Financial Accounting Concerns

1. Tokyo AFM recognized premium revenue at the time it received the policyholder’s up-front cash payment. The company’s accountants argued that since the level of up-front payments received from policyholders had been stable over the last few years, this method was an appropriate reflection of economic reality.

For example, Fuji Computers entered into a five-year insurance contract with Tokyo AFM against earthquake damage to its headquarters building. As is customary, it paid the 100 million premiums for the five-year coverage up front in cash.

Question: How would you recognize revenues associated with this type of catastrophe insurance contract?

This case can be considered as premiums from short-duration insurance contracts, which are intended to cover expected claim costs resulting from insured events that occur during a fixed period of short duration. As of now the management is recognizing premium at the time it received policyholder’s up-front cash payment, but they should recognize the premium as earned revenue over time as the risk covered by the policy runs off. This is called a “deferral-matching approach”, as it attempts to defer recognition of any revenue or expense so that it can be matched with the timing of the incurred losses. Therefore, premiums from short-duration contracts are earned and recognized as earned revenue evenly as insurance protection is provided. In this case of Fuji computers the 100 million premiums being recognized as revenue evenly over the contract period of five years. I believe that up-front payment, are earned as services are delivered and/or performed over the term of the arrangement or the expected period of contract and premiums shall be recognized as earned revenue over the period of risk in proportion to the amount of insurance protection provided.

2. Tokyo AFM immediately expensed incremental insurance contract acquisition costs related directly to the signing of the contract. The company’s accountants argued that this treatment was required in order to be consistent with the company’s premium revenue recognition policy.

For example, on June 30, 2001, a policyholder paid an up-front 210,000 premium for a 2 years property insurance contract for her Tokyo apartment. The contract was based on a product called “Home Umbrella”. It covered a variety of casualty losses, and the company sold it exclusively to individual residential customers.

The principal incremental contract acquisition costs were:

a. A 50,000-commission fee paid to the agent who had worked directly with the policyholder. The fee was due to the agent when the policyholder signed the contract and was paid immediately upon signing. b. A 20,000 cost of marketing efforts incurred over the past six months to promote Home Umbrella through broad-based advertising (50%) and targeted phone calls (50%) to existing Tokyo AFM customers as part of a cross-selling strategy. The policyholder, who had just bought her apartment, was already using Tokyo AFM for her car liability insurance.

Question: Would you capitalize any of the above acquisition costs, or would you expense them immediately? If you were to capitalize the costs, over what period would you amortize them?

Deferred Acquisition Costs include all expenses that vary with and are directly related to the acquisition of new and renewal contracts. These expenses are capitalized as an intangible asset to systematically match costs with related revenues and amortized over a period not exceeding the life of the policy. Having said that, $50,000-commission fee should be capitalized and amortized over the period of contract i.e. 2 years.

Another expense that can be considered for capitalization is advertising costs. Only advertising costs that are direct-response advertising can be capitalized. Direct-response advertising is advertising for which the primary purpose is to stimulate sales to customers or potential customers that have specifically responded to the advertising and it results in probable future benefits. Hence $20,000 cost of marketing efforts incurred over the past six months to promote Home Umbrella which is direct response advertising cost should be capitalized and amortized over the period of contract.

3. Broadly speaking, two major types of insured events could give rise to losses covered by insurance contracts:

* Events that actuarial analysis could assess and predict with a high level of accuracy across a large number of contracts (for example, events covered by automobile insurance). * Catastrophes, which were generally adverse natural events such as earthquakes and hurricanes, but which could also be human-induced events such as terrorist attacks. Catastrophes were considered “low probability-high consequence” events. They were uncertain and very difficult to predict in terms of timing and extent of damage. For the coming year, the company had estimated that expected losses across all its automobile insurance contracts would amount to 70% of premiums. (Exhibit 1 shows historical data on losses incurred by Tokyo AFM in automobile insurance and catastrophe insurance). With respect to catastrophes, Matsumoto had concluded that the average expected losses would be 12% of premiums, but any scenario between 4% and 20% was equally likely. Question: What accounting treatment would you choose for expected losses (a) associated with automobile contracts and (b) associates with catastrophes? From a shareholder’s perspective, what concerns do you think could arise with respect to the accounting treatment of expected losses? 4. Tokyo AFM accounted for its portfolio of investments in marketable securities at historical cost. The company invested primarily in long-term, liquid financial instruments (typically five-year bonds). Although he expected that a large portion of its portfolio would be held until the bonds matured, the CEO wanted to set aside the remainder as ready to be sold at any time. Indeed, adverse events triggering losses could occur any day, and the company needed to maintain a certain level of liquidity to meet immediate cash needs. Question: How would you account for the company’s marketable securities? (See Exhibit 2 for price data on a 100,000-bond representative of Tokyo AFM’s investments).