Most folks associated with insurance companies were pleased to note that the FASB’s ASU 2014-09 Revenue from Contracts with Customers, issued in May 2014, excluded insurance contracts from its scope. However, after going to bed with smiles on their faces from this news, we are sure many woke up wide-eyed in the middle of the night realizing that it only excluded insurance contracts, and NOT all of the revenue streams of insurance companies.
For some insurance companies where premium revenue is the only revenue source from customers, the ASU may still have little impact. However, insurance companies or stand-alone insurance brokers and third-party administrators (TPAs) that have revenue streams from brokerage and management services, such as underwriting, claims administration, and processing, should be going through an analysis of the ASU for these revenue streams.
New five-step revenue recognition process
There are five steps to be applied in analyzing a revenue stream under the new ASU:
- Identify the contract with a customer
- Identify the performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations in the contract
- Recognize revenue when (or as) the entity satisfies a performance obligation
Each step has its own complexities, and the intent of this article is only to cover certain basic aspects of these steps.
Aspects of step two: Performance obligations
Contracts need to be reviewed carefully to identify all the services and goods that have been promised (i.e., performance obligations). If a contract includes multiple services and goods to be delivered, then the company needs to analyze if it also has multiple performance obligations. This analysis is based upon whether or not the individual services and goods are “distinct,” as defined. For instance, if a company both places insurance policies and performs claims administration services, those services would typically be considered distinct and, therefore, separate performance obligations.
Aspects of step three: Transaction price
Contracts also need to be reviewed carefully to identify all consideration which the company expects to be entitled to from transferring the services or goods to its customer. Of special interest here are revenue streams with variable consideration, such as contingent or renewal commissions.
The ASU requires that the amount of variable consideration to include in the transaction price be an estimation of either the “expected value” (probability weighted) or the “most likely” amount, whichever method results in a better prediction of the amount of consideration. This estimate is, however, subject to a constraint that it must be probable that there will not be a significant reversal of revenue, once the uncertainty is resolved. We expect that the expected value methodology will be used more frequently by insurance and insurance-related entities, given the typical large volume of contracts with similar characteristics in the customer-related revenue streams for these entities.
There is additionally a time value of money element to the transaction price if the timing of payments results in a determination that there is a significant financing component in the contract. We would expect the existence of a practical expedient in the ASU to omit this determination if the expected time period between the transfer of services and receipt of consideration is one year or less, to disqualify many contracts from this analysis.
The impact of the variable consideration provisions of the ASU may result in an accelerated revenue recognition in certain circumstances for contingent and renewal commissions. It’s important to note, however, that existing accounting practices for contingent commissions are varied, given the current lack of clear guidance.
Aspects of step four: Allocation of transaction price to performance obligations
The allocation of the transaction price to performance obligations is based upon a determination at contract inception of the standalone selling price for the services or goods underlying each performance obligation. If such a price doesn’t exist, the company must estimate it.
There are contracts in which variable consideration may relate to only one of multiple performance obligations, and the ASU specifies when it should be allocated only to that performance obligation.
As an example, if a contract includes both policy placement and claims administration performance obligations, then any variable compensation included in the transaction price for renewal premiums would likely be solely associated with the policy placement performance obligation.
Aspects of step five: Satisfaction of performance obligation
Contracts also need to be reviewed carefully to specifically determine what the company needs to do to fulfill the performance obligation(s), so that the company can recognize the revenue associated with a specific performance obligation at either the proper point in time or over the proper time period.
As an example, a contract for claims processing and administration should indicate if the company’s responsibility is for services in only the coverage period, rather than in both the coverage and settlement periods.
Therefore, it is perhaps time to get those contracts out, and start evaluating where they stack up under the new revenue recognition rules. The new rules are effective beginning in calendar year 2018 for public business entities (plus certain not-for-profits and employee benefit plans) and in calendar year 2019 for everyone else.
That’s almost tomorrow, for companies that adopt under the full retrospective requirements of the ASU’s transition requirements. And only a few winks of winter sleep for everyone else.
We will be publishing future articles on the application of the new revenue recognition rules to non-insurance contract revenue streams of insurance and insurance-related entities. You may e-mail any questions or specific topics to your engagement partner, Joan Waggoner, professional standards partner in the insurance group, or John Fritz, primary technical specialist for the insurance group, for possible inclusion in future publications.