out the other 4. I think they picked the 2 that were the simplest. Sometimes there isn't really a satisfying answer because the accounting treatment of these items can be very complex and probably evolved over decades. With that said, here are my thoughts as a non-specialist in accounting...

    • DTAs: (Deferred Tax Assets) This arises from overpayment of taxes. They are subject to a strict admissibility test in SAP which reduces the value of the asset on the balance sheet. This supports the SAP purpose of solvency and conservatism because they would rather understate assets than overstate and then fall short when paying claims. GAAP recognizes DTAs fully, even if some of them may be on shaky grounds. GAAP is more concerned with an accurate valuation of a company and probably is too high as often as it's too low.

    • Goodwill: In SAP, goodwill is limited to 10% of surplus whereas GAAP does not impose a limit. Also, SAP amortizes goodwill into unrealized capital gains whereas GAAP recognizes goodwill immediately on the balance sheet (assuming it is > 0). This limit on goodwill and its amortization support the SAP purpose of conservatism and solvency. You can't use goodwill to pay claims because it's not a tangible asset. But GAAP is supposed to measure earning potential and goodwill (like reputation) contributes to the earning potential of a company and so should be reflected immediately as an asset.

    • Invested Assets: In SAP, these assets are generally valued according to their investment grade and an insurer can't control that. In GAAP, these assets are valued according to whether they are HFT, HTM, of AFS (Held-For-Trading, Held-To-Maturity, Available-For-Sale) and this is in control of the company. It seems to me the company could then manipulate the category to inflate (or deflate) the assets. This is something an insurance regulator wouldn't like hence the stricter method for valuing assets under SAP.

    • Reinsurance: This refers to ceded reinsurance only, not assumed reinsurance. The SAP vs GAAP difference is in the gory details of how ceded reinsurance is dealt with on the balance sheet and income statement. Plus there's a difference between prospective and retroactive reinsurance. It's all very complicated. You can try to figure out a reason from all of that but I think it boils down to that in GAAP, there's a better matching of the cost and benefit of reinsurance, at least for retroactive reinsurance, and this is explained more in the wiki. (In SAP, the balance sheet shows reserves net of reinsurance which actually seems NOT conservative, especially if the reinsurers are not highly rated, although there would presumably be a provision for reinsurance to offset that risk on the liability side of the balance sheet.)

    If I had been answering this exam question, I would have steered clear of invested assets and reinsurance in part (d). They just seem harder and more time-consuming to explain than DAC, DTAs, goodwill, and non-admitted assets.

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