Statutory Issue Paper No. 5 Definition Of Liabilities .

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Statutory Issue Paper No. 5Definition of Liabilities, Loss Contingencies and Impairments of AssetsSTATUSFinalized March 16, 1998Original SSAP: SSAP No. 5; Current Authoritative Guidance: SSAP No. 5RType of Issue:Common AreaSUMMARY OF ISSUE1.Statutory accounting currently does not define the term liability for use in preparation of statutoryfinancial statements. Statutory accounting does address the accounting for certain liabilities within thestatutory framework. The current statutory accounting guidance results in some confusion about when therecording of a liability, loss contingency or impairment of an asset is required outside the specificguidance prescribed by statutory accounting. The purpose of this issue paper is to provide a definition of a“liability” for statutory accounting purposes and to provide the accounting principles to be followed whenrecording such a liability in statutory financial statements. This paper also establishes the criteria forrecording loss contingencies and impairments of assets.SUMMARY CONCLUSIONLiabilities2.For purposes of statutory accounting, a “liability” shall be defined as certain or probable1 futuresacrifices of economic benefits arising from present obligations of a particular entity to transfer assets orto provide services to other entities in the future as a result of past transaction(s) or event(s). A liabilityhas three essential characteristics: (a) it embodies a present duty or responsibility to one or more otherentities that entails settlement by probable1 future transfer or use of assets at a specified or determinabledate, on occurrence of a specified event, or on demand, (b) the duty or responsibility obligates a particularentity, leaving it little or no discretion to avoid the future sacrifice, and (c) the transaction or other eventobligating the entity has already happened. This includes but is not limited to liabilities arising frompolicyholder obligations (e.g. policyholders benefits, reported claims and reserves for incurred but notreported claims). Liabilities shall be recorded on a Company’s financial statements when incurred.1FASB Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements (CON 6),states:Probable is used with its usual general meaning, rather than in a specific accounting or technical sense(such as that in FASB Statement 5, Accounting for Contingencies, par. 3), and refers to that which canreasonably be expected or believed on the basis of available evidence or logic but is neither certain norproved.3.Estimates (e.g., loss reserves) are required in financial statements for many ongoing and recurringactivities of a reporting entity. The mere fact that an estimate is involved does not of itself constitute aloss contingency. For example, estimates of losses utilizing appropriate actuarial methodologies meet thedefinition of liabilities as outlined above and are not loss contingencies. 1999-2015 National Association of Insurance CommissionersIP 5–1

IP No. 5Issue PaperLoss Contingencies or Impairments of Assets4.For purposes of implementing the statutory accounting principles of loss contingency orimpairment of an asset described below the following additional definitions shall apply:Probable - The future event or events are likely to occur.Reasonably Possible - The chance of the future event or events occurring is more than remotebut less than probable.Remote - The chance of the future event or events occurring is slight.5.A “loss contingency” or “impairment of an asset” is defined as an existing condition, situation, orset of circumstances involving uncertainty as to possible loss to an enterprise that will ultimately beresolved when one or more future event(s) occur or fail to occur (e.g., collection of receivables).6.An estimated loss from a loss contingency or the impairment of an asset shall be recorded by acharge to operations if both of the following conditions are met:a.Information available prior to issuance of the statutory financial statements indicates thatit is probable that an asset has been impaired or a liability has been incurred at the date ofthe statutory financial statements. It is implicit in this condition that it is probable thatone or more future events will occur confirming the fact of the loss or incurrence of aliability, andb.The amount of loss can be reasonably estimated.7.This accounting shall be followed even though the application of other prescribed statutoryaccounting principles or valuation criteria may not require, or does not address, the recording of aparticular liability or impairment of an asset (e.g., known impairment of an invested asset even thoughpublished VOS manual has not recognized impairment).8.Additionally, in instances where a judgment, assessment or fine has been rendered against acompany, there is a presumption that the criteria in paragraph 6.a. and 6.b. have been met. The amount ofthe liability shall include the anticipated settlement amount, legal costs, insurance recoveries and otherrelated amounts and shall take into account factors such as the nature of the litigation, progress of thecase, opinions of legal counsel, and management’s intended response to the litigation, claim, orassessment.9.When condition 6 a. above is met with respect to a particular loss contingency, and the reasonableestimate of the loss is a range, which meets condition 6 b. above, an amount shall be accrued for the loss.When an amount within management’s estimate of the range of a loss appears to be a better estimate thanany other amount within the range, that amount shall be accrued. When no amount within the range is abetter estimate than any other amount, however, the midpoint (mean) in the range shall be accrued. Forpurposes of this paragraph, it is assumed that management can quantify the high end of the range. Ifmanagement determines that the high end of the range cannot be quantified, then a range does not exist,and management’s best estimate shall be used.Disclosure10.If a loss contingency or impairment of an asset is not recorded because only one of the conditions6 a. or 6 b. is met, or if exposure to a loss exists in excess of the amount accrued pursuant to theprovisions described above, disclosure of the loss contingency or impairment of the asset shall be made inthe notes to the financial statements when there is at least a reasonable possibility that a loss or anadditional loss may have been incurred. The disclosure shall indicate the nature of the contingency andshall give an estimate of the possible loss or range of loss or state that such an estimate cannot be made. 1999-2015 National Association of Insurance CommissionersIP 5–2

Definition of Liabilities, Loss Contingencies and Impairments of AssetsIP No. 511.Disclosure is not required of a loss contingency involving an unasserted claim or assessmentwhen there has been no manifestation by a potential claimant of an awareness of a possible claim orassessment unless it is considered probable that a claim will be asserted and there is a reasonablepossibility that the outcome will be unfavorable.12.Certain loss contingencies, the common characteristic of each being a guarantee, shall bedisclosed in financial statements even though the possibility of loss may be remote. Examples include(a) guarantees of indebtedness of others, and (b) guarantees to repurchase receivables (or, in some cases,to repurchase related properties) that have been sold or otherwise assigned. The disclosure of those losscontingencies, and others that in substance have the same characteristics, shall be applied to statutoryfinancial statements. The disclosure shall include the nature and amount of the guarantee. Considerationshall be given to disclosing, if estimable, the value of any recovery that could be expected to result, suchas from the guarantor’s right to proceed against an outside party.DISCUSSION13.The Conclusion above adopts certain principles in FASB Statement No. 5, Accounting forContingencies (FAS 5), FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan(FAS 114) – only as it amends in part FAS 5, and paragraphs 35 and 36 of FASB Statement of ConceptsNo. 6—Elements of Financial Statements. FASB Interpretation No. 14, Reasonable Estimation ofAmounts of a Loss, An Interpretation of FASB Statement No. 5 is adopted with the modification to accruethe loss amount as the midpoint of the range rather than the minimum. This issue paper also adopts FASBInterpretation No. 34, Disclosure of Indirect Guarantees of Indebtedness of Others, An interpretation ofFASB Statement No. 5,and Accounting Principles Board Opinion No. 12, Omnibus Opinion—1967,paragraphs 2 and 3.14.Although the above accounting principles are not specifically discussed in current statutoryaccounting literature, these principles are well established in the determination of policy reserves in thelife insurance and property and casualty accounting models. Both models use actuarial methods toestablish the accounting estimates recorded. Obligations incurred in the normal conduct of business (e.g.,obligations to pay employees, obligations to pay for assets or services acquired, etc.) represent otherexamples of applying the accounting principles described above.15.Consistent with the solvency and conservatism concepts in the Statutory Accounting PrinciplesStatement of Concepts and Statutory Hierarchy, the statutory accounting model uses numerousaccounting methods to accomplish the objective of reporting a company’s statutory financial position todemonstrate solvency. These accounting methods (nonadmitted assets, Asset Valuation Reserves, etc.)normally do not meet the criteria required in applying the accounting principles described in theConclusion above. Therefore, such accounting methods should be applied by direct charges to orappropriation of a Company’s surplus. Notwithstanding the application of these statutory accountingmethods, when an event, situation, transaction or other information comes to the financial statementpreparer’s attention that indicates a liability or loss has been incurred or that an asset has been impaired,the accounting principles described in the Conclusion above should be followed.16.Paragraph 9 provides guidance on recording an estimate which lies within an estimated range. Itis anticipated that using the midpoint in a range will be applicable only in the rare instance where there isa continuous range of possible values, and no amount within that range is any more probable than anyother. This guidance is not applicable when there are several point estimates which have been determinedas equally possible values, but those point estimates do not constitute a range. If there are several pointestimates with equal probabilities, management should determine their best estimate of the liability.17.Disclosure of the nature of accruals made in applying the above statutory accounting principleand in some circumstances the amount accrued may be necessary for the fair presentation of the statutoryfinancial statements. 1999-2015 National Association of Insurance CommissionersIP 5–3

IP No. 5Issue PaperDrafting Notes/CommentsAppropriation of retained earnings and gain contingencies (e.g., paragraphs 15 and 17 of FAS 5)are covered in separate issue papers.FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan, is addressed in itsentirety in a separate issue paper.Impairment of mortgage loans, real estate investments and other invested assets are addressed inseparate issue papers.Policy, loss and claim reserves are addressed in separate issue papers.Surplus notes is addressed in a separate issue paper.RELEVANT STATUTORY ACCOUNTING AND GAAP GUIDANCEStatutory Accounting18.As discussed above, current statutory accounting is limited to dealing with specific asset andliability captions included on a company’s statement of financial position.Generally Accepted Accounting Principles19.Relevant sections of GAAP literature follow:FASB Statement of Concepts No. 6, Elements of Financial Statements35.Liabilities are probable21 future sacrifices of economic benefits arising from obligations22of a particular entity to transfer assets or provide services to other entities in the future asa result of past transactions or events.21 Probable is used with its usual general meaning, rather than in a specific accounting or technical sense(such as that in Statement 5, par. 3), and refers to that which can reasonably be expected or believed on thebasis of available evidence or logic but is neither certain nor proved (Webster’s New World Dictionary, p. 1132).Its inclusion in the definition is intended to acknowledge that business and other economic activities occur in anenvironment characterized by uncertainty in which few outcomes are certain (pars. 44-48).22 Obligations in the definition is broader than legal obligations. It is used with its usual general meaning to referto duties imposed legally or socially; to that which one is bound to do by contract, promise, moral responsibility,and so forth (Webster’s New World Dictionary, p. 981). It includes equitable and constructive obligations as wellas legal obligations (pars. 37-40).36.A liability has three essential characteristics: (a) it embodies a present duty orresponsibility to one or more other entities that entails settlement by probable futuretransfer or use of assets at a specified or determinable date, on occurrence of a specifiedevent, or on demand, (b) the duty or responsibility obligates a particular entity, leaving itlittle or no discretion to avoid the future sacrifice, and (c) the transaction or other eventobligating the entity has already happened. Liabilities commonly have other features thathelp identify them - for example, most liabilities require the obligated entity to pay cash toone or more identified other entities and are legally enforceable. However, those featuresare not essential characteristics of liabilities. Their absence, by itself, is not sufficient topreclude an item’s qualifying as a liability. That is, liabilities may not require an entity topay cash but to convey other assets, to provide or stand ready to provide services, or touse assets. And the identity of the recipient need not be known to the obligated entitybefore the time of settlement. Similarly, although most liabilities rest generally on afoundation of legal rights and duties, existence of a legally enforceable claim is not aprerequisite for an obligation to qualify as a liability if for other reasons the entity has theduty or responsibility to pay cash, to transfer other assets, or to provide services toanother entity. 1999-2015 National Association of Insurance CommissionersIP 5–4

Definition of Liabilities, Loss Contingencies and Impairments of AssetsIP No. 5FASB Statement No. 5, Loss Contingencies1.For the purpose of this Statement, a contingency is defined as an existing condition,situation, or set of circumstances involving uncertainty as to possible gain (hereinafter a“gain contingency”) or loss1 (hereinafter a “loss contingency”) to an enterprise that willultimately be resolved when one or more future events occur or fail to occur. Resolutionof the uncertainty may confirm the acquisition of an asset or the reduction of a liability orthe loss or impairment of an asset or the incurrence of a liability.1 The term loss is used for convenience to include many charges against income that are commonly referred toas expenses and others that are commonly referred to as losses.2.Not all uncertainties inherent in the accounting process give rise to contingencies as thatterm is used in this Statement. Estimates are required in financial statements for manyon-going and recurring activities of an enterprises. The mere fact that an estimate isinvolved does not of itself constitute the type of uncertainty referred to in the definition inparagraph 1. For example, the fact that estimates are used to allocate the known cost ofa depreciable asset over the period of use by an enterprise does not make depreciation acontingency; the eventual expiration of the utility of the asset is not uncertain. Thus,depreciation of assets is not a contingency as defined in paragraph 1, nor are suchmatters as recurring repairs, maintenance, and overhauls, which interrelate withdepreciation. Also, amounts owed for services received, such as advertising and utilities,are not contingencies even though the accrued amounts may have been estimated; thereis nothing uncertain about the fact that those obligations have been incurred.3.When a loss contingency exists, the likelihood that the future event or events will confirmthe loss or impairment of an asset or the incurrence of a liability can range from probableto remote. This Statement uses the terms probable, reasonably possible, and remote toidentify three areas within that range, as follows:a.Probable. The future event or events are likely to occur.b.Reasonably possible. The chance of the future event or events occurring is morethan remote but less than likely.c.Remote. The chance of the future event or events occurring is slight.Accrual of Loss Contingencies8.An estimated loss from a loss contingency (as defined in paragraph 1) shall be accruedby a charge to income3 if both of the following conditions are met:a)Information available prior to issuance of the financial statements indicates that itis probable that an asset had been impaired or a liability had been incurred at thedate of the financial statements.4 It is implicit in this condition that it must beprobable that one or more future events will occur confirming the fact of the loss.3 Paragraphs 23-24 of APB Opinion No. 9, “Reporting the Results of Operations,” describe the “rare”circumstances in which a prior period adjustment is appropriate. Those paragraphs are not amendedby this Statement.4 Date of the financial statements means the end of the most recent accounting period for whichfinancial statements are being presented.b)The amount of loss can be reasonably estimated. 1999-2015 National Association of Insurance CommissionersIP 5–5

IP No. 5Issue PaperDisclosure of Loss Contingencies9.Disclosure of the nature of an accrual5 made pursuant to the provisions of paragraph 8,and in some circumstances the amount accrued, may be necessary for the financialstatements not to be misleading.10.If no accrual is made for a loss contingency because one or both of the conditions inparagraph 8 are not met, or if an exposure to loss exists in excess of the amount accruedpursuant to the provisions of paragraph 8, disclosure of the contingency shall be madewhen there is at least a reasonable possibility that a loss or an additional loss may havebeen incurred.6 The disclosure shall indicate the nature of the contingency and shall givean estimate of the possible loss or range of loss or state that such an estimate cannot bemade. Disclosure is not required of a loss contingency involving an unasserted claim orassessment when there has been no manifestation by a potential claimant of anawareness of a possible claim or assessment unless it is considered probable that aclaim will be asserted and there is a reasonable possibility that the outcome will beunfavorable.5 Terminology used shall be descriptive of the nature of the accrual (see paragraphs 57-64 of AccountingTerminology Bulletin No. 1, “Review and Resume”).6 For example, disclosure shall be made of any loss contingency that meets the condition in paragraph 8.a. butthat is not accrued because the amount of loss cannot be reasonably estimated (paragraph 8(b)). Disclosure isalso required of some loss contingencies that do not meet the condition in paragraph 8.a. - namely, thosecontingencies for which there is a reasonable possibility that a loss may have been incurred even thoughinformation may not indicate that it is probable that an asset had been impaired or a liability had been incurredat the date of the financial statements.FASB Interpretation No. 14, Reasonable Estimation of the Amount of Loss, AnInterpretation of FASB Statement No. 53.When condition (a) in paragraph 8 is met with respect to a particular loss contingencyand the reasonable estimate of the loss is a range, condition (b) in paragraph 8 is metand an amount shall be accrued for the loss. When some amount within the rangeappears at the time to be a better estimate than any other amount within the range, thatamount shall be accrued. When no amount within the range is a better estimate than anyother amount, however, the minimum amount in the range shall be accrued.1 In addition,paragraph 9 of the Statement may require disclosure of the nature and, in somecircumstances, the amount accrued, and paragraph 10 requires disclosure of the natureof the contingency and the additional exposure to loss if there is at least a reasonablepossibility of loss in excess of the amount accrued.1 Even though the minimum amount in the range is not necessarily the amount of loss that will be ultimatelydetermined, it is not likely that the ultimate loss will be less than the minimum amount. 1999-2015 National Association of Insurance CommissionersIP 5–6

Definition of Liabilities, Loss Contingencies and Impairments of AssetsIP No. 5RELEVANT LITERATUREStatutory Accounting Practices and ProceduresStatutory Accounting Principles Statement of Concepts and Statutory HierarchyGenerally Accepted Accounting PrinciplesFASB Statement of Accounting Concepts No. 6, Elements of Financial StatementsFASB Statement No. 5, Accounting for ContingenciesFASB Statement No. 114, Accounting by Creditors for Impairment of a LoanFASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss, An Interpretation ofFASB Statement No. 5FASB Interpretation No. 34, Disclosure of Indirect Guarantees of Indebtedness of Others, Aninterpretation of FASB Statement No. 5Accounting Principles Board Opinion No. 12, Omnibus Opinion—1967, paragraphs 2 and 3State RegulationsOregon Insurance Statutes, Title 56, Chapter 733, Accounting and Investments 1999-2015 National Association of Insurance CommissionersIP 5–7

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RELEVANT STATUTORY ACCOUNTING AND GAAP GUIDANCE Statutory Accounting 18. As discussed above, current statutory accounting is limited to dealing with specific asset and liability captions included on a company’s statement of financial position. Generally Accepted Accounting Principles 19.

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